Sonic and Darden Offer Enticing Long-Term Prospects

A Thomson Reuters analysis of casual dining businesses Sonic and Darden reveal the businesses offer enticing long-term investment prospects.

PRESS RELEASE

As summer arrives, casual dining stocks like Sonic and Darden offer some intriguing long-term prospects, even though their short-term outlooks may vary.

Investing in the restaurant sector during summer can be tricky. As one highly-rated analyst recently noted, warm, dry summer weekends tend to drive potential patrons to fire up their own home grills instead of hopping in the car to head out to eat, “cannibalizing” business at the likes of Darden Restaurants Inc. (DRI.N). Nonetheless, an examination of two companies catering to those customers who do choose to abandon their grills seems to suggest that both appear to be undervalued at their current prices, even though only one of them – Sonic Corp. (SONC.O) – currently offers an obviously appetizing combination of robust growth in same-store sales and higher earnings.

Certainly, Sonic, a drive-in restaurant that is part of the Quick Service sub-sector, has the most appealing combination of ingredients: while the company has boosted its same-store sales forecasts, analysts have responded by boosting their outlook for earnings. That’s typical for this part of the industry, which, in contrast to Darden and the casual dining sub-sector, tends to feel less impact from the “home grilling” phenomenon. Since the beginning of June, 12 of the 14 analysts covering the stock have raised their earnings per share estimates for the company’s third quarter, which ended May 31. That isn’t surprising, given that Sonic pre-released same-store sales (SSS) of 3.7% for its fiscal third quarter, smashing the forecast by analysts polled by Thomson Reuters that those sales would remain flat over the same quarter in 2011. The reason for the unexpected surge in SSS, Clifford Hudson, Sonic’s chairman and CEO, said in a press release, comes down to a combination of service, product quality and marketing initiatives. In spite of some economic headwinds and what he referred to as “some restaurant-level cost challenges”, Hudson said the company remains confident about its ability to drive sales higher still.

In response to this news of the stronger-than-expected SSS, analysts raised their earnings projections to a mean consensus forecast of 22 cents a share; one highly-rated analyst boosted his estimate to 22 cents from 19 cents. And those upward revisions may not be at an end: the StarMine Analyst Revision Model (ARM) indicate that analysts are likely to continue boosting their earnings forecasts as the quarter progresses. Sonic can boast a StarMine ARM score of 99, which places it at the top of the top decile of all US companies with respect to this measure of change in the way analysts perceive the outlook for the company. The higher a company’s ARM, the more top-ranked analysts have been boosting their earnings forecasts and the greater the likelihood that they will continue to do so.

Moreover, there are indications that Sonic’s share price may not fully reflect those improved expectations; on a relative value basis, it may seem cheap to some investors. The stock is currently trading at 14 times forward 12-month earnings. That’s an apparent bargain when the valuation is compared to the company’s trailing 12-month price earnings ratio – 16 times earnings – and its 10-year median of 17.7 times earnings.

Exhibit 1. Sonic relative valuation model history

Source: Thomson Reuters StarMine Professional.

While Sonic’s sales are booming, those at Darden Restaurants appear to be flagging. The multi-brand restaurant operator is one of the few eateries in our Restaurant universe scheduled to report its fourth quarter earnings later this month, on June 25, and analysts have been cutting their estimates over the last few months, with some trimming a dime or more from their forecasts. One five-star rated analyst issued a Bold Estimate of $1.08: such a Bold Estimate, published by a top-tier analyst and differing significantly from the mean, often signals a major opportunity for investors or highlights a downside risk, as an analyst with a track record for timeliness and accuracy is willing to stick his or her neck out and break with the pack.

The seasonal trend to just stay home and throw some hamburgers and steaks on the grill rather than dining out is one of the factors that weighed on Darden’s same-store sales for the fourth quarter of 2012, ended May 31. Analysts polled by Thomson Reuters believe its SSS will grow only 1.1% in this period; a mediocre performance, especially when compared to the healthier 2.2% advance in same-store sales Darden recorded in the fourth quarter ended May 2011.

Analysts expect the casual dining industry’s sales and profits to stabilize in the fall, as the warm weekends draw to an end and prospective diners feel the urge to eat out once more, providing a boost to Darden as well as its rivals. Indeed, analysts believe that Darden’s same-store sales will grow by 1.6% during the second quarter (ending November 30). Meanwhile, there are some factors that make even Darden, with its underwhelming same-store sales and the prospect of an earnings disappointment, attractive to investors looking for a bargain today. Higher earnings may be in the offing further down the road, analysts’ forecasts suggest. (See Exhibit 2, below, for details of their forecasts for the next four quarters.) In light of those forecasts, Darden, like Sonic, may be undervalued: it currently trades at 12.7 times forward 12-month earnings per share. That makes it look like a bargain when set against its trailing 12-month valuation of 14.4 times earnings and the 10-year median of 13.3 times earnings. The StarMine Smart Holdings (SH) model, which gauges the level of buying interest on the part of institutional investors, suggests another reason Darden may be attracting investor attention right now. This model, which evaluates what kinds of securities find most favor with investors right now, screens for several kinds of factors, including profitability and earnings quality. Darden earns a high score of 78 on the SH model, signaling that it offers investors many of the fundamental characteristics that fund managers currently value, based on the kinds of stocks they are adding to their portfolios.

Source: Thomson Reuters StarMine Professional.

While restaurant chains like Sonic and Darden brace themselves for a summer in which their patrons will dine in rather than out in order to take advantage of the fine weather, this marks an opportunity for investors to scrutinize these companies’ fundamentals and evaluate their longer-term prospects.