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SONIC CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview Description of the Business. Sonic operates and franchises the largest chain of drive-in restaurants in the United States. As of August 31, 2014, the Sonic system was comprised of 3,518 drive-ins, of which 11% were Company Drive-Ins and 89% were Franchise Drive-Ins. Sonic's signature food items include specialty drinks (such as cherry limeades and slushes), ice cream desserts, made-to-order sandwiches and hamburgers, a variety of hot dogs including six-inch premium beef hot dogs and footlong quarter pound coneys, hand-battered onion rings, tater tots and wraps. Sonic Drive-Ins also offer breakfast items that include a variety of breakfast burritos and serve the full menu all day. We derive our revenues primarily from Company Drive-In sales and royalties from franchisees. We also receive revenues from leasing real estate to franchisees, franchise fees, earnings from minority investments in franchise operations and other miscellaneous revenues. Costs of Company Drive-In sales relate directly to Company Drive-In sales. Other expenses, such as depreciation, amortization and general and administrative expenses, relate to our franchising operations, as well as Company Drive-In operations. Our revenues and Company Drive-In expenses are directly affected by the number and sales volumes of Company Drive-Ins. Our revenues and, to a lesser extent, selling, general and administrative expenses also are affected by the number and sales volumes of Franchise Drive-Ins. Franchise royalties and franchise fees are directly affected by the number of operating Franchise Drive-Ins and new drive-in openings. Lease revenues are generated by the leasing of land and buildings for Company Drive-Ins that have been sold to franchisees. Overview of Business Performance. System-wide same-store sales increased 3.5% during fiscal year 2014 as compared to an increase of 2.3% for fiscal year 2013. Same-store sales at Company Drive-Ins increased by 3.5% during fiscal year 2014 as compared to an increase of 2.5% for fiscal year 2013. Our continued positive same-store sales are a result of the successful implementation of initiatives, including product quality improvements, a greater emphasis on personalized service and a tiered pricing strategy, that have set a solid foundation for growth. Along with new technology initiatives implemented in Company Drive-Ins during fiscal 2014, we continue to focus on key initiatives such as increased media effectiveness and our innovative product pipeline in supporting our layered day-part promotional strategy to drive same-store sales. All of these initiatives drive Sonic's multi-layered growth strategy, which incorporates same-store sales growth, operating leverage, deployment of cash, an ascending royalty rate and new drive-in development. Positive same-store sales is the most important layer and drives operating leverage and increased operating cash flows. Revenues increased to $552.3 million for fiscal year 2014 from $542.6 million for the same period last year, which was primarily due to an increase in Franchise Drive-In royalties and Company Drive-In sales driven by the growth of same-store sales. Franchising revenues increased $7.2 million during fiscal year 2014, reflecting an increase in royalties primarily related to positive same-store sales of 3.5% at Franchise Drive-Ins. Restaurant margins at Company Drive-Ins improved by 90 basis points during fiscal year 2014, reflecting the leverage of positive same-store sales. Net income and diluted earnings per share for fiscal year 2014 were $47.9 million and $0.85, respectively, as compared to net income of $36.7 million or $0.64 per diluted share for fiscal year 2013. Excluding the nonGAAP adjustments further described below, net income per diluted share was $0.84 for fiscal year 2014, compared to $0.72 per diluted share in fiscal year 2013. 17 -------------------------------------------------------------------------------- Table of Contents The following non-GAAP adjustments are intended to supplement the presentation of the Company's financial results in accordance with GAAP. We believe the exclusion of these items in evaluating the change in net income and diluted earnings per share for the periods below provides useful information to investors and management regarding the underlying business trends and the performance of our ongoing operations and is helpful for period-to-period and company-to-company comparisons, which management believes will assist investors in analyzing the financial results for the Company and predicting future performance. Fiscal year ended Fiscal year ended August 31, 2014 August 31, 2013 Net Diluted Net Diluted Income EPS Income EPS Reported - GAAP $ 47,916 $ 0.85 $ 36,701 $ 0.64 Tax benefit from the IRS' acceptance of a federal tax method change(1) (484) (0.01) - - After-tax loss from early extinguishment of debt(2) - - 2,798 0.05 Retroactive tax benefit of WOTC and resolution of tax matters(3) - - (743) (0.02) After-tax loss on closure of Company Drive-Ins(4) - - 1,510 0.03 After-tax impairment charge for point-of-sale assets(5) - - 1,013 0.02 Adjusted - Non-GAAP $ 47,432 $ 0.84 $ 41,279 $ 0.72 Fiscal year ended Fiscal year ended August 31, 2013 August 31, 2012 Net Diluted Net Diluted Income EPS Income EPS Reported - GAAP $ 36,701 $ 0.64 $ 36,085 $ 0.60 After-tax loss from early extinguishment of debt(2) 2,798 0.05 - - Retroactive tax benefit of WOTC and resolution of tax matters(3) (743) (0.02) - - After-tax loss on closure of Company Drive-Ins(4) 1,510 0.03 - - After-tax impairment charge for point-of-sale assets(5) 1,013 0.02 - - Adjusted - Non-GAAP $ 41,279 $ 0.72 $ 36,085 $ 0.60 --------- (1) Tax benefit resulting from the IRS' acceptance of a federal tax method change during the first quarter of fiscal year 2014. (2) Loss on early extinguishment of debt including $0.5 million and $3.9 million in the second and fourth quarters of fiscal year 2013, respectively. (3) Tax benefit which includes the retroactive reinstatement of the Work Opportunity Tax Credit ("WOTC") and resolution of certain income tax matters during the second quarter of fiscal year 2013. (4) Loss of $2.4 million on the closure of 12 lower-performing Company Drive-Ins as a result of an assessment in advance of capital expenditures for planned technology initiatives. (5) Impairment charge of $1.6 million related to the write-off of assets associated with a change in the vendor for the Sonic system's new point-of-sale technology. 18 -------------------------------------------------------------------------------- Table of Contents The following table provides information regarding the number of Company Drive-Ins and Franchise Drive-Ins operating as of the end of the years indicated as well as the system-wide change in sales and average unit volume. System-wide information includes both Company Drive-In and Franchise Drive-In information, which we believe is useful in analyzing the growth of the brand as well as the Company's revenues, since franchisees pay royalties based on a percentage of sales. System-wide Performance ($ In thousands) Year ended August 31, 2014 2013 2012 Increase in total sales 3.9 % 2.4 % 2.7 % System-wide drive-ins in operation(1): Total at beginning of year 3,522 3,556 3,561 Opened 40 27 37 Closed (net of re-openings) (44) (61) (42) Total at end of year 3,518 3,522 3,556 Average sales per drive-in $ 1,153 $ 1,109 $ 1,066 Change in same-store sales(2) 3.5 % 2.3 % 2.2 % --------- (1) Drive-ins that are temporarily closed for various reasons (repairs, remodeling, relocations, etc.) are not considered closed unless the Company determines that they are unlikely to reopen within a reasonable time. (2) Represents percentage change for drive-ins open for a minimum of 15 months. 19 -------------------------------------------------------------------------------- Table of Contents Results of Operations Revenues. The following table sets forth the components of revenue for the reported periods and the relative change between the comparable periods. Revenues ($ In thousands) Fiscal year ended Percent August 31, Increase Increase 2014 2013 (Decrease) (Decrease) Revenues: Company Drive-In sales $ 405,363 $ 402,296 $ 3,067 0.8 % Franchise Drive-Ins: Franchise royalties 137,125 130,009 7,116 5.5 Franchise fees 1,291 728 563 77.3 Lease revenue 4,291 4,785 (494) (10.3) Other 4,279 4,767 (488) (10.2) Total revenues $ 552,349 $ 542,585 $ 9,764 1.8 % Fiscal year ended Percent August 31, Increase Increase 2013 2012 (Decrease) (Decrease) Revenues: Company Drive-In sales $ 402,296 $ 404,443 $ (2,147) (0.5) % Franchise Drive-Ins: Franchise royalties 130,009 125,989 4,020 3.2 Franchise fees 728 2,024 (1,296) (64.0) Lease revenue 4,785 6,575 (1,790) (27.2) Other 4,767 4,699 68 1.4 Total revenues $ 542,585 $ 543,730 $ (1,145) (0.2) % 20 -------------------------------------------------------------------------------- Table of Contents The following table reflects the changes in sales and same-store sales at Company Drive-Ins. It also presents information about average unit volumes and the number of Company Drive-Ins, which is useful in analyzing the growth of Company Drive-In sales. Company Drive-In Sales ($ In thousands) Fiscal year ended 2014 2013 2012 Company Drive-In sales $ 405,363 $ 402,296 $ 404,443 Percentage increase (decrease) 0.8 % (0.5) % (1.6) % Company Drive-Ins in operation(1): Total at beginning of year 396 409 446 Opened 3 2 1 Acquired from (sold to) franchisees, net (7) 1 (35) Closed (net of re-openings) (1) (16) (3) Total at end of year 391 396 409 Average sales per Company Drive-In $ 1,043 $ 990 $ 958 Change in same-store sales(2) 3.5 % 2.5 % 2.8 % --------- (1) Drive-ins that are temporarily closed for various reasons (repairs, remodeling, relocations, etc.) are not considered closed unless the Company determines that they are unlikely to reopen within a reasonable time. (2) Represents percentage change for drive-ins open for a minimum of 15 months. Same-store sales for Company Drive-Ins increased 3.5% for fiscal year 2014 and 2.5% for fiscal year 2013, showing continued momentum from the Company's successful implementation of initiatives to improve product quality, service and value perception. Furthermore, we continued to focus on our innovative product pipeline and increased media effectiveness while implementing new technology initiatives. Company Drive-In sales increased $3.1 million, or 0.8%, during fiscal year 2014 as compared to fiscal year 2013. This improvement was primarily attributable to an increase of $14.4 million in same-store sales and $2.0 million in incremental sales from new drive-in openings. These increases were partially offset by an $8.9 million sales decrease primarily related to the closure of 12 lower-performing drive-ins on August 31, 2013 and a $4.4 million decrease related to the refranchising of seven drive-ins during the first quarter of fiscal year 2014. For fiscal year 2013, Company Drive-In sales decreased $2.1 million, or 0.5%, as compared to 2012. This decrease was primarily attributable to an $11.3 million reduction in sales from the refranchising of 34 lower-performing drive-ins during the second quarter of fiscal year 2012 and a $2.5 million decrease related to drive-ins that were closed during or subsequent to fiscal year 2012, partially offset by a $10.0 million improvement in same-store sales and $1.7 million of incremental sales from new drive-in openings. 21 -------------------------------------------------------------------------------- Table of Contents The following table reflects the change in franchise sales, the number of Franchise Drive-Ins, average unit volumes and franchising revenues. While we do not record Franchise Drive-In sales as revenues, we believe this information is important in understanding our financial performance since these sales are the basis on which we calculate and record franchise royalties. This information is also indicative of the financial health of our franchisees. Franchise Information ($ In thousands) Year ended August 31, 2014 2013 2012 Franchise Drive-In sales $ 3,627,395 $ 3,479,880 $ 3,386,218 Percentage increase 4.2 % 2.8 % 3.3 % Franchise Drive-Ins in operation(1): Total at beginning of year 3,126 3,147 3,115 Opened 37 25 36 Acquired from (sold to) the Company, net 7 (1) 35 Closed (net of re-openings) (43) (45) (39) Total at end of year 3,127 3,126 3,147 Average sales per Franchise Drive-In $ 1,170 $ 1,125 $ 1,081 Change in same-store sales(2) 3.5 % 2.3 % 2.2 % Franchising revenues(3) $ 142,707 $ 135,522 $ 134,588 Percentage increase (decrease) 5.3 % 0.7 % 2.0 % Effective royalty rate(4) 3.78 % 3.74 % 3.72 % --------- (1) Drive-ins that are temporarily closed for various reasons (repairs, remodeling, relocations, etc.) are not considered closed unless the Company determines that they are unlikely to reopen within a reasonable time. (2) Represents percentage change for drive-ins open for a minimum of 15 months. (3) Consists of revenues derived from franchising activities, including royalties, franchise fees and lease revenues. See Revenue Recognition Related to Franchise Fees and Royalties in the Critical Accounting Policies and Estimates section of Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in this Form 10-K. (4) Represents franchise royalties as a percentage of Franchise Drive-In sales. Same-store sales for Franchise Drive-Ins increased 3.5% for fiscal year 2014 and 2.3% for fiscal year 2013, showing continued momentum from the initiatives we have implemented to improve product quality, service and value perception. Furthermore, we continued to focus on our innovative product pipeline and increased media effectiveness. Franchising revenues increased $7.2 million, or 5.3%, for fiscal year 2014 as compared to fiscal year 2013. The increase in franchising revenues was driven by an increase in franchise royalties primarily attributable to a 3.5% increase in same-store sales and an increase in franchise fees from the increase in Franchise Drive-In openings. Lease revenues decreased compared to the prior year due to a franchisee's purchase during the second quarter of fiscal year 2013 of land and buildings leased or subleased from the Company. The effective royalty rate increased slightly compared to fiscal year 2013 primarily as a result of improved same-store sales. Franchising revenues increased by $0.9 million, or 0.7%, to $135.5 million for fiscal year 2013 as compared to $134.6 million for fiscal year 2012. The increase in franchise revenues was primarily driven by a $4.0 million increase in royalties resulting from same-store sales increases partially offset by various development incentives and certain franchisee restructuring efforts. These royalty increases were also partially offset by a $1.8 million decline in lease revenue due to the franchisee's purchase during the second quarter of fiscal year 2013 of land and buildings leased or subleased from the Company and a $1.3 million decline in franchise fees. 22 -------------------------------------------------------------------------------- Table of Contents Other revenues decreased $0.5 million to $4.3 in fiscal year 2014 and were flat in fiscal year 2013 as compared to the prior year. The decrease in fiscal year 2014 was partially due to changes in income from minority investments in franchise operations. Operating Expenses. The following table presents the overall costs of drive-in operations as a percentage of Company Drive-In sales. Other operating expenses include direct operating costs such as marketing, telephone and utilities, repair and maintenance, rent, property tax and other controllable expenses. Company Drive-In Margins Fiscal year ended August 31, Percentage Points 2014 2013 Increase (Decrease) Costs and expenses: Company Drive-Ins: Food and packaging 28.7 % 28.5 % 0.2 Payroll and other employee benefits 34.5 35.4 (0.9) Other operating expenses 21.2 21.4 (0.2) Cost of Company Drive-In sales 84.4 % 85.3 % (0.9) Fiscal year ended August 31, Percentage Points 2013 2012 Increase (Decrease) Costs and expenses: Company Drive-Ins: Food and packaging 28.5 % 28.1 % 0.4 Payroll and other employee benefits 35.4 35.7 (0.3) Other operating expenses 21.4 22.1 (0.7) Cost of Company Drive-In sales 85.3 % 85.9 % (0.6) Drive-in level margins improved by 90 basis points during fiscal year 2014 reflecting leverage from improved same-store sales and, to a lesser extent, the closure of 12 lower-performing Company Drive-Ins on August 31, 2013. Food and packaging costs were slightly unfavorable by 20 basis points, which primarily resulted from increased costs in beef and dairy that were partially offset by menu price increases in the second half of the fiscal year. Payroll and other employee benefits, as well as other operating expenses, improved 110 basis points mainly as a result of leveraging improved sales and the closure of lower-performing Company Drive-Ins discussed above. Drive-in level margins improved by 60 basis points during fiscal year 2013 reflecting leverage from improved same-store sales and, to a lesser extent, the refranchising of 34 lower-performing Company Drive-Ins during the second quarter of fiscal year 2012. Food and packaging costs were unfavorable by 40 basis points, which primarily resulted from a product mix shift due to summer promotion activity. Payroll and other employee benefits, as well as other operating expenses, improved 100 basis points primarily as a result of leveraging labor with improved sales and the refranchising of the 34 drive-ins discussed above. Selling, General and Administrative ("SG&A"). SG&A expenses increased 5.1% to $69.4 million for fiscal year 2014, and increased 1.3% to $66.0 million during fiscal year 2013 as compared to fiscal year 2012. The increase in SG&A expense for fiscal year 2014 was largely attributable to an increase in salary and benefits as a result of additional headcount in support of the company's technology initiatives and higher variable compensation due to improved operating performance. The increase for fiscal year 2013 was largely attributable to an increase in variable compensation offset by a decline in bad debt expense due to improved sales and profitability at Franchise Drive-Ins. 23 -------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization. Depreciation and amortization expense increased 4.5% to $42.2 million in fiscal year 2014. The increase during fiscal year 2014 was primarily attributable to our increased investment in technology initiatives at Company Drive-Ins partially offset by a franchisee's purchase, during the second fiscal quarter of 2013, of land and buildings previously leased or subleased from the Company. Depreciation and amortization decreased 3.6% to $40.4 million in fiscal year 2013. The decline in fiscal year 2013 was primarily a result of the franchisee's purchase of land and buildings described above. Provision for Impairment of Long-Lived Assets. Provision for impairment of long-lived assets decreased $1.7 million to $0.1 million in fiscal year 2014, compared to $1.8 million for fiscal year 2013 and $0.8 million for 2012. The decrease in fiscal year 2014 was primarily the result of the $1.6 million impairment charge in fiscal year 2013 for the write-off of assets associated with a change in the vendor for the Sonic system's new point-of-sale technology. Other Operating Income and Expense, Net. Fiscal year 2014 reflected $0.2 million in other operating income compared to other operating net expense of $1.9 million for fiscal year 2013 and other operating income of $0.5 million for fiscal year 2012. This $2.1 million change for fiscal year 2014 and $2.4 million change for fiscal year 2013 are both primarily the result of the loss recorded on the closure of 12 lower-performing Company DriveIns at the end of fiscal year 2013. Net Interest Expense. Excluding the item outlined below, net interest expense decreased $3.6 million in fiscal year 2014 and $2.5 million in fiscal year 2013. The decrease in fiscal year 2014 was primarily related to a decline in our weighted-average interest rate attributable to our partial debt refinancing completed in the fourth quarter of fiscal year 2013 and a decline in our long-term debt balance. The decrease in fiscal year 2013 was primarily the result of a decline in our long-term debt balance. Fiscal year 2013 reflects a $4.4 million loss on extinguishment of debt related to our $20.0 million debt prepayment during the second quarter and our $155.0 million partial debt refinancing in the fourth quarter. See "Liquidity and Sources of Capital" and "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" below for additional information on factors that could impact interest expense. Income Taxes. The provision for income taxes reflects an effective tax rate of 35.0% for fiscal year 2014 compared with 34.8% for fiscal year 2013. The slightly higher effective income tax rate for fiscal year 2014 was primarily attributable to legislation that reinstated and extended the Work Opportunity Tax Credit ("WOTC") in fiscal year 2013 but expired in fiscal year 2014. The tax rate for fiscal year 2013 decreased from the fiscal year 2012 rate of 37.7%. This decrease was primarily attributable to the expiration of a state statute of limitations related to an uncertain tax position and legislation that reinstated and extended the WOTC. Our fiscal year 2015 tax rate may vary depending upon the reinstatement of the WOTC, which expired on December 31, 2013, and pending resolution of certain tax matters. Further, our tax rate may continue to vary significantly from quarter to quarter depending on the timing of stock option exercises and dispositions by option holders and as circumstances on other tax matters change. Financial Position Total assets decreased $9.8 million, or 1.5%, to $651.0 million during fiscal year 2014 from $660.8 million at the end of fiscal year 2013. The decrease during the year was primarily attributable to a decline in cash of $42.2 million and current-year depreciation of $42.2 million. These declines were partially offset by $79.0 million in property and equipment additions (largely technology). Total liabilities increased $5.0 million to $588.3 million during fiscal year 2014 from $583.3 million at the end of fiscal year 2013. The increase was primarily attributable to the $4.9 million dividend declared in August 2014 and payable in November 2014. Total stockholders' equity decreased $14.8 million, or 19.1%, to $62.7 million during fiscal year 2014 from $77.5 million at the end of fiscal year 2013. This decrease was primarily attributable to $80.0 million in purchases of common stock under our stock repurchase program and was partially offset by current-year earnings of $47.9 million and $17.4 million from the issuance of stock related to stock option exercises during fiscal year 2014. 24 -------------------------------------------------------------------------------- Table of Contents Liquidity and Sources of Capital Operating Cash Flows. Net cash provided by operating activities increased $15.7 million to $103.5 million for fiscal year 2014 as compared to $87.8 million in fiscal year 2013. This increase primarily resulted from the receipt of federal income tax refunds of $9.2 million and lower income tax payments for fiscal year 2014 as compared to fiscal year 2013, mainly attributable to the timing of estimated payments along with an $11.2 million increase in net income. These increases were partially offset by a $4.4 million decrease due to the fiscal year 2013 loss from the early extinguishment of debt. Investing Cash Flows. Cash used in investing activities increased $69.3 million to $70.5 million for fiscal year 2014 compared to $1.2 million for fiscal year 2013. During fiscal year 2014, we used $79.0 million of cash for investments in property and equipment as outlined in the table below. The following table sets forth the components of our investments in property and equipment for fiscal year 2014 (in millions): Replacement equipment and technology for existing drive-ins $ 59.8 Rebuilds, relocations, remodels and retrofits of existing drive-ins 5.1 Brand technology investments 5.1 Newly constructed Company Drive-Ins 4.5 Newly constructed drive-ins leased to franchisees 3.2 Acquisition of underlying real estate for drive-ins 1.3 Total purchases of property and equipment $ 79.0 These purchases increased $37.7 million compared to the same period last year, mostly related to our increased investments in technology. Additionally, proceeds from the sale of assets declined $31.3 million primarily related to proceeds from a franchisee's purchase, during the second quarter of fiscal year 2013, of land and buildings previously leased or subleased from the Company. Financing Cash Flows. Net cash used in financing activities increased $13.8 million to $75.2 million for fiscal year 2014 as compared to $61.4 million in fiscal year 2013. This increase primarily relates to a $43.2 million increase in purchases of treasury stock, partially offset by a $24.5 million decrease in debt payments and a $5.0 million decrease in debt issuance and extinguishment costs during fiscal year 2014. In the second quarter of fiscal year 2013, we made a debt prepayment, at par, of $20.0 million on our Series 2011-1 Senior Secured Fixed Rate Notes, Class A-2 ("2011 Fixed Rate Notes"). In the fourth quarter of fiscal year 2013, in a private transaction we refinanced $155 million of the 2011 Fixed Rate Notes with the issuance of $155 million of Series 2013-1 Senior Secured Fixed Rate Notes, Class A-2 (the "2013 Fixed Rate Notes"), which bear interest at 3.75% per annum. The 2013 Fixed Rate Notes have an expected life of seven years, interest payable monthly, with no scheduled principal amortization. As a result, mandatory debt payments have decreased from $15.0 million to $9.8 million per year. Additionally, in the fourth quarter of fiscal year 2013, we extended the renewal date of our Series 2011-1 Senior Secured Variable Funding Notes, Class A-1 ("2011 Variable Funding Notes") by two years to May 2018 and decreased the base spread from 3.75% to 3.50%. At August 31, 2014, the balance outstanding under the 2011 Fixed Rate Notes and the 2013 Fixed Rate Notes, including accrued interest, totaled $282.6 million and $155.2 million, respectively, and there was no outstanding balance under our 2011 Variable Funding Notes. The weighted-average interest cost of the 2011 Fixed Rate Notes and 2013 Fixed Rate Notes was 5.7% and was 4.1%, respectively. The weighted-average interest cost includes the effect of the loan origination costs. In fiscal year 2013, the debt prepayment and the partial debt refinancing resulted in a pro-rata write-off of loan origination costs from the 2011 Fixed Rate Notes, representing a majority of the $4.4 million loss which is reflected in "Net loss from early extinguishment of debt" on the Consolidated Statements of Income. An additional $4.1 million in debt origination costs were capitalized in conjunction with the 2013 Fixed Rate Notes. Loan costs are being amortized over each note's expected life. The amount of loan costs expected to be amortized over the next 25 -------------------------------------------------------------------------------- Table of Contents 12 months is reflected in "Other current assets" on the Consolidated Balance Sheets. For additional information on our 2011 Notes and 2013 Fixed Rate Notes, see note 10 - Debt, included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. In October 2011, our Board of Directors approved a $30 million share repurchase program. Under that program, we were authorized to purchase up to $30 million of our outstanding shares of common stock through August 31, 2012. During fiscal year 2012, the Company completed this share repurchase program. In August 2012, our Board of Directors approved a $40 million share repurchase program. Under that program, we were authorized to purchase up to $40 million of our outstanding shares of common stock through August 31, 2013. In January 2013, the Board of Directors increased the purchase authorization to $55 million. During fiscal year 2013, we completed this share repurchase program. In August 2013, the Board of Directors extended the share repurchase program, authorizing us to purchase up to $40 million of our outstanding shares of common stock. In January 2014, our Board of Directors approved an incremental $40 million authorization for this program that allowed for up to $80 million of common stock to be repurchased through August 31, 2014. As part of this program, in February 2014, we entered into an accelerated share repurchase ("ASR") agreement with a financial institution to purchase $40 million of our common stock. In exchange for a $40 million up-front payment, the financial institution delivered approximately 2.1 million shares. During March 2014, the ASR purchase period concluded with no additional shares delivered, resulting in an average price per share of $19.13. We reflected the ASR transaction as a repurchase of common stock for purposes of calculating earnings per share and as a forward contract indexed to its own common stock. The forward contract met all of the applicable criteria for equity classification. The Company completed the Board-approved share repurchase program during fiscal year 2014, with approximately 4.1 million shares repurchased, resulting in an average price per share of $19.61. In August 2014, our Board of Directors further extended our share repurchase program, authorizing us to purchase up to $105 million of our outstanding shares of common stock during fiscal year 2015. Share repurchases will be made from time to time in the open market or otherwise, including through an accelerated share repurchase program, under the terms of a Rule 10b5-1 plan, in privately negotiated transactions or in round lot or block transactions. The share repurchase program may be extended, modified, suspended or discontinued at any time. We plan to fund the share repurchase program from existing cash on hand at August 31, 2014, cash flows from operations and borrowings under our 2011 Variable Funding Notes. As of August 31, 2014, our total cash balance of $55.6 million ($35.7 million of unrestricted and $19.9 million of restricted cash balances) reflected the impact of the cash generated from operating activities, cash used for share repurchases, debt prepayment and capital expenditures mentioned above. We believe that existing cash, funds generated from operations and the $100 million available under our 2011 Variable Funding Notes will meet our needs for the foreseeable future. The Company did not pay any cash dividends on its common stock during its two most recent fiscal years. However, in August 2014, the Board of Directors initiated a cash dividend program under which the Company will pay a regular quarterly cash dividend. The Board declared the first quarterly cash dividend of $0.09 per share of common stock to be paid to stockholders of record as of the close of business on November 12, 2014, with a payment date of November 21, 2014. The total dividend payable at August 31, 2014 was $4.9 million and is included in accrued liabilities in the consolidated balance sheet. Future declaration of quarterly dividends and the establishment of future record and payment dates are subject to the final determination of the Company's Board of Directors. Off-Balance Sheet Arrangements The Company has obligations for guarantees on certain franchisee loans, which in the aggregate are immaterial, and obligations for guarantees on certain franchisee lease agreements. Other than such guarantees and 26 -------------------------------------------------------------------------------- Table of Contents various operating leases and purchase obligations, which are disclosed below in "Contractual Obligations and Commitments" and in note 7 - Leases and note 15 - Commitments and Contingencies to our Consolidated Financial Statements, the Company has no other material off-balance sheet arrangements. Contractual Obligations and Commitments In the normal course of business, Sonic enters into purchase contracts, lease agreements and borrowing arrangements. The following table presents our commitments and obligations as of August 31, 2014 (in thousands): Payments Due by Fiscal Year More than Less than 1 - 3 3 - 5 5 Years 1 Year Years Years (2020 and Total (2015) (2016-2017) (2018-2019) thereafter) Contractual Obligations Long-term debt(1) $ 526,895 $ 31,198 $ 60,756 $ 274,774 $ 160,167 Capital leases 35,096 5,149 9,585 7,563 12,799 Operating leases 124,971 11,274 20,446 17,642 75,609 Purchase obligations(2) 307,997 29,050 44,435 47,338 187,174 Other(3) 18,008 - - - - Total $ 1,012,967 $ 76,671 $ 135,222 $ 347,317 $ 435,749 ---- (1) Includes scheduled principal and interest payments on our 2011 Fixed Rate Notes and 2013 Fixed Rate Notes and assumes these notes will be outstanding for the expected seven-year life with an anticipated repayment date in May 2018 and July 2020, respectively. (2) Purchase obligations primarily relate to the Company's estimated share of system-wide commitments to purchase food products. We have excluded agreements that are cancelable without penalty. These amounts require estimates and could vary due to the timing of volumes and changes in market pricing. (3) Includes $2.5 million of unrecognized tax benefits related to uncertain tax positions and $15.5 million related to guarantees of franchisee leases and loan agreements. As we are not able to reasonably estimate the timing or amount of these payments, if any, the related balances have not been reflected in the "Payments Due by Fiscal Year" section of the table. Impact of Inflation We are impacted by inflation which has caused increases in our food, labor and benefits costs and has increased our operating expenses. To the extent permitted by competition, increased costs are recovered through a combination of menu price increases and alternative products or processes, or by implementing other cost reduction procedures. 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 perform a periodic review of 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 the following significant accounting policies and estimates involve a high degree of risk, judgment and/or complexity. Accounting for Long-Lived Assets. We review Company Drive-In assets for impairment when events or circumstances indicate they 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 us 27 -------------------------------------------------------------------------------- Table of Contents to estimate fair values of our drive-ins by making assumptions regarding future cash flows and other factors. It is reasonably possible that our estimates of future cash flows could change resulting in the need to write down to fair value certain Company Drive-In assets. We assess the recoverability of goodwill at least annually and more frequently if events or changes in circumstances occur indicating that the carrying amount of goodwill may not be recoverable or as a result of allocating goodwill to Company Drive-Ins that are sold. Since the Company is one reporting unit, we identify potential goodwill impairment by comparing the fair value of the Company to its carrying value. The fair value of the Company is determined using a market approach. If the carrying value of the Company exceeds fair value, a comparison of the fair value of goodwill against the carrying value of goodwill is made to determine whether goodwill has been impaired. During the fourth quarter of fiscal year 2014, we performed our annual assessment of recoverability of goodwill and determined that no impairment was indicated. As of the impairment testing date, the fair value of the Company significantly exceeded the carrying value. As of August 31, 2014, the Company had $77.1 million of goodwill. Revenue Recognition Related to Franchise Fees and Royalties. Franchise fees are recognized in income when we have substantially performed or satisfied all material services or conditions relating to the sale of the franchise and the fees are nonrefundable. 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 franchise fees and 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 pay royalties based on a percentage of sales. Royalties are recognized as revenue when they are earned. Accounting for Stock-Based Compensation. We estimate the fair value of options granted using the Black-Scholes option pricing model along with the assumptions shown in note 13 - Stockholders' Equity in the Notes to the Consolidated Financial Statements in this Form 10-K. The assumptions used in computing the fair value of stock-based payments reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. We estimate expected volatility based on historical daily price changes of the Company's stock for a period equal to the current expected term of the options. The expected option term is the number of years the Company estimates that options will be outstanding prior to exercise considering vesting schedules and our historical exercise patterns. If other assumptions or estimates had been used, the stock-based compensation expense that was recorded could have been materially different. Furthermore, if different assumptions are used in future periods, stock-based compensation expense could be materially impacted. 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. Although we believe we have adequately accounted for our uncertain tax positions, from time to time, audits result in proposed assessments where the ultimate resolution may give rise to us owing additional taxes. We adjust our uncertain tax positions until they are resolved in light of changing facts and circumstances, such as the completion of a tax audit, expiration of a statute of limitations, the refinement of an estimate, and penalty and interest accruals associated with uncertain tax positions. We believe that our tax positions comply with applicable tax law and that we have adequately provided for these matters. However, to the extent that the final tax outcome of these matters is different from the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. 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. 28 -------------------------------------------------------------------------------- Table of Contents Adjustments to these estimates or returns can result in significant variability in the tax rate from period to period. Leases. We lease the land and buildings for certain Company Drive-Ins from third parties. Rent expense for operating leases is recognized on a straight-line basis over the expected lease term, including cancelable option periods when it is deemed to be reasonably assured that we would incur an economic penalty for not exercising the options. Judgment is required to determine options expected to be exercised. Within the terms of some of our leases, there are rent holidays and/or escalations in payments over the base lease term, as well as renewal periods. The effects of the rent holidays and escalations are reflected in rent expense on a straight-line basis over the expected lease term, including cancelable option periods when appropriate. The lease term commences on the date when we have the right to control the use of lease property, which can occur before rent payments are due under the terms of the lease. Contingent rent is generally based on sales levels and is accrued at the point in time we determine that it is probable that such sales levels will be achieved. Accounts and Notes Receivable. We charge interest on past due accounts receivable and recognize income as it is collected. Interest accrues on notes receivable based on the contractual terms of the respective notes. We monitor all accounts and notes receivable for delinquency and provide for estimated losses for specific receivables that are not likely to be collected. We assess credit risk for accounts and notes receivable of specific franchisees based on payment history, current payment patterns, the health of the franchisee's business, and an assessment of the franchisee's ability to pay outstanding balances. In addition to allowances for bad debt for specific franchisee receivables, a general provision for bad debt is estimated for accounts receivable based on historical trends. Account balances generally are charged against the allowance when we believe it is probable that the receivable will not be recovered and legal remedies have been exhausted. We continually review our allowance for doubtful accounts. |