Annual Report

It em 1A.  Risk Factors

 

This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances may not occur.  Investors should not place undue reliance on the forward-looking statements, which speak only as of the date of this report.  These forward-looking statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties.  Our actual future results and trends may differ materially depending on a variety of factors including, but not limited to, the risks and uncertainties discussed below.  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, except as may be required by law.

 

Events reported in the media, such as incidents involving food-borne illnesses or food tampering, whether or not accurate, can cause damage to our reputation and rapidly affect sales and profitability.

 

Reports, whether true or not, of food-borne illnesses, such as e-coli, avian flu, bovine spongiform encephalopathy (commonly known as mad cow disease), hepatitis A or salmonella, and injuries caused by food tampering have in the past severely injured the reputations of participants in the restaurant industry and could in the future affect us.  The potential for terrorism of our nation’s food supply also exists and, if such an event occurs, it could have a negative impact on our brand’s reputation and could severely hurt sales, revenues, and profits.

 

 Our brand’s reputation is an important asset to the business; as a result, anything that damages our brand’s reputation could immediately and severely hurt sales, revenues, and profits.  If customers become ill from food-borne illnesses or food tampering, we could also be forced to temporarily close some, or all, Sonic Drive-Ins.  In addition, instances of food-borne illnesses or food tampering occurring at the restaurants of competitors could, by resulting in negative publicity about the restaurant industry, adversely affect our sales on a local, regional, or

 

national basis.  A decrease in customer traffic as a result of these health concerns or negative publicity, or as a result of a temporary closure of any Sonic Drive-Ins, could materially harm our brand, sales, and profitability.

The restaurant industry is highly competitive, and that competition could lower our revenues, margins, and market share.

 

The restaurant industry is intensely competitive with respect to price, service, location, personnel, dietary trends, including nutritional content of quick-service foods, and quality of food, and is often affected by changes in consumer tastes and preferences, economic conditions, population, and traffic patterns.  We compete with international, regional and local restaurants, some of which operate more restaurants and have greater financial resources.  We compete primarily through the quality, price, variety, and value of food products offered. Other key competitive factors include the number and location of restaurants, quality and speed of service, attractiveness of facilities, effectiveness of advertising and marketing programs, and new product development by us and our competitors.  Some of our competitors have substantially larger marketing budgets, which may provide them with a competitive advantage.  In addition, our system competes within the quick-service restaurant industry not only for customers but also for management and hourly employees, suitable real estate sites, and qualified franchisees.

 

Changing dietary preferences may cause consumers to avoid our products in favor of alternative foods.

 

The restaurant industry is affected by consumer preferences and perceptions.  Although we monitor these changing preferences and strive to adapt to meet changing consumer needs, growth of our brand and, ultimately, system-wide sales depend on the sustained demand for our products.  If dietary preferences and perceptions cause consumers to avoid certain products offered by Sonic Drive-Ins in favor of different foods, demand for our products may be reduced, and our business could be harmed.

 

Our earnings and business growth strategy depends in large part on the success of our franchisees, who exercise independent control of their businesses.

 

We have significantly increased the percentage of restaurants owned and operated by our franchisees.  A portion of our earnings comes from royalties, rents and other amounts paid by our franchisees.  Franchisees are independent contractors, and their employees are not our employees.  We provide training and support to, and monitor the operations of, our franchisees, but the quality of their drive-in operations may be diminished by any number of factors beyond our control.  Franchisees may not successfully operate drive-ins in a manner consistent with our high standards and requirements, and franchisees may not hire and train qualified managers and other restaurant personnel.  Any operational shortcoming of a Franchise Drive-In is likely to be attributed by consumers to the entire Sonic brand, thus damaging our reputation and potentially affecting revenues and profitability.

 

Changes in economic, market and other conditions could adversely affect Sonic and its franchisees, and thereby Sonic’s operating results.

 

The quick-service restaurant industry is affected by changes in economic conditions, consumer tastes and preferences and spending patterns, demographic trends, consumer perceptions of food safety, weather, traffic patterns, the type, number and location of competing restaurants, and the effects of war or terrorist activities and any governmental responses thereto.  Factors such as interest rates, inflation, gasoline prices, food costs, labor and benefit costs, legal claims, and the availability of management and hourly employees also affect restaurant operations and administrative expenses.  Economic conditions, including interest rates and other government policies impacting land and construction costs and the cost and availability of borrowed funds, affect our ability and our franchisees’ ability to finance new restaurant development, improvements and additions to existing restaurants, and the acquisition of restaurants from, and sale of restaurants to, franchisees.  Inflation can cause increased food, labor and benefits costs and can increase our operating expenses.  As operating expenses increase, we recover increased costs by increasing menu prices, to the extent permitted by competition, or by implementing alternative products or cost reduction procedures.  We cannot ensure, however, that we will be able to recover increases in operating expenses in this manner.

 

Our financial results may fluctuate depending on various factors, many of which are beyond our control.

 

Our sales and operating results can vary from quarter to quarter and year to year depending on various factors, many of which are beyond our control.  Certain events and factors may directly and immediately decrease demand for our products.  If customer demand decreases rapidly, our results of operations would also decline precipitously.  These events and factors include:

 

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variations in the timing and volume of Sonic Drive-Ins’ sales;

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sales promotions by Sonic and its competitors;

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changes in average same-store sales and customer visits;

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variations in the price, availability and shipping costs of supplies such as food products;

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seasonal effects on demand for Sonic’s products;

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unexpected slowdowns in new drive-in development efforts;

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changes in competitive and economic conditions generally including increases in energy costs;

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changes in the cost or availability of ingredients or labor;

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weather and other acts of God; and

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changes in the number of franchise agreement renewals.

Our profitability may be adversely affected by increases in energy costs.

Our success depends in part on our ability to absorb increases in energy costs.  Various regions of the United States in which we operate multiple drive-ins have experienced in the recent past significant increases in energy prices.  If these increases occur again, they would have an adverse effect on our profitability.

 

Shortages or interruptions in the supply or delivery of perishable food products or rapid price increases could adversely affect our operating results.

 

  We are dependent on frequent deliveries of perishable food products that meet certain specifications.  Shortages or interruptions in the supply of perishable food products may be caused by unanticipated demand, problems in production or distribution, acts of terrorism, financial or other difficulties of suppliers, disease or food-borne illnesses, inclement weather or other conditions.  We purchase large quantities of food and supplies, which can be subject to significant price fluctuations due to seasonal shifts, climate conditions, industry demand, energy costs, changes in international commodity markets and other factors.  These shortages or rapid price increases could adversely affect the availability, quality and cost of ingredients, which would likely lower revenues and reduce our profitability.

 

Failure to successfully implement our growth strategy could reduce, or reduce the growth of, our revenue and net income.

 

We plan to increase the number of Sonic Drive-Ins, but may not be able to achieve our growth objectives, and any new drive-ins may not be profitable.  The opening and success of drive-ins depend on various factors, including:

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competition from other restaurants in current and future markets;

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the degree of saturation in existing markets;

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consumer interest in the Sonic brand;

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the identification and availability of suitable and economically viable locations;

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sales levels at existing drive-ins;

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the negotiation of acceptable lease or purchase terms for new locations;

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permitting and regulatory compliance;

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the cost and availability of construction resources;

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the ability to meet construction schedules;

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the availability of qualified franchisees and their financial and other development capabilities;the cost and availability of and delays in financing;

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the ability to hire and train qualified management personnel;

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weather; and

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general economic and business conditions.

 

If we are unable to open as many new drive-ins as planned, if the drive-ins are less profitable than anticipated or if we are otherwise unable to successfully implement our growth strategy, revenue and profitability may grow more slowly or even decrease.

 

Our outstanding and future leverage could have an effect on our operations.

 

On December 20, 2006, the Company closed on a securitized financing facility comprised of a $600 million fixed rate term loan and a $200 million variable rate revolving credit facility.  As of August 31, 2009, we had $ 511 million in outstanding debt under the fixed rate note at an interest rate of 5.7% and $ 187.3 million outstanding under the variable rate note at an interest rate of 1.4%.

 

Our increased leverage could have the following consequences:

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We may be more vulnerable in the event of deterioration in our business, in the restaurant industry or in the economy generally.  In addition, we may be limited in our flexibility in planning for or reacting to changes in our business and the industry in which we operate.

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We may be required to dedicate a substantial portion of our cash flow to the payment of interest on our indebtedness, which could reduce the amount of funds available for operations or development of new Partner Drive-Ins and thus place us at a competitive disadvantage as compared with competitors that are less leveraged.

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From time to time, we may engage in various capital markets, bank credit and other financing activities to meet our cash requirements.  We may have difficulty obtaining additional financing at economically acceptable interest rates.

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Our existing and future debt obligations may contain certain negative covenants including limitations on liens, consolidations and mergers, indebtedness, capital expenditures, asset dispositions, sale-leaseback transactions, stock repurchases and transactions with affiliates, which may reduce our flexibility in responding to changing business and economic conditions.

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Our debt obligations are subject to customary rapid amortization events and events of default.  Although management does not anticipate an event of default or any other event of noncompliance with the provisions of the notes, if such an event occurred, the unpaid amounts outstanding could become immediately due and payable.

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The third-party insurance company that provides credit enhancements in the form of financial guaranties of our fixed and variable rate note payments has been the subject of credit rating downgrades by Standard & Poor’s and Moody’s, which ratings were CC and Caa2, respectively, at October 29, 2009.  We are unable to determine whether additional downgrades may occur and what impact prior downgrades have had or additional downgrades would have on our insurer’s financial condition.  If the insurance company were to become the subject of insolvency or similar proceedings, our lenders would not be required to fund additional advances on our variable rate notes.  In addition, an event of default would occur if: (i) the insurance company were to become the subject of insolvency or similar proceedings and (ii) the insurance policy were not continued or sold to a third party (who would assume the insurance company’s obligations under the policy), but instead were terminated or canceled as a result of those proceedings. In an event of default, all unpaid amounts under the fixed and variable rate notes could become immediately due and payable only at the direction or consent of holders with a majority of the outstanding principal.  Such acceleration of our debt could have a material adverse effect on our liquidity if we were unable to negotiate mutually acceptable new terms with our lenders or if alternate funding were not available to us.

 

Sonic Drive-Ins are subject to health, employment, environmental and other government regulations, and failure to comply with existing or future government regulations could expose us to litigation, damage to our reputation and lower profits.

 

Sonic and its franchisees are subject to various federal, state and local laws affecting their businesses.  The successful development and operation of restaurants depends to a significant extent on the selection and acquisition of suitable sites, which are subject to zoning, land use (including the placement of drive-thru windows), environmental (including litter), traffic and other regulations.  More stringent requirements of local and state governmental bodies with respect to zoning, land use and environmental factors could delay, prevent or make cost prohibitive the continuing operations of an existing restaurant or the development of new restaurants in particular locations.  Restaurant operations are also subject to licensing and regulation by state and local departments relating to health, food preparation, sanitation and safety standards, federal and state labor and immigration laws (including applicable minimum wage requirements, overtime, working and safety conditions and work authorization requirements), federal and state laws prohibiting discrimination and other laws regulating the design and operation of facilities, such as the Americans with Disabilities Act.  If we fail to comply with any of these laws, we may be subject to governmental action or litigation, and our reputation could be accordingly harmed.  Injury to our reputation would, in turn, likely reduce revenues and profits.

 

In recent years, there has been an increased legislative, regulatory and consumer focus on nutrition and advertising practices in the food industry, particularly among restaurants.  As a result, we may become subject to regulatory initiatives in the area of nutritional content, disclosure or advertising, such as requirements to provide information about the nutritional content of our food products, which could increase expenses.  The operation of our franchise system is also subject to franchise laws and regulations enacted by a number of states and rules promulgated by the U.S. Federal Trade Commission.  Any future legislation regulating franchise relationships may negatively affect our operations, particularly our relationship with our franchisees.  Failure to comply with new or

 

existing franchise laws and regulations in any jurisdiction or to obtain required government approvals could result in a ban or temporary suspension on future franchise sales.  Changes in applicable accounting rules imposed by governmental regulators or private governing bodies could also affect our reported results of operations.

 

We are subject to the Fair Labor Standards Act, which governs such matters as minimum wage, overtime and other working conditions, along with the Americans with Disabilities Act, various family leave mandates and a variety of other laws enacted, or rules and regulations promulgated, by federal, state and local governmental authorities that govern these and other employment matters.  We have experienced and expect further increases in payroll expenses as a result of government-mandated increases in the minimum wage, and although such increases are not expected to be material, there may be material increases in the future.  Enactment and enforcement of various federal, state and local laws, rules and regulations on immigration and labor organizations may adversely impact the availability and costs of labor for our restaurants in a particular area or across the United States.  In addition, our vendors may be affected by higher minimum wage standards or availability of labor, which may increase the price of goods and services they supply to us.

Litigation from customers, franchisees, employees and others could harm our reputation and impact operating results.

 

Claims of illness or injury relating to food content, food quality or food handling are common in the quick-service restaurant industry.  In addition, class action lawsuits have been filed, and may continue to be filed, against various quick-service restaurants alleging, among other things, that quick-service restaurants have failed to disclose the health risks associated with foods we serve and that quick-service restaurants’ marketing practices have encouraged obesity and other health issues.  In addition to decreasing our sales and profitability and diverting management resources, adverse publicity or a substantial judgment against us could negatively impact our reputation, hindering the ability to attract and retain qualified franchisees and grow the business.

 

Further, we may be subject to employee, franchisee and other claims in the future based on, among other things, discrimination, harassment, wrongful termination and wage, rest break and meal break issues, including those relating to overtime compensation.

 

We may not be able to adequately protect our intellectual property, which could decrease the value of our brand and products.

 

The success of our business depends on the continued ability to use existing trademarks, service marks and other components of our brand in order to increase brand awareness and further develop branded products.  All of the steps we have taken to protect our intellectual property may not be adequate.

 

Our reputation and business could be materially harmed as a result of data breaches.

 

Unauthorized intrusion into portions of our computer systems or those of our franchisees that process and store information related to customer transactions may result in the theft of customer data.  We rely on proprietary and commercially available systems, software, tools and monitoring to provide security for processing, transmission and storage of confidential customer information, such as payment card and personal information.  Further, the systems currently used for transmission and approval of payment card transactions, and the technology utilized in payment cards themselves, all of which can put payment card data at risk, are determined and legally mandated by payment card industry standards, not by us.  Improper activities by third-parties, advances in computer and software capabilities and encryption technology, new tools and discoveries and other events or developments may facilitate or result in a compromise or breach of our or our franchisees’ computer systems.  Any such compromises or breaches could cause interruptions in our operations and damage to our reputation, subject us to costs and liabilities and hurt sales, revenues and profits.

 

Disruptions in the financial markets may adversely impact the availability and cost of credit and consumer spending patterns.

 

The disruptions to the financial markets and continuing economic downturn have adversely impacted the availability of credit already arranged and the availability and cost of credit in the future.  The disruptions in the financial markets also had an adverse effect on the economy, which has negatively impacted consumer spending patterns.  There can be no assurance that various governmental responses to the disruptions in the financial markets will restore consumer confidence, stabilize the markets or increase liquidity or the availability of credit.

 

Ownership and leasing of significant amounts of real estate exposes us to possible liabilities and losses.

 

We own or lease the land and building for all Partner Drive-Ins.  Accordingly, we are subject to all of the risks associated with owning and leasing real estate.  In particular, the value of our assets could decrease and our costs could increase because of changes in the investment climate for real estate, demographic trends and supply or demand for the use of our drive-ins, which may result from competition from similar restaurants in the area, as well as liability for environmental conditions.  We generally cannot cancel the leases, so if an existing or future Sonic Drive-In is not profitable, and we decide to close it, we may nonetheless be committed to perform our obligations under the applicable lease including, among other things, paying the base rent for the balance of the lease term.  In addition, as each of the leases expires, we may fail to negotiate renewals, either on commercially acceptable terms or at all, which could cause us to close drive-ins in desirable locations.

 

Catastrophic events may disrupt our business.

 

Unforeseen events, or the prospect of such events, including war, terrorism and other international conflicts, public health issues including health epidemics or pandemics, and natural disasters such as hurricanes, earthquakes, or other adverse weather and climate conditions, whether occurring in the United States or abroad, could disrupt our operations, disrupt the operations of franchisees, suppliers or customers, or result in political or economic instability.  These events could reduce demand for our products or make it difficult or impossible to receive products from suppliers.