Sonic 2007 Annual Report Download - page 26

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. Adjustments to these estimates or returns can result in significant variability in the tax
rate from period to period.
Leases. Certain Partner Drive-Ins lease land and buildings 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 provisions of certain 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.
Quantitative and Qualitative Disclosures About Market Risk
Sonic’s use of debt directly exposes the company to interest rate risk. Floating rate debt,
where the interest rate fluctuates periodically, exposes the company to short-term changes in
market interest rates. Fixed rate debt, where the interest rate is fixed over the life of the
instrument, exposes the company to changes in market interest rates reflected in the fair value
of the debt and to the risk that the company may need to refinance maturing debt with new
debt at a higher rate. Sonic is also exposed to market risk from changes in commodity prices.
Sonic does not utilize financial instruments for trading purposes. Sonic manages its debt
portfolio to achieve an overall desired position of fixed and floating rates and may employ
interest rate swaps as a tool to achieve that goal in the future.
Interest Rate Risk. At the time the company filed its Form 10-K for the year ended
August 31, 2006, the company had refinanced the debt outstanding as of year-end with
variable rate debt and had borrowed additional amounts for the tender offer. The market risk
disclosure for the prior year therefore addressed interest rate risk based upon $486 million of
variable rate debt. Our exposure to interest rate risk at August 31, 2007, is primarily based on
the fixed rate Class A-2 notes with an effective rate of 5.7%, before amortization of debt-
related costs. At August 31, 2007, the fair value of the Class A-2 notes was estimated at $591.7
million versus carrying value of $594.4 million (including accrued interest). Differences
between fair value versus carrying value are attributable to interest rate increases subsequent
to when the debt was originally issued. Should interest rates increase or decrease by one
percentage point, the estimated fair value of the Class A-2 notes would decrease by
approximately $21.9 million or increase by approximately $22.9 million, respectively. The Class
A-1 notes outstanding at August 31, 2007, totaled $116.0 million, with a variable rate of 6.4%.
The annual impact on our results of operations of a one-point interest rate change for the
balance outstanding at year-end would be approximately $1.2 million before tax. We have
made certain loans to our franchisees totaling $6.2 million as of August 31, 2007. The interest
rates on these notes are generally between 5.0% and 10.5%. We believe the fair market value
of these notes approximates their carrying amount.
Commodity Price Risk. The company and its franchisees purchase certain commodities
such as beef, potatoes, chicken and dairy products. These commodities are generally
purchased based upon market prices established with vendors. These purchase arrangements
may contain contractual features that limit the price paid by establishing price floors or caps;
however, we have not made any long-term commitments to purchase any minimum quantities
under these arrangements. We do not use financial instruments to hedge commodity prices
because these purchase agreements help control the ultimate cost.
This market risk discussion contains forward-looking statements. Actual results may
differ materially from this discussion based upon general market conditions and changes in
financial markets.
Pg. 24
Sonic Corp. 2007 Annual Report
Management’s Discussion and Analysis of Financial Condition and Results of Operations