Annual Report

PART I

Item 1. Business

General  

Sonic Corp. (the “Company”) operates and franchises the largest chain of drive-in restaurants (“Sonic Drive-Ins”) in the United States. As of August 31, 2005, the Company had 3,039 Sonic Drive-Ins in operation, consisting of 574 Partner Drive-Ins and 2,465 Franchise Drive-Ins, principally in the southern two-thirds of the United States. Partner Drive-Ins are those Sonic Drive-Ins owned and operated by either a limited liability company or a general partnership. We own a majority interest, typically at least 60%, and the supervisor and manager of the drive-in own a minority interest in each Partner Drive-In limited liability company or general partnership. Franchise Drive-Ins are owned and operated by our franchisees. At a typical Sonic Drive-In, a customer drives into one of 24 to 36 covered drive-in spaces, orders through an intercom speaker system, and has the food delivered by a carhop within an average of four minutes. Most Sonic Drive-Ins also include a drive-through lane and patio seating.

The Company has two operating subsidiaries, Sonic Industries Inc. and Sonic Restaurants, Inc. Sonic Industries Inc. serves as the franchisor of the Sonic Drive-In chain, as well as the administrative services center for the Company. Sonic Restaurants, Inc. develops and operates the Partner Drive-Ins. References to “Sonic,” the “Company,”“we,”“us,” and “our” in this report are references to Sonic Corp. and its subsidiaries and predecessors, unless the context indicates otherwise.

Our objective is to maintain our position as, or to become, a leading operator in terms of the number of quick-service restaurants within each of our core and developing markets. We have developed and are implementing a strategy designed to build the Sonic brand and to continue to achieve high levels of customer satisfaction and repeat business. The key elements of that strategy are: (1) a unique drive-in concept focusing on a distinctive menu of quality made-to-order food products including several signature items; (2) a commitment to customer service featuring the quick delivery of food by carhops; (3) the expansion of Partner Drive-Ins and Franchise Drive-Ins within Sonic’s core and developing markets; (4) an owner/operator philosophy, in which managers have an equity interest in their restaurant, thereby providing an incentive for managers to operate restaurants profitably and efficiently; and (5) a commitment to strong franchisee relationships.

The Sonic Drive-In restaurant chain was begun in the early 1950’s. Sonic Corp. was incorporated in the State of Delaware in 1990 in connection with its 1991 public offering of common stock. Our principal executive offices are located at 300 Johnny Bench Drive, Oklahoma City, Oklahoma 73104. Our telephone number is (405) 225-5000.

Menu

Sonic Drive-Ins feature Sonic signature items, such as specialty soft drinks including cherry limeades and slushes, frozen desserts, made-to-order sandwiches and hamburgers, extra-long cheese coneys, hand-battered onion rings, tater tots, salads, and wraps .

All Sonic Drive-Ins also offer a breakfast menu. Items on the breakfast menu include sausage, ham, or bacon with egg and cheese Breakfast Toaster _® sandwiches, sausage and egg burritos, and specialty breakfast drinks. Sonic Drive-Ins typically are open from 7 a.m. to 11:00 p.m. and serve the full menu all day.

---

Restaurant Locations

As of August 31, 2005, 3,039 Sonic Drive-Ins were in operation and located in 29 states, principally in the southern two-thirds of the United States, and in Mexico. We identify markets based on television viewing areas and further classify markets as either core or developing. We define our core television markets as those markets where the penetration of Sonic Drive-Ins (as measured by population per restaurant, advertising levels, and share of restaurant spending) has reached a certain level of market maturity established by management. All other television markets where Sonic Drive-Ins are located are referred to as developing markets. A market may be located where it extends into more than one state, causing some states to have both core and developing markets. Our core markets contain approximately 71% of all Sonic Drive-Ins as of August 31, 2005. Developing markets are located in the states indicated below and Mexico. The following table sets forth the number of Partner Drive-Ins and Franchise Drive-Ins by core and developing markets as of August 31, 2005:

 

	Core Markets			Developing Markets			Total
States	Partner	Franchise	Total	Partner	Franchise	Total
Alabama	16	14	30	14	60	74	104
Arizona					87	87	87
Arkansas	30	150	180				180
California					28	28	28
Colorado				33	37	70	70
Florida				23	68	91	91
Georgia				9	95	104	104
Idaho					15	15	15
Illinois		8	8	3	19	22	30
Indiana					12	12	12
Iowa					12	12	12
Kansas	38	93	131				131
Kentucky		8	8		56	56	64
Louisiana	22	130	152				152
Mississippi		117	117				117
Missouri	41	134	175		19	19	194
Nebraska				6	17	23	23
Nevada					17	17	17
New Mexico		69	69				69
North Carolina					81	81	81
Ohio					6	6	6
Oklahoma	77	182	259				259
South Carolina					69	69	69
Tennessee	30	168	198	10		10	208
Texas	195	643	838				838
Utah				7	18	25	25
Virginia				20	19	39	39
West Virginia					1	1	1
Wyoming					5	5	5
Mexico					8	8	8
Total	449	1,716	2,165	125	749	874	3,039

 

Expansion

During fiscal year 2005, we opened 175 Sonic Drive-Ins, which consisted of 37 Partner Drive-Ins and 138 Franchise Drive-Ins. During fiscal year 2006, we anticipate approximately 180 to 190 new Sonic Drive-In openings, including 150 to 160 openings by our franchisees. That expansion plan involves the opening of new Sonic Drive-Ins by franchisees under

 

 

2

---

 

existing area development agreements, single-store development by existing franchisees, and development by new franchisees. We believe that our existing core and developing markets offer a significant growth opportun ity for both Partner Drive-In and Franchise Drive-In expansion. The a bility of Sonic and its franchisees to open the anticipated number of Sonic Drive-Ins during fiscal year 2006 necessarily will depend on various factors. Those factors include (among others) the availability of suitable sites, the cost and availability of construction resources, the negotiation of acceptable lease or purchase terms for new locations, local permitting and regulatory compliance, the financial resources of Sonic and its franchisees, and the general economic and business conditions to be faced in fiscal year 2006.

Our expansion strategy for Partner Drive-Ins involves two principal components: (1) the building-out of existing core markets and (2) the further penetration of current developing markets. The Company is always in the process of identifying new developing markets for the opening of both Partner Drive-Ins and Franchise Drive-Ins. In addition, we may consider the acquisition of other similar concepts for conversion to Sonic Drive-Ins.

Restaurant Design and Construction

The typical Sonic Drive-In consists of a kitchen housed in a one-story building flanked by canopy-covered rows of 24 to 36 parking spaces, with each space having its own intercom speaker system and menu board. In addition, since 1995, most new Sonic Drive-Ins have incorporated a drive-through service and patio seating area. We have 151 Sonic Drive-Ins that provide an indoor seating area, 46 of which are located in non-traditional areas such as shopping mall food courts, airports, and universities, and 11 of which are located in convenience stores.

Marketing

We have designed our marketing program to differentiate Sonic Drive-Ins from our competitors by emphasizing five key areas of customer satisfaction: (1) wide variety of distinctive made-to-order menu items, (2) the personal manner of service by carhops, (3) speed of service, (4) quality, and (5) value. The marketing plan includes promotions for use throughout the Sonic chain. We support those promotions with television, radio commercials, interactive media, point-of-sale materials, and other media as appropriate. Those promotions generally center on products which highlight signature menu items of Sonic Drive-Ins.

Each year Sonic develops a marketing plan with the involvement of the Sonic Franchise Advisory Council. (Information concerning the Sonic Franchise Advisory Council is set forth on page 8 under Company Operations- Franchise Advisory Council .) Funding for our marketing plan has three components: (1) the Sonic Advertising Fund, (2) local advertising expenditures, and (3) the System Marketing Fund. The Sonic Advertising Fund is a national media production fund that we administer. Each Sonic Drive-In must contribute 0.375% to 0.75%, depending on the type of license agreement, of the Sonic Drive-In’s gross revenues to the Sonic Advertising Fund. Once a sufficient number of Sonic Drive-Ins have been opened in a market, we require the formation of advertising cooperatives among drive-in owners to pool and direct advertising expenditures in local markets. Each Sonic Drive-In must spend 2% to 3.25%, depending on the type of license agreement, of the drive-in’s gross revenues on local advertising, either directly (if the advertising cooperative for the drive-in’s market is not yet formed) or through participation in the local advertising cooperative. The members of each local advertising cooperative may elect and frequently do elect by majority vote to require the cooperative’s member drive-ins to contribute more than the minimum percentage of gross revenues to the advertising cooperative’s funds. For fiscal year 2005, drive-ins participating in cooperatives contributed an average of 4.1% of their Sonic Drive-In’s gross revenues to Sonic advertising cooperatives. As of August 31, 2005, 2,931 Sonic Drive-Ins (96% of the chain) participated in advertising cooperatives. The System Marketing Fund is funded out of the required local advertising expenditures by either redistributing 2.0% (1.0% prior to September 2004) of each Sonic Drive-In’s gross revenues from the local advertising cooperatives to the System Marketing Fund or, if no advertising cooperative has been formed, requiring the Sonic Drive-In to pay directly 2.0% of its gross revenues to the System Marketing Fund with a corresponding deduction in the amount the drive-in is required to spend on local advertising. The System Marketing Fund complements local advertising efforts in attracting customers to Sonic Drive-Ins by promoting the message of the Sonic brand to an expanded audience. The primary focus of the System Marketing Fund is to purchase advertising on national cable and broadcast networks and other national media and sponsorship opportunities.

 

 

3

---

The total amount spent on media (principally television) was approximately $125 million for fiscal year 2005 and we expect media expenditures of approximately $140 million for fiscal year 2006.

Purchasing

We negotiate with suppliers for our primary food products (hamburger patties, dairy products, chicken products, hot dogs, french fries, tater tots, cooking oil, fountain syrup, produce, and other items) and packaging supplies to ensure adequate quantities of food and supplies and to obtain competitive prices. We seek competitive bids from suppliers on many of our food products. We approve suppliers of those products and require them to adhere to product specifications that we establish. Suppliers manufacture several key products for Sonic under private label and sell them to authorized distributors for resale to Partner Drive-Ins and Franchise Drive-Ins.

 

We require our Partner Drive-Ins and Franchise Drive-Ins to purchase from approved distribution centers. By purchasing as a group, we have achieved cost savings, improved food quality and consistency, and helped decrease the volatility of food and supply costs for Sonic Drive-Ins. For fiscal year 2005, the average cost of food and packaging for a Sonic Drive-In, as reported to us by our Partner Drive-Ins and Franchise Drive-Ins, equaled approximately 28% of net revenues.

Food Safety and Quality Assurance

To ensure the consistent delivery of safe, high-quality food, we created a food safety and quality assurance program. Sonic’s food safety program promotes the quality and safety of all products and procedures utilized by all Sonic Drive-Ins, and provides certain requirements that must be adhered to by all suppliers, distributors, and Sonic Drive-Ins. We also have a comprehensive, restaurant-based food safety program called Sonic Safe. Sonic Safe is a risk-based system that utilizes Hazard Analysis & Critical Control Points (HACCP) principles for managing food safety and quality. Our food safety system includes employee training, supplier product testing, drive-in food safety auditing by independent third-parties, and other detailed components that monitor the safety and quality of Sonic’s products and procedures at every stage of the food preparation and production cycle. Employee training in food safety is covered under our Sonic Drive-In training program, referred to as the STAR Training Program. This program includes specific training information and requirements for every station in the drive-in. We also provide training in ServSafe to drive-in managers. ServSafe is the most recognized food safety training certification in the restaurant industry.

General Operations

Management Information Systems . We utilize point-of-sale equipment in each of our Partner Drive-Ins and Franchise Drive-Ins. Certain financial and other information is polled on a daily basis from most Partner Drive-Ins and many Franchise Drive-Ins. We are continuing to develop software and hardware enhancements to our management information systems to facilitate improved communication and the exchange of information among the corporate office and Partner Drive-Ins and Franchise Drive-Ins. These enhancements primarily utilize an intranet designed for that purpose, which we refer to as PartnerNet.

Reporting . The license agreement requires all Sonic Drive-Ins to submit a profit and loss statement on or before the 20 ^th of each month. All Partner Drive-Ins and 1,182 or 48% of Franchise Drive-Ins submit their data electronically. We expect to add more Sonic Drive-Ins to electronic reporting which will reduce resources needed for manual processing of restaurant level data.

Hours of Operation . Sonic Drive-Ins typically operate seven days a week and are open from 7:00 a.m. to 11:00 p.m.

 

4

---

Company Operations

Restaurant Personnel . A typical Partner Drive-In is operated by a manager, two to four assistant managers, and approximately 25 hourly employees, many of whom work part-time. The manager has responsibility for the day-to-day operations of the Partner Drive-In. Each supervisor has the responsibility of overseeing an average of four to seven Partner Drive-Ins. Sonic Restaurants, Inc. (“SRI”), Sonic’s operating subsidiary, oversees the operations and development of and provides administrative services to all Partner Drive-Ins. SRI employs directors of operations who oversee an average of five to six supervisors within their respective regions and report to either a regional vice president or a vice president of SRI. SRI’s three regional vice presidents and three vice presidents report to the president of SRI.

Ownership Program . The Sonic Drive-In philosophy stresses an ownership relationship with supervisors and managers. As part of the ownership program, either a limited liability company or a general partnership is formed to own and operate each individual Partner Drive-In. SRI owns a majority interest, typically at least 60%, in each of these limited liability companies and partnerships. Generally, the supervisors and managers own a minority interest in the limited liability company or partnership. The amount of ownership percentage is separately negotiated for each Partner Drive-In. Supervisors and managers are not employees of Sonic or of the limited liability companies or partnerships in which they have an ownership interest. As owners, they share in the profits and are responsible for their share of any losses incurred by their Partner Drive-Ins. We believe that our ownership structure provides a substantial incentive for Partner Drive-In supervisors and managers to operate their restaurants profitably and efficiently. Additional information regarding our ownership program is incorporated herein by reference to Ownership Program in Part II, Item 7, at page 26 of this Form 10-K.

Sonic records the interests of supervisors and managers as “minority interest in earnings of Partner Drive-Ins” under costs and expenses on its financial statements. We estimate that the average percentage interest of a supervisor was 16% and the average percentage interest of a manager in a Partner Drive-In was 19% in fiscal year 2005. Each Partner Drive-In distributes its available cash flow to its supervisors and managers and to Sonic on a monthly basis pursuant to the terms of the operating agreement or partnership agreement for that restaurant. Sonic has the right, but not the obligation, to purchase the minority interest of the supervisor or manager in the restaurant. The amounts of the buy-in and the buy-out are generally based on the Partner Drive-In’s sales during the preceding 12 months and approximate the fair market value of a minority interest in that restaurant. Most supervisors and managers finance the buy-in with a loan from a third-party financial institution.

Each Partner Drive-In usually purchases equipment with funds borrowed from Sonic at competitive rates. In most cases, Sonic alone owns or leases the land and building and guarantees any third-party lease entered into for the site.

   Partner Drive-In Data . The following table provides certain financial information relating to Partner Drive-Ins and the number of Partner Drive-Ins opened and closed during the past five fiscal years.

		2005			2004			2003			2002			2001
Average Sales per Partner Drive-In
( in thousands )		$	957		$	886		$	799		$	791		$	772
Number of Partner Drive-Ins:
Total Open at Beginning of Year			539			497			452			393			312
Newly-Opened and Re-Opened			37			21			35			40			34
Purchased from Franchisees*			4			24			52			25			50
Sold to Franchisees*			(5	)		(3	)		(41	)		(5	)		(2	)
Closed			(1	)		0			(1	)		(1	)		(1	)
Total Open at Year End			574			539			497			452			393

5

---

_________________

*The relatively large number of drive-ins sold to franchisees in fiscal year 2003 and purchased from franchisees in fiscal years 2001 through 2004 represent transactions where a majority of Sonic Drive-Ins in a certain market were sold to or purchased from a multi-unit franchisee group. In most instances where we purchased Sonic Drive-Ins, the selling multi-unit franchisee groups continued to own and operate multiple Franchise Drive-Ins.

Franchise Program

General . As of August 31, 2005, we had 2,465 Franchise Drive-Ins operating in 29 states and Mexico. A large number of successful multi-unit franchisee groups have developed during the Sonic system’s 52 years of operation. Those franchisees continue to develop new Franchise Drive-Ins in their franchise territories either through area development agreements or single site development. Our franchisees opened 138 Franchise Drive-Ins during fiscal year 2005 and we expect our franchisees to open approximately 150 to 160 Franchise Drive-Ins in fiscal 2006. We consider our franchisees a vital part of our continued growth and believe our relationship with our franchisees is good.

Franchise Agreements . Each Sonic Drive-In, including each Partner Drive-In, operates under a franchise agreement that provides for payments to Sonic of an initial franchise fee and a royalty fee based on a graduated percentage of the gross revenues of the drive-in. Our current standard license agreement provides for a franchise fee of $30,000 and an ascending royalty rate beginning at 1% of gross revenues and increasing to 5% as the level of gross revenues increases. For non-traditional drive-ins, which are those Sonic Drive-Ins located in venues such as shopping mall food courts, airports, and universities, the license agreement provides for a franchise fee of $15,000 and a graduated royalty rate from 1% to 5% of gross revenues. Approximately 97% of all Sonic Drive-Ins opening in fiscal year 2006 are expected to open under the current standard license agreement, with the remaining 3% expected to open in venues that would be included under the non-traditional license agreement. The current standard license agreement provides for a term of 20 years, with one 10-year renewal option. The term for a non-traditional Sonic Drive-In is typically 10 years, with two five-year renewal options. We have the right to terminate any franchise agreement for a variety of reasons, including a franchisee’s failure to make payments when due or failure to adhere to our policies and standards. Many state franchise laws affect our ability to terminate or refuse to renew a franchise.

As of August 31, 2005, 44% of all Sonic Drive-Ins were subject to the 1% to 5% graduated royalty rate, 49% were subject to a former version of the license agreement (no longer being issued) providing for a 1% to 4% graduated royalty rate, and 7% were subject to a former version of the license agreement (also no longer being issued) providing for a 1% to 3% graduated royalty rate. For fiscal year 2005, Sonic’s average royalty rate equaled 3.56%. The license agreements for those Franchise Drive-Ins which currently operate under the 1% to 4% or 1% to 3% graduated royalty rate begin expiring in fiscal year 2006 and will continue to expire through fiscal year 2023. We expect that almost all the Franchise Drive-Ins currently operating under those expiring license agreements will renew their licenses pursuant to the terms of the then current license agreement. Those renewals of the expiring license agreements to the current form of the license agreement with the 1% to 5% graduated royalty rate will contribute to an increase in our royalty revenues.

Area Development Agreements . We use area development agreements to facilitate the planned expansion of the Sonic Drive-In restaurant chain through multiple unit development. While many existing franchisees continue to expand on a single drive-in basis, approximately 64% of the new Franchise Drive-Ins opened during fiscal year 2005 occurred as a result of then-existing area development agreements. Each area development agreement gives a developer the exclusive right to construct, own, and operate Sonic Drive-Ins within a defined area. In exchange, each developer agrees to open a minimum number of Sonic Drive-Ins in the area within a prescribed time period. If the developer does not meet the minimum opening requirements, we have the right to terminate the area development agreement and grant a new area development agreement to other franchisees for the area previously covered by the terminated area development agreement.

During fiscal year 2005, we entered into 50 new area development agreements calling for the opening of 212 Franchise Drive-Ins and amended 14 existing area development agreements calling for the opening of an additional 40 Franchise Drive-Ins, all during the next seven years. As of August 31, 2005, we had a total of 163 area development agreements in effect, calling for the development of 635 additional Sonic Drive-Ins during the next seven years. We cannot give any assurance that our franchisees will achieve that number of new Franchise Drive-Ins for fiscal year 2006 or during the next seven years. Of the 205 Franchise Drive-Ins scheduled to open during fiscal year 2005 under area development

 

 

6

---

agreements in place at the beginning of that fiscal year, 88 or 43% opened during the period. During fiscal year 2005, we terminated 26 of the 157 area development agreements existing at the beginning of the fiscal year. The terminated area development agreements called for the opening of 32 Franchise Drive-Ins in fiscal year 2005 and an additional 30 Franchise Drive-Ins in the next three fiscal years. All of these terminations were as a result of the franchisee failing to meet the development schedule under the area development agreement.

Our realization of the expected benefits under various existing and future area development agreements currently depends and will continue to depend upon the ability of the developers to open the minimum number of Sonic Drive-Ins within the time periods required by the agreements. The financial resources of the developers, as well as their experience in managing quick-service restaurant franchises, represent critical factors in the success of area development agreements. Although we grant area development agreements only to those developers whom we believe possess those qualities, we cannot give any assurances that the future performance by developers will result in the opening of the minimum number of Sonic Drive-Ins contemplated by the area development agreements or reach the compliance rate we have previously experienced.

 

Franchise Drive-In Development . We assist each franchisee in selecting sites and developing Sonic Drive-Ins. Each franchisee has responsibility for selecting the franchisee’s drive-in location, but must obtain our approval of each Sonic Drive-In design and each location based on accessibility and visibility of the site and targeted demographic factors, including population density, income, age, and traffic. We provide our franchisees with the physical specifications for the typical Sonic Drive-In.

Franchisee Financing . Other than the agreements described below, we do not generally provide financing to franchisees or guarantee loans to franchisees made by third-parties.

 

We had 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, Sonic provided a guaranty of 10% of the outstanding balance of a loan from GEC to the Sonic franchisee. The portions of loans made by GEC to Sonic franchisees that are guaranteed by the Company total $3.8 million as of August 31, 2005. We ceased guaranteeing new loans made under the program during fiscal year 2003 and have not been required to make any payments under our agreement with GEC.

Franchisee Training . Each franchisee must have at least one individual working full time at the Sonic Drive-In who has completed the Sonic Management Development Program before opening or operating the Sonic Drive-In. The program consists of a minimum of 12 weeks of on-the-job training and one week of classroom development. The program emphasizes food safety, quality food preparation, quick service, cleanliness of Sonic Drive-Ins, management techniques and consistency of service. Furthermore, our management teams receive training in ServSafe, the most recognized food safety training certification in the restaurant industry.

Franchisee Support . In addition to training, advertising and food purchasing as a system, and marketing programs, we provide various other services to our franchisees. Those services include: (1) assistance with quality control through area field representatives, to ensure that each franchisee consistently delivers high quality food and service; (2) support of new franchisees with guidance and training in the opening of their first three Sonic Drive-Ins; and (3) assistance in selecting sites for new Sonic Drive-Ins using demographic data and studies of traffic patterns. Our field services organization consists of 17 field service consultants, 14 field marketing representatives, four regional marketing directors, one marketing manager, one senior marketing director, two new franchise consultants, five regional vice presidents, all with responsibility for defined geographic areas, a director of new franchise services, and two vice presidents of franchise finance. The field service consultants provide operational services and support for our franchisees, while the field marketing representatives assist the franchisees with the development of advertising cooperative and local market promotional activities. New franchise consultants support the successful integration of new franchisees into the Sonic system from training through the first months following the opening of each of the franchisee’s first three Sonic Drive-Ins. We also have six real estate directors who assist the franchisees with the identification of trade areas for new Franchise Drive-Ins and the franchisees’ selection of sites for their Franchise Drive-Ins, subject to Sonic’s final approval of those sites. Ten field trainers and four training consultants provide training to franchisees in such areas as shift management, customer service, time management, supervisory skills, and financial controls.

 

 

7

---

Franchise Operations . Sonic’s franchisees operate all Franchise Drive-Ins in accordance with uniform operating standards and specifications. These standards pertain to the quality and preparation of menu items, selection of menu items, maintenance and cleanliness of premises, and employee responsibilities. We develop all standards and specifications with input from franchisees, and they are applied on a system-wide basis. Each franchisee has full discretion to determine the prices charged to its customers.

Franchise Advisory Council . We have established a Franchise Advisory Council which provides advice, counsel, and input to Sonic on important issues impacting the business, such as marketing and promotions, operations, purchasing, building design, human resources, technology, and new products. The Franchise Advisory Council currently consists of 18 members selected by Sonic. Currently we have six executive committee members who are selected at large. The remaining 12 members are regional members who represent four defined regions of the country and serve three-year terms. We have five Franchise Advisory Council task groups comprised of 53   total members who serve two-year terms and lend support on individual key priorities.

Franchise Drive-In Data . The following table provides certain financial information relating to Franchise Drive-Ins and the number of Franchise Drive-Ins opened, purchased from or sold to Sonic, and closed during Sonic’s last five fiscal years.

		2005			2004			2003			2002			2001
Average Sales Per Franchise Drive-In ( in thousands )		$	1,039		$	983		$	929		$	935		$	899
Number of Franchise Drive-Ins:
Total Open at Beginning of Year			2,346			2,209			2,081			1,966			1,863
New Franchise Drive-Ins			138			167			159			142			157
Sold to the Company*			(4	)		(24	)		(52	)		(25	)		(50	)
Purchased from the Company*			5			3			41			5			2
Closed and Terminated,
Net of Re-openings			(20	)		(9	)		(20	)		(7	)		(6	)
Total Open at Year End			2,465			2,346			2,209			2,081			1,966

 

_______________

* The relatively large number of drive-ins purchased from Sonic in fiscal year 2003 and sold to Sonic in fiscal years 2001 through 2004 represent transactions where a majority of Sonic Drive-Ins in a certain market were sold to or purchased from a multi-unit franchisee group. In most instances where Sonic purchased Sonic Drive-Ins, the selling multi-unit franchisee groups continued to own and operate multiple Franchise Drive-Ins.

Competition

We compete in the quick-service restaurant industry, a highly competitive industry in terms of price, service, restaurant location, and food quality. The quick-service restaurant industry is often affected by changes in consumer trends, economic conditions, demographics, traffic patterns, and concerns about the nutritional content of quick-service foods. We compete on the basis of speed and quality of service, method of food preparation (made-to-order), food quality and variety, signature food items, and monthly promotions. The quality of service, featuring Sonic carhops, constitutes one of our primary marketable points of difference from the competition. There are many well-established competitors with substantially greater financial and other resources. These competitors include a large number of national, regional, and local food services, including quick-service restaurants and casual dining restaurants. A significant change in pricing or other marketing strategies by one or more of those competitors could have an adverse impact on Sonic’s sales, earnings, and growth. In selling franchises, we also compete with many franchisors of quick-service and other restaurants and other business opportunities.

8

---

Seasonality

Our results during Sonic’s 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 Drive-Ins and Franchise Drive-Ins.

Employees

As of August 31, 2005, we had 330 full-time corporate employees. This number does not include the approximately 19,000 full-time and part-time employees employed by separate partnerships and limited liability companies that operate our Partner Drive-Ins or the supervisors or managers of the Partner Drive-Ins who own a minority interest in the separate partnerships or limited liability companies.

None of our employees is subject to a collective bargaining agreement. We believe that we have good labor relations with our employees.

Trademarks and Service Marks

Sonic owns numerous trademarks and service marks. We have registered many of those marks, including the “Sonic” logo and trademark, with the United States Patent and Trademark Office and the Mexican Institute of Industrial Property. Trademarks and service marks generally are valid as long as they are used or registered. We believe that our trademarks and service marks have significant value and play an important role in our marketing efforts.

Government Regulations

We must comply with regulations adopted by the Federal Trade Commission (the “FTC”) and with several state laws that regulate the offer and sale of franchises. We also must comply with a number of state laws that regulate certain substantive aspects of the franchisor-franchisee relationship. The FTC’s Trade Regulation Rule on Franchising (the “FTC Rule”) requires that we furnish prospective franchisees with a franchise offering circular containing information prescribed by the FTC Rule.

State laws that regulate the franchisor-franchisee relationship presently exist in a substantial number of states. Those laws regulate the franchise relationship, for example, by requiring the franchisor to deal with its franchisees in good faith, by prohibiting interference with the right of free association among franchisees, by regulating discrimination among franchisees with regard to charges, royalties, or fees, and by restricting the development of other restaurants within certain prescribed distances from existing franchised restaurants. Those laws also restrict a franchisor’s rights with regard to the termination of a franchise agreement (for example, by requiring “good cause” to exist as a basis for the termination), by requiring the franchisor to give advance notice and the opportunity to cure the default to the franchisee, and by requiring the franchisor to repurchase the franchisee’s inventory or provide other compensation upon termination. To date, those laws have not precluded us from seeking franchisees in any given area and have not had a significant effect on our operations.

Each Sonic Drive-In must comply with regulations adopted by federal agencies and with licensing and other regulations enforced by state and local health, sanitation, safety, fire, and other departments. Difficulties or failures in obtaining the required licenses or approvals can delay and sometimes prevent the opening of a new Sonic Drive-In.

Sonic Drive-Ins must comply with federal and state environmental regulations, but those regulations have not had a material effect on their operations. More stringent and varied requirements of local governmental bodies with respect to zoning, land use, and environmental factors can delay and sometimes prevent development of new Sonic Drive-Ins in particular locations.

Sonic and its franchisees must comply with laws and regulations governing labor, employment and wage and hour issues, such as minimum wage, overtime, family and medical leave, discrimination, and other working conditions. Many of the food service personnel in Sonic Drive-Ins receive compensation at rates related to federal, state, and local minimum wage laws and, accordingly, increases in applicable minimum wage laws will increase labor costs at those locations.

 

 

9

---

Available Information

We maintain an internet website with the address of http://www.sonicdrivein.com . Copies of the Company’s reports filed with, or furnished to, the Securities and Exchange Commission on Forms 10-K, 10-Q, and 8-K and any amendments to such reports are available for viewing and copying at such internet website, free of charge, as soon as reasonably practicable after filing such material with, or furnishing it to, the Securities and Exchange Commission. In addition, copies of Sonic’s corporate governance materials, including the Corporate Governance Guidelines, Audit Committee Charter, Compensation Committee Charter, Nominating and Corporate Governance Committee Charter, Code of Ethics for Financial Officers, and Code of Business Conduct and Ethics are available for viewing and copying at the website, free of charge.  

Item 2. Properties

Of the 574 Partner Drive-Ins operating as of August 31, 2005, we operated 237 of them on property leased from third-parties and 337 of them on property we own. The leases expire on dates ranging from 2006 to 2024, with the majority of the leases providing for renewal options. All leases provide for specified monthly rental payments, and some of the leases call for additional rentals based on sales volume. All leases require Sonic to maintain the property and pay the cost of insurance and taxes.

We moved our corporate headquarters to a new building in the Bricktown district of downtown Oklahoma City in November 2003 and have a 15-year lease to occupy approximately 78,000 square feet in the new building. The lease expires in November 2018 and has two five-year renewal options. Sonic believes its properties are suitable for the purposes for which they are being used.

Item 3. Legal Proceedings

Sonic 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.

 

Item 4. Submission of Matters to a Vote of Security Holders

Sonic did not submit any matter during the fourth quarter of the Company’s last fiscal year to a vote of Sonic’s stockholders, through the solicitation of proxies or otherwise .

 

10

---

 

Item 4A. Executive Officers of the Company

Identification of Executive Officers

The following table identifies the executive officers of the Company.

 

Name	Age	Position	Executive Officer Since
J. Clifford Hudson	50	Chairman of the Board of Directors, Chief Executive Officer and President	June 1985
W. Scott McLain	43	Executive Vice President of Sonic Corp. and President of Sonic Industries Inc.	April 1996
Michael A. Perry	47	President of Sonic Restaurants, Inc.	August 2003
Ronald L. Matlock	54	Senior Vice President, General Counsel and Secretary	April 1996
Stephen C. Vaughan	39	Vice President and Chief Financial Officer	January 1996
V. Todd Townsend	41	Vice President and Chief Marketing Officer	August 2005
Carolyn C. Cummins	47	Vice President of Compliance	April 2004
Terry D. Harryman	40	Controller	January 1999
Renee G. Shaffer	44	Treasurer	April 2005

 

Business Experience

The following sets forth the business experience of the executive officers of the Company for at least the past five years.

J. Clifford Hudson has served as the Company’s Chairman of the Board and Chief Executive Officer since January 2000. Mr. Hudson served as Chief Executive Officer and President of the Company from April 1995 to January 2000 and reassumed the position of President in November 2004. He has served in various other offices with the Company since 1984. Mr. Hudson has served as a Director of the Company since 1993. He served as Chairman of the Board of Securities Investor Protection Corporation, the federally-chartered organization which serves as the insurer of customer accounts with brokerage firms, from 1994 to 2001.

W. Scott McLain has served as Executive Vice President of the Company and President and Director of Sonic Industries Inc. since September 2004. He served as the Company’s Executive Vice President and Chief Financial Officer from January 2004 until November 2004 and as the Company’s Senior Vice President and Chief Financial Officer from January 2000 until January 2004. Mr. McLain served as the Company’s Vice President of Finance and Chief Financial Officer from August 1997 until January 2000.

Michael A. Perry has served as President and Director of Sonic Restaurants, Inc. since September 2004. He served as Senior Vice President of Operations and Director of Sonic Restaurants, Inc. from August 2003 until September 2004. Mr. Perry served as Vice President of Franchise Services of Sonic Industries Inc. from September 1998 until August 2003.  

Ronald L. Matlock has served as the Company’s Senior Vice President, General Counsel and Secretary since January 2000. Mr. Matlock served as the Company’s Vice President, General Counsel and Secretary from April 1996 until January

 

 

11

---

2000. Mr. Matlock has also served as a Director of Sonic Restaurants, Inc. and as a Director of Sonic Industries Inc. since April 1996.  

Stephen C. Vaughan has served as Vice President and Chief Financial Officer of the Company since November 2004. Mr. Vaughan also served as Treasurer of the Company from November 2004 until April 2005. Mr. Vaughan served as Vice President of Planning and Analysis and Treasurer from November 2001 until November 2004 and served as Vice President of Planning and Analysis from January 1999 until November 2001. He joined the Company in 1992.

V. Todd Townsend has served as Vice President and Chief Marketing Officer of the Company since joining the Company in August 2005. Mr. Townsend served as Vice President of Marketing for Yahoo! Inc. from 2004 until joining the Company in 2005. Mr. Townsend served as Assistant Vice President of Marketing for Sprint Corp. from 2001 until 2003 and as   Senior Director of Marketing for Sprint Corp.   from 2000 until 2001.

 

Carolyn C. Cummins has served as the Company’s Vice President of Compliance since April 2004. Ms. Cummins has also served as Assistant General Counsel and Assistant Secretary since joining the Company in January 1999.

Terry D. Harryman has served as the Company’s Controller since January 1999. Mr. Harryman has also served as the Controller of Sonic Restaurants, Inc. and Sonic Industries Inc. since January 2002. He served as Assistant Treasurer of Sonic Restaurants, Inc. and Sonic Industries Inc. from October 1996 until January 2002.

Renee G. Shaffer has served as the Treasurer of the Company since joining the Company in April 2005. Ms. Shaffer served as an Assistant Vice President of Information Systems of Hobby Lobby Stores, Inc. from December 2003 until December 2004 and the Director of Information Systems of Hobby Lobby Stores, Inc. from January 2001 until December 2003. She worked as a certified public accountant providing financial and accounting services from 1998 until January 2001.

PART II

Item 5. Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

The Company’s common stock trades on the Nasdaq National Market ("Nasdaq") under the symbol "SONC." The following table sets forth the high and low closing bids for the Company’s common stock during each fiscal quarter within the two most recent fiscal years as reported on Nasdaq. Share amounts set forth below and elsewhere in this report have been adjusted to reflect the results of the May 2004 three-for-two stock split.

 

Quarter Ended	High	Low		Quarter Ended	High	Low
November 30, 2004	$29.980	$22.400		November 30, 2003	$20.587	$16.260
February 28, 2005	$33.870	$29.170		February 29, 2004	$23.247	$19.673
May 31, 2005	$35.470	$30.800		May 31, 2004	$24.313	$20.233
August 31, 2005	$33.970	$29.170		August 31, 2004	$23.500	$21.100

 

Stockholders

As of October 31, 2005, the Company had 601 record holders of its common stock.

 

 

12

---

 

Dividends

The Company did not pay any cash dividends on its common stock during its two most recent fiscal years and does not intend to pay any dividends in the foreseeable future as profits are reinvested in the Company to fund expansion of its business, acquisition of Franchise Drive-Ins, and repurchases of the Company’s common stock. As in the past, future payment of dividends will be considered after reviewing, among other factors, returns to stockholders, profitability expectations and financing needs.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table sets forth information about the Company’s equity compensation plans as of August 31, 2005.

Equity Compensation Plan Information        

	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights	Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Plan category	(a)	(b)	(c)
Equity compensation plans approved by security holders	5,216,919	$14.87	918,058
Equity compensation plans not approved by security holders	-0-	-0-	-0-

 

 

Issuer Purchases of Equity Securities

 

Shares repurchased during the fourth quarter of fiscal 2005 are as follows (in thousands, except share and per share amounts):

 

Period	Total Number of Shares Purchased   (a)		Average Price Paid per Share   (b)		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1)   (c)		Maximum Dollar Value that May Yet Be Purchased Under the Program   (d)
June 1, 2005 through June 30, 2005	228,700		$31.49		228,700		$122,800
July 1, 2005 through July 31, 2005	498,900		$30.31		498,900		$107,676
August 1, 2005 through August 31, 2005	-0-		$ 0.00		-0-		$107,676
Total	727,600		$30.68		727,600

(1) All of the shares purchased during the fourth quarter of fiscal 2005 were purchased as part of the Company’s share repurchase program which was first publicly announced on April 14, 1997. In April 2005, the Company’s Board of  Directors approved an increase in the share repurchase authorization from $60,000 to $150,000 and extended the program to August 31, 2006.

 

13

---

 

Item 6. Selected Financial Data

The following table sets forth selected financial data regarding the Company’s financial condition and operating results. One should read the following information in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” below, and the Company’s Consolidated Financial Statements included elsewhere in this report.

 

 

 

 

 

 

14

---

Selected Financial Data

(In thousands, except per share data)

 

		Year ended August 31,
		2005			2004			2003			2002			2001
Income Statement Data:
Partner Drive-In sales		$	525,988		$	449,585		$	371,518		$	330,707		$	267,463
Franchise Drive-Ins:
Franchise royalties			88,027			77,518			66,431			61,392			54,220
Franchise fees			4,311			4,958			4,674			4,020			4,408
Other			4,740			4,385			4,017			4,043			4,547
Total revenues			623,066			536,446			446,640			400,162			330,638
Cost of Partner Drive-In sales			421,906			358,859			291,764			257,057			207,782
Selling, general and administrative			40,746			38,270			35,426			33,444			30,602
Depreciation and amortization			35,821			32,528			29,223			26,078			23,855
Provision for impairment of long-lived assets			387			675			727			1,261			792
Total expenses			498,860			430,332			357,140			317,840			263,031
Income from operations			124,206			106,114			89,500			82,322			67,607
Net interest expense			5,785			6,378			6,216			6,319			5,525
Income before income taxes		$	118,421		$	99,736		$	83,284		$	76,003		$	62,082
Net income		$	75,381		$	63,015		$	52,261		$	47,692		$	38,956
Income per share (1) :
Basic		$	1.26		$	1.06		$	0.89		$	0.79		$	0.65
Diluted		$	1.21		$	1.02		$	0.86		$	0.75		$	0.62
Weighted average shares used in calculation (1) :
Basic			59,995			59,314			58,465			60,234			59,774
Diluted			62,431			61,654			60,910			63,310			62,598

Balance Sheet Data:
Working capital (deficit)		$	(30,093	)	$	(14,537	)	$	(2,875	)	$	(12,942	)	$	(3,335	)
Property, equipment and capital leases, net			422,825			376,315			345,551			305,286			273,198
Total assets			563,316			518,633			486,119			405,356			358,000
Obligations under capital leases (including current portion)			38,525			40,531			27,929			12,938			13,688
Long-term debt (including current portion)			60,195			82,169			139,587			109,375			109,168
Stockholders’ equity			384,539			334,762			265,398			230,670			200,719
Cash dividends declared per common share			–			–			–			–			–

(1)   Adjusted for a 3-for-2 stock split in 2004 and 2002

15

---

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Description of the Business . Sonic operates and franchises the largest chain of drive-ins in the United States. As of August 31, 2005, the Sonic system was comprised of 3,039 drive-ins, of which 19% or 574 were Partner Drive-Ins and 81% or 2,465 were Franchise Drive-Ins. Sonic Drive-Ins feature Sonic signature items, such as specialty soft drinks including cherry limeades and slushes, frozen desserts, made-to-order sandwiches and hamburgers, extra-long cheese coneys, hand-battered onion rings, tater tots, salads, and wraps. We derive our revenues primarily from Partner Drive-In sales and royalties from franchisees. We also receive revenues from initial franchise fees. To a lesser extent, we also receive income from the selling and leasing of signs and real estate, as well as from minority ownership interests 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 the Company’s franchising operations, as well as Partner Drive-In operations. Our revenues and expenses are directly affected by the number and sales volumes of Partner Drive-Ins. Our revenues and, to a lesser extent, expenses also are affected by the number and sales volumes of Franchise Drive-Ins. Initial franchise fees and franchise royalties are directly affected by the number of Franchise Drive-In openings.

Overview of Business Performance . Business performance was strong during fiscal year 2005 as net income increased 19.6% and earnings per share increased 18.6% to $1.21 per diluted share.

The Sonic brand achieved several milestones during fiscal year 2005, including:

·	Surpassing the $1.0 million mark in system-wide average unit volumes;

·	Opening of the 3,000 th Sonic Drive-In; and

·	Our 19 th consecutive year of higher system-wide same-store sales.

We continue to experience considerable momentum in our business fueled by strong growth in same-store sales that, despite some pressure on store-level operating costs during the year, led to a significant increase in system-wide average profit per store. The rise in store-level profits, in turn, helped produce a solid number of new drive-in openings by franchisees. 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 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.

Looking forward, these strategies are expected to continue to positively impact our business. We expect revenue growth of between 13% and 15% for fiscal year 2006, based upon same-store sales growth in the target range of 2% to 4%. This increase in revenues includes the expected benefit from 15 Franchise Drive-Ins which were acquired by the Company effective September 1, 2005.

The following table provides information regarding the number of Partner Drive-Ins and Franchise Drive-Ins in operation as of the end of the periods indicated as well as the system-wide growth in sales and average unit volume. System-wide information includes both Partner Drive-In and Franchise Drive-In information, which we believe is useful in analyzing the growth of the brand as well as the Company’s revenues since franchisees pay royalties based on a percentage of sales.

16

---

System-Wide Performance ($ in thousands)
		Year Ended August 31,
		2005			2004			2003
Percentage increase in sales			12.4	%		13.1	%		7.0	%
System-wide drive-ins in operation:
Total at beginning of period			2,885			2,706			2,533
Opened			175			188			194
Closed (net of re-openings)			(21	)		(9	)		(21	)
Total at end of period			3,039			2,885			2,706
Core markets			2,165			2,059			1,977
Developing markets			874			826			729
All markets			3,039			2,885			2,706
Average sales per drive-in:
Core markets		$	1,059		$	1,004		$	947
Developing markets			934			861			802
All markets			1,023			964			907
Change in same-store sales (1) :
Core markets			5.6	%		6.4	%		0.5	%
Developing markets			7.4			6.8			(1.2	)
All markets			6.0			6.5			0.3
(1) Represents percentage change for drive-ins open for a minimum of 15 months.

System-wide same-store sales increased 6.0% during fiscal year 2005, largely as a result of traffic growth (an increase in the number of transactions) across all day parts (e.g. morning, lunch, afternoon, dinner, and evening). Additionally, a lesser portion of the growth came from an increase in the average check (the average amount spent per transaction). This marked our 19 ^th consecutive year of positive same-store sales. We believe our strong sales performance is a direct consequence of our specific sales-driving initiatives including, but not limited to:

·	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 choices for our customers;

·	Continued growth of our business in non-traditional day parts including the morning, afternoon, and evening day parts, which saw solid increases in sales; and

·	Use of technology to reach customers and improve the customer experience.

During fiscal year 2005, our total system-wide media expenditures were approximately $125 million as compared to $110 million in fiscal year 2004, which we believe continues 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 efforts, which are largely used for network cable television advertising, growing this area of our advertising from approximately $32 million in fiscal year 2004 to approximately $60 million in fiscal year 2005. We believe increased network cable advertising provides several benefits including the ability to more effectively target and better reach the cable audience, which has now surpassed broadcast networks in terms of viewership. In addition, national cable advertising also allows us to bring additional depth to our media and expand our message beyond our traditional emphasis on a single monthly promotion. Looking forward, we expect system-wide media expenditures to be approximately $140 million in fiscal 2006. The system-wide marketing fund portion will again represent approximately one-half of total media expenditures for fiscal 2006.

 

17

---

 

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 past year, our new product offerings showcased the breadth of our menu and emphasized the opportunity for choice at Sonic. We will continue to have new product news in the coming months, all designed to meet customers’ evolving taste preferences including the growing desire for fresh, quality product offerings and healthier alternatives.

We continue to promote the expansion of our business in non-traditional day parts (morning, afternoon, and evening). The momentum in our evening business, which rose significantly with the return of our Sonic Nights initiative in the summer of fiscal year 2004, continued through fiscal year 2005. Every day part, including lunch and dinner, showed positive growth during fiscal year 2005 compared to fiscal year 2004, and we believe we have continuing opportunity to grow our non-traditional day parts like afternoon and evening throughout fiscal year 2006.

 

Implementation of the PAYS program, which began in the fall of 2003, was completed in the remainder of our Partner Drive-Ins during the second quarter of fiscal year 2005. Under the PAYS program, a credit card terminal is added to each drive-in stall to facilitate credit and debit card transactions. Rollout to Franchise Drive-Ins began in February 2005 and is expected to be completed system-wide by the end of calendar year 2006. The average investment to install PAYS in a typical Sonic Drive-In is approximately $25 thousand. In evaluating this initiative, we have targeted an “increased sales to investment ratio” of 1 to 1, and it has been our experience that the installation of the PAYS program has generally met and often exceeds this target.

A highlight of fiscal year 2005 was reaching the $1.0 million mark for system-wide average unit volumes. Another positive trend that has continued for seven consecutive quarters is the performance of developing markets relative to core markets. System-wide same-store sales in developing markets outpaced same-store sales in core markets, increasing 7.4% during fiscal year 2005 on top of a 6.8% increase in fiscal year 2004. We believe this increase was primarily due to additional 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 8.5% continuing the positive trend of the last year and well ahead of the average unit volume increase in core markets which increased 5.5%.

 

Another milestone reached during fiscal year 2005 was the opening of Sonic’s 3,000 ^th drive-in. We opened 175 new drive-ins during fiscal year 2005, consisting of 37 Partner Drive-Ins and 138 Franchise Drive-Ins, down slightly from 188 drive-in openings during fiscal year 2004 (21 Partner Drive-Ins and 167 Franchise Drive-Ins). Looking forward, the Company expects to open 180 to 190 new drive-ins during fiscal year 2006, including 150 to 160 by franchisees.

Results of Operations

Revenues . Total revenues increased 16.1% to $623.1 million in fiscal year 2005 from $536.4 million during fiscal year 2004. The increase in revenues primarily relates to strong sales growth for Partner Drive-Ins and, to a lesser extent, a rise in franchising income.

18

---

 

 

Revenues
(in thousands)
											Percent
								Increase/			Increase/
Year Ended August 31,		2005			2004			(Decrease)			(Decrease)
Revenues:
Partner Drive-In sales		$	525,988		$	449,585		$	76,403			17.0	%
Franchise revenues:
Franchise royalties			88,027			77,518			10,509			13.6
Franchise fees			4,311			4,958			(647	)		(13.0	)
Other			4,740			4,385			355			8.1
Total revenues		$	623,066		$	536,446		$	86,620			16.1

											Percent
								Increase/			Increase/
Year Ended August 31,		2004			2003			(Decrease)			(Decrease)
Revenues:
Partner Drive-In sales		$	449,585		$	371,518		$	78,067			21.0	%
Franchise revenues:
Franchise royalties			77,518			66,431			11,087			16.7
Franchise fees			4,958			4,674			284			6.1
Other			4,385			4,017			368			9.2
Total revenues		$	536,446		$	446,640		$	89,806			20.1

 

The following table reflects the growth in Partner Drive-In sales and changes in comparable drive-in sales for Partner Drive-Ins. It also presents information about average unit volumes and the number of Partner Drive-Ins, which is useful in analyzing the growth of Partner Drive-In sales.

 

Partner Drive-In Sales ($ in thousands)
		Year Ended August 31,
		2005			2004			2003
Partner Drive-In sales		$	525,988		$	449,585		$	371,518
Percentage increase			17.0	%		21.0	%		12.3	%
Partner Drive-Ins in operation:
Total at beginning of period			539			497			452
Opened			37			21			35
Acquired from (sold to) franchisees, net			(1	)		21			11
Closed			(1	)		-			(1	)
Total at end of period			574			539			497
Average sales per Partner Drive-In		$	957		$	886		$	799
Percentage increase			8.0	%		10.9	%		1.0	%
Change in same-store sales (1)			7.4	%		7.8	%		(0.3	%)
(1) Represents percentage change for drive-ins open for a minimum of 15 months.

19

---

The increases in Partner Drive-In sales result from newly constructed and acquired drive-ins and same-store sales increases in existing drive-ins, offset by the loss of sales for sold and closed drive-ins.

Change in Partner Drive-In Sales ($ in thousands)
		Year Ended August 31,
		2005			2004
Increase from addition of newly constructed drive-ins (1)		$	28,184		$	23,099
Increase from acquisition of drive-ins (2)			19,831			38,378
Increase from same-store sales			31,109			28,561
Decrease from drive-ins sold or closed (3)			(2,721	)		(11,971	)
Net increase in Partner Drive-In sales		$	76,403		$	78,067

(1) Represents the increase for 58 and 55 drive-ins opened since the beginning of the prior fiscal year as of August 31, 2005 and 2004, respectively.
(2) Represents the increase for 28 and 77 drive-ins acquired since the beginning of the prior fiscal year as of August 31, 2005 and 2004, respectively.
(3) Represents the decrease for 9 and 45 drive-ins sold or closed since the beginning of the prior fiscal year as of August 31, 2005 and 2004, respectively.

 

During fiscal year 2005, same-store sales at Partner Drive-Ins again exceeded the same-store sales performance of our franchisees. The increase in average unit volume was also strong - growing 8.0% during the year as a result of the acquisition of higher volume drive-ins in Colorado in July 2004 as well as strong performance from new stores. Effective July 1, 2005, we rolled over the acquisition of the Colorado drive-ins which accounted for approximately three percentage points of the growth in Partner Drive-In sales during fiscal year 2005.

Beginning in fiscal year 2004, we implemented initiatives designed to close the approximately $130 thousand 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 thousand per drive-in. During fiscal year 2005, the trend continued as same-store sales growth at Partner Drive-Ins outpaced same-store sales of Franchise Drive-Ins, closing the gap by another $15 thousand.

Over the past several years, we have completed the acquisition of several 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. Effective September 1, 2005, we acquired 15 franchise drive-ins located in the Tennessee and Kentucky markets. These acquisitions have added and are expected to continue to add to revenue growth and are expected to continue to be accretive to earnings over time. Our acquisitions are focused on higher volume stores with strong store-level management already in place. In addition, the selling franchisee usually retains a significant drive-in base and continues growing with us in other areas. We view these types of acquisitions of 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 franchise revenues (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 performance of our Franchise Drive-Ins.

20

---

Franchise Information ($ in thousands)
		Year Ended August 31,
		2005			2004			2003
Franchise fees and royalties (1)		$	92,338		$	82,476		$	71,105
Percentage increase			12.0	%		16.0	%		8.7	%
Franchise Drive-Ins in operation:
Total at beginning of period			2,346			2,209			2,081
Opened			138			167			159
Acquired from (sold to) Company, net			1			(21	)		(11	)
Closed			(20	)		(9	)		(20	)
Total at end of period			2,465			2,346			2,209
Franchise Drive-In sales		$	2,474,133		$	2,219,340		$	1,988,842
Percentage increase			11.5	%		11.6	%		6.1	%
Effective royalty rate			3.56	%		3.49	%		3.34	%
Average sales per Franchise Drive-In		$	1,039		$	983		$	929
Change in same-store sales (2)			5.8	%		6.2	%		0.4	%
(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.

Franchise income, which consists of franchise royalties and franchise fees, increased 12.0% to $92.3 million in fiscal year 2005.

Franchise royalties increased 13.6% to $88.0 million in fiscal year 2005, compared to $77.5 million in fiscal year 2004. Of the $10.5 million increase, approximately $6.3 million resulted from Franchise Drive-Ins’ same-store sales growth of 5.8% in fiscal year 2005, combined with an increase in the effective royalty rate to 3.56% during fiscal year 2005 compared to 3.49% during 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 attributable to growth in the number of Franchise Drive-Ins over the prior period.

Franchise royalties increased 16.7% to $77.5 million in fiscal year 2004, compared to $66.4 million in fiscal year 2003. Of the $11.1 million increase, approximately $6.7 million resulted from Franchise Drive-Ins’ same-store sales growth of 6.2% in fiscal year 2004, combined with an increase in the effective royalty rate to 3.49% during fiscal year 2004 compared to 3.34% during fiscal year 2003. The balance of the increase was attributable to growth in the number of Franchise Drive-Ins over the prior period.

Franchise fees decreased 13.0% to $4.3 million as franchisees opened 138 new drive-ins in fiscal year 2005 as compared to 167 openings in fiscal year 2004. Franchise fees increased 6.1% to $5.0 million during fiscal 2004 as 167 Franchise Drive-Ins opened compared to 159 during the previous year.

During fiscal year 2005, development on the franchise side was negatively impacted by a number of factors. We had numerous projects affected by various delays caused by zoning and permitting difficulties as well as site specific location and construction issues. We believe this is a direct by-product of a more challenging development environment as much of our development is occurring in harder-to-develop markets, including Florida and California. In addition, since the development cycle tends to be 18 to 24 months long, we are, to some degree, feeling the impact of a slowdown in store profitability during 2003 that tends to create a more cautious approach to development from franchisees.

 

 

21

---

Looking forward, there has been a strong rise in per store profits over the last 24 months that has positively impacted the pipeline for future franchise development. This is evidenced by 163 area development agreements at the end of fiscal year 2005 representing approximately 635 planned Franchise Drive-In openings over the next few years, compared to 157 such agreements at August 31, 2004 which represented approximately 570 planned Franchise Drive-In openings. Another step that has contributed to growth in the franchise pipeline is the recent planned expansion into a number of new markets, primarily located along the east and west coasts. In the past, our market expansion has been limited to a fewer number of markets at one time; we believe the brand awareness provided by our national cable advertising efforts will support this planned expansion to a greater number of markets.

 

Twenty Franchise Drive-Ins were closed during fiscal year 2005, which was an increase from the nine Franchise Drive-Ins closed during fiscal year 2004. Fifteen of the closings occurred during the second quarter and related primarily to two weaker franchise operators in two different markets. We do not believe that these drive-in closings are indicative of the Sonic brand’s success. We have taken steps to require stronger financial qualifications of new franchisees, which we believe will significantly mitigate this type of risk. In addition, we expect that some of these drive-ins may re-open under new franchisee ownership.

We anticipate 150 to 160 store openings by franchisees during fiscal year 2006. 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. As a result of these new Franchise Drive-In openings and the continued benefit of the ascending royalty rate, we expect approximately $10 million in incremental franchise fees and royalties in fiscal year 2006.

Operating Expenses . Overall, drive-in cost of operations, as a percentage of Partner Drive-In sales, increased to 80.2% in fiscal year 2005 from 79.8% in 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.

Operating Margins
		Year Ended August 31,
		2005			2004			2003
Costs and Expenses (1) :
Partner Drive-Ins:
Food and packaging			26.2	%		26.3	%		26.0	%
Payroll and other employee benefits			30.3			30.2			29.6
Minority interest in earnings of Partner Drive-Ins			4.1			4.4			3.9
Other operating expenses			19.6			18.9			19.0
Total Partner Drive-In cost of operations			80.2	%		79.8	%		78.5	%
(1) As a percentage of Partner Drive-In sales.

Food and packaging costs decreased by 0.1 percentage points during fiscal year 2005 compared to fiscal year 2004 following an increase of 0.3 percentage points during fiscal year 2004 compared to fiscal year 2003. In the early part of the year, we experienced significant, year-over-year increases in several commodities including beef, dairy, and tomatoes. They were offset by menu price increases of approximately 1% in December 2004 and 1.5% in May 2005, as well as abatement of price pressures for these items, particularly dairy, in the latter part of the year. Looking forward, we anticipate that slightly lower year-over-year costs for beef, as well as lower costs for other items will result in lower food and packaging costs, as a percentage of sales, on a year-over-year basis in fiscal year 2006. This favorable outlook may be negatively impacted if energy prices remain high throughout the year.

Labor costs increased by 0.1 percentage points during fiscal year 2005 compared to fiscal year 2004 after an increase of 0.6 percentage points during fiscal year 2004 compared to fiscal year 2003. The slight increase for fiscal year 2005 resulted from staffing increases at the assistant manager level, as well as higher labor costs related to opening newly constructed stores as higher staffing levels were required for pre-opening training and through the initial opening period. The 2004 increase was primarily a result of significant payments made under the sales-based incentive program for drive-

 

22

---

 

in management as well as higher staffing levels reflecting successful ongoing efforts to reduce turnover at Partner Drive- I ns.

Looking forward, the average wage rate has increased slightly in the last two quarters of fiscal year 2005, although the increase has not been significant to date. We plan to continue making significant payments under our sales incentive program, as we believe it has been a major driver of strong sales performance at Partner Drive-Ins. These increases, however, should be leveraged by higher volumes. As a result, we expect labor costs to be flat to slightly favorable, as a percentage of sales, on a year-over-year basis, in fiscal year 2006.

Minority interest, which reflects our store-level partners’ pro-rata share of earnings from our partnership program, increased by $1.6 million during fiscal year 2005, reflecting the increase in average profit per store. During fiscal year 2004, minority interest increased $5.5 million, also reflecting the increase in average profit per store. Overall, we continue to view the partnership program as an integral part of our culture at Sonic and a large factor in the success of our business, and we are pleased that profit distributions to our partners increased during fiscal year 2005. Since we expect our average store level profits to continue to grow in fiscal year 2006, we would expect minority interest to increase in dollar terms but stay relatively flat as a percentage of sales.

Other operating expenses increased by 0.7 percentage points during fiscal year 2005. Costs increased primarily as a result of credit card charges associated with the increase in credit card transactions stemming from the success of the PAYS program, as well as increased repairs and maintenance expenses resulting from a greater focus on the physical appearance of our drive-ins, both inside and outside. Utility costs also increased toward the end of fiscal year 2005 as a result of increased energy prices. During fiscal year 2004, other operating expenses decreased by 0.1 percentage points as the leverage of operating at higher unit volumes more than offset increased costs. Looking forward, we expect cost increases in many of the items listed above, particularly utility costs, to carry over into fiscal year 2006. Our expectations for other operating costs will continue to depend upon future swings in energy costs, but we generally expect that the cost increases will result in other operating expenses increasing 0.25 to 0.50 percentage points, in fiscal year 2006.

To summarize, we are expecting overall restaurant-level margins to be relatively flat during fiscal year 2006 on a year-over-year basis, depending upon the variability in energy costs.

Selling, General and Administrative . Selling, general and administrative expenses increased 6.5% to $40.7 million during fiscal year 2005 and 8.0% to $38.3 million during fiscal year 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 6.5% in fiscal year 2005, compared with 7.1% in fiscal year 2004 and 7.9% in fiscal year 2003. Beginning in the first quarter of fiscal year 2006, the Company will adopt FAS 123R which requires the fair value of stock options be charged to expense. The projected impact of adopting this standard is estimated to be additional expense of approximately $8 to $9 million during fiscal year 2006. This expense is expected to be incurred pro-rata over the fiscal year, with the amount increasing slightly in the third and fourth quarters due to the annual grant of options that typically occurs at Sonic’s spring board meeting. Excluding the impact of FAS 123R, we anticipate that these costs will increase in the range of 10% to 12% in fiscal year 2006 and to decline as a percentage of sales. This rate of increase is higher than prior years primarily because of increased headcount additions which management believes is necessary to support continued growth in our business.

Depreciation and Amortization . Depreciation and amortization expense increased 10.1% to $35.8 million in fiscal year 2005 due, in part, to additional depreciation stemming from the Colorado acquisition in July 2004. Similarly, depreciation and amortization expense increased 11.3% to $32.5 million in fiscal year 2004 as a result of the San Antonio and Colorado acquisitions, as well as the capital lease on our corporate office space. Capital expenditures, excluding acquisitions, were $85.9 million in fiscal year 2005. Looking forward, with approximately $75 to $80 million in capital expenditures planned for the year, normal depreciation and amortization is expected to increase by approximately 9% to 11% for the year. However, the Company re-evaluated the remaining asset life of certain assets related to the retrofit of Partner Drive-Ins in the late 1990s and has determined that the remaining useful life should be reduced. This reduction will cause an incremental increase in depreciation and amortization over the next four quarters of approximately 7% over the prior year, resulting in an overall expectation that depreciation and amortization will increase in the range of 16% to 18% for the year.

 

 

23

---

Provision for Impairment of Long-lived Assets . One Partner Drive-In and one property held for disposal became impaired during fiscal year 2005 under the guidelines of FAS 144 - “Accounting for the Impairment or Disposal of Long-Lived Assets.” As a result, a total provision for impairment of long-lived assets of $0.4 million was recorded for the carrying costs of these assets in excess of their estimated fair values. One Partner Drive-In became impaired during fiscal year 2004 which resulted in a provision for impairment of $0.7 million to reduce the drive-in’s carrying cost to its estimated fair value. During fiscal year 2003, two Partner Drive-Ins became impaired which resulted in a provision for impairment totaling $0.7 million to reduce the drive-ins’ carrying cost to their estimated fair value. We continue to perform quarterly analyses of certain underperforming drive-ins. It is reasonably possible that the estimate of future cash flows associated with these drive-ins may change in the near future resulting in the need to write-down assets associated with one or more of these drive-ins to fair value. While it is impossible to predict if future write-downs will occur, we do not believe that future write-downs will impede our ability to continue growing earnings at a solid rate.

Interest Expense . Net interest expense decreased 9.3% in fiscal year 2005 compared to a 2.6% increase in fiscal year 2004 as a result of strong cash flow from operations. The reduction in interest expense more than offset the decrease in interest income relating to the outsourcing of our partner notes to a third-party financial institution in August 2004. Interest expense increased in fiscal year 2004 largely due to the addition of the capital lease associated with our new office space. Our ability to generate positive operating cash flow enabled us to expend $85.9 million in capital expenditures, $42.3 million in share repurchases and still reduce our long-term debt by $22.0 million. Going forward, we expect our continued repurchase of stock, as well as the acquisition of 15 drive-ins effective September 1, 2005 will produce higher interest expense in future quarters depending on the level of shares repurchased or additional franchise acquisitions.

Income taxes . The provision for income taxes reflects an effective federal and state tax rate of 36.35% for fiscal year 2005 compared with 36.82% in fiscal year 2004 and 37.25% in fiscal year 2003. The lower rate for fiscal year 2005 resulted primarily from a retroactive tax law change that reinstated expired tax credits in the first quarter of fiscal year 2005. The reduction in our effective tax rate in fiscal year 2004 was primarily a result of the benefit of higher tax credits. We expect the adoption of FAS 123R for stock options in the first quarter of fiscal year 2006 to impact the tax rate, as only the portion of stock option expense expected to result in a future tax deduction is considered deductible for tax accounting purposes. Sonic currently estimates the tax benefit for stock options to be approximately 25% of the amount expensed. Considering these variables, we anticipate that our effective tax rate will increase during fiscal year 2006 to a range of 37.5% to 38.0% and vary from quarter to quarter as circumstances on individual tax matters change.

Financial Position  

 

During fiscal year 2005, current assets increased 1.9% to $35.2 million compared to $34.6 million as of the end of fiscal year 2004. Net property, equipment and capital leases increased by 12.4% as a result of capital expenditures. The increases in current assets and net property, equipment and capital leases were partially offset by decreases in notes receivable, resulting from early repayment by franchisees, to produce an 8.6% increase in total assets to $563.3 million as of the end of fiscal year 2005.

Total current liabilities increased $16.2 million or 33.0% during fiscal year 2005 as a result of increases in income taxes payable and trade payables. The non-current portion of long-term debt decreased $22.7 million or 28.9% as a result of repayment of debt using cash generated from operating activities. Overall, total liabilities decreased $5.1 million or 2.8% as a result of the items discussed above.

Stockholders’ equity increased $49.8 million or 14.9% during fiscal year 2005 primarily resulting from earnings during the period of $75.4 million offset by treasury stock repurchases of $42.3 million. Proceeds and the related tax benefit from the exercise of stock options accounted for the balance of the increase. At the end of fiscal year 2005, our debt-to-total capital ratio stood at 20.4%, down from 26.8% at the end of fiscal year 2004. For the twelve months ended August 31, 2005, return on average stockholders' equity was 21.0% and return on average assets was 13.9%.

 

24

---

 

Liquidity and Sources of Capital

Net cash provided by operating activities increased $25.6 million or 24.3% to $132.3 million in fiscal year 2005 as compared to $106.7 million in fiscal year 2004, primarily as a result of an increase in operating profit before depreciation and amortization and an increase in operating liabilities related to the amount and timing of tax and other liability 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, amortization and stock-based compensation expense 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. We expect free cash flow to approach $50 million for fiscal year 2006.

 

We have an agreement with a group of banks that provides us with a $150.0 million line of credit expiring in July 2010. As of August 31, 2005, our outstanding borrowings under the line of credit were $30.2 million at an effective borrowing rate of 5.11%, as well as $0.7 million in outstanding letters of credit. The amount available under the line of credit as of August 31, 2005, was $119.1 million. We have long-term debt maturing in fiscal year 2006 of $8.9 million. Of this amount, $4.6 million relates to our senior unsecured notes that will be maturing in August 2006, and is classified as long-term because we intend to utilize amounts available under our line of credit to fund this obligation. 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 and other planned capital expenditures, 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 for additional information regarding our long-term debt.

 

On April 7, 2005, our Board of Directors approved an increase in the amount available under our share repurchase program from $60.0 million to $150.0 million and extended the program through August 31, 2006. Pursuant to this program, the Company acquired 1.3 million shares at an average price of $31.48 for a total cost of $42.3 million during fiscal year 2005. As of August 31, 2005, we had $107.7 million available under the program.

We opened 37 newly constructed Partner Drive-Ins and sold a net of one drive-in to franchisees during fiscal year 2005. We funded total capital additions for fiscal year 2005 of $85.9 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 capital expenditures, from cash generated by operating activities and borrowings under our line of credit. During fiscal year 2005, we purchased the real estate for 31 of the 41 newly constructed and acquired drive-ins. Sales of real estate relating to drive-ins previously sold to franchisees are a component of cash from investing activities and totaled $1.3 million during fiscal year 2005 compared to $8.8 million during fiscal year 2004.

Subsequent to August 31, 2005, the Company acquired 15 Franchise Drive-Ins for $13.9 million, excluding any post-closing adjustments. The Company also continued to repurchase shares of stock under the share repurchase program, purchasing an additional 1.4 million shares for $40.0 million. The total remaining amount authorized for repurchase as of November 10, 2005 was $67.6 million. These cash outlays also led to additional advances under the available line of credit, with the total amount outstanding at November 10, 2005 of $63.0 million, an increase of $32.9 million over the balance at August 31, 2005.

We plan capital expenditures of approximately $75 to $80 million in fiscal year 2006, excluding potential 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 and point-of-sale system upgrades, and enhancements to existing financial and operating information systems. We expect to fund these capital expenditures through cash flow from operations and borrowings under our existing line of credit.

 

25

---

 

As of August 31, 2005, our total cash balance of $6.4 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.

 

Off-Balance Sheet Arrangements

The Company has obligations for guarantees on certain franchisee loans and lease agreements. See Note 15 of the Notes to Consolidated Financial Statements for additional information about these guarantees. The Company has no other off-balance sheet financings.

 

Contractual Obligations and Commitments

In the normal course of business, Sonic enters into purchase contracts, lease agreements and borrowing arrangements. Our commitments and obligations as of August 31, 2005 are summarized in the following table:

 

Payments Due by Period

(In Thousands)
		Total			Less than			1 - 3			3 - 5			More than
					1 Year			Years			Years			5 Years
Contractual Obligations
Long-term debt		$	60,195		$	4,261		$	9,461		$	42,199		$	4,274
Capital leases			58,960			4,960			9,522			9,547			34,931

Operating leases			154,782			9,722			19,056			18,515			107,489
Total		$	273,937		$	18,943		$	38,039		$	70,261		$	146,694

 

Impact of Inflation

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.

Seasonality

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.

Critical Accounting Policies and Estimates

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.

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), the following policies involve a higher degree of risk, judgment and/or complexity.

 

26

---

 

Impairment of Long-Lived Assets .   We review each Partner Drive-In for impairment when events or circumstances indicate it might be impaired. We test for impairment using historical cash flows and other relevant facts and circumstances as the primary basis for our estimates of future cash flows. 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 .   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 neither employees of Sonic nor 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.”

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 royalties to Sonic each month based on a percentage of actual net sales. However, the royalty payments and supporting financial statements are not due until the 20 ^th of the following month. As a result, we accrue royalty revenue in the month earned based on estimates of Franchise Drive-Ins 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 estimate certain components of our provision for income taxes. These estimates include, among other items, depreciation and amortization expense allowable for tax purposes, allowable tax credits for items such as wages paid to certain employees, effective rates for state and local income taxes and the tax deductibility of certain other items.

Our estimates are based on the best available information at the time that we prepare the provision, including legislative and judicial developments. We generally file our annual income tax returns several months after our fiscal year end. Income tax returns are subject to audit by federal, state and local governments, typically several years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws. Adjustments to these estimates or returns can result in significant variability in the tax rate from period to period.

27

---

Forward-looking Statements

 

This annual report 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 the following important economic and competitive factors, among others, could cause the actual results to differ materially from those in the forward-looking statements made in this report and from time to time in news releases, reports, proxy statements, registration statements, and other written or electronic communication, as well as verbal forward-looking statements made from time to time by representatives of the Company. Factors that may cause actual results to differ materially from forward-looking statements include, without limitation, risks of the restaurant industry, including risks of and publicity surrounding food-borne illnesses, a highly competitive industry and the impact of changes in consumer spending patterns, consumer tastes, local, regional, and national economic conditions, weather, demographic trends, traffic patterns, employee availability, increases in utility costs, and cost increases or shortages in raw food products. In addition, the opening and success of new drive-ins will depend on various factors, including weather, strikes, the availability of suitable sites for new drive-ins, the negotiation of acceptable lease or purchase terms for new locations, local 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. For these reasons, you should not place undue reliance on forward-looking statements. We undertake no obligation to publicly update or revise them.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

We are exposed to market risk from changes in interest rates on debt and notes receivable, as well as changes in commodity prices.

Our exposure to interest rate risk currently consists of our senior notes, outstanding line of credit, and notes receivable. The senior notes bear interest at fixed rates which average 6.8%. The aggregate balance outstanding under the senior notes as of August 31, 2005 was $24.4 million. Should interest rates increase or decrease, the estimated fair value of these notes would decrease or increase, respectively. As of August 31, 2005, the estimated fair value of the senior notes exceeded the carrying amount by approximately $0.6 million. The line of credit bears interest at a rate benchmarked to U.S. and European short-term interest rates. The balance outstanding under the line of credit was $30.2 million as of August 31, 2005. The impact on our results of operations of a one-point interest rate change on the average outstanding balance under the line of credit during fiscal year 2005 would be approximately $0.1 million. We have made certain loans to our franchisees totaling $3.5 million as of August 31, 2005. The interest rates on these notes are generally between 6.0% and 10.5%. We believe the fair market value of these notes approximates their carrying amount.

The Company and its franchisees purchase certain commodities such as beef, potatoes, chicken and dairy products. These commodities are generally purchased based upon market prices established with vendors. These purchase arrangements may contain contractual features that limit the price paid by establishing price floors or caps; however, we have not made any long-term commitments to purchase any minimum quantities under these arrangements. We do not use financial instruments to hedge commodity prices because these purchase agreements help control the ultimate cost and any commodity price aberrations are generally short term in nature.

This market risk discussion contains forward-looking statements. Actual results may differ materially from this discussion based upon general market conditions and changes in financial markets.

28

---

Item 8. Financial Statements and Supplementary Data

The Company has included the financial statements and supplementary financial information required by this item immediately following Part IV of this report and hereby incorporates by reference the relevant portions of those statements and information into this Item 8.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

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 the 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.

Management's Report on Internal Control over Financial Reporting

 

 The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

 

           The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of August 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of August 31, 2005, the Company’s internal control over financial reporting is effective based on those criteria.

 

           The Company’s independent registered public accounting firm has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting. This report appears on the following page.

 

29

---

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of

Sonic Corp.

 

 

        We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Sonic Corp. maintained effective internal control over financial reporting as of August 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Sonic Corp.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

        We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

        A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

        Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

        In our opinion, management’s assessment that Sonic Corp. maintained effective internal control over financial reporting as of August 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Sonic Corp. maintained, in all material respects, effective internal control over financial reporting as of August 31, 2005, based on   the COSO criteria .  

 

        We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Sonic Corp. as of August 31, 2005 and 2004, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended August 31, 2005 of Sonic Corp. and our report dated November 10, 2005 expressed an unqualified opinion thereon.

 

 

	ERNST & YOUNG LLP
Oklahoma City, Oklahoma
November 10, 2005

 

30

---

Item 9B. Other Information

No information was required to be disclosed in a Form 8-K during the Company’s fourth quarter of its 2005 fiscal year which was not reported.

PART III

Item 10. Directors and Executive Officers of the Company

 

Sonic has adopted a Code of Ethics for Financial Officers and a Code of Business Conduct and Ethics that applies to all directors, officers and employees.  Sonic has posted copies of these codes on the investor section of its internet website at the internet address: http://www.sonicdrivein.com. 

 

Information regarding Sonic’s executive officers is set forth under Item 4A of Part I of this report. The other information required by this item is incorporated by reference from the definitive proxy statement which Sonic will file with the Securities and Exchange Commission no later than 120 days after August 31, 2005 (the “Proxy Statement”), under the captions “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance.”

Item 11. Executive Compensation

The information required by this item is incorporated by reference from the Proxy Statement under the caption “Executive Compensation.”

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by this item is incorporated by reference from the Proxy Statement under the caption “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

Item 13. Certain Relationships and Related Transactions

The information required by this item is incorporated by reference from the Proxy Statement under the caption “Certain Relationships and Related Transactions.”

Item 14. Principal Accounting Fees and Services

The information required by this item is incorporated by reference from the Proxy Statement under the caption “Ratification of Independent Registered Public Accounting Firm.”

31

---

PART IV

Item 15. Exhibits and Financial Statement Schedules

Financial Statements

The following consolidated financial statements of the Company appear immediately following this Item 15:

	Pages
Report of Independent Registered Public Accounting Firm	F-1
Consolidated Balance Sheets at August 31, 2005 and 2004	F-2
Consolidated Statements of Income for each of the three years
in the period ended August 31, 2005	F-4
Consolidated Statements of Stockholders’ Equity for each of the three years
in the period ended August 31, 2005	F-5
Consolidated Statements of Cash Flows for each of the three years
in the period ended August 31, 2005	F-6
Notes to Consolidated Financial Statements	F-8

 

 Financial Statement Schedules

 

The Company has included the following schedule immediately following this Item 15:

		Pages
Schedule II         -	Valuation and Qualifying Accounts	F-30

 

The Company has omitted all other schedules because the conditions requiring their filing do not exist or because the required information appears in Sonic’s Consolidated Financial Statements, including the notes to those statements.

Exhibits

The Company has filed the exhibits listed below with this report. The Company has marked all management contracts and compensatory plans or arrangements with an asterisk (*).

3.01.   Certificate of Incorporation of the Company, which the Company hereby incorporates by reference from Exhibit 3.1 to the Company’s Form S-1 Registration Statement No. 33-37158.

3.02.   Bylaws of the Company, which the Company hereby incorporates by reference from Exhibit 3.2 to the Company’s Form S-1 Registration Statement No. 33-37158.

3.03.   Certificate of Designations of Series A Junior Preferred Stock, which the Company hereby incorporates by reference from Exhibit 99.1 to the Company’s Form 8-K filed on June 17, 1997.

3.04.   Rights Agreement, which the Company hereby incorporates by reference from Exhibit 99.1 to the Company’s Form 8-K filed on June 17, 1997.

3.05.   First Amendment to Rights Agreement dated January 28, 2003, which the Company hereby incorporates by reference from Exhibit 99.1 to the Company’s Form 8-K filed January 29, 2003.

 

 

32

---

3.06.   Second Amendment to Rights Agreement dated January 7, 2005, which the Company hereby incorporates by reference from Exhibit 4 to the Company’s Form 8-K filed January 7, 2005.

3.07.   Certificate of Amendment of Certificate of Incorporation of the Company, March 4, 1996, which the Company hereby incorporates by reference from Exhibit 3.05 to the Company’s Form 10-K for the fiscal year ended August 31, 2000.

3.08.   Certificate of Amendment of Certificate of Incorporation of the Company, January 22, 2002, which the Company hereby incorporates by reference from Exhibit 3.06 to the Company’s Form 10-K for the fiscal year ended August 31, 2002.

 

4.01.   Specimen Certificate for Common Stock, which the Company hereby incorporates by reference from Exhibit 4.01 to the Company’s Form 10-K for the fiscal year ended August 31, 1999.

4.02.   Specimen Certificate for Rights, which the Company hereby incorporates by reference from Exhibit 99.1 to the Company’s Form 8-K filed on June 17, 1997.

10.01.   Form of Sonic Industries Inc. License Agreement (the Number 4 License Agreement), which the Company hereby incorporates by reference from Exhibit 10.1 to the Company’s Form S-1 Registration Statement No. 33-37158.

10.02.   Form of Sonic Industries Inc. License Agreement (the Number 5 License Agreement), which the Company hereby incorporates by reference from Exhibit 10.2 to the Company’s Form S-1 Registration Statement No. 33-37158.

10.03.   Form of Sonic Industries Inc. License Agreement (the Number 4.2 License Agreement and Number 5.1 License Agreement), which the Company hereby incorporates by reference from Exhibit 10.03 to Sonic’s Form 10-K for the fiscal year ended August 31, 1994.

10.04.   Form of Sonic Industries Inc. License Agreement (the Number 6 License Agreement), which the Company hereby incorporates by reference from Exhibit 10.04 to the Company’s Form 10-K for the fiscal year ended August 31, 1994.

10.05.   Form of Sonic Industries Inc. License Agreement (the Number 6A License Agreement), which the Company hereby incorporates by reference from Exhibit 10.05 to the Company’s Form 10-K for the fiscal year ended August 31, 1998.

10.06.   Form of Sonic Industries Inc. License Agreement (the Number 5.2 License Agreement), which the Company hereby incorporates by reference from Exhibit 10.06 to the Company’s Form 10-K for the fiscal year ended August 31, 1998.

10.07.   Form of Sonic Industries Inc. License Agreement (the Number 6NT License Agreement) , which the Company hereby incorporates by reference from Exhibit 10.07 to the Company’s Form 10-K for the fiscal year ended August 31, 2004.

10.08.   Form of Sonic Industries Inc. Area Development Agreement, which the Company hereby incorporates by reference from Exhibit 10.05 to the Company’s Form 10-K for the fiscal year ended August 31, 1995.

10.09.   Form of Sonic Industries Inc. Sign Lease Agreement, which the Company hereby incorporates by reference from Exhibit 10.4 to the Company’s Form S-1 Registration Statement No. 33-37158.

10.10.   Form of General Partnership Agreement, Limited Liability Company Operating Agreement and Master Agreement, which the Company hereby incorporates by reference from Exhibit 10.09 to the Company’s Form 10-K for fiscal year ended August 31, 2003.

 

 

33

---

10.11.   1991 Sonic Corp. Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.5 to the Company’s Form S-1 Registration Statement No. 33-37158. ^*

10.12.   1991 Sonic Corp. Stock Purchase Plan, which the Company hereby incorporates by reference from Exhibit 10.6 to the Company’s Form S-1 Registration Statement No. 33-37158. ^*

10.13.   1991 Sonic Corp. Directors’ Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.08 to the Company’s Form 10-K for the fiscal year ended August 31, 1991. ^*

10.14.   Sonic Corp. Savings and Profit Sharing Plan, which the Company hereby incorporates by reference from Exhibit 10.8 to the Company’s Form S-1 Registration Statement No. 33-37158. ^*

10.15.   Net Revenue Incentive Plan, which the Company hereby incorporates by reference from Exhibit 10.19 to the Company’s Form S-1 Registration Statement No. 33-37158. ^*

10.16.   Form of Indemnification Agreement for Directors, which the Company hereby incorporates by reference from Exhibit 10.7 to the Company’s Form S-1 Registration Statement No. 33-37158. ^*

10.17.   Form of Indemnification Agreement for Officers, which the Company hereby incorporates by reference from Exhibit 10.14 to the Company’s Form 10-K for the fiscal year ended August 31, 1995. ^*

10.18.   Employment Agreement with J. Clifford Hudson dated August 20, 1996, which the Company hereby incorporates by reference from Exhibit 10.18 to the Company’s Form 10-K for the fiscal year ended August 31, 2002. ^*

10.19.   Employment Agreement with Ronald L. Matlock dated August 20, 1996, which the Company hereby incorporates by reference from Exhibit 10.20 to the Company’s Form 10-K for the fiscal year ended August 31, 2002. ^*

10.20.   Employment Agreement with W. Scott McLain dated January 27, 1998, which the Company hereby incorporates by reference from Exhibit 10.21 to the Company’s Form 10-K for the fiscal year ended August 31, 2002. ^*

10.21.   Employment Agreement with Michael A. Perry dated August 20, 2003, which the Company hereby incorporates by reference from Exhibit 10.22 to the Company’s Form 10-K for the fiscal year ended August 31, 2003. ^*

10.22.   Employment Agreement with Stephen C. Vaughan dated August 20, 1996, which the Company hereby incorporates by reference from Exhibit 10.23 to the Company’s Form 10-K for the fiscal year ended August 31, 2002. ^*

10.23.   Employment Agreement with Terry D. Harryman dated January 19, 2000, which the Company hereby incorporates by reference from Exhibit 10.24 to the Company’s Form 10-K for the fiscal year ended August 31, 2002. ^*

10.24.   Employment Agreement with Carolyn C. Cummins dated April 29, 2004, which the Company hereby incorporates by reference from Exhibit 10.25 to the Company’s Form 10-K for the fiscal year ended August 31, 2004. ^*

10.25.   Employment Agreement with Renee G. Shaffer dated April 7, 2005. ^*

10.26.   Employment Agreement with V. Todd Townsend dated August 18, 2005. ^*

10.27.   Consulting Agreement with Pattye L. Moore dated September 10, 2004, which the Company hereby incorporates by reference from Exhibit 10.26 to the Company’s Form 10-K for the fiscal year ended August 31, 2004 .   ^*

 

 

34

---

10.28.   Credit Agreement with Bank of America, N.A., dated April 23, 2003 which the Company hereby incorporates by reference from Exhibit 10.27 to the Company’s Form 10-K for the fiscal year ended August 31, 2004.