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EINSTEIN NOAH RESTAURANT GROUP INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) General We have a 52/53-week fiscal year ending on the Tuesday closest to December 31. Fiscal years 2012 and 2013 ended on January 1, 2013 and December 31, 2013, respectively, and each contained 52 weeks. Fiscal year 2011 ended on January 3, 2012 and contained 53 weeks. Comparable store sales percentages presented for fiscal 2011 in this Item 7 are calculated excluding the 53rd week. Overview We are the largest owner/operator, franchisor and licensor of bagel specialty restaurants in the United States. As a leading fast-casual restaurant chain, our restaurants specialize in high-quality foods for breakfast, lunch and afternoon snacks in a bakery-café atmosphere with a neighborhood emphasis. Our product offerings include fresh bagels and other bakery items baked on-site, made-to-order sandwiches on a variety of bagels, breads or wraps, gourmet soups and salads, assorted pastries, premium coffees and an assortment of snacks. Our manufacturing operations and network of independent distributors deliver high-quality ingredients to our restaurants. This Overview will review 2013 Highlights and Trends and provide a 2014 Outlook. 2013 Highlights and Trends Our results for 2013 reflect the continued soundness of our business model, the underlying strength of our brands and the talent and dedication of our employees. We continued to focus on our key strategies and tactics which are to: • Drive same-store sales growth; • Manage and enhance corporate margins through supply chain, manufacturing and store level efficiency; and • Accelerate unit growth primarily through franchise and license expansion. We opened a record 61 restaurants in 2013. For fiscal 2013, our system-wide and company-owned comparable store sales were -0.3% and -0.6%, respectively, with a quarterly distribution as follows: Q1 Q2 Q3 Q4 Year System-wide comparable sales -0.6 % +0.7 % -1.4 % +0.1 % -0.3 % Company-owned comparable sales -1.0 % +0.4 % -1.4 % -0.5 % -0.6 % While system-wide transaction decline was -2.4% for fiscal 2013, the fourth quarter posted a transaction decline of only -1.0%. During fiscal 2013, we focused on stimulating comparable transactions by improving our value layer deals coupled with innovative features on our premium sandwiches. Average check increased +2.1% for fiscal 2013 on a system-wide basis. Our focus on our online ordering system, online search engine and online marketing resulted in growth of our catering business by approximately 18%. Our catering business now makes up approximately 9% of our company-owned restaurant revenues. Coffee and blended beverage sales also represent approximately 9% of our menu mix and continue to grow. Our margin as a percentage of restaurant revenues declined at our company-owned restaurants by 1.5% primarily due to sales deleveraging. Our prime costs (combined costs of sales and total labor) increased 0.6% to 26-------------------------------------------------------------------------------- Table of Contents 57.4% of company-owned restaurant sales as a result of our investment in value-driven discounting. Our marketing expenses declined 0.2% to 2.8% of company-owned restaurant sales. Revenues from our manufacturing facility grew by $2.5 million, or 8.2%, to $33.6 million as a result of additional sales to our third-party wholesalers and additional sales to our franchisees and licensees. Gross margin increased 29.5% to $8.8 million on the strength of incremental sales. We again made progress in balancing our unit portfolio toward our goal of having at least 50% of our system-wide units being franchise and license units. The proportion of units opened in our franchise and license channels was approximately 84% of total openings in 2013 as we opened 51 franchise and license units in addition to 10 company-owned restaurants during fiscal 2013. Total net units increased in fiscal 2013 to 852 from 816 at the end of fiscal 2012, with 46% being franchised and licensed units, up from 43% at the end of fiscal 2012. Thus far in fiscal 2014, we have opened eight licensed units and two franchised units. Our Recapitalization - Fiscal 2012 and 2013 In 2012, our Board authorized a review of strategic alternatives to maximize value for all stockholders. This review was initiated in May and culminated in December with a recapitalization of the Company, including the payment of a one-time special cash dividend of $4.00 per share of common stock on December 27, 2012. The recapitalization included the amendment and restatement of the Company's existing Senior Credit Facility, which consists of a Term Loan A and a revolver with a syndicate of banks ("Senior Credit Facility"). The amendment and restatement of the Senior Credit Facility increased the Company's Term Loan A from $75 million to $100 million, increased the revolver availability from $50 million to $75 million, and extended the maturity date from December 20, 2015 to December 6, 2017. The additional borrowing capacity was used to fund the one-time special dividend of $68.1 million, as well as our ongoing quarterly dividends, working capital needs, capital expenditures, and other general corporate purposes. On June 27, 2013, the Facility was further amended and restated to lower its applicable interest rate and extend its maturity date without increasing its borrowing capacity. The Senior Credit Facility matures on June 6, 2018. We have also entered into two cash flow hedges in an effort to mitigate our variable interest rate risk. For a complete description of the terms for the Senior Credit Facility and our cash flow hedges, see Note 8 and Note 9, respectively, to our consolidated financial statements set forth in Item 8 of this Form 10-K. Secondary Offering As of December 31, 2013, Greenlight beneficially owned approximately 38% of our common stock. This represents a decrease from Greenlight's beneficial ownership of approximately 63% as of January 1, 2013. In August 2013, Greenlight sold 1.5 million shares of our stock in a secondary offering. In November 2013, Greenlight sold an additional 2.5 million shares of our stock in another secondary offering. As a result of these transactions, we are no longer a controlled company. We did not receive any proceeds from these sales of shares and all costs associated with this transaction were charged to Greenlight. 2014 Outlook Our execution plan to grow comparable store sales includes: • Building traffic by: • Promoting innovative and effective value • Enhance our healthy options • Focusing on fresh baked bagels and beverage innovation • Delivering relevant, reliable and valuable guest experiences 27 -------------------------------------------------------------------------------- Table of Contents • Building average check through bulk bagels, and accelerating catering growth • Increasing media and brand awareness with a balanced approach of local ("grass roots") and mass marketing: • Local brand activation • Directional outdoor and radio support • Digital marketing/social media We expect that our catering channel will benefit from new initiatives in fiscal 2014 that include an enhanced call center, expanded search engine marketing, utilization of sales coordinators in smaller markets and database activation. Our plan is to improve corporate margins by focusing on strategic contract renegotiations, distribution optimization, improving packaging quality and costs, and improving marketing and construction materials purchases. Our emphasis on acceleration of unit growth includes the opening of 75 to 85 units in 2014. We will seek to accomplish this objective by continuing to focus on a franchise first growth model, asset light unit economics, penetration into new key channels and opportunistic refranchising and acquisition efforts. We see refranchising our units as an opportunity to attract high quality franchisees that will support our accelerated growth initiatives. The airport channel currently consists of sixteen licensed locations with an average unit volume of $1.9 million and a total of $24.3 million in sales for 2013, on which we receive a royalty. We opened units in Dallas/Fort Worth, Denver, San Diego and Atlanta in fiscal 2013 and were recently awarded additional locations in the San Diego, Atlanta, La Guardia (New York), Miami and San Jose (California) airports. We currently have a robust pipeline of existing franchise development agreements and new license locations. As of February 21, 2014, we have 27 development agreements in place for 186 total restaurants, 47 of which have already opened. Based upon the development agreements, we expect the remaining 139 new restaurants will open on various dates through 2021. We expect to spend between $24 million and $26 million in capital expenditures in 2014 which includes the opening of company-owned restaurants and the relocation of additional company-owned restaurants. We also intend to deploy our capital into areas such as the remodeling or refreshing of existing stores, installing drive-thru lanes and adding new exterior signage at certain locations. Our free cash flow is expected to continue to provide us with the financial resources to execute on our fiscal 2014 plan, including the continued servicing of our elevated level of debt. Use of Non-GAAP Financial Information In addition to the results reported in accordance with accounting principles generally accepted in the United States of America ("GAAP") included in this filing, we have provided certain non-GAAP financial information, including non-GAAP total revenues excluding the extra week in fiscal 2011; adjusted earnings before interest, taxes, depreciation and amortization, restructuring expenses, strategic alternative expenses, and other operating expenses/income ("Adjusted EBITDA"); net income adjusted for the extra 53rd week in fiscal 2011, restructuring expenses, strategic alternatives expense, incremental interest expense on additional credit facility borrowings and other operating expenses/income ("Adjusted Net Income"); earnings per share adjusted for the extra 53rd week in fiscal 2011, restructuring expenses, strategic alternatives expense, incremental interest expense on additional credit facility borrowings and other operating expenses/income ("Adjusted Net Income Per Share"); and "Free Cash Flow", which we define as net cash provided by operating activities less net cash used in investing 28 -------------------------------------------------------------------------------- Table of Contents activities. Management believes that the presentation of this non-GAAP financial information provides useful information to investors because this information may allow investors to better evaluate our ongoing business performance and certain components of our results. In addition, the Board uses this non-GAAP financial information to evaluate the performance of the Company and its management team. This information should be considered in addition to the results presented in accordance with GAAP, and should not be considered a substitute for the GAAP results. Not all of the aforementioned items defining Adjusted EBITDA occur in each reporting period, but have been included in our definitions of these terms based on historical activity. We have reconciled the non-GAAP financial information to the nearest GAAP measure on pages 31, 37, 42 and 46. We include in this report information on system-wide comparable store sales percentages. Restaurants included in our comparable store sales percentages include those restaurants in operation for a full six fiscal quarters. System-wide comparable store sales percentages refer to changes in sales of our restaurants, whether operated by the Company or by franchisees and licensees, in operation for six fiscal quarters including those restaurants temporarily closed for an immaterial amount of time. Some of the reasons restaurants may be temporarily closed include remodeling, relocations, road construction, rebuilding related to site-specific catastrophes and natural disasters. Franchise and license comparable store sales percentages are based on sales of franchised and licensed restaurants, as reported by franchisees and licensees. Management reviews the increase or decrease in comparable store sales to assess business trends. Comparable store sales exclude permanently closed locations. When we intend to relocate a restaurant, we consider that restaurant to be temporarily closed for up to twelve months after it ceases operations. If a suitable relocation site has not been identified by the end of twelve months, we consider the restaurant to be permanently closed. Until that time, we include the restaurant in our open store count, but exclude its sales from our comparable store sales. As of December 31, 2013, there are four stores that are currently closed but that we intend to relocate, and are thus considered to be temporarily closed. We use company-owned store sales, franchise and license sales and the resulting system-wide sales information internally in connection with restaurant development decisions, planning, and budgeting analyses. We believe system-wide comparable store sales information is useful in assessing consumer acceptance of our brands; facilitates an understanding of our financial performance and the overall direction and trends of sales and operating income; helps us appreciate the effectiveness of our advertising and marketing initiatives; and provides information that is relevant for comparison within the industry. Comparable store sales percentages are non-GAAP financial measures, which should not be considered in isolation or as a substitute for other measures of performance prepared in accordance with GAAP, and may not be equivalent to comparable store sales as defined or used by other companies. We do not record franchise or license restaurant sales as revenues. However, royalty revenues are calculated based on a percentage of franchise and license restaurant sales, as reported by the franchisees or licensees. 29-------------------------------------------------------------------------------- Table of Contents Results of Operations for Fiscal 2013 as compared to Fiscal 2012 Financial Highlights • Total revenues increased $7.5 million, or 1.8%, which was driven by an increase in company-owned restaurant revenue of $3.6 million, an increase of $3.0 million from our manufacturing operations and an increase in franchise and license related revenue of $1.3 million, partially offset by a decline in revenue of $0.5 million from commissaries that were closed by the end of the first quarter of fiscal 2012. Increase/ Fiscal Year Ended (Decrease) January 1, December 31, 2013 2013 2013 vs. 2012 (in thousands) Revenues: Company-owned restaurant sales $ 384,783 $ 388,362 0.9 % Manufacturing and commissary revenues 31,037 33,585 8.2 % Franchise and license related revenues 11,186 12,534 12.1 % Total revenues 427,006 434,481 1.8 % • System-wide comparable store sales decreased -0.3%, primarily due to a company-owned comparable store sales decrease of -0.6%. During fiscal 2013, we focused on stimulating comparable transactions by improving our value layer deals coupled with innovative features on our premium sandwiches. While we faced challenging economic headwinds in fiscal 2013, we believe that the investment in value and additional discounting had a positive impact on transactions for the year and that we are well positioned for fiscal 2014. • Our overall gross margin (excluding depreciation and amortization) for fiscal 2012 was $88.6 million for fiscal 2013, a decrease of 1.9%. We attribute this decrease to the deleveraging of company-owned restaurant costs resulting from our investment in discounting. Increase/ Fiscal Year Ended (Decrease) January 1, December 31, 2013 2013 2013 vs. 2012 (in thousands) Total revenues $ 427,006 $ 434,481 1.8 % Company-owned restaurant costs 312,402 321,072 2.8 % Manufacturing and commissary costs 24,236 24,779 2.2 % Gross Margin $ 90,368 $ 88,630 (1.9 %) • Interest expense increased $2.6 million due to an increase of $50.6 million in our average debt balance and a 0.4% increase in our weighted average interest rate. In fiscal 2012, we funded a special dividend through an amendment of our Senior Credit Facility. • Net income was $14.6 million for fiscal 2013, an increase of 14.3% from net income of $12.7 million for fiscal 2012. • Diluted earnings per share ("EPS") were $0.82 for fiscal 2013 compared to $0.74 in fiscal 2012. The increase in diluted EPS is primarily due to an increase in earnings from operations and the elimination of one-time expenses incurred in fiscal 2012 towards a strategic alternatives review process and restructuring, partially offset by an increase in interest expense in fiscal 2013 resulting from a higher amount of third party debt incurred for the funding of a special dividend in fiscal 2012. Diluted EPS for fiscal 2012 was impacted by approximately $0.15 per share for strategic alternative transaction expenses and restructuring charges. For fiscal 2013, increased interest expense impacted diluted EPS by approximately $0.10 per share. 30 -------------------------------------------------------------------------------- Table of Contents • Adjusted EBITDA was $47.2 million for fiscal 2013, a decrease of 5.0% from Adjusted EBITDA of $49.7 million for fiscal 2012. In fiscal 2012, we expensed $3.7 million towards the strategic alternatives review process. We did not incur similar costs in fiscal 2013. Consolidated Results - Fiscal 2013 vs Fiscal 2012 Fiscal Year Ended Increase/ (in thousands) (Decrease) January 1, December 31, 2013 2013 2013 vs. 2012 Revenues $ 427,006 $ 434,481 1.8 % Cost of sales 336,638 345,851 2.7 % Operating expenses 66,140 60,766 (8.1 %) Income from operations 24,228 27,864 15.0 % Interest expense, net 3,384 5,970 76.4 % Income before income taxes 20,844 21,894 5.0 % Total provision for income taxes 8,103 7,329 (9.6 %) Net income $ 12,741 $ 14,565 14.3 % Adjustments to net income: Interest expense, net 3,384 5,970 76.4 % Provision for income taxes 8,103 7,329 (9.6 %) Depreciation and amortization 19,707 18,203 (7.6 %) Restructuring expenses 480 - * * Strategic alternatives expenses 3,677 - * * Other operating expenses, net 1,592 1,138 (28.5 %) Adjusted EBITDA $ 49,684 $ 47,205 (5.0 %) ** Not meaningful To stimulate transaction growth in fiscal 2013, we concentrated on value bundling to our customers. Our discounting, which is recorded against revenue, increased $7.7 million from fiscal 2012. While fiscal 2013 proved to be challenging, we believe that this investment in discounting has had a positive impact on transaction growth for the year and that we are well positioned for fiscal 2014. Strong third-party sales from our manufacturing operation and an increase in comparable store sales from our franchise and license operations of +0.4% helped mitigate the impact of this discounting at our company-owned restaurants. Our income from operations increased by $3.6 million in fiscal 2013 to $27.9 million primarily as a result of the reversing effect of expenses incurred with the strategic alternatives review process we undertook in 2012, improved manufacturing results and increased franchise and license revenue, partially offset by a decline in operations at our company-owned restaurants resulting from the deleveraging of costs associated with our investment in discounting. Net income was $14.6 million for fiscal 2013, an increase of $1.8 million, or 14.3%, from fiscal 2012. We attribute this increase to an improvement in overall income from operations, the reversing effect of one-time expenses related to the strategic alternatives review process incurred by us in fiscal 2012 and a lower effective tax rate, partially offset by increased interest expense due primarily to a larger amount of debt in fiscal 2013. 31-------------------------------------------------------------------------------- Table of Contents Company-Owned Restaurant Operations Fiscal Year Ended Increase/ Percentage of company-owned (in thousands) (Decrease) restaurant sales January 1, December 31, 2013 January 1, December 31, 2013 2013 vs. 2012 2013 2013 Company-owned restaurant sales $ 384,783 $ 388,362 0.9 % Percent of total revenues 90.1 % 89.4 % Cost of sales (exclusive of depreciation and amortization): Cost of goods sold $ 106,925 $ 109,122 2.1 % 27.8 % 28.1 % Labor costs 111,784 113,849 1.8 % 29.0 % 29.3 % Rent and related expenses 41,993 44,233 5.3 % 10.9 % 11.4 % Other operating costs 40,320 42,962 6.6 % 10.5 % 11.1 % Marketing costs 11,380 10,906 (4.2 %) 3.0 % 2.8 % Total company-owned restaurant costs $ 312,402 $ 321,072 2.8 % 81.2 % 82.7 % Total company-owned restaurant gross margin $ 72,381 $ 67,290 (7.0 %) 18.8 % 17.3 % In fiscal 2013, we opened ten restaurants, acquired three restaurants from a franchisee, closed ten restaurants and sold six restaurants to franchisees. Company-owned restaurant sales for fiscal 2013 increased $3.6 million. We attribute this increase to net incremental revenue of $3.9 million from new company-owned restaurants opened in 2013, $6.9 million from stores opened in fiscal 2012 that are not yet eligible to be included in our comparable store base and $0.4 million from stores we acquired from franchisees, partially offset by a $2.8 decline in year-over-year sales at restaurants closed during 2013, a $3.3 million decline in year-over-year sales from restaurants that were sold to franchisees and a decline in company-owned comparable store sales. Company-owned comparable store sales decreased -0.6% in fiscal 2013. The decrease in company-owned comparable store sales is due to a decrease in transactions (-2.7%) and the impact of discounting (-1.9%), partially offset by an increase from pricing (+0.9%) and a shift in product mix (+3.1%). We took two price increases in fiscal 2013, totaling approximately 1.4%. Comparable store sales for our company-owned restaurants for each quarter in fiscal 2012 and 2013 were as follows: Fiscal 2012 Fiscal 2013 Change First Quarter +1.1 % -1.0 % -2.1 % Second Quarter +1.2 % +0.4 % -0.8 % Third Quarter +0.2 % -1.4 % -1.6 % Fourth Quarter +1.1 % -0.5 % -1.6 % Annual +0.9 % -0.6 % -1.5 % Total costs for company-owned restaurants, as a percentage of company-owned restaurant sales, increased 150 basis points primarily due to our investment in discounting, minimum wage increases and the initial ramp up of 21 stores opened since the start of the fourth quarter 2012. Our prime costs, consisting of costs of goods sold and labor costs, increased 60 basis to 57.4% of company-owned restaurant revenues. 32 -------------------------------------------------------------------------------- Table of Contents As a percentage of company-owned restaurant sales, we saw an increase in our food costs from 27.8% for fiscal 2012 to 28.1%. The following items affected the comparability of our cost of sales for fiscal 2013 compared to fiscal 2012: Cost of Goods Sold - 2012 27.8 % Inflation 0.2 % Investment in value and discounting 0.6 % Shift in product mix 0.1 % Savings from initiatives ($1.1 million) (0.3 %) Price increases (0.3 %) 0.3 % Cost of Goods Sold - 2013 28.1 % As of December 31, 2013, we have secured price protection on the following commodity needs for fiscal 2014: Commodity % Locked Coffee 92 % Wheat 100 % Butter 84 % Class III Milk 100 % We anticipate overall inflation to be in the range of 1.0% to 2.0% for fiscal 2014. As a percentage of company-owned restaurant sales, labor costs increased by 30 basis points to 29.3% in fiscal 2013, primarily due to deleveraging of costs resulting from our investment in discounting, new stores and larger insurance claims, partially offset by a decrease in variable incentive compensation. As a percentage of company-owned restaurant sales, rent and related expenses increased by 50 basis points to 11.4% in fiscal 2013, primarily due to unit growth, rent increases on renegotiated leases and related increases in property taxes. As a percentage of company-owned restaurant sales, other operating costs increased by 60 basis points to 11.1% in fiscal 2013, primarily due to increased utility charges, increased store supply expenditures and increased bank charges. Gross margin for our company-owned restaurant segment decreased in fiscal 2013 by $5.1 million, or 7.0%, to $67.3 million. We attribute this to sales deleveraging resulting from our investment in discounting. Manufacturing and Commissary Operations Fiscal Year Ended Increase/ Percentage of manufacturing (in thousands) (Decrease) and commissary revenues January 1, December 31, 2013 January 1, December 31, 2013 2013 vs. 2012 2013 2013Manufacturing and commissary revenues $ 31,037 $ 33,585 8.2 % Percent of total revenues 7.3 % 7.7 % Manufacturing and commissary costs (exclusive of depreciation and amortization) $ 24,236 $ 24,779 2.2 % 78.1 % 73.8 % Total manufacturing and commissary gross margin $ 6,801 $ 8,806 29.5 % 21.9 % 26.2 % 33 -------------------------------------------------------------------------------- Table of Contents We closed all five of our commissaries by the end of the first quarter 2012. Sales that were previously made to our franchisees and licensees by the commissaries are now being handled directly through our distributors. Cost savings resulting from the closures of our commissaries and other initiatives continue to have a significant positive impact on our margins. On a year-to-date basis, sales from our manufacturing facility grew by $3.0 million, or 10.2%, to $33.6 million as a result of additional sales to our wholesalers and additional third party franchise and licensee sales when compared to the same period last year. This increase was partially offset by a decrease in commissary revenues of $0.5 million, a direct result of the commissary closures. Franchise and License Operations Fiscal Year Ended Increase/ (in thousands) (Decrease) January 1, December 31, 2013 2013 2013 vs. 2012 Franchise and license related revenues $ 11,186 $ 12,534 12.1 % Percent of total revenues 2.6 % 2.9 % Number of franchise and license restaurants 355 394 Franchise and license revenue improved by $1.3 million, or 12.1% from fiscal 2012, primarily the result of increased comparable store sales, continued unit development and an increase in initial franchise and license fee revenue recorded on unit openings. Franchise and license comparable store sales were +0.4% for the fiscal year ended December 31, 2013. In fiscal 2013, we opened 37 licensed locations and 14 franchised locations, including our first restaurants in Montana, Vermont and Iowa. As of February 21, 2014, we have 27 development agreements in place for 186 total restaurants, 47 of which have already opened. Based upon the development agreements, we expect the remaining 139 new restaurants will open on various dates through 2021. Corporate Support Fiscal Year Ended Increase/ Percentage of (in thousands) (Decrease) total revenues January 1, December 31, 2013 January 1, December 31, 2013 2013 vs. 2012 2013 2013General and administrative expenses $ 39,569 $ 40,350 2.0 % 9.3 % 9.3 % Depreciation and amortization 19,707 18,203 (7.6 %) 4.6 % 4.2 % Pre-opening expenses 1,115 1,075 (3.6 %) 0.2 % 0.2 % Restructuring expenses 480 - * * 0.1 % 0.0 % Strategic alternatives expense 3,677 - * * 0.9 % 0.0 % Other operating expenses, net 1,592 1,138 (28.5 %) 0.4 % 0.3 % Total operating expenses $ 66,140 $ 60,766 (8.1 %) 15.6 % 14.0 % Interest expense, net 3,384 5,970 76.4 % 0.8 % 1.4 % Provision for income taxes 8,103 7,329 (9.6 %) 1.9 % 1.7 % ** Not meaningful As a percentage of revenues, our total general and administrative expenses remained flat at 9.3% in fiscal 2013. On May 3, 2012, we announced that our Board authorized a review of strategic alternatives to maximize value for all stockholders. The review was completed on December 6, 2012. During the review period, we had a number of open corporate support positions that remained open. Upon completion of the review, we filled the 34-------------------------------------------------------------------------------- Table of Contents majority of these vacant positions. While this resulted in an increase to our base compensation (including payroll taxes) of $0.8 million, our performance incentive compensation decreased $1.7 million from fiscal 2012 as we reached a lower bonus threshold in fiscal 2013 than we did in fiscal 2012. This decrease was offset by increased professional fees and travel charges. We expect general and administrative expenses for fiscal 2014 to be approximately $10.5 million to $11.5 million per quarter. Depreciation and amortization expenses decreased $1.5 million, or 7.6%. This decrease is primarily due to three and five year equipment becoming fully depreciated and the write-off of fixed assets relating to store closures. Based on our current planned purchases of capital assets, our existing base of assets and our projections for new purchases of fixed assets, we believe depreciation expense for fiscal 2014 will be in the range of $16.0 million to $18.0 million. Pre-opening expenses, which include rent, wages, marketing, food and other restaurant operating costs, remained flat. We estimate pre-opening expenses to be approximately $65,000 to $75,000 per new Company-owned restaurant. We incurred an additional $0.5 million of restructuring expenses in fiscal 2012 related to the closure of our five commissaries. All of our commissaries were closed by the end of the first quarter 2012. In fiscal 2012, we expensed approximately $1.2 million for an employee benefit settlement. We also incurred $0.1 million in acquisition costs in fiscal 2012 towards the purchase of seven restaurants from our franchisees. In fiscal 2013, we recorded losses of $1.3 million on the closure of six company-owned restaurants. We also expensed approximately $0.8 million for an employee wage settlement and approximately $0.4 million of losses on the retirement of fixed assets. These expenses were offset by gains of approximately $1.3 million as we sold five existing restaurants to a franchisee in Pittsburgh, Pennsylvania and one restaurant to a franchisee in Fairfield, Connecticut. These items are recorded as components of other operating expenses, net on our consolidated statements of income and consolidated income. Interest expense, net has increased in fiscal 2013 due to additional borrowings and an increase in our weighted average interest rate. Our average debt balance increased from $75.1 million for fiscal 2012 to $125.7 million for fiscal 2013. Our weighted average interest rate for fiscal 2013 was 3.8% compared to 3.4% for fiscal 2012. We amended our Senior Credit Facility in June 2013. This amendment reduced the applicable margin on Eurodollar and base rate loans by 75 basis points. This amendment, combined with our consolidated leverage rate, resulted in a weighted average interest rate of 3.1% as of December 31, 2013. Subject to pay-downs of the revolving credit facility, we estimate interest expense to be in the range of $4.5 million to $5.0 million for fiscal 2014. The components of our provision for income taxes were as follows: Fiscal Year Ended January 1, December 31, 2013 2013 (in thousands) Current Total current income tax provision $ 235 $ 415 Deferred Total deferred income tax provision 12,658 6,914 Change in valuation allowance (4,790 ) - Total deferred income tax provision 7,868 6,914 Total income tax provision $ 8,103 $ 7,329 35 -------------------------------------------------------------------------------- Table of Contents Our effective tax rate decreased from 38.9% for fiscal 2012 to 33.5% for fiscal 2013 as a result of deferred tax true-ups, the effects of estimate-to-actual income tax provision adjustments and federal employment tax credits. The American Taxpayer Relief Act of 2012 was enacted on January 2, 2013, which coincided with the start of our 2013 fiscal year. As a result, these federal employment tax credits were applied to our fiscal 2013 annual effective tax rate. Results of Operations for Fiscal 2012 as compared to Fiscal 2011 Financial Highlights • System-wide comparable store sales increased +1.0%. • Total revenues increased $3.4 million, or 0.8%, which was driven by an increase in company-owned restaurant revenue of $6.1 million and franchise and license related revenue of $0.9 million, partially offset by a decline in manufacturing and commissary revenue. The extra 53rd week in fiscal 2011 contributed an additional $7.3 million of revenue. Excluding the extra week in fiscal 2011, total revenues increased 2.6% in 2012, with revenue growth offset by the closure of our commissaries. • Manufacturing and commissary revenue decreased $3.5 million due to the closure of our commissaries and one less week in fiscal 2012. A decrease in commissary revenue of $4.9 million was partially offset by a 4.7% increase in manufacturing revenue of $1.4 million. We attribute this increase in manufacturing revenue to higher export sales. The extra 53rd week in fiscal 2011 contributed an additional $0.5 million of revenue. • Franchise and license related revenues grew 8.3%, or $0.9 million, and was driven by an increase in comparable store sales of +1.3% and unit growth. The extra 53rd week in fiscal 2011 contributed an additional $0.1 million of revenue. • Cost of goods sold decreased 180 basis points as a percentage of company-owned restaurant sales as a result of our cost savings initiatives and the leveraged impact of price increases. • Net income decreased 3.5% primarily due to the extra 53rd week in fiscal 2011 and the above mentioned strategic alternative review process, partially offset by our cost saving initiatives. • Adjusted net income increased $3.1 million, or 23.9% to $16.3 million, or $0.94 adjusted earnings per diluted share, compared to adjusted net income of $13.1 million, or $0.78 adjusted earnings per diluted share, on a comparable 52-week basis. • Adjusted EBITDA increased 11.7% primarily due to improved revenue and cost saving initiatives. • Our Board authorized a review of strategic alternatives to maximize value for all stockholders. This review was initiated in May and culminated in December with a recapitalization of the Company, including the payment of a one-time special cash dividend of $4.00 per share of common stock totaling $68.1 million on December 27, 2012. 36 -------------------------------------------------------------------------------- Table of Contents Consolidated Results - Fiscal 2012 vs Fiscal 2011 Fiscal Year Ended Increase/ (in thousands) (Decrease) January 3, January 1, 2012 2012 2013 vs. 2011 Revenues $ 423,595 $ 427,006 0.8 % Cost of sales 342,075 336,638 (1.6 %) Operating expenses 57,002 66,140 16.0 % Income from operations 24,518 24,228 (1.2 %) Interest expense, net 3,357 3,384 0.8 % Income before income taxes 21,161 20,844 (1.5 %) Total provision for income taxes 7,958 8,103 1.8 % Net income $ 13,203 $ 12,741 (3.5 %) Adjustments to net income: Interest expense, net 3,357 3,384 0.8 % Provision for income taxes 7,958 8,103 1.8 % Depreciation and amortization 19,259 19,707 2.3 % Restructuring expenses 1,099 480 (56.3 %) Strategic alternatives expenses - 3,677 * * Other operating expenses (income), net (395 ) 1,592 * * Adjusted EBITDA $ 44,481 $ 49,684 11.7 % ** Not meaningful Our income from operations decreased by $0.3 million in 2012 to $24.2 million primarily as a result of the non-recurring strategic alternatives review process we undertook in 2012 and an additional $0.8 million in income from operations resulting from the 53rdweek in fiscal 2011, primarily offset by improved margins in fiscal 2012. Total revenues increased by $3.4 million to $427.0 million, primarily the result of increased revenue from our company-owned stores. The extra 53rd week in 2011 contributed an additional $7.3 million in revenue. System-wide comparable stores were +1.0% for fiscal 2012 which we attribute to strong check growth of +4.2%, reflecting price and product mix favorability. Our catering business continues to be a strong revenue generator, as evidenced by an increase in catering sales of 18.1% over fiscal 2011. To build same store sales, we focus on building traffic by leveraging our strengths, growing average check and building brand awareness through various marketing initiatives. Net income decreased for fiscal 2012 primarily due to the extra 53rd week in 2011, which contributed net income of $0.5 million, and $3.7 million ($2.2 million, net of tax) in non-recurring strategic alternatives expenses, partially offset by improved margins. 37 -------------------------------------------------------------------------------- Table of Contents Company-Owned Restaurant Operations Fiscal Year Ended Increase/ Percentage of company-owned (in thousands) (Decrease) restaurant sales January 3, January 1, 2012 January 3, January 1, 2012 2013 vs. 2011 2012 2013Company-owned restaurant sales $ 378,723 $ 384,783 1.6 % Percent of total revenues 89.4 % 90.1 % Cost of sales (exclusive of depreciation and amortization): Cost of goods sold $ 112,002 $ 106,925 (4.5 %) 29.6 % 27.8 % Labor costs 110,467 111,784 1.2 % 29.2 % 29.0 % Rent and related expenses 40,277 41,993 4.3 % 10.6 % 10.9 % Other operating costs 39,092 40,320 3.1 % 10.3 % 10.5 % Marketing costs 9,796 11,380 16.2 % 2.6 % 3.0 % Total company-owned restaurant costs $ 311,634 $ 312,402 0.2 % 82.3 % 81.2 % Total company-owned restaurant gross margin $ 67,089 $ 72,381 7.9 % 17.7 % 18.8 % Comparable store sales for our company-owned restaurants for each quarter in fiscal 2011 and 2012 were as follows: Fiscal 2011 Fiscal 2012 Change First Quarter -1.4 % +1.1 % +2.5 % Second Quarter -0.3 % +1.2 % +1.5 % Third Quarter +0.7 % +0.2 % -0.5 % Fourth Quarter +0.8 % +1.1 % +0.3 % Annual 0.0 % +0.9 % +0.9 % Company-owned restaurant sales for fiscal 2012 increased $6.1 million, which is attributable to favorable company-owned comparable store sales, net incremental revenue of $1.7 million from new company-owned stores opened in 2012, $3.4 million from stores we acquired from franchisees and income from gift card breakage of $1.0 million. Stores that we opened in the fourth quarter 2011 further contributed incremental revenue of $5.3 million in fiscal 2012. Company-owned comparable store sales increased +0.9%, with average check increasing +4.9% partially offset by a decline in transactions. In fiscal 2012, we opened fifteen restaurants, acquired eight restaurants and closed one restaurant. Restaurant sales for 2011 benefited from $6.7 million in revenue resulting from the extra 53rd week. We took two price increases in fiscal 2012 totaling approximately 1.0%. Catering sales, which continue to be a strong revenue driver, comprised approximately 8% of our company store sales for fiscal 2012, an increase of 18.1% from fiscal 2011. We believe that the implementation of a new online ordering system and an outsourced/expanded call center contributed to the growth in catering sales. Coffee sales represent approximately 10% of our comparable company-owned restaurant sales. Total costs for company-owned restaurants, as a percentage of company-owned restaurant sales, decreased 110 basis points primarily due to sales leveraging and our cost saving initiatives, which in 2012 included a manufacturing packing efficiency review, the introduction of reusable egg boats and the closure of our commissaries. Our prime costs, consisting of costs of goods sold and labor costs, decreased by 2.0% to 56.8% of company-owned restaurant revenues. 38-------------------------------------------------------------------------------- Table of Contents As a percentage of company-owned restaurant sales, we saw a decrease in our food costs from 29.6% for fiscal 2011 to 27.8% for fiscal 2012. This 180 basis point decrease includes savings from our initiatives (-140 basis points) and the leveraged impact of price increases (-80 basis points), partially offset by a shift in product mix (-20 basis points) and deflation in our commodity costs (-20 basis points). Most of our commodity-based food costs decreased in fiscal 2012 as we were able to lock in several of our prices. As a percentage of company-owned restaurant sales, labor costs decreased by 0.2% to 29.0% in fiscal 2012. Rent and related expenses increased primarily due to unit growth, scheduled rent increases and related increases in property taxes. Other operating expenses increased primarily due to higher credit card fees resulting from the Durban Act, which began to take effect in October 2011. We invested $1.6 million more in marketing during fiscal 2012, primarily related to product testing in certain markets, grass roots marketing and grand opening support. Gross margin for our company-owned restaurant segment increased in fiscal 2012 by $5.3 million, or 7.9%, to $72.4 million. We attribute this to an increase of $6.1 million, or 1.6%, in company-owned restaurant sales while holding company-owned restaurant costs to a modest increase of $0.8 million, or 0.2%, in fiscal 2012 due to our focus on our initiatives. Manufacturing and Commissary Operations Fiscal Year Ended Increase/ Percentage of manufacturing (in thousands) (Decrease) and commissary revenues January 3, January 1, 2012 January 3, January 1, 2012 2013 vs. 2011 2012 2013 Manufacturing and commissary revenues $ 34,542 $ 31,037 (10.1 %) Percent of total revenues 8.2 % 7.3 % Manufacturing and commissary costs $ 30,441 $ 24,236 (20.4 %) 88.1 % 78.1 % Total manufacturing and commissary gross margin $ 4,101 $ 6,801 65.8 % 11.9 % 21.9 % Manufacturing and commissary revenue was down 10.1% when compared to fiscal 2011. We closed all five of our commissaries by the end of the first quarter 2012. A decrease in commissary revenue of $4.9 million resulting from the closure of the commissaries was partially offset by an increase in manufacturing revenue of $1.4 million. We attribute this increase in manufacturing revenue to higher export sales. Cost savings resulting from the closures of our commissaries have had a significant positive impact on our margins. We believe that the commissary closures resulted in saving of $1.5 million to the company in fiscal 2012. Franchise and License Operations Fiscal Year Ended Increase/ (in thousands) (Decrease) January 3, January 1, 2012 2012 2013 vs . 2011 Franchise and license related revenues $ 10,330 $ 11,186 8.3 % Percent of total revenues 2.4 % 2.6 % Number of franchise and license restaurants 333 355 39 -------------------------------------------------------------------------------- Table of Contents Overall, franchise and license revenue improvement was driven by continued unit development as we opened 27 licensed locations and 13 franchised locations during fiscal 2012. Franchise and license comparable store sales were +1.3% for the fiscal year ended January 1, 2013. Franchise and license revenue improved by $0.9 million, or 8.3% from fiscal 2011, primarily the result of continued unit development and increases in comparable store sales, partially offset by a decline in initial license fee revenue recorded on unit openings. Corporate Support Fiscal Year Ended Increase/ Percentage of (in thousands) (Decrease) total revenues January 3, January 1, 2012 January 3, January 1, 2012 2013 vs. 2011 2012 2013 General and administrative expenses $ 36,774 $ 39,569 7.6 % 8.7 % 9.3 % Depreciation and amortization 19,259 19,707 2.3 % 4.5 % 4.6 % Pre-opening expenses 265 1,115 * * 0.0 % 0.3 % Restructuring expenses 1,099 480 (56.3 %) 0.3 % 0.1 % Strategic alternatives expense - 3,677 * * 0.0 % 0.9 % Other operating (income) expenses, net (395 ) 1,592 * * (0.1 %) 0.4 % Total operating expenses $ 57,002 $ 66,140 16.0 % 13.4 % 15.6 % Interest expense, net 3,357 3,384 0.8 % 0.8 % 0.8 % Provision for income taxes 7,958 8,103 1.8 % 1.9 % 1.9 % ** Not meaningful Our total general and administrative expenses increased $2.8 million, or 7.6%, primarily due to an increase of $3.0 million in variable incentive compensation. Our performance incentive compensation increased from fiscal 2011 as we reached a higher bonus threshold in fiscal 2012 than we did in fiscal 2011. Depreciation and amortization expenses increased $0.4 million, or 2.3%. The increase is due to approximately $24.0 million in capital asset expenditures since fiscal 2011. These additions included the construction and outfitting of 15 new company-owned stores, the relocation of 6 stores, the implementation of new POS systems and the replacement of older equipment. Pre-opening expenses, which include rent, wages, marketing, food and other restaurant operating costs, increased $0.9 million due to eleven more store openings in fiscal 2012. We opened fifteen company-owned stores in fiscal 2012 compared to four company-owned stores in fiscal 2011. We incurred an additional $0.5 million of restructuring expenses in fiscal 2012 related to our plan to close our five commissaries. All of our commissaries were closed by the end of the first quarter 2012. Restructuring expenses in fiscal 2011 included charges related to the initiation of our plan to close our commissaries and the completion of our plan to restructure the organization to align with our franchise and license growth model. On May 3, 2012, we announced that our Board authorized a review of strategic alternatives, including a possible business combination or sale of the Company, to maximize value for all stockholders. On December 6, 2012, we announced that our Board had completed its review and elected to recapitalize the Company by amending our existing credit facility and declared a one-time special cash dividend of $4.00 per share payable to holders of record of the Company's common stock as of the close of business on December 17, 2012. The payment date of the dividend was December 27, 2012. We expensed $3.7 million towards this review. Other operating (income) expenses, net changed by $2.0 million from income of $0.4 million in fiscal 2011 to expense of $1.6 million in fiscal 2012. In fiscal 2011, we recognized gains on the sale of three restaurants, a 40-------------------------------------------------------------------------------- Table of Contents gain on the insurance proceeds from a restaurant fire and we incurred acquisition costs related to the purchase of nine stores. In fiscal 2012, we expensed approximately $1.2 million for an employee benefit settlement. We also incurred $0.1 million in acquisition costs in fiscal 2012 towards the purchase of seven restaurants from our franchisees. Interest expense, net remained flat in fiscal 2012, primarily due to scheduled term loan repayments totaling $5.6 million offset by incremental interest on borrowings of $68.1 million in December 2012. As of January 1, 2013, we had an outstanding debt balance of $136.7 million. Our weighted average interest rate for fiscal 2012 was 3.4% compared to a weighted average rate of 3.1% for fiscal 2011. As of January 1, 2013, our weighted average interest rate was 4.3%. The components of our provision for income taxes were as follows: Fiscal Year Ended January 3, January 1, 2012 2013 (in thousands) Current Total current income tax provision $ 1,040 $ 235 Deferred Total deferred income tax provision 6,900 12,658 Change in valuation allowance 18 (4,790 ) Total deferred income tax provision 6,918 7,868 Total income tax provision $ 7,958 $ 8,103 Our effective tax rate increased from 37.6% for fiscal 2011 to 38.9% for fiscal 2012 because certain federal employment tax credits that were available to us in fiscal 2011 were not available to us during fiscal 2012. As of January 3, 2012, we had a valuation allowance of approximately $4.8 million established against our deferred tax assets. This valuation was applied against NOLs that will expire prior to their utilization. During fiscal 2012, we eliminated these NOLs and accordingly eliminated the related valuation allowance. 41-------------------------------------------------------------------------------- Table of Contents EINSTEIN NOAH RESTAURANT GROUP, INC. NON-GAAP FINANCIAL INFORMATION Fiscal Year Ended January 3, January 1, 2012 2013 (in thousands, except earnings per share and related share information) Total revenues, as reported $ 423,595 $ 427,006 Impact of extra week in fiscal 2011 (7,300 ) - Non-GAAP total revenues $ 416,295 $ 427,006 Net income available to common stockholders $ 13,203 $ 12,741 Adjustments for, net of tax: Extra week in fiscal 2011 (528 ) - Restructuring expenses 686 293 Strategic alternatives expense - 2,247 Other operating expenses, net (246 ) 973 Adjusted net income $ 13,115 $ 16,254 Weighted average number of common shares outstanding: Basic 16,629,098 16,935,018 Diluted 16,880,321 17,217,180 Net income per share available to common stockholders - Basic $ 0.79 $ 0.75 Adjustments for, net of tax: Extra week in fiscal 2011 (0.03 ) - Restructuring expenses 0.04 0.02 Strategic alternatives expense - 0.13 Other operating expenses, net (0.01 ) 0.06 Adjusted net income per common share - Basic $ 0.79 $ 0.96 Net income per share available to common stockholders - Diluted $ 0.78 $ 0.74 Adjustments for: Extra week in fiscal 2011 (0.03 ) - Restructuring expenses 0.04 0.02 Strategic alternatives expense - 0.13 Other operating expenses, net (0.01 ) 0.05 Adjusted net income per common share - Diluted $ 0.78 $ 0.94 42 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table summarizes the amounts of payments due under specified contractual obligations as of December 31, 2013: Payments Due by Fiscal Period More Less than 1 - 3 than 5 Total 1 year Years 3 - 5 Years years (in thousands) Long-term debt obligations 107,000 3,750 16,250 87,000 - Estimated interest expense on our credit facility (a) 14,118 3,559 6,524 4,035 - Capital lease obligations 855 288 561 6 - Operating lease obligations (b) 200,190 36,666 66,387 41,376 55,761 Purchase obligations (c) 26,676 26,676 - - - Other long-term obligations (d) 4,451 - 1,800 1,610 1,041 Accounts payable and accrued expenses 39,032 39,032 - - - Total $ 392,322 $ 109,971 $ 91,522 $ 134,027 $ 56,802 (a) Calculated as of December 31, 2013, using the variable LIBOR and U.S. Prime rates, plus the applicable margin in effect for the remainder. As the interest rates on our term loan facility and the revolving credit facility are variable, actual payments could differ materially. (b) Amounts represent cash payments and do not include potential renewal options. (c) Purchase obligations consist of non-cancelable minimum purchases of certain raw ingredients that are used in our products. (d) Other long-term obligations primarily consist of the remaining liability related to minimum future purchase commitments with a supplier that advanced us $10.0 million in 1996. Financial Condition, Liquidity and Capital Resources The restaurant industry is predominantly a cash business where cash is received at the time of the transaction. We believe that we will generate sufficient cash flow to fund operations, capital expenditures, and required debt and interest payments. Our investment in inventory is minimal because our products are perishable. Our accounts payable are on terms that we believe are consistent with those of other companies within the industry. The primary driver of our operating cash flow is our restaurant revenue, specifically the gross margin from our company-owned restaurants. Therefore, we focus on the elements of those operations including store sales and controllable expenses to ensure a steady stream of operating profits that enable us to meet our cash obligations. Including tenant improvement allowances that we typically receive from the landlord, the average cost of a new restaurant was approximately $556,000 in 2013. This amount can vary and is dependent on square footage, layout and location. The cost includes equipment, leasehold improvements, furniture and fixtures, and other related capital. This average cost does not include any pre-opening expenses or capitalized internal development costs. While tenant allowances reduce the cash cost of our restaurants, the amounts vary amongst restaurants as they depend on the location of the restaurant and on other terms of the lease. We continue to deploy our capital into specific areas of the business such as adding drive-thru lanes to restaurants, adding new exterior signage, upgrades and remodels. We anticipate that the majority of our capital expenditures for 2014 will be focused on the addition of fifteen to twenty new company-owned restaurants and the relocation of seven to ten company-owned restaurants. We also intend to deploy capital into areas such as the remodeling or refreshing of existing properties, installing drive-thru lanes and adding new exterior signage. 43-------------------------------------------------------------------------------- Table of Contents The following is information on our restaurant economics as of December 31, 2013 and represents the average company-owned restaurant that has been open longer than one year: Unit Economics December 31, 2013 (in thousands) A) Last 12 months average restaurant sales $ 874 B) Restaurant operating profit $ 162 C) Margin (B/A) 18.5 % D) Cash investment cost (1) $ 556 E) Cash on cash return (B/D) 29 % F) Restaurant-level earnings before interest, taxes, depreciation, amortization and rent (2) $ 237 G) Fully capitalized investment (3) $ 1,156 H) Fully capitalized cash on cash return (F/G) 21 % (1) Amount excludes pre-opening expenses. (2) Restaurant operating profit $162,000 plus 2013 average restaurant rent expense of $75,000 per year. (3) Average rent expense capitalized at 8 times plus cash investment cost of $556,000. Cash Flow Through On A Per Store Basis Fiscal Year Ended December 31, 2013 Company-Owned Licensed Franchised(3) (in thousands) Average unit volume $ 874 $ 460 $ 895 Contribution margin % (1) (2) 18.5 % 6.5 % 5.0 % Contribution margin $ 162 $ 30 $ 45 Cash investment $ 556 $ - $ - Upfront fee $ - $ 12.5 $ 35 (1) Reflects contribution margin for company-owned restaurants open for greater than one year and weighted average royalty rate of system for license and franchise. (2) Franchisees also contribute 4.0% of sales for marketing activities which equates to an average of $36,000 per location. (3) Only reflects Einstein Bros. Senior Credit Facility As previously discussed, in December 2012, we entered into an amended and restated senior credit facility with Bank of America and a syndicate of institutional lenders, which was further amended in June 2013. The Senior Credit Facility consists of a: • $75.0 million revolving credit facility maturing on June 6, 2018; and • $100.0 million first lien term loan maturing June 6, 2018. We may prepay amounts outstanding under the Senior Credit Facility and may terminate commitments in whole at any time without penalty or premium upon prior written notice. 44 -------------------------------------------------------------------------------- Table of Contents In addition, the Senior Credit Facility provides for (i) an incremental term loan (the "Incremental Term Loan") and (ii) an increase in the revolver (the "Revolving Facility Increase" and together with the Incremental Term Loan, the "Incremental Facilities") of up to $50 million to be used by us, if needed, solely for the purpose of making acquisitions permitted under the Senior Credit Facility. If we choose to draw down the Incremental Facilities, the outstanding amount of the Incremental Facilities must be repaid in equal quarterly installments on the last day of each calendar quarter, with any remaining amounts due and payable on June 6, 2018. Availability of the Incremental Facilities is subject to customary borrowing conditions, including the absence of any default or material adverse change, and to a requirement of advanced successful syndication of the Incremental Facilities. A portion of the revolver remains available, subject to certain conditions, to finance our ongoing working capital, capital expenditure and general corporate needs. In addition, $20.0 million of the revolver is available for letters of credit, which reduce the availability on the line. As of December 31, 2013, our availability under the revolver was $56.3 million. Working Capital Our working capital position decreased by $7.8 million in fiscal 2013. We began fiscal 2013 with working capital of $5.4 million and ended fiscal 2013 with negative working capital of $2.4 million. January 1, December 31, 2013 2013 Change (in thousands) Current assets: Cash and cash equivalents $ 17,432 $ 5,982 $ (11,450 ) Restricted cash 998 1,287 289 Accounts receivable 9,024 9,875 851 Inventories 5,382 5,634 252 Current deferred income tax assets, net 8,190 9,920 1,730 Prepaid expenses 7,059 7,252 193 Other current assets 661 682 21 Total current assets 48,746 40,632 (8,114 ) Current liabilities: Accounts payable $ 10,243 $ 13,485 $ 3,242 Accrued expenses and other current liabilities 28,104 25,773 (2,331 ) Current portion of long-term debt 5,000 3,750 (1,250 ) Total current liabilities 43,347 43,008 (339 ) Working capital surplus (deficit) $ 5,399 $ (2,376 ) $ (7,775 ) The decrease in working capital is primarily due to a decrease in cash resulting from net repayments on our revolving credit facility of $24.7 million and term loan repayments of $5.0 million in 2013, partially offset by cash received from operations. As of December 31, 2013 we had unrestricted cash of $6.0 million, representing a decrease in unrestricted cash of $11.5 million during fiscal 2013. In addition to changes in our unrestricted cash, other elements of working capital fluctuated in the normal course of business. 45-------------------------------------------------------------------------------- Table of Contents Free Cash Flow Free Cash Flow increased by $1.5 million in fiscal 2013, primarily due to an increase in proceeds received from the sale of company-owned restaurants to franchisees combined with a decrease in property and equipment purchases, partially offset by the payment of 2012 company-wide bonuses in the first quarter of 2013 and a decrease in gross margins due to our investment in discounting. Fiscal Year Ended January 1, December 31, 2013 2013 (in thousands) Net cash provided by operating activities $ 48,511 $ 42,625 Net cash used in investing activities (25,861 ) (18,508 ) Free cash flow 22,650 24,117 Net cash used in financing activities (13,870 ) (35,567 ) Net increase (decrease) in cash and cash equivalents 8,780 (11,450 ) Cash and cash equivalents, beginning of period 8,652 17,432 Cash and cash equivalents, end of period $ 17,432 $ 5,982 Based upon our projections for fiscal 2014, we believe our various sources of capital, including availability under our Senior Credit Facility, and cash flow provided by operating activities, are adequate to finance operations and capital expenditures as well as to satisfy the repayment of current debt obligations. Net Cash Provided by Operating Activities Net cash generated by operating activities was $42.6 million for fiscal 2013 compared to $48.5 million for fiscal 2012, a 12.1% decrease. We attribute a majority of this decrease to the payment of 2012 company-wide bonuses in the first quarter of 2013 and the payment of strategic alternative transaction expenses, coupled with a decrease in gross margins due to our investment in discounting. The remaining decrease can be attributed to timing differences within our working capital accounts. Net Cash Used in Investing Activities During fiscal 2013, we spent $1.0 million, net of cash acquired, on the purchase of three restaurants. We also used approximately $19.6 million of cash to purchase additional property and equipment as follows: • $12.7 million for new restaurants and upgrades of existing restaurants, including the installation of new equipment, exterior signs and new menu boards; • $6.1 million for replacement of equipment at our existing company-owned restaurants and at our manufacturing operations; and • $0.8 million for information technology upgrades and other general corporate purposes. We also received $2.1 million in proceeds from the sale of six company-owned restaurants to existing franchisees. 46-------------------------------------------------------------------------------- Table of Contents During fiscal 2012, we spent $2.2 million, net of cash acquired, on the purchase of eight restaurants. We also used approximately $24.0 million of cash to purchase additional property and equipment as follows: • $20.2 million for new restaurants and upgrades of existing restaurants, including the installation of new equipment, exterior signs and new menu boards; • $3.7 million for replacement of equipment at our existing company-owned restaurants and at our manufacturing operations; and • $0.1 million for general corporate purposes. We also received $0.4 million in proceeds from the sale of one company-owned restaurant to a franchisee. Net Cash Used in Financing Activities During fiscal 2013, we used approximately $35.6 million for financing activities. This included $5.0 million in scheduled term loan repayments, $24.7 million in additional net payments towards our revolving facility, $0.6 million in debt issuance costs relating to the amendment of our Senior Credit Facility in June 2013 and $9.1 million in dividend payments. We received $3.9 million in proceeds from stock options exercised during fiscal 2013. During fiscal 2012, we amended our Senior Credit Facility to increase the availability and then borrowed an additional $38.1 million on our term loan and an additional $30.0 million on our revolving line of credit. With these proceeds, we paid a one-time special cash dividend of $4.00 per share of common stock to stockholders totaling approximately $68.1 million. We paid $1.6 million in debt issuance costs associated with this amendment. Prior to the amendment of the Senior Credit Facility, we made term loan payments totaling $5.6 million throughout the year. In addition to the $68.1 million dividend payment referred to above, we also made $8.5 million in regular quarterly dividend payments in 2012. We received $1.8 million in proceeds from stock options exercised during fiscal 2012. Off-Balance Sheet Arrangements Letters of Credit We have $6.7 million in letters of credit outstanding under our Senior Credit Facility. The letters of credit expire on various dates during 2014, are generally automatically renewable for one additional year and are payable upon demand in the event that we fail to pay the underlying obligation. Economic Environment and Commodity Volatility Our results depend on discretionary consumer spending, which is influenced by consumer confidence and disposable income. Declining home values and sales, the negative impact of the changes in the subprime mortgage and credit markets, high unemployment rates and lower consumer confidence as a result of the changes within the economic environment have caused the consumer to experience a real and perceived reduction in disposable income. We believe that this has negatively impacted consumer spending in most segments of the restaurant industry, including the segment in which we compete. Any material decline in the amount of discretionary spending could have a material adverse effect on our sales and income. We believe our current strategy for dealing with inflation, which is to maintain operating margins through a combination of menu price increases, cost controls, efficient purchasing practices and careful evaluation of property and equipment needs, has been an effective tool for dealing with increased costs. However, the impact of inflation on labor and occupancy costs could, in the future, affect our operations. We pay many of our 47-------------------------------------------------------------------------------- Table of Contents associates based on hourly rates slightly above the applicable minimum federal, state or municipal "living wage" rates. Recent changes in minimum wage laws may create pressure to increase the pay scale for our associates, which would increase our labor costs. Costs for construction, taxes, repairs, maintenance and insurance impact our occupancy costs. Inflation on food costs also can also increase our cost of goods sold, which includes food and product costs, compensation costs and other operating costs. Wheat, coffee, butter and cheese are our primary agricultural commodities. Chicken and turkey are other major agricultural commodities which are included in our cost of goods sold. We have utilized a third party advisor to manage our wheat purchases. In addition to wheat, we have established contracts and entered into commitments with our vendors for Class III milk, butter, cheese and coffee. We believe that this strategy has been effective in dealing with increases to our food and product costs. Recent Accounting Pronouncements See Note 2 to our consolidated financial statements set forth in Item 8 of this Form 10-K for a detailed description of recent accounting pronouncements. We do not expect these recently issued accounting pronouncements to have a material impact on our results of operations, financial condition, or liquidity in future periods. Critical Accounting Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Additionally, any estimates for contingent liabilities that arise as result of any legal proceedings are discussed in Item 3 of this report. Our significant accounting policies are discussed in Note 2 to our consolidated financial statements set forth in Item 8 of this Form 10-K. Income Taxes We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the respective tax bases of our assets and liabilities. Deferred tax assets and liabilities are measured using current enacted tax rates expected to apply to taxable income in the years in which we expect the temporary differences to reverse. We routinely evaluate the likelihood of realizing the benefit of our deferred tax assets and may record a valuation allowance if, based on all available evidence, we determine that some portion of the tax benefit will not be realized. In addition, our income tax returns are periodically audited by federal and state tax authorities. These audits include questions regarding our tax filing positions, including the timing and amount of deductions taken and the allocation of income amongst various tax jurisdictions. We evaluate our exposures associated with our various tax filing positions and record a related liability. We adjust our liability for unrecognized tax benefits and income tax provision in the period in which an uncertain tax position is effectively settled, the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. As of December 31, 2013, we have not recorded a valuation allowance on our deferred tax assets. We have also recorded a liability for unrecognized tax benefits of $0.7 million. The recording of these amounts requires 48-------------------------------------------------------------------------------- Table of Contents significant management judgment regarding the interpretation of applicable statutes, the status of various income tax audits, and our particular facts and circumstances. We believe that our estimates are reasonable; however, actual results could differ from these estimates. Impairment of Long-Lived Assets We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying values of these assets may not be recoverable. For the purpose of reviewing restaurant assets for indicators of potential impairment, assets are grouped together at the market level. The Company manages its restaurants by market with significant common costs and promotional activities which are generally not clearly identifiable with an individual restaurant's cash flows. We believe that historical cash flows, in addition to other relevant facts and circumstances, are the primary basis for estimating future cash flows. Relevant facts and circumstances may include, but are not limited to, local competition in the area, the ability of existing restaurant management, the necessity of tiered pricing structures and the impact that upgrading our restaurants may have on our estimates. Recoverability of restaurant assets is measured by a comparison of the carrying amount of an individual restaurant's assets to the estimated identifiable undiscounted future cash flows expected to be generated by those restaurant assets. This process requires the use of estimates and assumptions, which are subject to a high degree of judgment. If the carrying amount of an individual restaurant's assets exceeds its estimated, identifiable, undiscounted future cash flows, an impairment charge is recognized as the amount by which the carrying amount of the assets exceeds its fair value. Generally, a restaurant's identifiable future cash flows are discounted to estimate its fair value. Based upon our testing, we had no impairments for fiscal 2012 and fiscal 2013. Impairment of Goodwill and Other Indefinite Lived Intangible Assets At least annually, we assess the recoverability of goodwill and other intangible assets that are not subject to amortization. These impairment tests require us to estimate the fair values of our restaurant concepts by making assumptions regarding future profits and cash flows, expected growth rates, terminal values, discount rates and other factors. As of December 31, 2013, the fair value of goodwill and other intangible assets not subject to amortization sufficiently exceeded the carrying values. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and other intangible assets and are also consistent with the projections and assumptions that are used in current operating plans. These assumptions are subject to change as a result of changing economic and competitive conditions. In the event that these assumptions change in the future, we may be required to record impairment charges for these assets. Leases Under 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 rent holidays and escalations are reflected in rent costs on a straight-line basis over the expected lease term, which includes cancelable option periods when it is deemed to be reasonably assured that we will exercise such option periods. The lease term commences on the date when we become legally obligated for the rent payments which coincides with the time when the landlord delivers the property for us to develop and we waive contract contingencies. All rent costs recognized during construction periods are expensed immediately as pre-opening expenses. Judgments made by management for its lease obligations include the probable term for each lease that affects the classification and accounting for a lease as capital or operating; the rent holidays and/or escalations in payments that are taken into consideration when calculating straight-line rent; incremental borrowing rates; and the term over which leasehold improvements for each restaurant facility are amortized. These judgments may produce materially different amounts of depreciation, amortization and rent expense than would be reported if different assumed lease terms were used. 49-------------------------------------------------------------------------------- Table of Contents Business Combinations We account for our acquisitions using the acquisition method of accounting. This method of accounting involves the allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed. This allocation process involves the use of estimates and assumptions to derive fair values and to complete the allocation. Acquisition accounting allows for up to one year to obtain the information necessary to finalize the fair value of all assets acquired and liabilities. As of December 31, 2013, all our recorded acquisition accounting allocations have been finalized. Insurance Liabilities We use a combination of insurance and self-insurance mechanisms to provide for potential liabilities on workers' compensation, general liability and healthcare benefits. The insurance liabilities represent an estimate of the ultimate cost of claims incurred and unpaid as of the balance sheet date. The estimated liabilities are established and are not discounted, with the exception of the workers' compensation, which is discounted at 10% based upon analysis of historical data and actuarial estimates, and they are reviewed on a quarterly basis to ensure that the liabilities are appropriate. If actual trends, including the severity or frequency of claims differ from our estimates, our financial results could be favorably or unfavorably impacted. The total estimated insurance liabilities as of December 31, 2013 were $3.0 million. Stock-Based Compensation We use the Black-Scholes model to estimate the fair value of our option awards. The Black-Scholes model requires estimates of the expected term of the option, as well as future volatility and the risk-free interest rate. Our stock options generally vest over a period of 6 months to 3 years and have contractual terms to exercise of 5 to 10 years. The expected term of options is based upon evaluations of historical and expected future exercise behavior. The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected term at the grant date. Implied volatility is based on the mean reverting average of our stock's historical volatility and that of an industry peer group. The use of mean reversion is supported by evidence of a correlation between stock price volatility and a company's leverage combined with the effects mandatory principal payments will have on our capital structure, as defined under our Senior Credit Facility. We routinely declare quarterly dividends and anticipate that we will continue to pay dividends in the future, at the discretion of the Board, dependent on a variety of factors, including available cash and the overall financial condition of the Company. There is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may differ from the actual values realized upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly in excess of the fair values originally estimated on the grant date and reported in our financial statements. Although the fair value of our share-based awards is determined in accordance with GAAP and the SEC's Staff Accounting Bulletin No. 107 using an option-pricing model, the value calculated may not be indicative of the fair value observed in a willing buyer / willing seller market transaction. 50-------------------------------------------------------------------------------- Table of Contents |