The restaurant business has been in a tough spot recently. The sector is heavily influenced by job growth, which has barely been enough to keep up with the population growth over the last several months.
The fourth quarter of 2014 also saw rising commodity prices, which increased costs at the same time consumers pulled back on spending.
The combination of these factors contributed to some hefty corrections within the small-cap segment of this group at the end of the first quarter.
However, despite some of these problems, we are interested in a few hidden gems within the restaurant sector that look oversold. Some of these firms are hovering at values where we expect to see buyers step back in, which includes the companies themselves as they deploy massive cash reserves in continued buyback programs.
One of the stocks we like the best in the sector is Sonic Corporation (NASDAQ:SONC). We expect three key factors to work in their favor.
- Small-cap stocks should begin attracting investment now that support has been reconfirmed.
- Discounts in the first quarter (due to higher costs in last year’s fourth quarter) have been over-priced.
- Although slow, improvement in employment continues in a positive direction.
Like the Russell 2000 small-cap index, SONC is at a support level following a first-quarter correction. In SONC’s case, the correction began late in the quarter following its earnings report on March 25. The issue that SONC faced at the time had nothing to do with a lack of same-store sales, missed earnings expectations or a decline in revenue — the numbers were all green in those categories.
The real problem that SONC faced was a rich valuation. The company is growing so investors have implied a premium on the stock’s value. That seems perfectly reasonable to us. A common comparison between the value for SONC and McDonald’s Corporation (NYSE:MCD) is unfair, as MCD is shrinking rather than growing. A growing stock should have higher multiples to account for better present value of future earnings.
However, when a sector rallies in the face of rising costs (regardless of growth), it’s not uncommon for investors in the aggregate to sell because of “myopic loss aversion.” This is a behavioral factor that helps explain why growing companies will sell off following good news while the broader indexes are stuck in a channel.
Investors feel more pain when they think about the possibility of giving up their unrealized gains than they feel good about the potential for further profits — so they sell.
This is not just an issue during market channels, but it tends to get worse during those periods. Technicians, however, see this as a catalyst for buying opportunities. Profit-takers drove the stock down excessively just as they drove it up in the prior quarter in spite of rising costs.
We believe the stock hit support and more aggressive buyers can move back in.
As you can see in the chart, SONC fell from $36 to support at $30 per share following its top- and bottom-line surprises in March. This coincides with the gap higher on the unbelievably good report in January. The chart also includes the Tecrium Wheat Fund (NYSEARCA:WEAT) below, so you can see the lagged reaction that SONC had to rising input costs.
We should note that most animal products have not fallen much since the rally last year, but, on average, they haven’t moved higher either. Put together, input costs have fallen on average. We think that this will provide support for SONC at this price level and should send the stock back up to its March highs later this year.
While the company shouldn’t be considered a “market timer,” SONC’s board and management team are executing a buyback program, which they say will be ongoing through the coming quarter. Growth has brought an influx of cash that can’t be completely absorbed through the current growth and marketing plans.
Buybacks at this level will have a greater effect than they would have through most of the first quarter when the stock’s price was higher.
What if Consumers Have Gas Pains?
That was a terrible joke, but we feel that the risk is quite real. Although SONC’s management denies that lower gas prices affected sales growth very much last year (attributing it to marketing instead), it seems likely that lower gas prices still helped give the company a boost. Many retail/restaurant stocks in the small cap sector are exposed to declining growth rates if gasoline prices rise again.
Rising gas prices can be offset by rising wages, increased growth, technological improvements and capturing market-share, but SONC can’t control all those factors completely. If gains in employment and wages do not materialize like we believe, then rising gasoline prices will continue to put pressure on SONC through 2015 and stunt its potential despite buybacks and growth.
The Bottom Line
Although the broader small-cap indexes are still stuck in a channel, we believe that growth investors will start moving in to pick up stocks that have been oversold off their highs in the first quarter. We like SONC because its growth rates have been high on both top and bottom lines, which should be very attractive for early buyers.
We expect the stock to return to its March highs in the near term. However, if gasoline prices continue to spike without a similar move higher in wages/jobs, then we would recommend a more cautious outlook.
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