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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended January 3, 2012
For the transition period from to
Commission File Number 001-33515
EINSTEIN NOAH RESTAURANT GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)
Registrants telephone number, including area code: (303) 568-8000
Securities registered pursuant to Section 12(b) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments of this Form 10-K. ¨
Indicate by check mark whether the registrant is large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the voting common equity held by non-affiliates of the registrant as of the last business day of the second fiscal quarter, June 28, 2011 was $89,026,891 (computed by reference to the closing sale price as reported on the NASDAQ Global Market). As of February 27, 2012 there were 16,849,728 shares of the registrants Common Stock, par value of $0.001 per share outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated herein by reference from the registrants definitive proxy statement for the 2012 annual meeting of stockholders, which will be filed with the SEC within 120 days after the close of the 2011 fiscal year.
TABLE OF CONTENTS
Cautionary Note Regarding Forward-Looking Statements:
We wish to caution our readers that this Annual Report on Form 10-K and certain information incorporated herein by reference contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act) and Section 27A of the Securities Act of 1933, as amended (the Securities Act). Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or achievements to be materially different from any future performance or achievements expressed or implied by these forward-looking statements. Factors that might cause actual events or results to differ materially from those indicated by these forward-looking statements may include matters such as future economic performance, general economic conditions, consumer preferences and spending, costs, competition, new product execution, restaurant openings or closings, operating margins, the availability of acceptable real estate locations, the sufficiency of our cash balances and cash generated from operating and financing activities for our future liquidity and capital resource needs, growth of franchise and licensing, the impact on our business as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and the rules promulgated there under, future litigation and other matters, and are generally accompanied by words such as: believes, anticipates, plans, intends, estimates, predicts, targets, expects, contemplates and similar expressions that convey the uncertainty of future events or outcomes. These risks and uncertainties include, but are not limited to, the risk factors discussed under Item 1A.Risk Factors of this Annual Report on Form 10-K. We do not undertake any obligation to update or revise any forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as may be required under applicable law.
As used in this report, the terms Company, ENRGI, we, our, or us refer to Einstein Noah Restaurant Group, Inc. and its consolidated subsidiaries, taken as a whole, unless the context otherwise indicates. The terms fiscal year ended, fiscal year, year ended, or fiscal refer to the entire fiscal year, unless the context otherwise indicates.
General development of our Company:
Einstein Noah Restaurant Group, Inc. is a Delaware corporation operating primarily under the Einstein Bros. Bagels (Einstein Bros.), Noahs New York Bagels (Noahs) and Manhattan Bagel Company (Manhattan Bagel) brands. We commenced operations as an operator and franchisor of coffee cafes in 1993. Substantial growth in our restaurant counts have occurred organically and through a series of acquisitions. Our largest acquisition was in 2001 when we acquired substantially all the assets of Einstein/Noah Bagel Corp. We have also grown by opening company-owned restaurants, working with franchisees on development agreements and promoting the licensing of our brand.
On November 29, 2011, we acquired the assets of Kettleman Bagel Company (Kettleman Bagel), a five-store bagel chain in Portland, Oregon. We expect to rebrand Kettleman Bagel into Einstein Bros in the first half of fiscal 2012. We paid $5.0 million for all tangible and intangible assets used in the business and expect the five locations, in total, to generate over $5.0 million in annual revenues on a go-forward basis.
We operate under a 52/53-week fiscal year ending on the Tuesday closest to December 31. Fiscal years 2009 and 2010 each contained 52 weeks. Fiscal year 2011 contained 53 weeks. Comparable store sales percentages presented elsewhere in this report are calculated excluding the 53rd week.
Financial information about segments:
We operate in three key business segments, which are supported by a centralized corporate operation:
See Note 19 to the consolidated financial statements included in Item 8 of this 10-K for the financial results by segment for fiscal years 2009, 2010 and 2011.
Narrative description of business:
We are the largest owner/operator, franchisor and licensor of bagel specialty restaurants in the United States. As of January 3, 2012, we had 773 restaurants in 39 states and in the District of Columbia. 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. Collectively, our concepts span the nation with Einstein Bros. restaurants, Noahs restaurants in three states on the west coast, Manhattan Bagel restaurants concentrated in eight states primarily in the Northeast, and Kettleman Bagel restaurants located in Portland, Oregon. Currently, our Einstein Bros. and Noahs are predominantly company-owned or licensed, Kettleman Bagel is company-owned and Manhattan Bagel restaurants are franchised except for one company-owned location.
Our product offerings include fresh-baked bagels and other bakery items baked on-site, made-to-order breakfast and lunch sandwiches on a variety of bagels, breads or wraps, gourmet soups and salads, assorted pastries, premium coffees and an assortment of snacks. Our manufacturing and commissary operations prepare and assemble consistent, high-quality ingredients that are delivered fresh to our restaurants through our network of independent distributors. We seek to create an inviting atmosphere which enables us to attract a diverse group of customers, approximately 60% women and 40% men, primarily in the middle to upper-middle income brackets within our breakfast traffic.
We believe that controlling the development, sourcing, manufacturing and distribution of our key products is an important element in ensuring both quality and profitability. To support this strategy, we have developed proprietary recipes, invested in processing technology and manufacturing capacity, and aligned ourselves with strategic suppliers.
We also believe that through franchising and licensing, we are able to increase our geographic footprint and brand recognition. This allows us to generate additional revenues without incurring significant additional expenses, such as those for capital commitments and rents, and avoid many of the other risks associated with opening new company-owned restaurants.
As of January 3, 2012, the Company had 6,506 employees, of whom 200 were corporate personnel, 127 were manufacturing and commissary personnel and 6,179 were restaurant personnel. Most restaurant personnel work part-time and are paid on an hourly basis. We have never experienced a work stoppage and our employees are not represented by a labor organization.
We generated approximately 90% of our 2011 total revenue from restaurant sales at our company-owned restaurants. For the fiscal year ended January 3, 2012, approximately 67% of our company-owned restaurant revenue was generated from restaurant sales during breakfast hours.
Noahs is a neighborhood-based, New York inspired bakery/deli restaurant that serves fresh-baked bagels, hot breakfast sandwiches, made-to-order deli-style sandwiches, cream cheese and other spreads, specialty coffees and teas, soups, salads and other unique menu offerings. Our company-owned Noahs restaurants typically generate approximately 20% of our total company-owned restaurant sales.
Manhattan Bagel provides a traditional New York style boil and baked bagel. Manhattan Bagel also serves a variety of grilled sandwiches, freshly made deli sandwiches, freshly prepared breakfast sandwiches, soups, and a variety of other fresh-baked sweets. Similar to Einstein Bros. and Noahs, Manhattan Bagel also features a full line of fresh brewed coffees and specialty coffee/espresso beverages. We have one company-owned Manhattan Bagel restaurant that we use for employee and manager training, and to test out new products and services before they are rolled out system-wide.
In 2011, we launched our enhanced coffee program. We incurred $8.0 million towards the installation of new coffee machines at our stores. Coffee sales now represent over 10% of our menu mix and continue to grow.
Throughout most of our Einstein Bros. restaurants, we have implemented an improved kitchen display ordering system (KDS). The introduction of the KDS is designed to:
As of January 3, 2012, the KDS has been implemented at 83% of our company-owned restaurants.
We believe catering is an effective way to generate incremental sales, drive trial and expose more people to our food and our brands. We recognize that an effective catering program requires different skills for effectively selling to businesses that frequently utilize catering. In 2009, we implemented a new software program that provides on-line ordering capabilities for our customers, helping us generate, fulfill and deliver catering sales. We believe that this change has reduced the cost of our catering program while at the same time providing a more robust method of attracting new customers and increasing the order frequency of existing customers. Additionally, we believe that our catering channel will continue to benefit from an outsourced and expanded call center, digital marketing and an optimized menu. Catering accounts for approximately 6% of our company-owned restaurant sales.
Manufacturing and Commissaries:
We generated approximately 8% of our fiscal year 2011 total revenue from our manufacturing and commissary operations.
Commissaries: During fiscal year 2011, we operated five commissaries that were geographically located to best serve our existing company-owned, franchised and licensed restaurants. These operations provided our restaurants with critical food products such as sliced meats, cheeses, and/or certain salad ingredients. We have decided to close our commissaries to help streamline our supply chain and to reduce our costs. We closed one commissary in the fourth quarter of 2011 and expect to close the remaining four commissaries in the first quarter of 2012. We expect that the closing of these facilities will result in annual cost savings of approximately $1.5 million. We recorded restructuring
charges of $0.7 million during the fiscal year ended January 3, 2012 related to these closings. We estimate that an additional $0.5 million to $0.8 million of charges will be incurred in 2012 for this restructuring.
Frozen, or partially baked and frozen, bagel dough is shipped to all of our company-owned, franchised and licensed restaurants where the dough is then baked on-site. We believe that our significant know-how and technical expertise for manufacturing and freezing mass quantities of raw dough produces a high-quality product more commonly associated with smaller bakeries.
We negotiate price agreements and contracts depending on supply and demand for our products and commodity trends. These agreements can range in duration from six months to five years. Most of our commodity based food-costs increased in fiscal year 2011. We implemented a cross functional cost team to evaluate innovative ways to target $3.0 million in annualized incremental savings on a go-forward basis without negatively impacting the customer experience.
Wheat represents the most significant raw ingredient we purchase. In an effort to mitigate the risk of increasing market prices, we utilize a third party advisor to manage our wheat purchases. We will continue to work with our third party advisor to strategically source our wheat purchases. As of January 3, 2012, we have secured price protection on approximately 88% of our wheat needs for fiscal year 2012.
We also have developed proprietary coffee blends for sale at our company-owned, franchised and licensed restaurants. In an effort to mitigate the risk of increasing market prices, we utilize a third party advisor to manage our coffee purchases. As of January 3, 2012, we have secured price protection on approximately 93% of our coffee needs for fiscal year 2012.
Our cream cheese is manufactured to our specifications utilizing proprietary recipes. Our cream cheese and sliced cheese products are purchased from one supplier under a contract that expires in 2013. As of January 3, 2012, our supplier has secured pricing on our behalf for 94% of our butter needs and 98% of our Class III milk needs, which are the primary ingredients of our cream cheese and sliced cheese products.
We purchase other ingredients used in our restaurants, such as meat, lettuce, tomatoes and condiments, from a select group of third party suppliers. Our chicken products come from chickens that are cared for in strict accordance with established animal care guidelines and without the use of growth accelerators such as steroids or hormones. Where available, we buy high quality fresh fruits, vegetables and specialty produce from a nationally recognized group of third party suppliers and distributors.
Franchise and Licensing
Approximately 2% of our 2011 total revenue was generated by our franchise and license operations. Revenue from our franchise and licensing segments are derived from initial up-front fees, royalties on net sales and the purchases of our proprietary products from our manufacturing plant and commissaries.
We franchise rights to develop restaurants within a defined geographic region within a specified period of time. We are targeting potential franchisees who have the existing infrastructure, operational experience and financial strength to develop several restaurants in a designated market. The franchise agreement requires an up-front fee of $35,000 per restaurant and a 5% royalty based on net sales. Our Einstein Bros. franchise restaurants that have been open for one year generally have average unit volumes of approximately $882,000.
Financial information about geographic areas:
Our manufacturing operations sell bagels to third parties who take possession in the United States and sell outside of the United States. As the product is shipped FOB domestic dock, invoiced in U.S. dollars and paid in U.S. dollars, there are no international risks of loss or foreign exchange currency issues. Sales shipped internationally are included in manufacturing and commissary revenue, and were $5.3 million, $5.3 million and $7.1 million for fiscal years 2009, 2010 and 2011, respectively. The increase in revenue from fiscal 2010 to fiscal 2011 is primarily due to increased sales volume and price increases. All other revenues were from sales to external customers located in the United States.
We are subject to the informational requirements of the Exchange Act. We therefore file periodic reports, proxy statements and other information with the Securities Exchange Commission (the SEC). Such reports may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, N.E., Washington, D.C. 20549, or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.
Additionally, copies of our reports on Forms 10-K, 10-Q and 8-K and any amendments to such reports are available for viewing and copying through our internet site (www.einsteinnoah.com), free of charge, as soon as reasonably practicable after filing such material with, or furnishing it to, the SEC. We typically post information about us on our website under the Financials & Media tab.
We also make available on our website and in print to any stockholder who requests it, our Audit and Compensation Committees charters, as well as the Code of Conduct that applies to all directors, officers and associates of the company. Amendments to these documents or waivers related to the Code of Conduct will be made available on our website as soon as reasonably practicable after their execution.
Executive Officers of the Registrant:
Jeffrey J. ONeill. Mr. ONeill joined us in December 2008 when he was appointed President and Chief Executive Officer. Previously, Mr. ONeill worked for Priszm Income Fund from April 2005 to November 2008. At that time, Priszm was a publicly traded Canadian restaurant income trust with a portfolio of popular brands such as Pizza Hut and Taco Bell and was one of the largest independent KFC franchisees in the world. Mr. ONeill joined Priszm as President and Chief Operating Officer and was promoted to Chief Executive Officer in January 2008. Mr. ONeill began his career in Brand Marketing with The Quaker Oats Company. In April 1999, he joined PepsiCo as the President of Pepsi Cola Canada. In 2002, PepsiCo acquired the Quaker Oats Company and in January 2003, Mr. ONeill returned to Chicago to help lead the integration of the Quaker Oats/Gatorade acquisition. Mr. ONeill has an Honors Bachelor of Business degree from the University of Ottawa.
Emanuel P.N. Hilario. Mr. Hilario joined us in May 2010 as Chief Financial Officer. Previously, Mr. Hilario served as the Founder and Managing Director of Koios Path, LLC, a management advisory and consulting services company from May 2009 until May 2010. Prior to that, he served as Chief Financial Officer of McCormick & Schmicks Seafood Restaurants, Inc. from April 2004 until May 2009 and was elected to their Board of Directors in May 2007 where he served as a Director until July 2009. From April 2000 to April 2004, Mr. Hilario served as Vice President and Chief Financial Officer of Angelo and Maxies, Inc., which was formerly known as Chart House Enterprises, Inc. Mr. Hilario began his career at McDonalds Corporation. Mr. Hilario holds a B.S. degree in Commerce and Accounting from Santa Clara University.
Rhonda J. Parish. Ms. Parish joined us in January 2010 as Chief Legal Officer. Before joining us, she took a personal sabbatical from August 2008 to December 2009. Ms. Parish worked for Dennys Corporation from January 1995 to July 2008. She joined Dennys Corporation as Senior Vice President and General Counsel and was promoted to Executive Vice President/Chief Legal Officer and Secretary of Dennys Corporation in July 1998. Prior to this, Ms. Parish served as Assistant General Counsel for Wal-Mart Stores, Inc. Ms. Parish received a B.S. degree in Political Science from the University of Central Arkansas and her J.D. degree from the University of Arkansas School of Law.
The following important factors, among others, could cause the actual results to differ materially from those indicated by forward-looking statements made in this report and from time to time in news releases, reports, proxy statements, registration statements and other written communications, as well as verbal forward-looking statements made from time to time by representatives of the Company. An expanded discussion of some of these risk factors follows. The list of risk factors below is not exhaustive. Additional risks not presently known to us or which we currently consider immaterial may also adversely affect our business, financial condition or results of operations.
Risk Factors Relating to Our Business and Our Industry
General economic conditions, including continuing effects from the recent recession, have affected, and could continue to affect, discretionary consumer spending, particularly spending for meals prepared away from home.
We, together with the rest of the restaurant industry, depend upon consumer discretionary spending. The recent recession, coupled with lay-offs, high unemployment rates, foreclosures, bankruptcies, falling home prices and other economic impacts has affected consumers ability and willingness to spend discretionary dollars. In recent years, restaurants industry-wide have been adversely affected as a result of reduced consumer spending due to these and other factors. If the weak economy continues for a prolonged period of time or worsens, it could further reduce discretionary consumer spending, cause consumers to trade down to lower priced products within our restaurants, and/or shift to competitors with lower priced products, which in turn could reduce our guest traffic or average check. If negative economic conditions persist for a long period of time or worsen, consumers may make long-lasting changes to their discretionary purchasing behavior, including less frequent discretionary purchases on a more permanent basis. Adverse changes in consumer discretionary spending could be affected by many different factors that are out of our control, including international, national and local economic conditions, any of which could harm our business prospects, financial condition, operating results and cash flows. Our success will depend in part upon our ability to anticipate, identify and respond to changing economic and other conditions.
Failure to protect food supplies and adhere to food safety standards could result in food-borne illnesses and adversely affect our business.
We believe that food safety and reputation for quality is of significant importance to any company that, like us, operates in the restaurant industry. Food safety is a focus of increased government regulatory initiatives at the local, state and federal levels.
Failure to protect our food supply or enforce food safety policies, such as proper food temperatures and adherence to shelf life dates, could result in food-borne illnesses and/or injuries to our guests. Also, our reputation of providing high quality food is an important factor in our guests choosing our restaurants. Instances of food borne illness, or other food safety issues, including food tampering and food contamination, whether or not traced to our restaurants or those of our competitors, could reduce demand for certain or all of our menu offerings. If any of our guests become ill from consuming our products, the affected restaurants may be forced to close and we may be subject to legal liability. An instance of food contamination originating from one of our restaurants, our commissaries or suppliers, or our manufacturing plant could have far-reaching effects, as the contamination, or the perception of contamination could affect substantially all of our restaurants. Publicity related to either product contamination or recalls may also injure our brand and may affect the selection of our restaurants by guests, franchisees and licensees based on fear of such illnesses. In addition, the occurrence of food-borne illnesses or food safety issues could also adversely affect the price and availability of affected ingredients, which could result in disruptions in our supply chain and/or lower margins for us and our franchisees and licensees.
Increases in commodity prices would adversely affect our results of operations.
Global demand for commodities such as wheat, coffee and dairy products has resulted, and could in the future result, in higher prices which would increase our costs. The prices of our main ingredients are directly associated with the changing weather conditions as well as economic factors such as supply and demand of certain commodities within the United States and other countries. Our ability to forecast and manage our commodities could significantly affect our gross margins. Any increase in the prices of the ingredients most critical to our products could adversely affect our operating results.
Additionally, in the event of the destruction of products such as tomatoes, peppers or massive culling of specific animals such as chickens or turkeys to prevent the spread of disease, the supply and availability of ingredients may become limited. This could dramatically increase the price of certain menu items which could decrease sales of those items or could force us to eliminate those items from our menus entirely. All of these factors could adversely affect our business, reputation and financial results.
Any material failure, inadequacy, interruption or security failure of information technology could harm our ability to effectively operate our business.
We rely on information technology systems across our operations, including for management of supply chain, point-of-sale (POS) processing in our restaurants, and various other processes and transactions. Our ability to effectively manage our business and coordinate the production, distribution and sale of products depends on the reliability and capacity of these systems. Despite our implementation of security measures, all of our technology systems are vulnerable to damage, disability or failures due to physical theft, fire, power loss, telecommunications failure or other catastrophic events, as well as from internal and external security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers. The failure of these systems to operate effectively, problems with transitioning to upgraded or replacement systems, or a breach in security of these systems could cause delays in product sales and reduced efficiency of the Companys operations, and significant capital investments could be required to remediate the problem.
Credit and debit card data loss, litigation and/or liability could significantly harm our reputation and adversely impact our business.
In connection with credit and debit card sales, we transmit confidential credit and debit card information securely over public networks. Third parties may have the technology or know-how to breach the security of this customer information, and our security measures may not effectively prohibit others from obtaining improper access to this information. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Several companies in a variety of industries recently have reported security breaches during which credit/debit card or other personal identifying information has been compromised. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and any resulting negative publicity could significantly harm our reputation. Furthermore, as a result of legislative and regulatory rules, we may be required to notify the owners of the information of any data breaches, which could harm our reputation and financial results, as well as subject us to litigation or actions by regulatory authorities.
Unsuccessful implementation of any or all of the initiatives of our business strategy could negatively impact our operations.
Our success depends in part on our ability to understand and satisfy the needs of our guests, franchisees and licensees. Our key strategies are:
Our ability to achieve any or all of these initiatives is uncertain. Our success in expanding sales at company-owned restaurants through various sub-initiatives including: promoting and offering value to our customers through marketing, discounts, coupons and new menu offerings and broadening our offerings across multiple dayparts, improving our ordering and production systems, expanding our catering program and upgrading our restaurants is dependent in part on our ability to offer value to consumers, attract new customers, predict and satisfy consumer preferences and as mentioned above, consumers ability to respond positively in a challenging economic environment.
Our success in growing our business through opening new company-owned restaurants is dependent on a number of factors, including our ability to: find suitable locations, reach acceptable lease terms, have adequate capital, find acceptable contractors, obtain licenses and permits, manage construction and development costs, recruit and train appropriate staff and properly manage the new restaurant. Our success in opening new franchise and license restaurants is dependent upon, among other factors, our ability to: attract quality businesses with the interest and desire to invest/purchase in our core brands, maintain the effectiveness of our franchise disclosure documents in target states, offer restaurant solutions for a variety of location types and the ability of our franchisees and licensees to: find suitable locations, reach acceptable lease terms, have adequate capital, secure reasonable financing, find available contractors, obtain licenses and permits, manage construction and development costs, locate and train staff appropriately and properly manage the new restaurants. Our success in expanding our franchise business is dependent upon signing additional development agreements along with the refranchising our company-owned restaurants. If we are not successful in implementing any or all of the initiatives of our business strategy, it could have a material adverse effect on our business, results of operations, and financial condition.
Competition in the restaurant industry is intense.
Our industry is highly competitive and there are many well-established competitors, some of which have substantially greater resources than we do. While we operate in the fast-casual segment of the restaurant industry, we also consider restaurants in the fast-food and full-service segments as competitors. Several fast-casual and fast-food chains are focusing more on breakfast offerings and expanding their specialty coffee offerings. This could further increase competition in the breakfast daypart. In addition to current competitors, one or more new major competitors with substantially greater financial, marketing and operating resources could enter the market at any time and compete directly against us. Also, in virtually every major metropolitan area in which we operate or expect to enter, local or regional competitors already exist. This may make it more difficult to attract and retain guests and potential franchisees and licensees.
Our success depends in large part on our continued ability to convince customers that food made with higher-quality ingredients, including our fresh-baked bagels and made-to-order breakfast and lunch sandwiches, is worth the prices at our restaurants relative to lower prices offered by some of our competitors. Numerous factors including changes in consumer tastes and preferences often affect restaurants. Shifts in consumer preferences away from our type of cuisine and/or the fast-casual style could have a material effect on our results of operations. Dietary trends, such as the consumption of food low in carbohydrate content have, in the past, and may, in the future, negatively impact our sales. Changes in our guests spending habits and preferences could have a material adverse effect on our sales. Our results will depend on our ability to respond to changing consumer preferences and tastes. In addition, recent local and state regulations mandating prominent disclosure of nutritional and calorie information may result in reduced demand for some of our products which could be viewed as containing too much fat or too many calories.
We occupy our company-owned restaurants under long-term non-cancelable leases, and we may be unable to renew leases at the end of their lease periods or obtain new leases on acceptable terms.
We do not own any real property, and all of our company-owned restaurants are located in leased premises. Many of our current leases are non-cancelable and typically have terms ranging from five to ten years with two three- to five-year renewal options. We believe leases that we enter into in the future likely will also be long-term
and non-cancelable and have similar renewal options. Most of our leases provide that the landlord may increase the rent over the term of the lease, and require us to pay our proportionate share of the cost of insurance, taxes, maintenance and utilities. If we close a restaurant, we generally remain committed to perform our obligations under the applicable lease, which would include, among other things, payment of the base rent for the balance of the lease term. In some instances, we may be unable to close an underperforming restaurant due to continuous operation clauses in our lease agreements. Our obligation to continue making rental payments in respect of leases for closed or underperforming restaurants could have an adverse effect on our business and results of operations.
If we are unable to renew our restaurant leases, we may be forced to close or relocate a restaurant, which could subject us to construction and other costs and risks, and could have a material adverse effect on our business and results of operations. For example, closing a restaurant, even during the time of relocation, will reduce the sales that the restaurant would have contributed to our revenues. Additionally, the revenue and profit, if any, generated at a relocated restaurant may not equal the revenue and profit generated at the prior location. We also face competition from both restaurants and other retailers for suitable sites for new restaurants.
Our operations may be negatively impacted by seasonality, adverse weather conditions, natural disasters or acts of terror.
Our business is subject to seasonal fluctuations, as well as adverse weather conditions and natural disasters that may at times affect regions in which our company-owned, franchised and licensed restaurants are located, regions that produce raw ingredients for our restaurants, or locations of our distribution network. As a result of the seasonality of our business and our industry, our quarterly and yearly results have varied in the past, and we believe that our quarterly operating results will vary in the future. In addition, if adverse weather conditions or natural disasters such as fires and hurricanes affect our restaurants, we could experience closures, repair and restoration costs, food spoilage, and other significant reopening costs as well as increased food costs and delayed supply shipments, any of which would adversely affect our business. We could also experience shortages or delayed shipments at our restaurants if adverse weather or natural disasters affect our distribution network, which could adversely affect our restaurants and our business as a whole. Additionally, during periods of extreme temperatures (either hot or cold) or precipitation, many individuals choose to stay indoors. This impacts transaction counts in our restaurants and could adversely affect our business and results of operations.
The effects of hurricanes, fires, snowstorms, freezes and other adverse weather conditions are likely to affect supply of and costs for raw ingredients and natural resources, near-term construction costs for our new restaurants as well as sales in our restaurants going forward. If we do not anticipate or react to changing costs of food and other raw materials by adjusting our purchasing practices or menu prices, our operating margins would likely deteriorate.
The impact on our business from terrorism (including cyber-terrorism or efforts to tamper with food supplies) could have an adverse impact on our brand and results of operations.
We have single suppliers and vendors for many of our key products and services and the failure of any of these suppliers or vendors to perform could harm our business.
We currently purchase our raw materials from various suppliers; however, we have only one supplier for many of our key products. We purchase all of our cream cheese from a single source. Also, we purchase a majority of our frozen bagel dough from one supplier, who uses our proprietary processes and on whom we are dependent in the short-term. All of our remaining frozen bagel dough is produced at our dough manufacturing facility in Whittier, California or by a second supplier. Although to date we have not experienced significant difficulties with our suppliers, our reliance on a single supplier for most of our key ingredients subjects us to a number of risks, including possible delays or interruption in supplies, diminished control over quality and a potential lack of adequate raw material capacity. Any disruption in the supply or degradation in the quality of the materials provided by our suppliers could have a material adverse effect on our business, operating results and financial condition. In addition, any such disruptions in supply or degradations in quality could have a long-term
detrimental impact on our efforts to maintain a strong brand identity and a loyal consumer base. Additionally, we rely upon a single vendor for various services crucial to our business operations. Any loss or disruption in these services could detrimentally impact our business.
Distribution disruptions or other distribution issues could adversely affect our business and reputation.
We depend on our network of independent regional distributors to distribute frozen bagel dough and other products and materials to our company-owned, franchised and licensed restaurants. Any failure by one or more of our distributors to perform as anticipated, or any disruption in any of our distribution relationships for any reason, would subject us to a number of risks, including inadequate products delivered to our restaurants, diminished control over quality of products delivered, and increased operating costs to prevent delays in deliveries. Any of these events could harm our relationships with our franchisees or licensees, or diminish the reputation of our menu offerings or our brands in the marketplace. In addition, a negative change in the volume of products ordered from our distributors by our company-owned, franchised and licensed restaurants could increase our distribution costs. These risks could have a material adverse effect on our business, financial condition and results of operations.
Additionally, increased costs and distribution issues related to fuel and utilities could also materially impact our business and results of operations.
Increasing labor costs or labor discord could adversely affect our results of operations and cash flows.
We depend upon an available labor pool of associates, many of whom are hourly employees whose wages may be affected by increases in the federal, state or municipal living wage rates. Numerous increases have been made on federal, state and local levels to increase minimum wage levels. Increases in the federal minimum hourly wage rate became effective in mid-2009. Additionally, many states have increased their minimum hourly wage rate above that of the 2009 federal rate with adjustments to many state rates effective in 2011 and 2012. Increases in the minimum wage may create pressure to increase the pay scale for our associates, which would increase our labor costs and those of our franchisees and licensees.
A shortage in the labor pool or other general inflationary pressures or changes could also increase labor costs. Changes in the labor laws, reclassifications of associates from management to hourly employees, or the potential impact of union organizing efforts could affect our labor cost. An increase in labor costs could have a material adverse effect on our income from operations and decrease our profitability and cash flows if we are unable to recover these increases by raising the prices we charge our guests.
In March 2010, comprehensive health care reform legislation was passed and signed into law. Among other things, the health care reform legislation includes guaranteed coverage requirements, eliminates pre-existing condition exclusions and annual and lifetime maximum limits, restricts the extent to which policies can be rescinded, and imposes new and significant taxes on health insurers and health care benefits. Due to the breadth and complexity of the health care reform legislation, the lack of implementing regulations and interpretive guidance, and the phased-in nature of the implementation, it is difficult to predict the overall impact of the health care reform legislation on our business over the coming years, but our results of operations, financial position and cash flows could be materially affected.
We may not be able to comply with certain debt covenants or generate sufficient cash flow to make payments on our debt or to pay dividends to our stockholders in the future.
Our current credit facility contains certain covenants, which, among others, include certain financial covenants such as limitations on capital expenditures, maintenance of the business, use of proceeds from sales of assets and consolidated leverage and fixed charge coverage ratios as defined in the agreements. We are subject to multiple economic, financial, competitive, legal and other risks that are beyond our control and could harm our future financial results. Any adverse effect on our business or financial results could affect our ability to maintain compliance with our debt covenants, and any failure by us to comply with these covenants could result in an
event of default. If we were to default under our covenants and such default were not cured or waived, our indebtedness could become immediately due and payable, which could render us insolvent.
We have $74.2 million in debt as of January 3, 2012. In addition, we may, subject to certain restrictions, incur substantial additional indebtedness in the future. Our debt, among other things, could:
Economic, financial, competitive, legislative and other factors beyond our control may affect our ability to generate cash flow from operations to make payments on our indebtedness, to fund necessary working capital or to pay dividends to our stockholders in the future. A significant reduction in operating cash flow would likely increase the need for alternative sources of liquidity. If we are unable to generate sufficient cash flow to make payments on our debt, we will have to pursue one or more alternatives, such as reducing or delaying capital expenditures, refinancing our debt on terms that are not favorable to us, selling assets or issuing additional equity securities. We may not be able to accomplish any of these alternatives on satisfactory terms, if at all, and even if accomplished, they may not yield sufficient funds to service our debt.
We face the risk of adverse publicity and litigation in connection with our operations.
We are from time to time the subject of complaints or litigation from our consumers alleging illness, injury or other food quality, health or operational concerns. Adverse publicity resulting from these allegations may materially adversely affect us and our brand, regardless of whether the allegations are valid or whether we are liable. In addition, employee claims against us based on, among other things, alleged discrimination, harassment or wrongful termination, or labor code violations may divert financial and management resources that would otherwise be used to benefit our future performance. For example, in 2008 we settled two class actions in California and made payments of $1.9 million during 2009 in connection with such settlements. There is also a risk of litigation from our franchisees and licensees. We have been subject to a variety of these and other claims from time to time and a significant increase in the number of these claims or the number that are successful could materially adversely affect our business, prospects, financial condition, operating results or cash flows.
A regional or global health pandemic could severely affect our business.
A health pandemic is a disease that spreads rapidly and widely by infection and affects many individuals in an area or population at the same time. If a regional or global health pandemic were to occur, depending upon its duration and severity, our business could be severely affected. We have positioned ourselves as a neighborhood atmosphere between home and work where people can gather for human connection and high quality food. Customers might avoid public gathering places in the event of a health pandemic, and local, regional or national governments might limit or ban public gatherings to halt or delay the spread of disease. A regional or global pandemic might also adversely impact our business by disrupting or delaying production and delivery of products and materials in our supply chain and causing staff shortages in our restaurants. The impact of a health pandemic might be disproportionately greater on us than on other companies that depend less on the gathering of people in a neighborhood atmosphere.
Approximately 42% of our restaurants are concentrated in five main states and, as a result, we are sensitive to economic and other trends and developments in these states.
As of January 3, 2012, 325 of our restaurants were located in five states (California, Colorado, Florida, Illinois and Texas). As a result, we are particularly susceptible to adverse trends and economic conditions in these states, including their labor markets. Several of these markets have been particularly affected by the economic downturn and the timing and strength of any economic recovery is uncertain. Our geographic concentration increases vulnerability to general adverse economic and industry conditions and may have a disproportionate effect on our overall results of operations as compared to some of our competitors that may have less restaurant concentration. In addition, given our geographic concentration, negative publicity regarding any of our restaurants in these states could have a material adverse effect on our business and operations, as could other regional occurrences such as local labor strikes, energy shortages or increases in energy prices, droughts, earthquakes, fires, or other natural disasters.
Our franchisees and licensees may not help us develop our business as we expect, or could take actions that harm our business.
We rely in part on our franchisees and licensees and the manner in which they operate their restaurants to develop and promote our business. Franchisees and licensees are independent operators and are not our employees. As we offer and grant franchises for our Einstein Bros. and Manhattan Bagel brands, our reliance on our franchisees is expected to increase in proportion to growth of the franchisee base. With respect to franchising our Einstein Bros. brand, we may not be able to identify franchisees that meet our criteria, or to enter into franchise area development agreements with prospective franchisee candidates that we identify. As a result, our franchise program for the Einstein Bros. brand may not grow at the rate we currently expect, or at all.
Although we have developed criteria to evaluate and screen prospective candidates, we are limited in the amount of control we can exercise over our franchisees and licensees, and the quality of franchised and licensed restaurant operations may be diminished by any number of factors beyond our control. Franchisees and licensees may not have the business acumen or financial resources necessary to operate successful restaurants in a manner consistent with our standards and requirements and may not hire and train qualified managers and other restaurant personnel. Poor restaurant operations may affect each restaurants sales. Our image and reputation, and the image and reputation of other franchisees and licensees, may suffer materially and system-wide sales could significantly decline if our franchisees do not operate successfully. In addition, franchisees and licensees are subject to business risks similar to those we face such as competition; consumer acceptance; fluctuations in the cost, availability and quality of raw ingredients; increasing labor costs; and difficultly obtaining proper financing as a result of the downturn in the credit markets. The failure of franchisees and licensees to meet their development obligations or to operate successfully could have a material adverse effect on us, our reputation, our ability to collect royalties, our brands and our ability to attract prospective candidates.
Our restaurants and products are subject to numerous and changing government regulations. Failure to comply with or substantial changes in government regulations could negatively affect our sales, increase our costs or result in fines or other penalties against us.
Each of our restaurants is subject to licensing and regulation by the health, sanitation, safety, labor, building and fire agencies of the respective states, counties, cities and municipalities in which it is located. A failure to comply with one or more regulations could result in the imposition of sanctions, including the closing of facilities for an indeterminate period of time, or third party litigation, any of which could have a material adverse effect on us and our results of operations.
Recently, many government bodies have begun to legislate or regulate high-fat and high sodium foods and require disclosure of nutritional information as a way of combating concerns about obesity and health. In addition to the phase-out of artificial trans-fats, public interest groups have focused attention on the marketing of high-fat and high-sodium foods to children in a stated effort to combat childhood obesity. Some cities and states have recently adopted or are considering regulations requiring disclosure of nutritional facts, including calorie
information, on menus and/or menu boards. Additional cities or states may propose or adopt similar regulations. The cost of complying with these regulations could increase our expenses and the possible negative publicity arising from such legislative initiatives could reduce our future sales.
Our franchising operations are subject to regulation by the Federal Trade Commission. We must also comply with state franchising laws and a wide range of other state and local rules and regulations applicable to our business. In addition, the Dodd-Frank Act and the rules promulgated thereunder may impose new business or disclosure obligations on us. The failure to comply with or substantial changes in federal, state and local rules and regulations would have an adverse effect on us.
Under various federal, state and local laws, an owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on or in such property. Such liability may be imposed without regard to whether the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. Although we are not aware of any environmental conditions that require remediation by us under federal, state or local law at our properties, we have not conducted a comprehensive environmental review of our properties or operations. We may not have identified all of the potential environmental liabilities at our properties, and any such liabilities that are identified in the future may have a material adverse effect on our financial condition. Moreover, the adoption of new or more stringent environmental laws or regulations could result in a material liability to us and the current environmental condition of our leased properties could be harmed by third parties or by the condition of land or operations in the vicinity of our leased properties.
We may not be able to protect our brands, trademarks, service marks and other proprietary rights.
Our brands, which include our trademarks, service marks and other proprietary rights, are important to our success and our competitive position. Accordingly, we devote substantial resources to the establishment and protection of our brands. However, the actions we take may be inadequate to prevent imitation of our products and concepts by others, to prevent various challenges to our registrations or applications or denials of applications for the registration of trademarks, service marks and proprietary rights in the U.S. or other countries, or to prevent others from claiming violations of their trademarks and proprietary marks. In addition, others may assert rights in our trademarks, service marks and other proprietary rights.
The loss of key personnel or difficulties recruiting and retaining qualified personnel could adversely affect our business and financial results.
Our success depends substantially on the contributions and abilities of key executives and other employees, and on our ability to recruit and retain high quality employees to work in and manage our restaurants. We must continue to recruit, retain and motivate management and other employees sufficient to maintain our current business and support our projected growth. A loss of key employees or a significant shortage of high quality restaurant employees to maintain our current business and support our projected growth could adversely affect our business and financial results.
Our ability to use net operating loss carryforwards to offset future taxable income for U.S. federal income tax purposes is subject to limitation.
In general, under Section 382 of the Internal Revenue Code, a corporation that undergoes an ownership change is subject to limitations on its ability to utilize its pre-change net operating loss (NOL) carryforwards to offset future taxable income. A corporation generally undergoes an ownership change when the stock ownership percentage (by value) of its 5 percent stockholders increases by more than 50 percentage points over any three-year testing period.
Due to transactions involving the sale or other transfer of our stock from the date of our last ownership change through the date of the secondary public offering of our common stock, and changes in the value of our stock during that period, any new offerings may result in an additional ownership change for purposes of
Section 382 or will significantly increase the likelihood that we will undergo an additional ownership change in the future (which could occur as a result of transactions involving our stock that are outside of our control). In either event, the occurrence of an additional ownership change would limit our ability to utilize a portion of our NOL carryforwards that are not currently subject to limitation, and could further limit our ability to utilize our remaining NOL carryforwards and possibly other tax attributes. Limitations imposed on our ability to use NOL carryforwards and other tax attributes to offset future taxable income could cause us to pay U.S. federal income taxes earlier than we otherwise would if such limitations were not in effect, and could cause such NOL carryforwards and other tax attributes to expire unused, in each case reducing or eliminating the benefit of such NOL carryforwards and other tax attributes to us and adversely affecting our future cash flow. Similar rules and limitations may apply for state income tax purposes as well.
Failure of our internal controls over financial reporting could harm our business and financial results.
Our management is responsible for establishing and maintaining effective internal control over financial reporting. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of financial reporting for external purposes in accordance with accounting principles generally accepted in the United States. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that we would prevent or detect a misstatement of our financial statements or fraud. Any failure to maintain an effective system of internal control over financial reporting could limit our ability to report our financial results accurately and timely or to detect and prevent fraud. A significant financial reporting failure or material weakness in internal control over financial reporting could cause a loss of investor confidence and decline in the market price of our stock.
Risk Factors Relating to Our Common Stock
We have a majority stockholder and are a controlled company.
Greenlight Capital, L.L.C. and its affiliates (Greenlight) beneficially own approximately 64% of our common stock as of January 3, 2012. As a result, Greenlight has sufficient voting power, without the vote of any other stockholders, to determine what matters will be submitted for approval by our stockholders to elect all of the members of our board of directors, and to determine whether a change in control of the Company occurs. Greenlights interests on matters submitted to stockholders may be different from those of other stockholders. Greenlight has voted its shares to elect our current board of directors, and the chairman of our board of directors was an employee of Greenlight until February 2011, when he retired from Greenlight.
We have listed our common stock on the NASDAQ Global Market. NASDAQ rules require us to have an audit committee consisting entirely of independent directors. However, under NASDAQ rules, if a single stockholder holds more than 50% of the voting power of a listed company, that company is considered a controlled company, and is exempt from several other corporate governance rules, including the requirement that companies have a majority of independent directors and independent director involvement in the selection of director nominees and in the determination of executive compensation. As a result, our stockholders do not have, and may never have, the protections that these rules are intended to provide. We currently have a majority of independent directors on the board of directors and an audit committee and a compensation committee that each consist entirely of independent directors. We do not have a nominating committee; however, all directors participate in the consideration of director nominees.
Future sales of shares of our common stock by our stockholders could cause our stock price to fall.
If a substantial number of shares of our common stock are sold in the public market, the market price of our common stock could fall. The perception among investors that these sales will occur could also produce this effect. Sales of our common stock by our majority stockholder, Greenlight, or a perception that Greenlight will sell their shares could cause a decrease in the market price of our common stock.
Our headquarters, manufacturing and commissary facilities and all of our restaurants are located on leased premises. Lease terms are usually 5 to 10 years, with two or three 5-year renewal option periods, for total lease terms that average 10 to 20 years. The average company-owned restaurant is 1,800 to 2,500 square feet in size with 30 to 40 seats and is generally located in a neighborhood or regional shopping center. As of January 3, 2012, leases for 56 restaurants are set to expire within the next 12 months and most of these leases contain a renewal option, usually with modified pricing terms to reflect current market rents. We expect to close six to ten company-owned restaurants over the next three years as their leases expire and they cannot be relocated to another area in their market. We expect six to ten restaurant unit relocations to occur in 2012. 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 located by the end of twelve months, we consider the restaurant to be closed.
Information with respect to our headquarters, production and commissary facilities is presented below:
We have decided to close all our commissaries by the end of the first quarter of fiscal 2012. Accordingly, we do not plan on renewing the leases for the commissaries.
Our Current Restaurants
As of January 3, 2012, we owned and operated, franchised or licensed 773 restaurants. Our current base of company-owned restaurants under our core brands includes 364 Einstein Bros. restaurants, 70 Noahs restaurants, 5 Kettleman Bagel restaurants and one Manhattan Bagel restaurant. Also, we franchise 71 Manhattan Bagel restaurants and 23 Einstein Bros. restaurants, and license 239 Einstein Bros. restaurants. We believe that our properties are suitable, adequate, well-maintained and sufficient for our operations.
The following table details our restaurant openings and closings for fiscal 2011:
As of January 3, 2012, our company-owned facilities, franchisees and licensees operated in various states and in the District of Columbia as follows:
We are subject to claims and legal actions in the ordinary course of business, including claims by or against our franchisees, licensees and employees or former employees and/or contract disputes. We do not believe any currently pending or threatened matter would have a material adverse effect on our business, results of operations or financial condition.
Our common stock is traded on the NASDAQ Global Market under the symbol BAGL. The following table sets forth the high and low sale prices for our common stock for each fiscal quarter during the periods indicated.
As of February 27, 2012, there were approximately 268 holders of record of our common stock. This number does not include individual stockholders who own common stock registered in the name of a nominee under nominee security listings.
As permitted by our credit facility, described in further detail in Item 7, our Board of Directors (the Board) declared the following dividends in 2010 and 2011:
It is the current expectation of our Board that we will continue to pay a quarterly cash dividend, at the discretion of the Board, dependent on a variety of factors, including available cash and the overall financial condition of the Company. Like other companies incorporated in Delaware, we are also limited by Delaware law as to the payment of dividends. On January 18, 2012, the Board declared a cash dividend on our common stock in the amount of $0.125 per share, payable on April 15, 2012, to shareholders of record as of March 1, 2012.
Prior to December 20, 2010, we had not declared or paid any cash dividends on our common stock as we were precluded from paying cash dividends under our prior financing agreements.
In December 2010, our Board approved a discretionary program to repurchase up to $20.0 million of our outstanding common stock. We did not purchase any shares of our common stock on the open market in December 2010 or fiscal 2011. The total remaining authorization under the repurchase program was $20.0 million as of January 3, 2012. The repurchase program expires in December 2012 and is subject to compliance with applicable laws and the terms of our credit facility.
The included performance graph covers the fiscal five-year period from January 3, 2007 through January 3, 2012. The graph compares the total return of our common stock (BAGL) to our current peer group of companies (PGI) and the NASDAQ Composite Index. We believe that the selected PGI represents our competitive peer group as the included companies are multi-concept companies with a similar organizational structure, are participants of the restaurant industry and have a sufficient period of operating history for continuous inclusion in the PGI.
Our selected consolidated financial data shown below should be read together with Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and respective notes included in Item 8. Financial Statements and Supplementary Data. The data shown below is not necessarily indicative of results to be expected for any future period.
We have a 52/53-week fiscal year ending on the Tuesday closest to December 31. Fiscal years 2009 and 2010 ended on December 29, 2009 and December 28, 2010, respectively, and each contained 52 weeks. Fiscal year 2011 contained 53 weeks and ended on January 3, 2012. Comparable store percentages presented in this Item 7 are calculated excluding the 53rd week.
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 breakfast and lunch sandwiches on a variety of bagels, breads or wraps, gourmet soups and salads, assorted pastries, premium coffees and an assortment of snacks. Our manufacturing and commissary operations prepare and assemble consistent, high-quality ingredients that are delivered fresh to our restaurants through our network of independent distributors.
2011 Highlights and Trends
Our results for 2011 reflect the soundness of our business model, the underlying strength of our brands and the talent and dedication of our employees. Despite significant headwinds from commodity costs and another year of a challenging economic environment for our consumers, our results progressively improved as we went through 2011. We continued to focus on our key strategies which are:
Our 2011 system-wide comparable store sales were positive in each of the last three quarters of 2011, with sequential improvement for all quarters in 2011. Comparable store sales in our third and fourth quarters were progressively stronger than the first-half of 2011 on a system-wide and company-owned restaurants basis.
The primary reasons for this sequential improvement was strong growth in average check, a favorable mix shift and strength in catering sales. This was partially offset by lower comparable transactions due largely to the rollover of free bagel promotions in 2010.
We grew our breakfast sandwich business, on a comparable store basis, by 12.8% which benefited from the continued success of our bagel thin sandwich platform and our focus on healthy, low calorie food options. Our catering business, on a comparable store basis, grew by approximately 16.5% with our focus on our online ordering system and on search engine/online marketing. We targeted our marketing investments at coupons, directional billboards and digital online media. In 2011, we launched our enhanced coffee program which helped bolster comparable coffee sales by approximately 9% in the fourth quarter. Coffee sales now represent over 10% of our menu mix and continue to grow.
The impact of higher commodity costs negatively impacted our operating margin at our company-owned restaurants and was the primary underlying cause for the 1.1% increase in cost of goods sold as a percentage of company-owned restaurant sales. Most of the commodity pressure was related to wheat, coffee and dairy. As a
percentage of company-owned restaurant sales, cost of goods sold increased to 29.6% from 28.5% in 2010. On a combined basis, labor, other operating expenses, occupancy and marketing expenses were flat to 2010 as a percentage of company-owned restaurant sales. To partially offset the impact of inflation, we increased our menu prices and delivered on planned initiatives to reduce our costs.
Our cost initiatives drove $2.7 million in savings primarily driven by:
Although revenues increased by 13.6% for our manufacturing plant and commissaries, our margins declined by approximately $0.7 million, or 15.3%, as a result of inflationary commodity costs and a shift in sales volume to lower margin export customers.
To streamline our supply chain and to reduce our cost base, in September 2011, we initiated a plan to close our five food commissary facilities. Related to this plan, we incurred approximately $0.7 million of restructuring expenses in 2011 including employee termination benefits and lease termination expenses. We completed the closure of the Grove City (Columbus), Ohio commissary in the fourth quarter and the remaining four commissaries will be closed in the first quarter of 2012. We expect to incur an additional $0.5 million to $0.8 million of restructuring expenses in 2012. We expect to realize annual cost savings of approximately $1.5 million from the closure of these facilities.
We 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 in our franchise and license segment to total system-wide units increased to 43% at the end of 2011 from 41% at the end of 2010 as we added a total of 55 new units, which included 46 franchisee and licensee restaurants and nine new company-owned restaurants. We closed 15 units on a system-wide basis. Our refranchising efforts were focused on positioning our franchise base for healthy growth as we acquired four Einstein Bros. and sold three Einstein Bros. We also acquired five restaurants in the Portland, Oregon area which we intend to convert in the first half of fiscal 2012 to Einstein Bros. Bagels. Total net units increased by 40 in fiscal 2011 to 773 from 733 at the end of fiscal 2010.
Throughout 2011, we reaped the rewards of deleveraging our balance sheet in 2010. Our interest expense declined by approximately $1.8 million to $3.4 million as a result of the refinancing our debt and the redemption of all remaining outstanding shares of the Series Z mandatorily redeemable preferred stock (Series Z) in 2010. Our average debt balance was $78.9 million in 2011 compared to $101.6 million in 2010 while our weighted average interest rate declined 150 basis points to 3.1% Total debt at the end of the year was $74.2 million.
Our execution plan to grow comparable store sales includes:
Our catering channel will continue to benefit from our online ordering system, an outsourced and expanded call center, focus on online and digital marketing, and an optimized menu.
Our approach to enhancing corporate margins will extend and build on the initiatives that we have already started, namely, aggressively managing the sourcing of our commodities, completing the closure of our five food commissaries, utilizing technology to drive sustainable cost advantage, and improving restaurant level operating efficiency through targeted initiatives around product costs and labor.
Our emphasis on acceleration of unit growth will continue to focus on a Franchise First growth model, asset light unit economics, penetration into new key channels and expansion of our refranchising and acquisition efforts. Our unit growth plan for 2012 considers our long-term annual growth objective of +10%, or 60 to 80 system-wide openings for 2012. This includes the openings of 8 to 12 company-owned restaurants, 12 to 14 franchised restaurants and 40 to 54 licensed restaurants. We see refranchising our units as an opportunity to attract high quality franchisees that will support our accelerated growth initiatives.
The airport channel is key for us in terms of securing success for our licensees. Highlights of our airport program include:
We expect to spend between $24 million and $26 million in capital expenditures in 2012 which includes the opening of company-owned restaurants and the relocation of additional company-owned restaurants, along with the continued roll-out of our new POS system. We also intend to deploy our capital into areas such as installing drive-thru lanes and adding new exterior signage.
As we move into 2012, we have a robust pipeline of existing franchise development agreements and new license locations. We will continue to host discovery days for potential franchisees as well as expand our license footprint.
We believe we are well positioned to execute on our 2012 plan as our free cash flow continues to be consistently robust as a result of a strong balance sheet as well as our utilization of our deferred tax assets, primarily our net operating loss carryforwards. Furthermore, we expect favorable interest rates in 2012 which, coupled with lower debt balances, will further benefit net income.
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 adjusted earnings before interest, taxes, depreciation and amortization, adjustment for Series Z modification, restructuring expenses, write-off of debt issuance costs, and other operating expenses/income
(Adjusted EBITDA); net income adjusted for changes in our tax valuation allowance, all adjustments related to the Series Z modification, restructuring expenses, write-off of debt issuance costs, and the reversing effect of a residual amount in other comprehensive income related to a cash flow hedge (Adjusted Net Income); earnings per share (EPS) adjusted for changes in our tax valuation allowance, all adjustments related to the Series Z modification, restructuring expenses, write-off of debt issuance costs, and the reversing effect of residual amount in other comprehensive income related to cash flow hedge (Adjusted EPS) and Free Cash Flow, which we define as net cash provided by operating activities less net cash used in investing 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, Adjusted Net Income or Adjusted EPS 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 29, 34, 39 and 43.
We include in this report information on system-wide comparable store sales percentages. In fiscal 2011, we modified the method by which we determine restaurants included in our comparable store sales percentages to include those restaurants in operation for a full six fiscal quarters. Previously, comparable store sales percentages were based on restaurants that had been in operation for thirteen months. This methodology modification did not have a material impact on previously reported amounts, and therefore previously reported amount have not been restated. 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. System-wide sales include sales at all our restaurants including those operated by franchisees and licensees. Management reviews the increase or decrease in comparable store sales to assess business trends. Comparable store sales exclude closed locations.
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.
Results of Operations for Fiscal 2011 as compared to Fiscal 2010
Consolidated Results Fiscal 2011 vs Fiscal 2010
Our income from operations declined by $3.1 million in 2011 to $24.5 million primarily as a result of inflationary pressures on our product costs, partially offset by $0.8 million in income from operations resulting from the 53rd week in fiscal 2011.
Total revenues increased by $11.9 million to $423.6 million, primarily the result of increased revenue from our manufacturing and commissary segment and $7.3 million in revenue from the extra 53rd week. System-wide comparable stores were +0.4% for fiscal 2011 due to an increase in average check of +3.7% that was partially offset by a decline in system-wide transactions of -3.3%. Our comparable transactions decreased from 2010
primarily due to the transaction impact of our 2011 promotion not generating as many transactions as our 2010 free bagel Friday promotion. We believe that our catering business will continue to be a strong revenue generator, as evidenced by an increase in catering sales of 16.3% over fiscal 2010. In addition, we maintained our focus on delivering product innovation focused on health and quality, under the theme of Club Favorites, a new menu program we introduced in 2011.
Net income increased for fiscal 2011 due to decreases in our overall interest expense, a lower effective tax rate, partially offset by a decline in income from operations. Interest expense, net decreased by $1.8 million primarily due to realizing the impacts of decreasing our overall debt balance during the second half of 2010. The refinancing of our debt combined with the expiration of our interest rate swap, the pay down of our credit facility and the full redemption of our Series Z lowered our average debt balance from $101.6 million for fiscal 2010 to $78.9 million for fiscal 2011. These efforts also decreased our weighted average interest rates on our overall debt from 4.6% for fiscal 2010 to 3.1% for fiscal 2011. Our effective tax rate decreased from 48.3% from fiscal 2010 to 37.6% for fiscal 2011. This decrease relates to the elimination of several items that were non-deductible in 2010, including the $0.9 million adjustment on the modification of the Series Z, the additional redemption amount of the Series Z and the remaining deferred tax associated with our interest rate swap which expired in 2010. Also, the realization of higher federal employment tax credits in 2011 lowered our effective tax rate.
Company-Owned Restaurant Operations
Comparable store sales for our company-owned restaurants for each quarter in 2010 and 2011 were as follows:
Company-owned restaurant sales for fiscal 2011 increased $6.5 million, which was primarily due to the impact of the additional 53rd week in fiscal 2011. Company-owned comparable store sales remained flat, with transactions declining by -4.0% offset by an increase in average check of +4.0%. In fiscal 2011, we acquired nine restaurants, opened an additional four restaurants and closed one restaurant. The majority of our acquisitions and
openings occurred during the fourth quarter and contributed $0.9 million of incremental net sales for the year. Restaurant sales for 2010 benefited from $0.4 million in gift certificate breakage from a program that no longer exists.
Our bagel thin sandwich offerings, which were introduced in the second quarter of 2010, comprised 4.9% of our total mix for fiscal 2011, compared to 2.6% for fiscal 2010. Catering sales, which comprised approximately 6.2% of our total sales for fiscal 2011, increased 16.3% from fiscal 2010.
The total costs for company-owned restaurants increased by $9.5 million, primarily due to additional expenses of $5.1 million contributed by the extra 53rd week and inflationary pressures in our product costs. To help offset these costs, we took price increases of 4.0% during 2011 and established several initiatives to control costs.
As a percentage of company-owned restaurant sales, we saw an increase in our food costs from 28.5% for fiscal 2010 to 29.6% for fiscal 2011. This 110 basis point increase includes the impacts of inflation in our commodity costs (+120 basis points) and a product mix shift towards catering and sandwiches (+100 basis points) partially offset by price increases (-60 basis points) and savings from our initiatives (-50 basis points). We anticipate overall inflation to be in the range of 2.0% to 3.0% for fiscal 2012. Most of our commodity-based food costs increased in 2011. We have secured price protection for 88% of our wheat needs and 93% of our coffee needs for fiscal 2012. At this time last year, we had secured price protection on only 44% of our wheat needs and on 70% of our coffee needs. We have also implemented a cross functional team to evaluate innovative ways to target $3.0 million in annualized incremental savings on a go-forward basis without negatively impacting the customer experience.
As a percentage of company-owned restaurant sales, labor costs, other operating costs (which include marketing costs), and rent and related costs were essentially flat to fiscal 2010. We incurred approximately $9.9 million in marketing costs for both fiscal 2010 and fiscal 2011.
Our company-owned restaurant gross margin decreased from 18.8% for fiscal 2010 to 17.6% for fiscal 2011, primarily due to inflationary pressures in our product costs.
Manufacturing and Commissary Operations
Manufacturing and commissary revenues for fiscal 2011 increased $4.1 million compared to fiscal 2010, driven mainly by higher frozen dough sales to third parties from our manufacturing facilities and $0.5 million contributed by the extra 53rd week in fiscal 2011. Manufacturing and commissary gross margin decreased 15.3% primarily due to higher commodity costs and a shift in sales volume to lower margin export customers. On a year to date basis, gross margin as a percentage of manufacturing and commissary revenue was 11.9%, down from 15.9% in 2010.
We closed our Grove City (Columbus), Ohio commissary in the fourth quarter of 2011 and expect to close the remaining four commissaries in the first quarter of 2012. Based on the operating results of our commissaries for fiscal 2012, we expect to realize annual cost savings of approximately $1.5 million from the closure of these facilities.
Franchise and License Operations
Overall, franchise and license revenue improvement was driven by continued unit development which has netted an additional 29 licensed locations and 2 franchised locations since December 28, 2010. Franchise and license comparable store sales were +1.8% for the fiscal year ended January 3, 2012. Franchise and license revenue improved by $1.2 million, or 13.3% from 2010, primarily the result of continued unit development and single-digit increases in comparable store sales.
Our total general and administrative expenses decreased $1.7 million, or 4.5%, primarily due to declines of $1.9 million in variable incentive compensation and $0.5 million in corporate travel expenses. These decreases in general and administrative expenses were partially offset by an increase in our stock based compensation
expense of $0.8 million. Our performance incentive compensation decreased from 2010 as we reached a higher bonus threshold in fiscal 2010 than we did in fiscal 2011. We expect general and administrative expenses for 2012 to be approximately $10.0 million per quarter.
Depreciation and amortization expenses increased $1.5 million, or 8.4%. The increase is due to additional investments in company-owned restaurants that were either added or upgraded throughout fiscal 2011, as well as a full year of depreciation on capital assets added in fiscal 2010. 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 2012 will be in the range of $19.0 million to $21.0 million.
We also incurred $1.1 million in restructuring expenses for fiscal 2011. In 2011, we committed to a plan to close our five commissaries. As a result of this plan, we incurred $0.7 million in charges relating to severance charges, contract termination costs and other miscellaneous charges. We estimate that we will incur an additional $0.5 million to $0.8 million in restructuring expense related to the closing of the commissaries in 2012. In 2010, we approved a plan to restructure the organization to align with our franchise growth model. This reorganization included eliminating certain redundant positions and reducing headcount. We also eliminated redundant positions in the fourth quarter of 2011. As a result of these actions, we incurred an additional $0.4 million of severance charges and other miscellaneous charges during 2011.
Other operating income decreased $0.1 million from fiscal 2010 to fiscal 2011. In the third quarter of 2010, we recognized a gain on the sale of a restaurant to a franchisee. For fiscal 2011, we recognized gains on the sale of three restaurants to franchisees as well as a gain on the insurance proceeds from a restaurant fire, partially offset by $0.3 million in acquisition costs related to the purchase of nine stores in fiscal 2011.
Interest expense, net decreased in 2011 primarily due to the expiration of an interest rate swap agreement in August 2010 and a decrease in additional redemption amounts on previously outstanding mandatorily redeemable preferred stock. Our weighted average interest rate for fiscal 2011 was 3.1%.
The components of our provision for income taxes are as follows:
Our effective tax rate decreased from 48.3% from fiscal 2010 to 37.6% for fiscal 2011. This decrease relates to the elimination of several items that were non-deductible in 2010, including the $0.9 million adjustment on the modification of the Series Z, the additional redemption amount of the Series Z and the remaining deferred tax associated with our interest rate swap which expired in 2010. We also realized higher federal employment tax credits in fiscal 2011.
Results of Operations for Fiscal 2010 as compared to Fiscal 2009
Consolidated Results Fiscal 2010 vs Fiscal 2009
Our income from operations improved by $2.6 million in 2010 to $27.6 million as a result of higher revenues and lower cost of sales offset by an increase in operating expenses.
Total revenues increased by $3.1 million to $411.7 million as a result of increases in company-owned restaurant sales and franchise and license related revenues. Our catering business saw an increase of 9.2% over 2009. System-wide comparable store sales increased +0.3% due to a turnaround in our transactions trend from -2.3% in fiscal 2009 to flat in fiscal 2010 and an increase in average check of +0.3%. We achieved this by growing our base bagel sales and by turning around breakfast sales. Total costs in our company-owned
restaurants and manufacturing and commissaries segments decreased $2.9 million. The combination of this increase in revenues and decrease in total cost of sales resulted in an increase of $6.0 million in contribution margin.
Our operating expenses increased by $3.4 million as a result of a $3.0 million increase in general and administrative expenses, a $1.1 million increase in depreciation and amortization expense and $0.5 million in severance expense offset by a net improvement in other operating items of $1.2 million.
Income before income taxes improved $1.7 million in fiscal 2010 to $20.5 million. This comparative of fiscal 2010 to fiscal 2009 is $0.9 million lower than the improvement in our income from operations as a result of the non-cash charges of $1.9 million for an adjustment for our Series Z modification and the write-off of debt issuance costs offset by a $1.0 million decrease in interest expense. Our interest expense declined primarily due to lower additional redemption on our Series Z as a result of the impact of the significant Series Z redemptions we have made since 2009 as well as the expiration of our interest rate swap in August of 2010.
Company-Owned Restaurant Operations
Our company-owned restaurants vary in their unit volume, profitability and recent comparable store sales performance. As of December 28, 2010, we had 107 restaurants that generated an average unit volume in excess of $1.0 million. These 107 restaurants had an average unit volume of approximately $1.2 million. In the aggregate, these restaurants contribute approximately 35% of total restaurant sales and 48% of total restaurant operating profit.
Company-owned restaurant sales for fiscal 2010 increased $1.8 million, which was primarily due to three net new company-owned restaurants. Additionally, restaurant sales for fiscal 2010 benefited from $0.4 million in gift certificate breakage from a program that no longer exists.
Comparable store sales for our company-owned restaurants for each quarter in fiscal 2009 and fiscal 2010 were as follows:
Our company-owned restaurant gross margin increased $3.7 million, or 5.6%, in 2010 primarily due to an increase in sales combined with the success of our operations initiatives. Company-owned restaurant sales increased $1.8 million, or 0.5%, to $372.2 million. Comparable store sales declined -0.4% with transactions declining by -0.8% offset by an increase in average check of +0.4%.
The total costs for company-owned restaurants declined by $1.9 million with our cost of goods sold and labor costs declining by a combined $6.7 million, or 3.0%. This decline in our costs was substantially offset in part by an increase of $5.3 million in our marketing costs.
We were able to control and lower our variable cost of goods sold by 1.9% causing our cost of goods sold to decline from 29.2% to 28.5% as a percent of company-owned restaurant revenues. We renegotiated agreements with several of our suppliers in early 2010 that will further decrease our costs for certain products over the next several years. Most of our commodity-based food costs decreased during fiscal 2010. Wheat represents the most significant raw ingredient we purchase at approximately 8.0% of our cost of goods sold. To mitigate the risk of increasing market prices, we utilized a third party advisor to manage our wheat purchases for our company-owned manufacturing facility. As a result of this relationship, our wheat costs declined throughout fiscal 2010. Further, we believe that we benefited from the successful implementation of our food waste management initiatives and from the installations of our on-site restaurant cameras.
Total labor costs decreased 1.4% as a percentage of company-owned restaurant sales in fiscal 2010 due to labor initiatives we undertook in 2010 and lower health care benefit costs that were incurred.
Other operating costs increased $5.6 million as we more than doubled our investment in marketing to $9.9 million in fiscal 2010 from $4.6 million in fiscal 2009. The increase was principally attributable to increased media marketing including billboard advertising and radio spots.
Manufacturing and Commissary Operations
Manufacturing and commissary revenues for fiscal 2010 decreased $0.2 million compared to fiscal 2009. The modest decline was due to a decrease in third party domestic bagel sales, partially offset by a slight increase in international bagel sales as well as growth in sales to our franchise and license locations. Manufacturing and commissary costs decreased substantially in fiscal 2010 as a result of lower raw ingredient costs coupled with savings due to lower use taxes, maintenance and insurance costs for manufacturing and commissary locations, and continued efficiency improvements in our bagel manufacturing facility.
Franchise and License Operations
Overall, franchise and license revenue improvement of 21.3% from 2009 was driven by strong royalty streams that were a result of the net opening of 32 license locations and 15 franchise locations over the last twelve months. For fiscal 2010, franchise and license comparable store sales were +2.7%.
Our general and administrative expenses increased $3.0 million in fiscal 2010 compared to fiscal 2009 due to an increase of $1.8 million in incentive compensation as a result of the achievement of performance targets in fiscal 2010 and $0.6 million in stock based compensation. We also incurred $0.5 million in severance expense related to a restructuring plan which was implemented late in 2010. We approved a plan to reorganize the organization to align with our franchise growth model. This reorganization included eliminating certain redundant positions and reducing headcount.
Depreciation and amortization expenses increased $1.1 million or 6.9% in fiscal 2010 compared to fiscal 2009 due to additional assets invested in the company-owned restaurants that were added or upgraded in 2010.
Interest expense, net decreased in fiscal 2010 primarily due to the expiration of the swap in August 2010 and a decrease in the Series Z additional redemption amounts of $0.4 million.
The components of our provision for income taxes are as follows:
In 2009, we recorded a net deferred tax benefit of $71.8 million, comprised of a $79.3 million reversal of substantially all of our valuation allowance, partially offset by deferred tax expense of $7.6 million.
Reconciliation of Non-GAAP Measures to GAAP Measures
EINSTEIN NOAH RESTAURANT GROUP, INC.
NON-GAAP FINANCIAL INFORMATION
The following table summarizes the amounts of payments due under specified contractual obligations as of January 3, 2012:
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 products 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.
Excluding tenant improvement allowances that we typically receive from the landlord, the average cost of a new restaurant was approximately $0.5 million. 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 are planning 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, and continuing with our KDS installations. We believe that this system improves production accuracy compared to the paper tickets process and helps to reduce waste.
We anticipate that the majority of our capital expenditures for 2012 will be focused on the addition of eight to twelve new company-owned restaurants and the relocation of six to ten company-owned restaurants, along with the continued roll out of our new POS system. We also intend to deploy capital into areas such as installing drive-thru lanes and adding new exterior signage.
The following is information on our restaurant economics as of January 3, 2012 and represents the average company-owned restaurant that has been open longer than one year:
Senior Credit Facility
In December 2010, we entered into a new senior $125 million credit facility with Bank of America and a syndicate of institution lenders, which has since been amended (the Senior Credit Facility).
The Senior Credit Facility consists of a:
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, the entire revolver is available for letters of credit, which reduce the availability on the line. As of January 3, 2012, our availability under the revolver was $36.0 million.
We may prepay amounts outstanding under the credit facility and may terminate commitments in whole at any time without penalty or premium upon prior written notice.
Our working capital position declined by $5.9 million in fiscal 2011. We began fiscal 2011 with working capital of $6.1 million and ended fiscal 2011 with $0.2 million.
The decrease is primarily due to the increase in our accrued expenses and other current liabilities, which have increased due to an increase in deferred revenue for gift card sales and for amounts still owed for our acquisitions of restaurant assets. The increase in accounts receivable was the result of an increase in franchise and license billings for purchases from our commissaries as well as vendor rebates and credits. As of January 3, 2012 we had unrestricted cash of $8.7 million, representing a decrease in unrestricted cash of $3.1 million during fiscal 2011. In addition to changes in our unrestricted cash, other elements of working capital fluctuated in the normal course of business.
Free Cash Flow
Free Cash Flow declined by $12.6 million in fiscal 2011, primarily due to a decline of $3.1 million in income from operations, $8.0 million towards the installation of new coffee machines at our stores and $1.9 million towards the implementation of new POS systems at our stores.
Based upon our projections for 2012, we believe our various sources of capital, including availability under our existing 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 $39.1 million for fiscal 2011 compared to $43.8 million for fiscal 2010, a 10.6% decrease. The decrease can be attributed to timing differences within our accrued liabilities and accounts receivable. Our accrued expenses increased due to an increase in deferred revenue for gift card sales and for amounts still owed for our acquisitions of restaurant assets. Our accounts receivable increased due to an increase in franchise and license billings for purchases from our commissaries as well as vendor rebates and credits.
Cash Used in Investing Activities
During fiscal 2011, we spent $6.8 million, net of cash acquired, on the purchase of nine restaurants. We also used approximately $18.2 million of cash to purchase additional property and equipment as follows:
We also received $1.4 million in proceeds from the sale of three company-owned restaurants to franchisees and insurance proceeds from a restaurant fire.
During fiscal 2010, we used approximately $16.6 million of cash to purchase additional property and equipment as follows and we also received $0.9 million in proceeds from the sale of one company-owned restaurant to a franchisee and sales of equipment:
Cash Used in Financing Activities
During fiscal 2011, we made payments on our Senior Credit Facility totaling $15.5 million, of which $7.5 million went towards the term loan in accordance with our debt repayment schedule and $8.0 million towards the revolving line of credit. Our outstanding debt balance decreased $13.5 million, based on the above repayments, partially offset by $2.0 million in borrowings on the revolving line of credit. We also paid dividends of $6.3 million during fiscal 2011. We received $1.3 million in proceeds from stock options exercised during fiscal 2011.
During 2010, we made payments on our prior credit facility totaling $79.8 million on the term loan and $11.0 million on the line of credit. We also redeemed $32.2 million of our Series Z. In connection with the entrance into our Senior Credit Facility, we had borrowings of $75.0 million on the term loan, received $12.7 million in proceeds from the line of credit and incurred $2.3 million in debt issuance costs which were capitalized. We received $1.0 million in proceeds from stock option exercises.
Off-Balance Sheet Arrangements
Letters of Credit
We have $7.3 million in letters of credit outstanding under our Senior Credit Facility. The letters of credit expire on various dates during 2012, 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 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 all 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. Utilizing a third party, we attempt to lock in our food and product costs over an extended period of time. 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.
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 January 3, 2012, we have recorded a valuation allowance of $4.8 million on certain of our deferred tax assets. We have also recorded a liability for unrecognized tax benefits of $1.0 million. The recording of these amounts requires 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 restaurants 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 restaurants 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 restaurants 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 restaurants identifiable future cash flow are discounted to estimate its fair value. We have not recorded impairment charges for fiscal 2010 and fiscal 2011.
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 January 3, 2012, 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.
We account for our acquisitions using the acquisition method of accounting, or acquisition 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 January 3, 2012, we have recorded preliminary acquisition accounting allocations, which are subject to revision as we obtain additional information necessary to complete the fair value studies and acquisition accounting. In the event that actual results vary from any of the estimates or assumptions used in the valuation or allocation process, we may be required to record an impairment charge or an increase in depreciation or amortization in future periods, or both.
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.
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 life at the grant date. Implied volatility is based on the mean reverting average of our stocks 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 companys leverage combined with the effects mandatory principal payments will have on our capital structure, as defined under our new credit facility. Starting in 2010, we began declaring 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 SECs 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.
Gift Card Breakage
Proceeds from the sale of gift cards are recorded as deferred revenue and recognized as income when redeemed by the holder. While we will continue to honor all gift cards presented for payment, we may determine the likelihood of redemption to be remote for certain gift card balances due to the age of the unredeemed balance. In these circumstances, to the extent we determine there is no requirement for remitting balances to government agencies under unclaimed property laws, gift card balances may be recognized as gift card breakage and recorded as a reduction to deferred revenue and an increase to company-owned restaurant revenues. Our estimate of gift card breakage is based upon reasonable and reliable company-specific historical information that we believe is predictive of the future and relates to a large pool of homogenous gift card transactions over a sufficient time frame. We recognized $0.2 million in gift card breakage in each of fiscal 2010 and fiscal 2011. We also recognized $0.4 million in revenue in 2010 related to gift certificate breakage from a gift certificate program that is no longer in place. While these gift certificates will continue to be honored, we have determined the likelihood to be remote for redemption of these gift certificates due to their age and the fact that the program is no longer in place.
The following market risk discussion contains forward-looking statements. Actual results may differ materially from this discussion based upon general market conditions and changes in domestic and global financial markets, among other factors.
For fiscal years 2010 and 2011, our results of operations, financial position and cash flows were not materially affected by changes in the relative values of non-U.S. currencies to the U.S. dollar. We do not use derivative financial instruments to limit our foreign currency risk exposure since virtually all of our business is conducted in the United States. Our manufacturing operations sell bagels to a wholesaler and a distributor who take possession in the United States and sell outside of the United States. As the product is shipped FOB domestic dock, invoiced in U.S. dollars and paid in U.S. dollars, there are no international risks of loss or foreign exchange currency issues.
Our debt as of January 3, 2012 was composed of the Senior Credit Facility. For fixed rate debt, interest rate changes affect the fair market value of such debt but do not impact earnings or cash flows. Conversely, for variable rate debt, including borrowings under our Senior Credit Facility, interest rate changes generally do not affect the fair market value of such debt, but they do impact future earnings and cash flows, assuming other factors are held constant.
On March 3, 2011, we entered into two interest rate cap agreements, to cap our rate on $37.6 million of our debt. The effect of these interest rate caps is to cap the LIBOR portion of the interest rate on our Senior Credit Facility to 3.0%. Each agreement has a two-year term.
Assuming no change in the size or composition of debt as of January 3, 2012, and presuming that the utilization of our accumulated net operating losses would minimize the tax implications for the next several years, a 100 basis point increase in short-term effective interest rates would increase the annual interest expense on our Senior Credit Facility by approximately $0.8 million. Currently, the interest rates on our Senior Credit Facility are predominantly at LIBOR rates plus an applicable margin through short-term fixed rate financing. The estimated increase in interest expense incorporates the fixed interest financing into its assumptions.
On an annual basis, we purchase a substantial amount of agricultural products that are subject to fluctuations in price based upon market conditions. Our purchase arrangements may contain contractual features that limit the price paid by establishing certain price floors or caps. We do not use financial instruments to hedge commodity prices. 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 turkey, butter, cheese and coffee.
Board of Directors and Stockholders
Einstein Noah Restaurant Group, Inc.
We have audited the accompanying consolidated balance sheets of Einstein Noah Restaurant Group, Inc. and subsidiaries (collectively, Einstein Noah) (a Delaware corporation) as of January 3, 2012, and December 28, 2010, and the related consolidated statements of operations, comprehensive income, shareholders (deficit) equity, and cash flows for each of the three years in the period ended January 3, 2012. Our audits of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under Item 15 (2). These financial statements and financial statement schedule are the responsibility of Einstein Noahs management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Einstein Noah and subsidiaries as of January 3, 2012 and December 28, 2010, and the results of their operations and their cash flows for each of the three years in the period ended January 3, 2012, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of January 3, 2012, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 1, 2012 expressed an unqualified opinion.
/s/ GRANT THORNTON LLP
March 1, 2012
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Einstein Noah Restaurant Group, Inc.
We have audited Einstein Noah Restaurant Group, Inc. and subsidiaries (collectively, Einstein Noah) (a Delaware Corporation) internal control over financial reporting as of January 3, 2012, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Einstein Noahs management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on Einstein Noahs internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Einstein Noah maintained, in all material respects, effective internal control over financial reporting as of January 3, 2012, based on criteria established in Internal ControlIntegrated Framework issued by COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Einstein Noah as of January 3, 2012, and December 28, 2010, and the related consolidated statements of operations, comprehensive income, shareholders (deficit) equity, and cash flows for each of the three years in the period ended January 3, 2012, and our report dated March 1, 2012 expressed an unqualified opinion.
/s/ GRANT THORNTON LLP
March 1, 2012
CONSOLIDATED BALANCE SHEETS
(in thousands, except share information)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except earnings per share and related share information)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS (DEFICIT) EQUITY
(in thousands, except share information)