Sonic Restaurants: Does Its Drive-In Business Model Limit Future Growth Potential?

Company Background In 1953 Troy Smith founded the Top Hat in Oklahoma, a restaurant where customers parked their cars and walked up to the root beer stand to order. On a trip to Louisiana a year later, Smith noticed that similar drive-in restaurants used speakers for ordering. Convinced the speakers would be a game changer, Smith implemented the same system at the Top Hat, marking out parking spots for customers and using carhops on roller skates to deliver the orders. The new business model was a hit. Sales tripled instantly, which caught the attention of entrepreneur Charles Pappe, and together he and Smith began franchising in the region. As the name “Top Hat” had already been trademarked, they changed the company’s name to Sonic, a play on its slogan, “Service with the Speed of Sound.”1 Over the next few decades, the company expanded from small towns in Oklahoma to Kansas, New Mexico, Missouri, and Arkansas. From 1967 to 1978, Sonic grew from 41 drive-ins to 1,000. After a change in leadership in 1984, the company sought to redevelop  markets that had not been successful in the past. Using a new advertising campaign that featured the talents of singer/actor Frankie Avalon, Sonic quickly became a household name. In 1991, Sonic became a publicly traded company on the NASDAQ. After the IPO the company renegotiated its current franchise agreements and opened 100–150 new drive-ins per year. By 1998, the company had more than 1,700 restaurants, and decided to redesign them with a new, chic “retro-future” look that became the standard Sonic image. For its 50th anniversary in 2003 Sonic re-introduced classic items such as Pickleo’s, inaugurating a decade of remarkable growth. During this period Sonic opened its 3,000th drive-in in Shawnee, Oklahoma, then its 3,500th drive-in outside Chicago. The company regularly posted increases in net income and revenues, and increased the efficiency of its process by introducing card readers in the car stalls in its parking lots. However, the 2008 recession hit the company hard, and plans to expand into new markets like Alaska were put on hold. Nevertheless, the company recorded steady growth every year since then, and recently announced plans to add 1,000 new drive-ins by 2024.

Strategic Direction

Sonic Corporation envisioned becoming “America’s most loved restaurant brand” by fulfilling America’s nostalgia for drive-in restaurants. Its very successful niche was drive in fast food: hot dogs, hamburgers, sandwiches, lemonade, handmade milk shakes, and shaved ice ordered over speakers and delivered by roller-skating carhops so that customers did not have to leave their cars. Its unique, low cost, drive-up, eat-in-your-car model was designed to be highly customizable and adaptable to indoor dining for cold weather climates, and to a smaller footprint for more developed urban environments. In recent years, the company shifted its innovative focus to developing exciting menu items, products, and processes that were ahead of its competitors, offering customizable drinks, an evolving menu, and a slice of American nostalgia. Yet that model presented challenges. Sonic’s main objective over its 60-year history was growth. New stores were added through franchising, which, simply put, meant opening new stores with other people’s money. One of the largest fast-food brands in America as of 2015, the company envisioned further expansion by opening franchises in small towns across America as well as internationally using a new low cost building format.2 To this end, the company planned to develop some more non-traditional locations, breaking away from its original drive-in concept and shifting to indoor dining while continuing to leverage its fully customizable menu that allowed customers more control over what they ordered than its competitors. However, over the next 10 years Sonic’s goal was to open 1,000 new drive-in restaurants, expanding from its current position of 44 states to all 50 states and establishing an international foothold.

Sonic’s Competitors

Sonic’s competitors in the quick service restaurant sector were always other large fastfood franchises that served breakfast, lunch, and dinner, plus franchised coffeehouses. Its largest competitors by sales were McDonald’s, Subway, Starbucks, Wendy’s, and Burger King. As of 2013, Sonic was tied for sales with Domino’s, although Domino’s had 1,464 more franchise units than Sonic, thus Sonic’s profitability per franchise was 41.6% greater than Domino’s. In terms of franchise unit growth, another important indicator, Sonic’s five largest competitors from 2012–2013 were Subway, Dunkin’ Donuts, Starbucks, Jimmy John’s, and Little Caesars. Traditionally, the two main barriers to entry into the quick service food industry were brand recognition and infrastructure. The brand built around fast-food establishments was developed over time, and sometimes concentrated in particular regions. Sonic built its brand for over 60 years. The cornerstone of Sonic’s branding was its nostalgic carhop/drive-in model, unique in the industry. More recently, the company implemented branding of menu customization options as a differentiator in the market. Many brands such as McDonald’s and Dunkin’ Donuts also built elaborate branding models extending into markets outside the United States. The history and reach of these brands helped to establish an identity in consumers’ eyes. The cost of infrastructure, that is, the technology and real estate required, was the other major barrier to entry in the quick service industry. Implementing systems and acquiring and/or building out real estate was time-consuming and cost-intensive. To succeed, Sonic developed its Point of Personalized Service System, an intricate technological advantage not easily replicable. Common belief was that low-income people ate at fast-food restaurants because they were the most affordable alternative for dining out. However, scientists from the University of California, Davis found that fast-food eatery visits increased proportionately with individuals’ income, stabilizing for those with annual incomes of $60,000; thus, white collar workers were the main purchaser of fast food.3 At the same time, regardless of vows to curtail their more questionable marketing practices, fast-food restaurants stepped up their practice of targeting kids.

Finance

For fiscal year 2015 Sonic’s financial objectives were: ■

■ Positive same-store sales in the low to mid-single digits. ■

■ Net profit margin in the range of 10%–12%. ■

■ Incremental royalty revenue growth from same-store sales improvements, new unit development, and 900 drive-ins converting to a higher royalty rate structure. ■

■ Drive-in-level margin improvement of between 100 to 150 basis points, reflecting an improving outlook for commodity cost inflation and leverage from company drive-in same-store sales growth. Prior to 2015, sales derived from company drive-ins (73%) and franchise drive-ins (27%) (Exhibit 1). In 2014, same-store sales increased 3.5%, an increase of 3.3% at franchise drive-ins plus an increase of 3.5% at company drive-ins. The company’s continued positive same-store sales were a result of successful implementation of initiatives, including product quality improvements, a greater emphasis on personalized service, and a tiered pricing strategy that created a solid foundation for growth. Along with new technology initiatives implemented at drive-in locations during fiscal year 2014, the company continued to focus on key promotional strategies such as increased media effectiveness and its innovative product pipeline to drive same-store sales. Sales increased from $542.6M in fiscal year 2013 to $552.3M in fiscal year 2014, an increase of 1.8%, attributable to a 6% increase in franchise royalties and fees and an increase in company drive-in sales of 0.76% compared to the previous year. Company drive-in margins improved by 90 basis points, reflecting the leverage of positive samestore sales. The cost of company drive-ins decreased to 84.4% for 2014 from 85.3% in 2013, primarily from a reduction in food and packaging expenses and reduced payroll and other employee benefits. Sonic’s net income for fiscal year 2014 was $47.9M or $0.85 per diluted share compared with $36.7M or $0.64 per diluted share for fiscal year 2013, an increase in net income of 31% as compared to the previous year. Net income as a percentage of total sales increased to 9% in 2014 from 7% in 2013.4 As of August 31, 2014, Sonic’s long-term debt was $428M. Sonic’s cash and cash equivalents amounted to just $27.23M as of February 28, 2015, decreasing from $35.69M as of August 31, 2014. Sonic’s cash on hand consisted of highly liquid investments, primarily money market accounts that matured in three months or less from date of purchase, and depository accounts. As indicated above, Sonic’s long-term debt was 15 times its cash on hand as of August 31, 2014. The increase in the company’s long-term debt derived mostly from the company’s strategic expansion across the country and the implementation of its goal of opening 1,000 more Sonic drive-ins over 10 years. The company invested heavily in buildings and improvements, new drive-in equipment, and brand technology development to achieve its long-term expansion goals. The estimated useful life of these investments was calculated as 8–25 years, 5–7 years, and 2–5 years, respectively.13 However, if the company were to face tough times in the future, it could have difficulty repaying its debt.