Between 1998 and 2008, you may have noticed that Sonic drive-thrus didn’t change much. The same remote ordering technology. The same burgers. The same items. Prices that might have increased here and there. But nothing meaningful you could point to and say, “This is different than it was ten years ago.”
That was not a coincidence.
In 1998, Sonic was earning $30 million per year in total profits and had $100 million in debt. That was a slightly better than average balance sheet for a fast food operator.
At that point, the management team decided that it would use its retained earnings and begun a massive borrowing program to reduce share count from 95 million in 1998 to 60 million in 2008.
The problem? That $500 million in additional debt, for the sole purpose of repurchasing stock, cost 5% in interest and the share repurchases occurred at an average price of $23.27 between 1998 and 2008. That was a stunningly terrible use of shareholder resources.
When I say that, I am not relying on the hindsight bias that the stock fell to $5 during the Great Recession in 2009. Instead, I am basing my conclusion on the information that was perfectly available in the late 1990s and drove Sonic to repurchase the stock in the first place. Even in 2002, Sonic was delivering no earnings growth except for the stock buyback. The stock was trading at 40x earnings. The management team should have known that repurchasing gigantic blocks of the stock was foolish. In what world is it sensical to pay 5% to retire stock in a no-growth asset selling for at least twice its intrinsic value?
And this has caused long-range problems to this day. Warren Buffett had a joke that, for every business he has ever valued, the assets may or may not be overstated, but the liabilities have always been rock solid.
With Sonic, there is currently $700 in debt on the balance sheet. About $500 million of that is attribute to the buybacks that occurred over a decade ago.
What does Sonic have to show for it? Profits in the $1.35-$1.55 range, up a bit from the $1 per share in 2007 earnings. That may sound mediocre but not disastrous, but you must remember that the profit engine is $63 million per year. The $700 debt burden is a leverage rate of more than ten-fold. As a result, the average stock price in 2018 has been $24.57, barely a budge above the $23.27 price that Sonic was paying to repurchase its stock a generation ago.
Sonic does not pose a bankruptcy risk because almost none of its debt is due prior to 2023, it has refinanced some of the debt to bring the blended rate down to 4.5%, but the balance sheet remains a mess. I cannot evaluate it as an investment.The owners could do very well in the future, but I put in my too hard pile. Many of the same executives that made the poor stock repurchase decision are still running the firm today, so I move on. Maybe it makes sense when it trades at $5 per share in a deep recession if you knowledge that the debt isn’t due for 5+ years so the bankruptcy risk is limited, but outside of that scenario, Sonic provides limited usefulness to investors outside of providing the lesson that the purchase price at which corporations buy back shares actually matters.