Description
J. Alexander's Corporation. 10% Owner Financial, I Fidelity National bought 346,105 shares on 9-24-2012 at $ 14.5
BUSINESS OVERVIEW
J. Alexander’s Corporation (the “Company” or “J. Alexander’s”) was organized in 1971 and, as of January 1, 2012, operated as a proprietary concept 33 J. Alexander’s full-service, casual dining restaurants located in Alabama, Arizona, Colorado, Florida, Georgia, Illinois, Kansas, Kentucky, Louisiana, Michigan, Ohio, Tennessee and Texas. J. Alexander’s is a traditional restaurant with an American menu featuring prime rib of beef; hardwood-grilled steaks, seafood and chicken; pasta; salads and soups; assorted sandwiches, appetizers and desserts; and a full-service bar.
Unless the context requires otherwise, all references to the Company include J. Alexander’s Corporation and its subsidiaries.
RESTAURANT OPERATIONS
General. J. Alexander’s is a quality casual dining restaurant with a contemporary American menu. J. Alexander’s strategy is to provide a broad range of high-quality menu items that are intended to appeal to a wide range of consumer tastes and which are served by a courteous, friendly and well-trained service staff. The Company believes that quality food, outstanding service, attractive ambiance and value are critical to the success of J. Alexander’s.
Each restaurant is generally open from 11:00 a.m. to 11:00 p.m. Monday through Thursday, 11:00 a.m. to 12:00 midnight on Friday and Saturday, and 11:00 a.m. to 10:00 p.m. on Sunday. Entrees available at lunch and dinner generally range in price from $9.00 to $33.00. The Company estimates that the average check per customer for fiscal 2011, including alcoholic beverages, was $26.87. J. Alexander’s net sales during fiscal 2011 were $157,175,000, of which alcoholic beverage sales accounted for 17.0%.
Menu. Emphasis on quality is present throughout the entire J. Alexander’s menu, which is designed to appeal to a wide variety of tastes. The menu features prime rib of beef; hardwood-grilled steaks, seafood and chicken; pasta; salads and soups; and assorted sandwiches, appetizers and desserts. As a part of the Company’s commitment to quality, soups, sauces, salsa, salad dressings and desserts are made daily from scratch; fresh steaks, chicken and seafood are grilled over genuine hardwood; and all steaks are U.S.D.A. midwestern, corn-fed choice beef or higher, with a targeted aging of 24 to 41 days.
Guest Service. Management believes that prompt, courteous and efficient service is an integral part of the J. Alexander’s concept. The management staff of each restaurant are referred to as “coaches” and the other employees as “champions”. The Company seeks to hire coaches who are committed to the principle that quality products and service are key factors to success in the restaurant industry. Each J. Alexander’s restaurant typically employs three to five fully-trained concept coaches and one or two kitchen coaches. Many of the coaches have previous experience in full-service restaurants and all complete an intensive J. Alexander’s development program, generally lasting for 19 weeks, involving all aspects of restaurant operations.
Each J. Alexander’s restaurant employs approximately 30 to 50 service personnel, 20 to 25 kitchen employees, eight to ten hosts or hostesses and six to eight pubkeeps. The Company places significant emphasis on its initial training program. Management believes J. Alexander’s restaurants have a low table to server ratio compared to many other casual dining restaurants, which allows its servers to provide better, more attentive service. The Company is committed to employee empowerment, and each member of the service staff is authorized to provide complimentary food in the event that a guest has an unsatisfactory dining experience or the food quality is not up to the Company’s standards. Further, all members of the service staff are trained to know the Company’s product specifications and to alert management of any potential problems.
Quality Assurance. A key position in each J. Alexander’s restaurant is the quality control coordinator. This position is staffed by a coach who inspects each plate of food before it is served to a guest. The Company believes that this product inspection by a member of management is a significant factor in maintaining consistent, high food quality in its restaurants.
Another important component of the quality assurance system is the preparation of taste plates. Certain menu items are taste-tested daily by a coach to ensure that only the highest quality, properly prepared food meeting the Company’s specifications is served in the restaurant. The Company also uses a service evaluation program to monitor service staff performance, food quality and guest satisfaction.
Restaurant Design and Site Selection. The J. Alexander’s restaurants are generally free-standing structures that typically contain approximately 7,000 to 8,000 square feet with seating for an average of approximately 220 guests. The restaurants’ interiors are designed to provide an upscale ambiance and feature an open kitchen. The Company has used a variety of interior and exterior finishes and materials in its building designs which are intended to provide a high level of curb appeal as well as a comfortable dining experience.
The design of J. Alexander’s restaurant exteriors has evolved through the years. Several of the Company’s newer restaurants feature a patio complemented by an exposed fire pit, designed to enhance the guests’ overall dining experience. The Company’s restaurants opened from 2001 through 2003 in Boca Raton, Florida, Atlanta, Georgia and Northbrook, Illinois utilize a Wrightian architectural style featuring a high central-barreled roof and exposed structural steel system over an open, symmetrical floor plan. Angled window wall projections from the dining room provide a focus into the interior and create an anchor for the building. A garden seating area for waiting is provided by the patio and open trellis adjacent to the entrance, integrating the building into the adjacent landscape.
From 1996 through 2000, the Company’s building designs generally utilized craftsman-style architecture, which featured natural materials such as stone, wood and weathering copper, as well as a blend of international and craftsman architecture featuring elements such as steel, concrete, stone and glass, subtly incorporated to give a contemporary feel. Prior to 1996, the building style most frequently used by the Company featured high ceilings, wooden trusses and exposed ductwork.
Departures from the more typical building designs have also been made as necessary to accommodate unique situations. For example, the Company’s restaurant in Nashville, Tennessee, which opened in 2005 required the complete renovation of an older building to incorporate the development of 8,100 square feet of contemporary restaurant space along a busy thoroughfare just outside downtown Nashville, with a special emphasis on providing views both into and out of the dining area. The Company’s restaurant in Chicago, Illinois is located in a developing upscale urban shopping district and prominently occupies over 9,000 square feet of a restored warehouse building. The J. Alexander’s restaurant located in Troy, Michigan is located inside the prestigious Somerset Collection Mall and features a very upscale, contemporary design developed specifically for that location.
Management does not plan to open any new restaurants in 2012 and remains cautious about future development. Since no restaurants have been opened by the Company in several years, management does not have a precise estimate of future development costs for any new restaurants. While costs of developing future restaurants could vary considerably based on location and other factors, the Company plans to target total development costs of less than $4,000,000, before any landlord tenant improvement allowances, for site preparation and for constructing and equipping a new, free-standing J. Alexander’s restaurant at a leased location. The Company is evaluating a number of opportunities that would include tenant improvement allowances from landlords which would significantly decrease the cash investment required for new restaurants.
The Company intends to resume new restaurant development in the future. The timing and number of restaurant openings will depend, however, upon a number of factors including the state of the U.S. economy, the operating and financial condition of the Company, the selection and availability of suitable sites, and the Company’s ability to finance new restaurant development on a basis satisfactory to the Company. The Company has no plans to franchise J. Alexander’s restaurants.
The Company believes that its ability to select high profile restaurant sites is critical to the success of the J. Alexander’s operations. Once a prospective site is identified and preliminary site analysis is performed and evaluated, members of the Company’s senior management team visit the proposed location and evaluate the particular site and the surrounding area. The Company analyzes a variety of factors in the site selection process, including local market demographics, the number, type and success of competing restaurants in the immediate and surrounding area and accessibility to and visibility from major thoroughfares. The Company believes that this site selection strategy generally results in quality restaurant locations.
Information Systems. The Company utilizes a Windows-based accounting software package and a network that enables electronic communication throughout the Company. In addition, all of the Company’s restaurants utilize touch screen point-of-sale and electronic gift card systems, and also employ a theoretical food costing program. The Company utilizes its management information systems to develop pricing strategies, identify food cost issues, monitor new product acceptance and evaluate restaurant-level productivity. The Company expects to continue to develop its management information systems to assist management in analyzing business issues and to improve efficiency.
SERVICE MARK
The Company has registered the service mark J. Alexander’s Restaurant with the United States Patent and Trademark Office and believes that it is of material importance to the Company’s business.
COMPETITION
The restaurant industry is highly competitive. The Company believes that the principal competitive factors within the industry are site location, product quality, service and price; however, menu variety, attractiveness of facilities and customer recognition are also important factors. The Company’s restaurants compete not only with numerous other casual dining restaurants with national or regional images, but also with other types of food service operations in the vicinity of each of the Company’s restaurants. These include other restaurant chains or franchise operations with greater public recognition, substantially greater financial resources and higher total sales volume than the Company. The restaurant business is often affected by changes in consumer tastes, national, regional or local economic conditions, demographic trends, traffic patterns and the type, number and location of competing restaurants. The Company believes that its commitment to outstanding professional service, high-quality food, and an attractive environment with an upscale, high-energy ambiance distinguishes J. Alexander’s from other casual dining competitors.
PERSONNEL
As of January 1, 2012, the Company employed approximately 2,720 persons, including 37 on the corporate staff. The Company believes that its employee relations are good. It is not a party to any collective bargaining agreements.
GOVERNMENT REGULATION
Each of the Company’s restaurants is subject to numerous federal, state and local laws, regulations and administrative practices relating to the sale of food and alcoholic beverages, and sanitation, fire and building codes. Restaurant operating costs are also affected by other governmental actions that are beyond the Company’s control, which may include increases in the minimum hourly wage requirements, workers’ compensation insurance rates, unemployment and other taxes, required health insurance and other benefits, and legislation requiring restaurants to provide specific nutritional information on their menus. Restaurant operating costs may also be affected by federal government actions related to energy policies, particularly those affecting the price of petroleum products and development of alternative fuel sources such as ethanol. In addition, difficulties or failures in obtaining any required governmental licenses or approvals could delay or prevent the opening of a new restaurant.
Alcoholic beverage control regulations require each of the Company’s J. Alexander’s restaurants to apply for and obtain from state and local authorities a license or permit to sell alcoholic beverages on the premises and, in some states, to provide service for extended hours and on Sundays. Typically, licenses must be renewed annually and may be revoked or suspended for cause at any time. The failure of any restaurant to obtain or retain any required alcoholic beverage licenses would adversely affect the restaurant’s operations. In certain states, the Company may be subject to “dram-shop” statutes, which generally provide a person injured by an intoxicated person the right to recover damages from the establishment which wrongfully served alcoholic beverages to the intoxicated person. Of the 13 states where J. Alexander’s operates, 11 have dram-shop statutes or recognize a cause of action for damages relating to sales of alcoholic beverages to obviously intoxicated persons and/or minors. The Company carries liquor liability coverage as part of its comprehensive general liability insurance in amounts which the Company believes are appropriate for its size and scope of operations.
The Americans with Disabilities Act (“ADA”) prohibits discrimination on the basis of disability in public accommodations and employment. The ADA became effective as to public accommodations and employment in 1992. Construction and remodeling projects completed by the Company since January 1992 have taken into account the requirements of the ADA. During the latter part of 2011, the Company began a review of all existing facilities to ensure they are in full compliance with the ADA.
FORWARD-LOOKING STATEMENTS
The forward-looking statements included in this Annual Report on Form 10-K relating to certain matters involve risks and uncertainties, including anticipated financial performance, business prospects, economic conditions, anticipated capital expenditures, financing arrangements and other similar matters, which reflect management’s best judgment based on factors currently known. Generally, the words “believe”, “expect”, “intend”, “estimate”, “anticipate”, “project”, “may”, “will”, “should”, and similar expressions identify forward-looking statements. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements as a result of a number of factors. Forward-looking information provided by the Company pursuant to the safe harbor established under the Private Securities Litigation Reform Act of 1995 should be evaluated in the context of these factors. In addition, the Company disclaims any intent or obligation to update these forward-looking statements.
CEO BACKGROUND
E. Townes Duncan
Mr. Duncan, 57, has been a director of the Company since May 1989. Mr. Duncan is the Chief Executive Officer of Solidus General Partner, LLC, the general partner of Solidus, a private investment firm, where he oversees early-stage and venture capital investments as well as the management and development of those companies. Mr. Duncan has been associated with Solidus or its predecessor since January 1997. Mr. Duncan served as a director of Bright Horizons Family Solutions, Inc., a childcare services company, from 1998 until 2008. He is a graduate of Washington & Lee University School of Law and received his undergraduate degree from Vanderbilt University. Mr. Duncan’s background as an attorney and his service as a member of the board of directors of various public and private companies provide unique perspectives to the Company’s Board.
Brenda B. Rector
Ms. Rector, 63, has been a director since May 2004. From October 1996 until March 2004, Ms. Rector was the Vice President, Controller and Chief Accounting Officer of Province Healthcare Company, an owner and operator of acute care hospitals in non-urban markets. Ms. Rector has over 34 years of experience practicing as a certified public accountant working with and for public companies. She received her B.S. in accounting from Tennessee Technological University. Ms. Rector’s experience in accounting and financial management of public companies makes her an important contributor to the Board and as a member of the Company’s Audit Committee.
Joseph N. Steakley
Mr. Steakley, 56, has been a director since May 2004. He currently serves as Senior Vice President – Internal Audit of HCA Holdings, Inc. (“HCA”), an owner and operator of hospitals, a position he has held since July 1999. From November 1997 to July 1999, Mr. Steakley was Vice President – Internal Audit for HCA. Mr. Steakley has over 32 years of experience practicing as a certified public accountant and auditor working with and for public companies. He received his B.B.A. in accounting from Middle Tennessee State University. Mr. Steakley’s expertise in the areas of internal control over financial reporting for public companies and other internal auditing matters make him an important contributor to the Board and as Chair of the Company’s Audit Committee.
Lonnie J. Stout II
Mr. Stout, 64, has been a director and President and Chief Executive Officer of the Company since May 1986. Since July 1990, Mr. Stout has also served as Chairman of the Company. From 1982 to May 1984, Mr. Stout was a director of the Company, and served as Executive Vice President and Chief Financial Officer of the Company from October 1981 to May 1984. He is a graduate of Tennessee Technological University. Mr. Stout has over 30 years experience in the hospitality and food services business. His industry knowledge and experience make him a vital component to the Company’s Board.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
J. Alexander's Corporation (the “Company”) operates upscale casual dining restaurants. At January 1, 2012, the Company operated 33 J. Alexander’s restaurants in 13 states. The Company’s net sales are derived primarily from the sale of food and alcoholic beverages in its restaurants. The Company’s 2009 fiscal year included 53 weeks compared to 52 weeks for both 2011 and 2010.
The Company’s strategy is for J. Alexander’s restaurants to compete in the restaurant industry by providing guests with outstanding professional service, high-quality food, and an attractive environment with an upscale, high-energy ambiance. Quality is emphasized throughout J. Alexander’s operations and substantially all menu items are prepared on the restaurant premises using fresh, high-quality ingredients. The Company’s goal is for each J. Alexander’s restaurant to be perceived by guests in its market as a market leader in each of the areas above. J. Alexander’s restaurants offer a contemporary American menu designed to appeal to a wide range of consumer tastes. The Company believes, however, that its restaurants are most popular with more discriminating guests with higher discretionary incomes. J. Alexander’s typically does not advertise in the media and relies on each restaurant to increase sales by building its reputation as an outstanding dining establishment. The Company has generally been successful in achieving sales increases in its restaurants over time using this strategy. However, during fiscal 2008 and the first three quarters of fiscal 2009, the Company experienced decreases in same store sales which had a significant negative impact on the Company’s profitability. Management believes these decreases were primarily the result of weak economic conditions and lower levels of discretionary consumer spending during those periods. In addition, the Company’s restaurants which opened in late fiscal 2007 and fiscal 2008 have experienced particular difficulties in building sales and certain of them are having a significant negative impact on the Company’s profitability. Same store sales were positive in the fourth quarter of fiscal 2009 and have remained positive for each quarter during fiscal 2010 and fiscal 2011.
The restaurant industry is highly competitive and is often affected by changes in consumer tastes and discretionary spending patterns; changes in general economic conditions; public safety conditions or concerns; demographic trends; weather conditions; the cost of food products, labor, energy and other operating costs; and governmental regulations. Because of these factors, the Company’s management believes it is of critical importance to the Company’s success to effectively execute the Company’s operating strategy and to constantly develop and refine the critical conceptual elements of J. Alexander’s restaurants in order to distinguish them from other casual dining competitors and maintain the Company’s competitive position.
The restaurant industry is also characterized by high capital investments for new restaurants and relatively high fixed or semi-variable restaurant operating expenses. Because of the high fixed and semi-variable expenses, changes in sales in existing restaurants are generally expected to significantly affect restaurant profitability because many restaurant costs and expenses are not expected to change at the same rate as sales. Restaurant profitability can also be negatively affected by inflationary and regulatory increases in operating costs and other factors. Management continues to believe that excellence in restaurant operations, and particularly providing exceptional guest service, will increase net sales in the Company’s restaurants over time.
Changes in sales for existing restaurants, or same store sales, are generally measured in the restaurant industry by computing the change in sales for the same group of restaurants from the same period in the prior year. Same store sales changes can be the result of changes in guest counts, which the Company estimates based on a count of entrée items sold, and changes in the average check per guest. The average check per guest can be affected by menu price changes and the mix of menu items sold. Management regularly analyzes guest count, average check and product mix trends for each restaurant in order to improve menu pricing and product offering strategies. Management believes it is important to maintain or increase guest counts and average guest checks over time in order to improve the Company’s profitability.
Other key indicators which can be used to evaluate and understand the Company’s restaurant operations include cost of sales, restaurant labor and related costs and other operating expenses, with a focus on these expenses as a percentage of net sales. Since the Company uses primarily fresh ingredients for food preparation, the cost of food commodities can vary significantly from time to time due to a number of factors. The Company generally expects to increase menu prices in order to offset the increase in the cost of food products as well as increases in labor and related costs and other operating expenses, but attempts to balance these increases with the goals of providing reasonable value to the Company’s guests. Management believes that restaurant operating margin, which is net sales less total restaurant operating expenses expressed as a percentage of net sales, is an important indicator of the Company’s success in managing its restaurant operations because it is affected by the level of sales achieved, menu offering and pricing strategies, and the management and control of restaurant operating expenses in relation to net sales.
Because large capital investments are required for J. Alexander’s restaurants and because a significant portion of labor costs and other operating expenses are fixed or semi-variable in nature, management believes the sales required for a J. Alexander’s restaurant to break even are relatively high compared to break-even sales volumes of many other casual dining concepts. As a result, it is necessary for the Company to achieve relatively high sales volumes in its restaurants compared to the average sales volumes of other casual dining concepts in order to achieve desired financial returns.
The opening of new restaurants by the Company can have a significant impact on the Company’s financial performance because pre-opening expense for new restaurants is significant and most new restaurants incur operating losses during their early months of operation. Some of the Company’s restaurants, including its newer ones, have experienced losses for considerably longer periods. The Company opened two new restaurants in fiscal 2007 and three new restaurants in fiscal 2008. No new restaurants have been opened since fiscal 2008 and none are planned for fiscal 2012.
As further discussed below, the Company recorded a significant income tax benefit in fiscal 2010 primarily as the result of additional depreciation deductions taken based on an asset cost segregation study performed by the Company during the year. The Company’s results for 2009 were significantly impacted by adjustments made in connection with the preparation of its financial statements for fiscal year 2009, including non-cash asset impairment charges of $3,889,000 and an increase of $7,405,000 in the Company’s beginning of the year valuation allowance for net deferred tax assets.
Net Sales
Net sales increased by $8,157,000, or 5.5%, in 2011 compared to fiscal year 2010 due to higher weekly average net sales per restaurant and by $4,824,000, or 3.3%, in 2010 compared to fiscal year 2009 as the effect of higher average weekly net sales per restaurant more than offset the effect of having one less operating week in 2010. Net sales for 2010 increased by $8,148,000, or 5.8%, compared to the comparable 52 weeks of 2009.
Average weekly same store sales per restaurant increased by 5.5% to $91,600 in 2011 from $86,800 in 2010 on a base of 33 restaurants. Average weekly same store sales per restaurant increased by 5.5% to $87,000 in 2010 from $82,500 in 2009 on a base of 33 restaurants on a fiscal year basis, and by 5.8% when the 2010 average is compared to the average for the corresponding 52 weeks ended January 3, 2010.
The Company computes average weekly sales per restaurant by dividing total restaurant sales for the period by the total number of days all restaurants were open for the period to obtain a daily sales average, with the daily sales average then multiplied by seven to arrive at weekly average sales per restaurant. Days on which restaurants are closed for business for any reason other than the scheduled closure of all J. Alexander’s restaurants on Thanksgiving day and Christmas day are excluded from this calculation. Average weekly same store sales per restaurant are computed in the same manner as described above except that sales and sales days used in the calculation include only those for restaurants open for more than 18 months. Revenue associated with reductions in liabilities for gift cards which are considered to be only remotely likely to be redeemed is not included in the calculation of average weekly sales per restaurant or average weekly same store sales per restaurant.
Management estimates the average check per guest, including alcoholic beverage sales, in 2011 was $26.87, up approximately 3.8% from $25.88 in 2010. The average check for 2010 increased by approximately 2.8% compared to 2009. Management estimates that average menu prices increased by approximately 2.6% in 2011 over 2010 and by 2.0% in 2010 over 2009. Management estimates that weekly average guest counts increased on a same store basis by approximately 1.4% in 2011 compared to 2010 and by over 2% in 2010 compared to 2009.
Management believes that the same store sales decreases experienced by the Company during 2009 were primarily due to a significant slowdown in discretionary consumer spending caused by weak economic conditions, the tightening of consumer credit, and general concerns about unemployment, lower home values and turmoil and uncertainty in the financial markets. The Company experienced notable improvement in same store sales trends in the fourth quarter of 2009, with those trends continuing and same store sales remaining positive during 2010 and 2011. Management is encouraged by these trends which it believes are due to improved economic conditions and consumer spending patterns as well as the Company’s continued emphasis on maintaining excellent operations. However, there can be no assurance that favorable trends will continue or that consumer spending patterns have not been altered on a long-term basis, which would make it difficult to sustain the current sales momentum.
The Company recognizes revenue from reductions in liabilities for gift cards which, although they do not expire, are considered to be only remotely likely to be redeemed. These revenues are included in net sales in the amounts of $138,000, $144,000 and $217,000 for 2011, 2010 and 2009, respectively.
Restaurant Costs and Expenses
Total restaurant operating expenses were 91.5% of net sales in 2011, down from 92.3% in 2010. Total restaurant operating expenses in 2009 were 94.7% of net sales. The decreases in both 2011 and 2010 were due primarily to the favorable impact of higher sales which more than offset increases in cost of sales. Restaurant operating margins were 8.5% in 2011, 7.7% in 2010 and 5.3% in 2009.
Cost of sales, which includes the cost of food and beverages, increased to 33.2% of net sales in 2011 from 32.3% of net sales in 2010. The 2010 percentage represented an increase from 31.7% of net sales in 2009. In both instances, the increases in cost of sales were due primarily to higher prices paid by the Company for beef and certain other food commodities which more than offset the effect of the higher menu prices noted above. Approximately 25% to 30% of cost of sales is comprised of beef purchases which are made at weekly market prices. Prices paid for beef were higher in 2011 than they were in 2010 and prices in 2010 were higher than 2009. Management estimates that the effect of higher beef prices increased cost of sales by an estimated 0.7% of net sales in 2011 and by an estimated 0.3% of net sales in 2010. The Company’s beef purchases remain subject to variable market conditions and management anticipates that prices for beef in 2012 will exceed those paid in 2011.
Restaurant labor and related costs decreased to 33.3% of net sales in 2011 from 33.9% in 2010 and 35.2% of net sales in 2009. The decreases in both 2011 and 2010 compared to the respective previous years were due primarily to the effects of higher average weekly net sales per restaurant and modestly lower restaurant management staffing levels when compared to the preceding year.
Depreciation and amortization of restaurant property and equipment decreased by $48,000 in 2011 compared to 2010. The effect of higher average weekly net sales per restaurant combined with this decrease resulted in a decrease in depreciation and amortization expense as a percentage of net sales. Depreciation and amortization of restaurant property and equipment decreased by $768,000 in 2010 compared to 2009 primarily because asset impairment charges recorded at the end of 2009 in connection with the preparation of the Company’s financial statements for fiscal year 2009 significantly lowered the depreciable basis of the impaired assets and because the 2009 fiscal year included an additional week compared to 2010. The effect of this decrease combined with higher average weekly net sales per restaurant also resulted in a decrease in depreciation and amortization expense as a percentage of net sales.
Other operating expenses, which include restaurant level expenses such as china and supplies, laundry and linen costs, repairs and maintenance, utilities, credit card fees, rent, property taxes and insurance, decreased to 21.3% of net sales in 2011 from 22.2% of net sales in 2010 and 23.1% of net sales in 2009. The decreases in both 2011 and 2010 compared to the respective previous years were due primarily to the effect of higher average weekly net sales per restaurant.
General and Administrative Expenses
Total general and administrative expenses, which include all supervisory costs and expenses, management training and relocation costs, and other costs incurred above the restaurant level, increased by $1,398,000 in 2011 compared to 2010. The increase was primarily attributable to expenses of approximately $900,000 related to the defense and settlement, which remains subject to court approval, of a lawsuit involving allegations of tip share pool violations. Costs related to this litigation, coupled with an increase in restaurant management training costs, more than offset reductions in tax advisory service fees in 2011 compared to 2010. General and administrative expenses decreased by $840,000 in 2010 compared to 2009. The decrease included lower total salary and training costs combined with the effect of charges of approximately $500,000 included in 2009 general and administrative expenses related to the defense and settlement of litigation pending at that time, which more than offset increases in tax advisory service fees and severance costs incurred in 2010 in connection with changes in management personnel.
Asset Impairment Charges
In connection with the preparation of its financial statements for fiscal year 2009, long-lived assets held and used with a carrying amount of $4,117,000 were written down to their fair value of $228,000, resulting in a non-cash impairment charge of $3,889,000, which was included in the net loss for the year ended January 3, 2010. Fair value is determined by projected future discounted cash flows for each restaurant location combined with the estimated salvage value of each restaurant’s furnishings, fixtures and equipment. The applicable discount rate is the Company’s estimated weighted average cost of capital which the Company believes is commensurate with the required rate of return that a potential buyer would expect to receive when purchasing a similar restaurant and the related long-lived assets. The Company limits assumptions about important factors such as sales and margin change to those that are supportable based upon its plans for the restaurant.
Other Income (Expense)
Interest expense decreased by $196,000 in 2011 compared to 2010 due primarily to the prepayment of a term loan totaling approximately $2,400,000 during the third quarter of 2010 combined with lower interest expense on the Company’s mortgage loan due to reductions in the outstanding balance of the loan resulting from scheduled principal payments. Interest expense was lower in 2010 than in 2009 primarily because of reductions in long-term debt resulting from scheduled principal payments.
Income Taxes
The Company’s income tax provision for 2011 is based on an effective tax rate of 25.3% which includes an expense item of $132,000 related to completion of the Internal Revenue Service’s field examination of the Company’s income tax returns for fiscal years 2008 and 2009 and related tax refunds for previous years. In addition, the 2011 income tax provision includes a benefit of $255,000 related to the expiration of the statute of limitations associated with previously unrecognized tax benefits and related interest expense. The results of the Internal Revenue Service’s audit of the fiscal 2008 and 2009 income tax returns are subject to final approval by the U.S. Congress Joint Committee on Taxation. As of January 1, 2012, periods subject to examination for the Company’s federal income tax returns are the 2008 through 2010 tax years. During the third quarter of 2011, the Internal Revenue Service commenced an employment tax audit related to 2009 and 2010.
The Company recorded a significant income tax benefit in 2010 related to tax strategies which it implemented during the year to accelerate certain tax deductions for the 2009 tax year. The additional deductions, the most significant of which were based on an asset cost segregation study completed during 2010, increased the federal net operating loss for the 2009 tax year which was available for carryback to offset taxable income in previous tax years.
In connection with the preparation of its financial statements for fiscal year 2009, the Company determined that a valuation allowance for substantially all of its deferred tax assets was necessary in order to reflect the Company’s assessment of its ability to realize the benefits of those assets. As a result, the Company recorded an increase in the Company’s beginning of the year valuation allowance for deferred tax assets which increased the income tax provision for the year by $7,405,000. The Company’s total income tax provision for 2009 of $7,102,000 included the effect of the beginning of the year valuation allowance adjustment which was partially offset by current tax benefits generated during the year, including the benefit of a net operating loss generated for federal tax purposes which was carried back to previous years.
The U. S. Tax Code allows employers who pay social security and Medicare taxes on tipped income to claim tax credits equal to such taxes paid. Based upon the existing inventory of such credits previously claimed and carried forward by the Company, the existence of certain limitations on their utilization and the requirement that these credits must be included in taxable income if claimed, to date the Company has elected not to claim the credits for any year subsequent to 2008. Such credits may be claimed by filing an amended federal income tax return for any year at any time within three years of the due date for the original or amended return.
The Company continues to maintain a valuation allowance for substantially all of its net deferred tax assets and as long as it does so its future income tax provisions will consist of income tax expense currently payable or the income tax benefit currently receivable, which amounts will include the effect of differences between book and taxable income. The Company’s effective annual tax rate has historically been reduced by its ability to utilize FICA tip credits to offset a significant amount of the current portion of its federal tax liability. The Company will continue to have FICA tip credit carryforwards available to reduce its federal income tax liability in 2012. In addition, due to changes in certain state income tax regulations and to the timing of certain tax deductions the Company expects to receive in 2012, the Company’s effective income tax rate is expected to decrease significantly in 2012 compared to the effective rate in 2011, and is currently estimated to be in the range of 10% to 15%.
Outlook
Management is pleased with the Company’s sales performance in recent quarters and its outlook for 2012 is that as the economy continues to recover, the Company should continue to post positive same store sales. Weekly average same store sales are expected to increase by 4.0% to 5.0 % in the first quarter of 2012 compared to the first quarter of 2011. In addition, as a result of increases in menu prices in late 2011, certain buying and product decisions recently made by the Company and other factors, cost of sales as a percentage of net sales is expected to decrease in the first quarter of 2012 compared to both the fourth quarter of 2011 and the comparable quarter of 2011. While additional increases in food input costs are expected over the course of 2012, management expects that based on current trends and its outlook for the remainder of the year, cost of sales as a percentage of sales will decrease in 2012 compared to 2011, although there can be no assurance that these results will be achieved. Depending on the magnitude of additional input cost increases, management may consider increasing menu prices or making other menu revisions in order to offset some portion of the impact of cost increases. However, there can be no assurance that any such changes will offset the full effect of these or other cost increases or that they will not negatively affect guest counts or profitability.
The Company has received notice from Privet Fund LP that it and certain other activist shareholders intend to nominate four director candidates for election, intended to replace the Company’s entire Board of Directors, at the Company’s 2012 Annual Meeting of Shareholders. If a contested election and proxy contest involving these shareholders ensues, costs associated with such an event are expected to be significant.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s capital needs are currently primarily for maintenance of and improvements to its existing restaurants, and for meeting debt service requirements and operating lease obligations. The Company has met its cash requirements and maintained liquidity in recent years primarily through use of cash and cash equivalents on hand, cash flow from operations and the availability of a bank line of credit. In addition, during 2009 the Company borrowed $3,000,000 under a term loan which funded purchase of shares of the Company’s common stock. The loan was repaid in 2010 as further discussed below.
Cash and cash equivalents at January 1, 2012, totaled $7,917,000 compared to $8,602,000 at the end of 2010. Cash balances at January 1, 2012, would have been approximately $3,900,000 higher, and accounts receivable lower by a corresponding amount, if the Company had not elected during 2011 to change the settlement terms for transactions with a major credit card issuer as described below. Substantially all of the Company’s cash and cash equivalents are maintained in bank accounts which are fully insured by the FDIC or in money market funds which invest primarily in short-term U.S. Treasury securities. The Company had a working capital surplus of $4,342,000 at January 1, 2012, compared to a surplus of $837,000 at January 2, 2011.
The Company’s net cash provided by operating activities totaled $4,143,000, $12,255,000 and $7,323,000 for 2011, 2010 and 2009, respectively. The Company’s decrease in cash flow from operating activities in 2011 was due in part to an election by the Company to use a payment plan offered by one of the major credit card issuers which increases the number of days for cash settlement of credit card charges receivable from that issuer. This change was made because it lowers the merchant discount rate paid by the Company; however, the change increased accounts receivable and decreased cash flow from operating activities by approximately $3,900,000 for fiscal 2011. The Company can elect to revert to the previous settlement terms at any time, which would significantly increase the Company’s cash position within 30 days. Cash provided by operating activities for 2010 included $3,043,000 of federal income tax refunds related to prior years. Cash provided by operating activities for 2009 included the receipt of a $1,145,000 contribution from a landlord for improvements made by the Company for a new restaurant developed on leased property in 2008. Management expects that future cash flows from operating activities will vary primarily as a result of future operating results.
Deferred compensation obligations increased by $628,000 from January 2, 2011, to January 1, 2012, and by $491,000 from January 3, 2010, to January 2, 2011, due primarily to accruals for benefits payable under individual Salary Continuation Agreements (“Agreements”) between the Company and certain of its employees. These Agreements provide for the payment of retirement benefits upon retirement from the Company at or after age 65 and also provide certain vested benefits in the event of termination of employment with the Company prior to reaching age 65. The increases referenced above included adjustments of $323,000, $215,000 and $237,000 for 2011, 2010, and 2009, respectively, related to changes in the interest rates used to compute the present value of the vested liabilities.
Deferred rent obligations and other deferred credits increased by $22,000 from January 2, 2011, to January 1, 2012, and by $477,000 from January 3, 2010, to January 2, 2011. The Company recognizes rent expense on a straight-line basis over the expected lease term which typically results in recognizing rent expense which exceeds cash rents paid in the early stages of the applicable lease terms. Increases for each of the years noted above include the excess of rent expense over rents paid for those years, which amounts will be paid in future years. In addition, the $22,000 net increase noted above relative to fiscal 2011 reflects a $255,000 reduction in income tax liabilities related to the expiration of the statute of limitations associated with previously unrecognized tax benefits and related interest expense discussed previously in “Income Taxes”.
The Company’s capital expenditures can vary significantly from year to year depending primarily on the number, timing and form of ownership of new restaurants under development. Cash expenditures for capital assets totaled $3,823,000, $2,755,000 and $2,581,000 for 2011, 2010 and 2009, respectively. The Company places a high priority on maintaining the image and condition of its restaurants. Substantially all of the capital expenditures in 2011 and 2010 were for remodels, enhancements and asset replacements in the Company’s existing restaurants, and $2,012,000 of the expenditures in 2009 were for that purpose. Cash provided by operating activities exceeded capital expenditures in each of fiscal years 2011, 2010 and 2009.
Management currently estimates that capital expenditures for 2012 will be approximately $5,000,000. This amount includes expenditures for improvements and asset replacements related to the Company’s restaurants of approximately $4,500,000, of which $700,000 is designated for certain ADA compliance upgrades and the remodel of one location. Management does not plan to open any new restaurants in 2012 and remains cautious about future development. New restaurant development could also be constrained in the future due to lack of capital resources depending on the amount of cash flow generated by future operations of the Company or the availability to the Company of additional financing on terms acceptable to the Company, if at all.
On May 22, 2009, the Company entered into a bank loan agreement which provided two credit facilities, including a three-year $5,000,000 revolving line of credit, which may be used for general corporate purposes, and a $3,000,000 term loan which funded the purchase in 2009 of 808,000 shares of the Company’s common stock from Solidus Company, L.P., which was the Company’s largest shareholder prior to the purchase, and E. Townes Duncan, a director of the Company. See Note N “Related Party Transactions” to the Company’s Consolidated Financial Statements for additional description of the transaction. During the third quarter of 2010, the Company prepaid without penalty the remaining balance of $2.4 million outstanding on the term loan using cash and cash equivalents on hand at that time. The revolving line of credit remains in place on the same terms that were in effect prior to the prepayment of the term loan and is secured by liens on certain personal property of the Company and its subsidiaries, subsidiary guaranties and a negative pledge on certain real property.
Amounts borrowed under the loan agreement bear interest at an annual rate of 30-day LIBOR plus a margin of 3.50% to 4.50% depending on the adjusted debt to EBITDAR ratio achieved, with a minimum interest rate of 4.60%. Any amounts outstanding can be prepaid at any time without penalty. The loan agreement, among other things, limits capital expenditures, asset sales and liens and encumbrances, prohibits dividends, and contains certain other provisions customarily included in such agreements.
The bank loan agreement also includes certain financial covenants. The Company must maintain a fixed charge coverage ratio of at least 1.05 to 1 as of the end of any fiscal quarter measured based on the four quarters then ending. The fixed charge coverage ratio is defined in the loan agreement as the ratio of (a) the sum of net income for the applicable period (excluding the effect on such period of any extraordinary or non-recurring gains or losses, including any asset impairment charges, and deferred income tax benefits and expenses) plus depreciation and amortization plus interest expense plus scheduled monthly rent payments plus non-cash share-based compensation expense minus certain capital expenditures, to (b) the sum of interest expense during such period plus scheduled monthly rent payments made during such period plus scheduled payments of long-term debt and capital lease obligations made during such period, all determined in accordance with U.S. generally accepted accounting principles (“GAAP”).
In addition, the Company’s adjusted debt to EBITDAR ratio originally was not to exceed 6.0 to 1 as of the end of the second and third quarters of 2009, 5.0 to 1 as of the quarter ended January 3, 2010, and 4.5 to 1 as of the end of each quarter thereafter. The maximum adjusted debt to EBITDAR ratios allowed under the loan agreement were increased to 5.25 to 1 and 5.0 to 1 for the first and second quarters of 2010, respectively, by an amendment to the loan agreement dated April 2, 2010. Under the loan agreement, EBITDAR is measured based on the then-ending four fiscal quarters and is defined as the sum of net income for the applicable period (excluding the effect of any extraordinary or non-recurring gains or losses, including any asset impairment charges) plus an amount which, in the determination of net income for such period has been deducted for (i) interest expense; (ii) total federal, state, foreign or other income taxes; (iii) all depreciation and amortization; (iv) scheduled monthly rent payments; and (v) non-cash share-based compensation expense, all as determined in accordance with GAAP. Adjusted debt is (i) the Company’s debt obligations net of any short-term investments, cash and cash equivalents plus (ii) rent payments multiplied by seven.
No amounts were outstanding under the revolving line of credit at January 1, 2012, or subsequent to that time through March 30, 2012.
A mortgage loan obtained in 2002 represents the most significant portion of the Company’s outstanding long-term debt. The loan, which was originally for $25,000,000, had an outstanding balance of $18,332,000 at January 1, 2012. It has an effective annual interest rate, including the effect of the amortization of deferred issue costs, of 8.6% and is payable in equal monthly installments of principal and interest of approximately $212,000 through November 2022. Provisions of the mortgage loan and related agreements require that a minimum fixed charge coverage ratio of 1.25 to 1 be maintained for the businesses operated at the properties included under the mortgage and that a funded debt to EBITDA (as defined in the loan documents) ratio of 6.0 to 1 be maintained for the Company and its subsidiaries. The loan is secured by the real estate, equipment and other personal property of nine of the Company’s restaurant locations with an aggregate book value of $21,894,000 at January 1, 2012. The real property at these locations is owned by JAX Real Estate, LLC, the borrower under the loan agreement, which leases them to a wholly-owned subsidiary of the Company as lessee. The Company has guaranteed the obligations of the lessee subsidiary to pay rents under the lease. JAX Real Estate, LLC is an indirect wholly-owned subsidiary of the Company which is included in the Company’s Consolidated Financial Statements. However, JAX Real Estate, LLC was established as a special purpose, bankruptcy remote entity and maintains its own legal existence, ownership of its assets and responsibility for its liabilities separate from the Company and its other affiliates.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Overview
J. Alexander's Corporation (the “Company”) operates upscale casual dining restaurants. At July 1, 2012, the Company operated 33 J. Alexander’s restaurants in 13 states. The Company’s net sales are derived primarily from the sale of food and alcoholic beverages in its restaurants.
The Company’s strategy is for J. Alexander’s restaurants to compete in the restaurant industry by providing guests with outstanding professional service, high-quality food, and an attractive environment with an upscale, high-energy ambiance. Quality is emphasized throughout J. Alexander’s operations and substantially all menu items are prepared on the restaurant premises using fresh, high-quality ingredients. The Company’s goal is for each J. Alexander’s restaurant to be perceived by guests in its market as a market leader in each of the areas above. J. Alexander’s restaurants offer a contemporary American menu designed to appeal to a wide range of consumer tastes. The Company believes, however, that its restaurants are most popular with more discriminating guests with higher discretionary incomes. J. Alexander’s typically does not advertise in the media and relies on each restaurant to increase sales by building its reputation as an outstanding dining establishment. The Company has generally been successful in achieving sales increases in its restaurants over time using this strategy. However, the Company’s restaurants which opened in late 2007 and 2008 have experienced particular difficulties in building sales and certain of them are having a significant negative impact on the Company’s profitability.
The restaurant industry is highly competitive and is often affected by changes in consumer tastes and discretionary spending patterns; changes in general economic conditions; public safety conditions or concerns; demographic trends; weather conditions; the cost of food products, labor, energy and other operating costs; and governmental regulations. Because of these factors, the Company’s management believes it is of critical importance to the Company’s success to effectively execute the Company’s operating strategy and to constantly develop and refine the critical conceptual elements of J. Alexander’s restaurants in order to distinguish them from other casual dining competitors and maintain the Company’s competitive position.
The restaurant industry is also characterized by high capital investment for new restaurants and relatively high fixed or semi-variable restaurant operating expenses. Because of the high fixed and semi-variable expenses, changes in sales in existing restaurants are generally expected to significantly affect restaurant profitability because many restaurant costs and expenses are not expected to change at the same rate as sales. Restaurant profitability can also be negatively affected by inflationary and regulatory increases in operating costs and other factors. Management continues to believe that excellence in restaurant operations, and particularly providing exceptional guest service, will increase net sales in the Company’s restaurants over time.
Changes in sales for existing restaurants, or same store sales, are generally measured in the restaurant industry by computing the change in sales for the same group of restaurants from the same period in the prior year. Same store sales changes can be the result of changes in guest counts, which the Company estimates based on a count of entrée items sold, and changes in the average check per guest. The average check per guest can be affected by menu price changes and the mix of menu items sold. Management regularly analyzes guest count, average check and product mix trends for each restaurant in order to improve menu pricing and product offering strategies. Management believes it is important to maintain or increase guest counts and average guest checks over time in order to improve the Company’s profitability.
Other key indicators which can be used to evaluate and understand the Company’s restaurant operations include cost of sales, restaurant labor and related costs and other operating expenses, with a focus on these expenses as a percentage of net sales. Since the Company uses primarily fresh ingredients for food preparation, the cost of food commodities can vary significantly from time to time due to a number of factors. The Company generally expects to increase menu prices in order to offset the increase in the cost of food products as well as increases in labor and related costs and other operating expenses, but attempts to balance these increases with the goals of providing reasonable value to the Company’s guests. Management believes that restaurant operating margin, which is net sales less total restaurant operating expenses expressed as a percentage of net sales, is an important indicator of the Company’s success in managing its restaurant operations because it is affected by the level of sales achieved, menu offering and pricing strategies, and the management and control of restaurant operating expenses in relation to net sales.
Because large capital investments are required for J. Alexander’s restaurants and because a significant portion of labor costs and other operating expenses are fixed or semi-variable in nature, management believes the sales required for a J. Alexander’s restaurant to break even are relatively high compared to break-even sales volumes of many other casual dining concepts. As a result, it is necessary for the Company to achieve relatively high sales volumes in its restaurants compared to the average sales volumes of other casual dining concepts in order to achieve desired financial returns.
The opening of new restaurants by the Company can have a significant impact on the Company’s financial performance because pre-opening expense for new restaurants is significant and most new restaurants incur operating losses during their early months of operation. Some of the Company’s restaurants, including the two restaurants opened in 2007 and the three restaurants opened in 2008, have experienced losses for considerably longer periods. No restaurants have been opened since 2008 and none are planned for 2012.
On July 30, 2012, the Company entered into an Amended and Restated Agreement and Plan of Merger (the “Restated Merger Agreement”) with Fidelity National Financial, Inc., a Delaware corporation (“Fidelity”), New Athena Merger Sub, Inc., a Tennessee Corporation and an indirect, wholly owned subsidiary of Fidelity (“Merger Sub”), and certain other affiliates of Fidelity. For more information, see Note G of the Notes to the Company’s Condensed Consolidated Financial Statements included in this Form 10-Q.
Net Sales
Net sales increased by $1,622,000, or 4.2%, in the second quarter of 2012 compared to the second quarter of 2011 and by $3,584,000, or 4.5%, in the first half of 2012 compared to the first half of 2011. For the second quarter of 2012, the Company recorded average weekly net sales per restaurant of $93,700, up from $89,900 in the corresponding quarter a year earlier. For the first half of 2012, average weekly net sales per restaurant totaled $96,600, up from $92,600 in the first half of 2011. The Company’s average weekly same store net sales per restaurant for the second quarter and the first half of 2012 were the same as the average weekly net sales per restaurant for those periods because same store sales calculations are based on restaurants open for more than 18 months and no new restaurants have opened since 2008. The 4.3% increase in average weekly net sales per restaurant for the first half of 2012 compared to the first half of 2011 was less than the 4.5% increase in total net sales because of the exclusion from the weekly average calculation of a total of eleven restaurant days that certain restaurants were closed in the first half of 2011 due primarily to inclement weather, as compared to only two restaurant days that were excluded from the calculation for the first half of 2012.
Management estimates the average check per guest, including alcoholic beverage sales, increased by 6.1% to $27.95 in the second quarter of 2012 from $26.33 in the second quarter of 2011 and by 5.7% to $28.04 for the first half of 2012 from $26.53 for the first half of 2011. Management estimates that the effect of menu price increases was approximately 4.2% and 4.1% in the second quarter and first six months of 2012, respectively, compared to the corresponding periods of 2011. Management estimates that weekly average guest counts decreased by approximately 2.0% and 1.4% in the second quarter and first six months of 2012, respectively, compared to the same periods of 2011.
The Company has experienced positive same store sales for the last eleven consecutive quarters. Management is encouraged by recent same store sales trends which it believes are due to improved economic conditions and consumer spending patterns as well as the Company’s continued emphasis on maintaining excellent operations. However, there can be no assurance that favorable trends will continue or that consumer spending patterns will not weaken in the future, which would make it difficult to sustain the current sales momentum.
Restaurant Costs and Expenses
Total restaurant operating expenses decreased to 89.5% of net sales in the second quarter of 2012 from 92.6% in the second quarter of 2011 and to 87.9% of net sales in the first half of 2012 from 91.1% of net sales in the first half of 2011. Restaurant operating margins increased to 10.5% in the second quarter of 2012 from 7.4% in the comparable period of 2011 and to 12.1% in the first half of 2012 from 8.9% in the same period of 2011. These improvements were due primarily to lower cost of sales and restaurant operating expenses combined with the impact of higher sales.
Cost of sales, which includes the cost of food and beverages, decreased to 31.6% of net sales in the second quarter of 2012 from 33.2% of net sales in the corresponding period of 2011 and to 31.5% of net sales for the first half of 2012 from 33.1% of net sales in the first half of 2011. Although beef prices paid by the Company increased by approximately 11% and 15% in the second quarter and first half of 2012, respectively, compared to the same periods in 2011, the Company was able to more than offset these increases with the effect of a combination of menu price increases, lower prices paid for certain other food commodities and other actions taken to lower food costs. Approximately 25% to 30% of cost of sales is comprised of beef purchases which are made at weekly market prices. Management estimates that the effect of higher beef prices was approximately 0.9% and 1.1% of net sales in the second quarter and first half of 2012, respectively, compared to the corresponding periods of the prior year. The Company’s beef purchases remain subject to variable market conditions and management anticipates that prices for beef in 2012 will continue to exceed those paid in 2011.
Restaurant labor and related costs totaled 33.7% of net sales in the second quarter of both 2012 and 2011 and decreased slightly to 32.9% of net sales for the first half of 2012 compared to 33.0% for the corresponding period of 2011 as the effects of higher sales generally offset additional incentive compensation expense, increased restaurant management staffing levels, and normal inflationary increases during the 2012 periods.
Depreciation and amortization of restaurant property and equipment decreased by $21,000 in the second quarter of 2012 and $35,000 for the first six months of 2012 compared to the corresponding periods of 2011 primarily due to restaurant equipment which became fully depreciated subsequent to the second quarter of 2011.
Other operating expenses, which include restaurant level expenses such as china and supplies, laundry and linen costs, repairs and maintenance, utilities, credit card fees, rent, property taxes and insurance, decreased to 20.6% of net sales in the second quarter of 2012 from 21.9% of net sales in the second quarter of 2011 and to 19.9% of net sales for the first six months of 2012 from 21.2% in the comparable period of 2011 due to the effect of both higher net sales and reductions in certain operating expenses achieved by the Company.
General and Administrative Expenses
Total general and administrative expenses, which include all supervisory costs and expenses, management training and relocation costs, and other costs incurred above the restaurant level, increased by $1,230,000 in the second quarter of 2012 and by $1,471,000 for the first six months of 2012 compared to the corresponding periods of 2011. Expenses related to the evaluation of strategic alternatives by the Company, including expenses associated with the negotiation and execution of a definitive merger agreement for the sale of the Company, and a possible contested election of directors totaled approximately $900,000 and $1,050,000 for the second quarter and first half of 2012, respectively. Incentive compensation accruals and certain other expenses were also higher in the second quarter and first half of 2012 than in the corresponding periods of 2011.
Income Taxes
Income tax expense for the first half of 2012 has been provided for based on an estimated effective tax rate of 13.3% expected to be applicable for the full 2012 fiscal year. This compares to an effective tax rate of 21.1% used for the first half of 2011.
The Company’s effective annual tax rate has historically been reduced by its ability to utilize FICA tip credits to offset a significant amount of the current portion of its federal tax liability, and the Company will continue to have FICA tip credit carryforwards available to reduce its federal income tax liability in 2012. In addition, because the Company continues to maintain a valuation allowance for substantially all of its net deferred tax assets, its income tax provision consists of income taxes currently payable which include the effect of differences between book and taxable income. The effect of certain tax deductions the Company expects to receive in 2012 as well as changes in certain state income tax regulations are factors which contribute to the reduction of the Company’s estimated effective tax rate for the current year compared to the rate used in the first half of 2011.
Outlook
Based on improvements in sales and operating performance in recent quarters as well as management’s current outlook, management expects continued improvement in restaurant operating performance during the remainder of 2012. There can be no assurance that these results will be achieved, however, given continuing uncertain economic conditions which could affect consumer discretionary spending and have a negative impact on the Company’s sales performance at some point during the year and management’s concerns about the possible impact of increases in food commodity costs, particularly with regard to the impact of current drought conditions across much of the United States which could further increase beef prices as well as other food commodities.
In June of 2012, the Company entered into a merger agreement for the sale of the Company that was subsequently amended and restated in July 2012 by the Restated Merger Agreement to provide for a two step tender offer and merger acquisition transaction. Expenses associated with the completion of this proposed transaction, including the costs of defense of shareholder litigation in connection with the transaction, or the Company’s evaluation of any alternative transaction to the extent allowed under the terms of the Restated Merger Agreement will involve significant legal and professional fees which cannot be reasonably estimated at this time but which will have a significant effect on consolidated operating results. In addition, the Company has and may continue to incur expenses in connection with the activities of an activist shareholder. Costs associated with these matters could be significant.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s capital needs are currently primarily for maintenance of and improvements to its existing restaurants, and for meeting debt service requirements and operating lease obligations. The Company has met its cash requirements and maintained liquidity in recent years primarily through use of cash and cash equivalents on hand, cash flow from operations and the availability of a bank line of credit.
Cash and cash equivalents as of July 1, 2012 totaled $12,810,000 compared to $7,917,000 at the end of 2011. Substantially all of the Company’s cash and cash equivalents are maintained in bank accounts which are fully insured by the FDIC or in money market funds which invest primarily in short term U.S. Treasury securities. The Company had a working capital surplus of $7,717,000 at July 1, 2012 compared to a surplus of $4,342,000 at January 1, 2012. Management expects that future cash flows from operating activities will vary primarily as a result of future operating results.
Management currently estimates that capital expenditures for the last half of 2012 will be approximately $2,000,000. Management does not plan to open any new restaurants in 2012 and remains cautious about future development. New restaurant development could also be constrained in the future due to lack of capital resources depending on the amount of cash flow generated by future operations of the Company or the availability to the Company of additional financing on terms acceptable to the Company, if at all.
On June 27, 2012, the Company amended its revolving bank line of credit agreement to, among other things, extend the maturity date to June 27, 2015, increase the maximum principal amount available for borrowing from $5,000,000 to $6,000,000, and adjust and modify the interest rate charged on any outstanding borrowings from LIBOR plus a variable margin based on the Company’s Adjusted Debt to EDITDAR Ratio (with such margin ranging from 3.5% to 4.5%) to LIBOR plus 3% with a minimum applicable interest rate of 4.25%. No amounts were outstanding under the revolving line of credit at July 1, 2012, or subsequent to that time through August 14, 2012.
A mortgage loan obtained in 2002 represents the most significant portion of the Company’s outstanding long-term debt. The loan had an outstanding balance of $17,803,000 at July 1, 2012. The loan is secured by the real estate, equipment and other personal property of nine of the Company’s restaurant locations with an aggregate net book value of $21,850,000 at July 1, 2012.
The Company believes that cash and cash equivalents on hand as of July 1, 2012 and cash flow generated by future operations will be adequate to meet the Company’s operating and capital needs for 2012. The Company was in compliance with the financial covenants of its debt agreements as of July 1, 2012. Should the Company fail to comply with these covenants, management would likely request waivers of the covenants, attempt to renegotiate them or seek other sources of financing. However, if these efforts were not successful, the unused portion of the Company’s bank line of credit would not be available for borrowing and amounts outstanding under the Company’s debt agreements could become immediately due and payable, and there could be a material adverse effect on the Company’s financial condition and operations.
OFF BALANCE SHEET ARRANGEMENTS
As of August 14, 2012, the Company had no financing transactions, arrangements or other relationships with any unconsolidated affiliated entities. Additionally, the Company is not a party to any financing arrangements involving synthetic leases or trading activities involving commodity contracts.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Critical accounting policies are those that management believes to be the most significant judgments and estimates used in the preparation of the Company’s Condensed Consolidated Financial Statements. Judgments or uncertainties regarding the application of these policies could potentially result in materially different amounts being reported under different assumptions and conditions. There have been no material changes to the critical accounting policies previously reported in the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, 2012.
FORWARD-LOOKING STATEMENTS
In connection with the safe harbor established under the Private Securities Litigation Reform Act of 1995, the Company cautions investors that certain information contained in this Form 10-Q, particularly information regarding future economic performance and finances, development plans, and objectives of management is forward-looking information that involves risks, uncertainties and other factors that could cause actual results to differ materially from those expressed or implied by forward-looking statements. The Company disclaims any intent or obligation to update these forward-looking statements. Other risks, uncertainties and factors which could affect actual results include, but are not limited to, the costs and expenses of the Company’s evaluation of strategic alternatives; the costs and uncertainties relating to the consummation of the transactions contemplated by the definitive agreement with Fidelity including uncertainties as to how many of the Company’s shareholders will tender their stock in the tender offer, the risk of shareholder litigation in connection with the transaction and any related significant costs of defense, indemnification and liability, and the possibility that various closing conditions for the transaction may not be satisfied or waived; the Company’s ability to maintain satisfactory guest count levels and maintain or increase sales and operating margins in its restaurants under varying economic conditions, which could worsen, potentially resulting in additional asset impairment charges and/or restaurant closures and charges associated therewith; the effect of higher gasoline prices or commodity prices, unemployment and other economic factors on consumer demand; increases in food input costs or product shortages and the Company’s response to them; changes in consumer spending, consumer tastes, and consumer attitudes toward nutrition and health; the potential impact of mandated food content labeling and disclosure legislation; costs that may be incurred in connection with the contested election of directors; expenses incurred if the Company is the subject of claims or litigation, including matters resulting from complaints or allegations from shareholders or from current, former or prospective employees, or increased governmental regulation; the impact associated with recently passed federal health care reform legislation, including the operating costs necessary to comply with applicable health care benefit requirements; the impact of tax audits conducted by the Internal Revenue Service and various state tax authorities; increases in the minimum wage the Company is required to pay; availability of qualified employees; increased cost of utilities, insurance and other restaurant operating expenses; potential fluctuations of quarterly operating results due to seasonality and other factors; the effect of hurricanes and other weather disturbances which are beyond the control of the Company; the number and timing of new restaurant openings and the Company’s ability to operate them profitably; competition within the casual dining industry, which is very intense; competition by the Company’s new restaurants with its existing restaurants in the same vicinity; fluctuations in the Company’s operating results which could affect compliance with its debt covenants and ability to borrow funds; conditions in the U.S. credit markets and the availability of bank financing on acceptable terms; changes in accounting standards, which may affect the Company’s reported results of operations; and expenses the Company may incur in order to comply with changing corporate governance and public disclosure requirements of the Securities and Exchange Commission and The NASDAQ Stock Market. See “Risk Factors” included in the Company’s Annual Report on Form 10-K for the year ended January 1, 2012 for a description of a number of risks and uncertainties which could affect actual results.
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Fund Letters
