SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 28, 2010
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 ¨ 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. x
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 29, 2010 was $62,454,390 (computed by reference to the closing sale price as reported on the NASDAQ Global Market). As of March 11, 2011 there were 16,687,215 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 2011 annual meeting of stockholders, which will be filed with the SEC within 120 days after the close of the 2010 fiscal year.
TABLE OF CONTENTS
On February 22, 2011, Company management determined, after discussion with the Audit Committee of our Board of Directors, that previously issued financial statements for the fiscal years 2008 and 2009, each of the four quarters of fiscal 2008 and fiscal 2009 and selected financial data for the fiscal years 2006, 2007, 2008 and 2009 should be restated in order to revise our accounting for the provision for income taxes. These matters are described in more detail in Note 3 and Note 20 to our consolidated financial statements included in Item 8 of this Annual Report. The restated consolidated balance sheet as of December 29, 2009 and the related restated consolidated statements of operations, stockholders equity and cash flows for the years ended December 29, 2009 and December 30, 2008 are included in this Annual Report. The selected financial data for those fiscal years, as well as fiscal years 2006 and 2007 in this Annual Report, have also been restated because of these matters. The accompanying Managements Discussion and Analysis of Financial Condition and Results of Operations section gives effect to these restatements and a detailed discussion follows.
We have not amended our reports previously filed under the Securities Exchange Act of 1934, and therefore the financial statements and related financial information contained in those reports should no longer be relied upon and are superseded by the financial statements and financial information in this Annual Report on Form 10-K.
General development of our Company:
Einstein Noah Restaurant Group, Inc. (the Company or we) operates 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 occurred through a series of acquisitions. Our largest acquisition was in 2001 when we acquired substantially all the assets of Einstein/Noah Bagel Corp. Since then, we have grown organically by opening company-owned restaurants, working with franchisees on development agreements, and promoting the licensing of our brand.
Financial information about segments:
We operate three business segments plus a corporate support unit:
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 2008 (as restated), 2009 (as restated) and 2010.
Narrative description of business:
We are the largest owner/operator, franchisor and licensor of bagel specialty restaurants in the United States. As of December 28, 2010, we had 733 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 in 38 states and in the District of Columbia, Noahs restaurants in three states on the west coast and Manhattan Bagel restaurants concentrated in eight states in the Northeast. Currently, our Einstein Bros. and Noahs restaurants are predominantly company-owned or licensed, while 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 guest base of women and men, approximately 64% women and 36% men and in the middle to upper-middle income brackets within our breakfast traffic.
We believe 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.
Franchising and licensing our brands allows us to increase our geographic footprint and brand recognition. This allows us to generate additional revenues without incurring significant additional expense, capital commitments and avoid many of the other risks associated with opening new company-owned restaurants.
As of December 28, 2010, the Company had 6,796 associates, of whom 211 were corporate personnel, 145 were manufacturing and commissary personnel and 6,440 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 associates are not represented by a labor organization.
We generated approximately 91% of our 2010 total revenue from restaurant sales at our Einstein Bros. and Noahs company-owned restaurants. For the year ended December 28, 2010, approximately 66% of our revenues were generated from restaurant sales during the breakfast hours.
Noahs is a neighborhood-based, New York City 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. During fiscal years 2008, 2009 and 2010, Noahs company-owned restaurants generated approximately 20% of our total company-owned restaurant sales.
Manhattan Bagel provides a traditional New York City 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. In late 2007, we acquired a location from one of our franchisees, which made it our only company-owned Manhattan Bagel restaurant. We use this location for employee and manager training, and to test out new products and services before they are rolled out system-wide.
Throughout most of our Einstein Bros. restaurants, we have implemented an improved kitchen display ordering system (KDS) that reduces the time our guests wait in line before they receive their food. We believe that this system improves production accuracy compared to the paper tickets process and helps to reduce waste. In 2010, we continued to roll out KDS across our system and it is now in 82% 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 and on-line ordering capabilities which helped us to establish a new process to generate, fulfill and deliver catering sales. This change has reduced the cost of our catering program considerably in 2010 while at the same time providing a more robust method of attracting new customers and increasing the order frequency of existing customers. Catering accounted for approximately 6% of our company-owned restaurant sales in 2010.
We experience competition from numerous sources in our trade areas. Our restaurants compete based on guests needs for breakfast, lunch and afternoon snacks. Our competitors are different for each daypart. The competitive factors include brand awareness, advertising effectiveness, location and attractiveness of facilities, hospitality, environment, quality and speed of guest service and the price/value of products offered. We compete in the fast-casual segment of the restaurant industry, but we also consider other restaurants in the fast-food, specialty food and full-service segments to be our competitors.
Manufacturing and Commissaries:
We generated approximately 7% of our 2010 total revenue from our manufacturing and commissary operations.
Frozen, or partially baked and frozen, bagel dough is shipped to all of our company-owned, franchised and licensed restaurants and baked on-site. 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.
Our cream cheese is manufactured to our specifications utilizing proprietary recipes. Our cream cheese and certain other cheese products are purchased from one supplier under a contract that has been extended through the end of 2013. We also have developed proprietary coffee blends for sale at our company-owned, franchised and licensed restaurants.
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 naturally cage-free raised 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. Our roast beef is United States Department of Agriculture (USDA) Choice, Grade A, and comes only from corn-fed, domestic cattle. Where available, we buy high quality fruits, vegetables and specialty produce from a nationally recognized group of third party suppliers and distributors.
Franchise and Licensing
Approximately 2% of our 2010 total revenue was generated by our franchise and license operations.
We utilize a franchise area development model for the Einstein Bros. brand in which we assign 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 $988,000.
Financial information about geographic areas:
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, and invoiced 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 approximately $4.8 million, $5.3 million and $5.3 million for 2008, 2009 and 2010, respectively. All other revenues were from external customers domiciled in the United States of America.
We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended. 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 the Company on our website under the Financials & Media tab.
We also make available on our website and in print to any stockholder who requests it, the Charters for our Audit and Compensation Committees, as well as the Code of Conduct that applies to all directors, officers, and associates of our 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.
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. Priszm is a publicly traded Canadian restaurant income trust with a portfolio of popular brands such as Pizza Hut and Taco Bell and is 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 his old company in 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.
Daniel J. Dominguez. Mr. Dominguez was appointed Chief Operating Officer in December 2005. Mr. Dominguez joined us in November 1995 and served as Senior Vice President of Operations for Noahs New York Bagels from April 1998 to December 2005. From 1995 to April 1998, Mr. Dominguez served as the Director of Operations for Einstein Bros. for the Midwest. Prior to joining us, Mr. Dominguez was Executive Vice President of JB Patt America, Beverly Hills, CA, dba Koo Koo Roo Restaurants, from July 1994 to October 1995. From May 1987 to July 1994, he was the Divisional Vice President of Food Services for Carter Hawley Hale in San Francisco, California. From November 1976 to May 1987 he was the Vice President of Operations for Bakers Square Restaurants in California.
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.
James P. OReilly. Mr. OReilly joined us in April 2009 as our Chief Concept Officer after consulting with us from January 2009 to March 2009. Previously, Mr. OReilly worked at Yum! Brands, Inc. from November 1996 until January 2009. He joined Yum! as a Director of Marketing, worked internationally in Canada, Latin America and the United Kingdom before returning to the United States in June 2008 as Vice President, U.S. Marketing and becoming Chief Marketing Officer of KFC U.S. Mr. OReilly received a B.S. degree from McMaster University and holds an MBA from York 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. 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.
Cautionary Note Regarding Forward-Looking Statements:
We wish to caution our readers that this report, including the Managements Discussion and Analysis of Financial Conditions and Results of Operations (MD&A), contains forward-looking statements within the meaning of the federal securities laws. All such statements are qualified by this cautionary note, which is provided pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended (1933 Act). 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. Such 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. Our financial condition and results of operations are sensitive to, and may be adversely affected by, a number of factors, many of which are largely outside the Companys control. 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, 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, 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 thereunder, 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. 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. An expanded discussion of some of these risk factors follows. The list of risk factors below is not exhaustive.
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, 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 which in turn could reduce our guest traffic or average check. Adverse changes in consumer discretionary spending, which could be affected by many different factors that are out of our control, including international, national and local economic conditions, 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 a significant risk 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 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, could reduce demand for 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 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 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. 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. 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.
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, 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, 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. 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 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.
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. 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.
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 $87.7 million in debt as of December 28, 2010. 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, 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 43% 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 December 28, 2010, a total of 318, or 43.4%, of all 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. 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 affect 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.
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 December 28, 2010. 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 as of December 28, 2010. Subsequent to December 28, 2010, the chairman of our board 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. The Company currently has 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. The Company does not have a nominating committee and 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 five to 10 years, with two or three five-year renewal option periods, for total lease terms that average approximately 10 to 20 years. The average company-owned restaurant is approximately 1,800 to 2,500 square feet in size with approximately 3040 seats and is generally located in a neighborhood or regional shopping center. As of December 28, 2010, leases for approximately 70 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 estimate closing approximately six to ten company-owned restaurants over the next three years as their leases expire and they cannot be relocated.
Information with respect to our headquarters, production and commissary facilities is presented below:
Our Current Restaurants
As of December 28, 2010, we owned and operated, franchised or licensed 733 restaurants. Our current base of company-owned restaurants under our core brands includes 358 Einstein Bros. restaurants, 72 Noahs restaurants and one Manhattan Bagel restaurant. Also, we franchise 73 Manhattan Bagel restaurants and 19 Einstein Bros. restaurants, and license 210 Einstein Bros. restaurants. In support of our strategy to only license the Einstein Bros. brand, in 2010, we converted our final Noahs licensed restaurant to the Einstein Bros. brand. In addition, we had one company-owned restaurant which we owned and operated under another brand, which we closed during the first quarter of 2010 and one company-owned restaurant that we sold to a franchisee during the third quarter of 2010. We also closed one company-owned Einstein Bros. location in the second quarter of 2010.
The following table details our restaurant openings and closings for each respective fiscal year:
As of December 28, 2010, 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 March 11, 2011, there were 16,687,215 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 new credit facility in 2010, described in further detail in Item 7, our Board of Directors declared the following dividend in 2010:
It is the current expectation of our Board of Directors that we will continue to pay a quarterly cash dividend, at the discretion of the Board of Directors, dependent on a variety of factors, including available cash and the overall financial condition of the Company. In addition, like other companies that are incorporated in Delaware, we are also limited by Delaware law as to the payment of dividends.
Previously, we had not declared or paid any cash dividends on our common stock since our inception as we were precluded from paying cash dividends under our financing agreements.
The included performance graph covers the fiscal five-year period from January 3, 2006 through December 28, 2010. The graph compares the total return of our common stock (BAGL) to our current peer group of companies (PGI) and the NASDAQ Composite Index. The PGI was selected representing our competitive peer group, comprised of multi-concept companies and/or companies with a similar organizational structure. The companies selected are participants of the restaurant industry with a sufficient period of operating history for continuous inclusion in the Index.
The following selected financial data for each fiscal year was extracted or derived from our consolidated financial statements and has been restated to reflect adjustments to the financial data that is further discussed in the Restatement of Financial Information section in Managements Discussion and Analysis of Financial Condition and Results of Operations and in Note 3 in the Notes to Consolidated Financial Statements.
We have a 52/53-week fiscal year ending on the Tuesday closest to December 31. Fiscal years 2008, 2009 and 2010 ended on December 30, 2008, December 29, 2009 and December 28, 2010, respectively, and each contained 52 weeks. Our next 53-week fiscal year is 2011 which ends on January 3, 2012.
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.
Restatement of Financial Information
On February 22, 2011, management, after discussion with the Audit Committee of our Board of Directors, determined that previously issued financial statements for the fiscal years 2006, 2007, 2008 and 2009 and each of the four quarters of fiscal 2009 and fiscal 2008 should be restated in order to revise our accounting for the provision for income taxes. These matters are described in more detail in Note 3 and Note 20 to our Consolidated Financial Statements included in this Annual Report. The restated consolidated balance sheet as of December 29, 2009 and the related restated consolidated statements of operations, stockholders equity and cash flows for the years ended December 29, 2009 and December 30, 2008 are included in this Annual Report. The selected financial data for those fiscal years, as well as fiscal years 2006 and 2007 in this Annual Report, have also been restated because of these matters. The accompanying Managements Discussion and Analysis of Financial Condition and Results of Operations section gives effect to these restatements and a detailed discussion follows.
We have not amended our reports previously filed under the Securities Exchange Act of 1934, and therefore the financial statements and related financial information contained in those reports should no longer be relied upon and are superseded by the financial statements and financial information in this Annual Report on Form 10-K.
During the year end close process, the Company identified two types of errors while preparing its income tax provision. These errors only impact the provision for income taxes and resulted in errors to the Companys income tax provisions, net income (loss) amounts and earnings per share amounts for 2001 through 2009. The errors do not impact income from operations for 2001 through 2009.
The first error relates to the incorrect netting of deferred tax liabilities (DTL) against deferred tax assets (DTA). This relates to the cost basis under Generally Accepted Accounting Principles (GAAP) versus the cost basis for tax purposes for amortization of indefinite-lived intangibles that do not amortize for GAAP. This DTL should not be a source of future taxable income in calculating a valuation allowance or assessing whether deferred tax assets are more likely than not to be realized. The Company maintained a full valuation allowance against its net deferred tax assets from 2000 through the third quarter of 2009. However, the Companys valuation allowance became understated over the years 2001 through 2008 by a cumulative $16.3 million as a result of offsetting this DTL against its DTAs in calculating its valuation allowance and its annual tax expense.
This DTL should have been presented as a DTL on the Companys balance sheet. Likewise, as a result of understating its provision for income taxes in each of these years, cumulative losses for these years and the Companys accumulated deficit were understated by $16.3 million as of the end of fiscal 2008. The Companys
income tax expense was understated by $1.4 million in 2008 giving rise to an overstatement of net income in 2008 of $1.4 million. Correction of this item did not change income (loss) before income taxes for any year from 2001 through 2009. Correction for this item would increase income tax expense by a total of $7.5 million (an average of $1.1 million per year) from 2002 through 2008 with an initial increase in income tax expense of approximately $8.9 million in 2001. As a result of the Company reversing the valuation allowance in 2009, the impact to 2009 is that the Company understated its tax benefit by $16.3 million for this item. As of the end of fiscal 2009, this error had no further impact on the Companys financial statements.
The second error was due to improper recognition of certain deferred tax assets and liabilities relating to years prior to 2009 totaling approximately $2.0 million and includes the following:
The Company maintained a full valuation allowance against its net deferred tax assets from 2000 through the third quarter of 2009. Thus, any incremental changes in income tax expense/benefit arising out of these items in its DTAs and DTLs were offset by a commensurate change in the Companys valuation allowance against its deferred tax assets. The impact of this error is an increased tax benefit of approximately $2.0 million to be recorded in the third quarter of 2009 when the valuation allowance was reversed.
The combined $18.4 million impact of these errors will increase the income tax benefit and net income by $18.4 million in 2009. Restated net income is $90.4 million for 2009 from the previously reported $72.0 million.
2010 Highlights and Trends
During 2010, we focused on our key strategies and resetting the financial levers within our balance sheet and focused on regaining momentum in comparable store sales with an emphasis on building transaction growth. Our key strategies are:
While our 2010 system-wide comparable store sales were positive, the more important trend that we focused on was an improvement in system-wide comparable transactions in the third quarter and then the fourth quarter. System-wide comparable transactions improved to 1.2% for the second half of 2010 compared to minus 1.3% for the first half of 2010 a positive change in trend of 2.5%. Approximately 51.0% of our 2010 system-wide comparable transactions occurred in third and fourth quarters. We saw a very similar change in trend for comparable transactions at our company-owned restaurants. For 2010, our system-wide comparable store sales were positive 0.3% with flat transactions and an increase of 0.3% in average check.
The below table represents our system-wide comparable store sales percentages, average check percentages and transaction percentages since 2008.
We grew our base bagel business, which is made up of single bagel sales, by approximately 5.2% over 2009 as well as accelerated revenue growth in breakfast sandwiches in the fourth quarter to a positive 13.9%. Our catering business grew by approximately 9.2% with our focus on the roll-out of our online ordering system. We increased our marketing initiatives, concentrating primarily on the breakfast daypart, with increased efforts aimed at the lunch daypart. We continued to expand our company-owned restaurants in 2010 as well as our franchise and license locations. We targeted our marketing investments at coupons and print and radio advertising. In the second quarter we launched our Bagel Thin lunch sandwiches which helped bolster the lunch daypart.
From an operational standpoint, we continued our initiatives aimed at reducing our cost structure. These targeted initiatives focused on efficient labor utilization and scheduling, consistency in our product standards and portion control, and other programs aimed at restoring margins in outlier restaurants. Additionally, we successfully completed renegotiations with several of our major vendors resulting in lower primary food costs.
We added 50 net locations in 2010 compared to 34 net additions in 2009. 46 of these net additions were in our franchise and license segment as we continue to intensely focus on expansion in this area.
We strengthened our balance sheet by refinancing our debt and redeeming all remaining outstanding shares of the Series Z preferred stock. We entered into a new senior $125 million credit facility with a syndicate of banks. The new senior credit facility has a five-year term expiring December 20, 2015, with a term loan of up to $75 million and a revolving credit facility of up to $50 million. The loans will bear interest at LIBOR, plus an applicable margin ranging from 2.5% to 3.0% and or Prime, plus an applicable margin ranging from 1.5% to 2.0%. In addition, the new facility provides flexibility to make share repurchases and pay dividends to shareholders, subject to certain limits. Our capital structure has been simplified to include only this new bank facility and common stock. We redeemed all remaining outstanding shares of the Companys Series Z preferred
stock with Halpern Denny III, L.P., the holder of the Series Z. Excluding the related additional redemption amounts, we redeemed $32.2 million in 2010 and $57 million over the last two years.
During 2011, we plan to intensely execute around our key strategies which are as follows:
To drive comparable store sales growth, we will seek to build traffic by leveraging our strengths in core bagels, breakfast and healthy innovation; drive average check increases through innovation, beverage incidence, catering, modest price increases, and additional premium sandwiches, as well as build brand awareness by leveraging learnings from our 2010 mass marketing tests. We will reinforce our product differentiation in terms of Fresh Baked Goodness combined with quality ingredients and innovation. Initiatives to increase our average check include bundled combos and additional snack items in the breakfast and lunch dayparts, and a repositioning of our coffee offering to include dedicated baristas and specialty coffee. If we expand our coffee offering to all locations, it will be an additional cost of $8.0 million to $9.0 million in 2011. Based on results from our 2010 mass marketing tests, we plan to regionally expand our broadcast radio and outdoor advertisements.
To enhance corporate margins, we will focus on manufacturing efficiencies and commodity purchasing enhancements, utilize technology to drive sustainable cost advantage, and improve restaurant level operating efficiency through targeted initiatives around product costs and labor.
To accelerate unit growth of our company-owned restaurants, our Board of Directors has approved the expansion of our capital expenditure budget by $11.0 million to a projected $28.0 million to $30.0 million in 2011. This capital expenditure budget includes the opening of 10 to 14 new company-owned restaurants and the relocation of an additional 10 to 14 company-owned restaurants, along with the continued roll-out of the new coffee program. The new units will primarily be in our more developed markets, such as Denver, Baltimore, Washington D.C. and Texas. We also intend to deploy our capital into areas such as installing drive-thru lanes and adding new exterior signage.
As we move into 2011, 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 plan to open 20 to 26 franchise locations in 2011 in markets that have already been established and have shown a strong following. We plan to open 45 to 50 license restaurants in 2011, primarily in colleges and universities, hospitals, airports and military bases.
Subsequent to December 28, 2010, the Company extended an offer to sell two company-owned restaurants to a franchisee for approximately $0.8 million and has received a deposit from the franchisee. This purchase is expected to close in the first half of 2011. Further, the Company extended an offer to buy back one franchised restaurant from a franchisee for approximately $0.6 million. This buy back deal is expected to close in the first half of 2011.
Results of Operations for 2010 as compared to 2009
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, the Company has provided certain non-GAAP financial information, including adjusted earnings before interest, taxes, depreciation, 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 residual amount in other comprehensive income related to cash flow hedge (adjusted net income); earnings per share 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, or 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 ongoing business performance and certain components of the Companys results. In addition, the Companys Board of Directors uses this non-GAAP financial information to evaluate the performance of the Company and the 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. The Company has reconciled the non-GAAP financial information to the nearest GAAP measure on pages 33-34.
We include in this report information on company-owned, franchise and license and system-wide comparable store sales percentages. Comparable store sales percentages refer to changes in sales of our restaurants, whether operated by the company or by franchisees and licensees, in operation at least thirteen months including those restaurants temporarily closed for an immaterial amount of time. Some of the reasons restaurants may be temporarily closed include remodeling, 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 restaurants, whether operated by the Company, franchisees or 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.
System-wide 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.
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 were 0.3% due to a turnaround in our transactions trend from -2.3% in 2009 to flat in 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 expense 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 by $1.7 million in 2010 to $20.5 million. This comparative of 2010 to 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 2010 increased $1.8 million, which was primarily due to three net new company-owned restaurants. Additionally, restaurant sales for 2010 benefited from $0.4 million in gift certificate breakage. We do not expect any benefit from gift certificate breakage in the future as this gift certificate program has ceased to exist.
Comparable store sales for our company-owned restaurants for each quarter in 2009 and 2010 were as follows:
Our company-owned restaurant gross profit 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 0.3%.
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%, from 2009. 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 in 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, similar to 2009, 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 2010. We will continue to work with our third party advisor to strategically source our wheat purchases. However, there can be no assurance that we will benefit from a decline in the cost of any of the commodity-based products that we purchase. Further, we benefited from our successful implementation our food waste management initiatives as well as the benefits from our on-site restaurant cameras.
Total labor costs decreased 1.4% as a percentage of company-owned restaurant sales in 2010 due to our labor initiatives in 2010 and lower health care benefit costs that were incurred.
During 2010, we more than doubled our investment in marketing to $9.9 million from $4.6 million in 2009. The increase was principally attributable to increased media marketing including billboard advertising and radio spots. We intend to expand on this media marketing in 2011 as we believe the increased marketing creates awareness of our brand which will help facilitate the trial of our products with new customers and increase loyalty and frequency of our guests visits.
Manufacturing and Commissary Operations
Manufacturing and commissary revenues for 2010 decreased $0.2 million compared to 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 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 the fifty-two weeks ended December 28, 2010, franchise and license comparable store sales were a positive 2.7%.
Our general and administrative expenses increased $3.0 million in 2010 compared to 2009 due to an increase of $1.8 million in incentive compensation as a result of the achievement of performance targets in 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 duplicate positions and reducing headcount. We expect general and administrative expenses for 2011 to be approximately $10.0 million per quarter.
Depreciation and amortization expenses increased $1.1 million or 6.9% in 2010 compared to 2009 due to additional assets invested in the company-owned restaurants that were added or upgraded in 2010. We expect depreciation expense for 2011 to be in the range of approximately $19 million to $21 million.
Interest expense, net decreased in 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 as restated, comprised of a $79.3 million reversal of substantially all of our valuation allowance as restated, partially offset by deferred tax expense of $7.6 million as restated. In the third quarter of 2009, we reduced our $84.3 million valuation allowance by $79.3 million, as restated, to $4.9 million after concluding the likelihood for realization of the benefits of our deferred tax assets is more likely than not. As discussed under Restatement of Financial Information above, the impact of the restatement on these items is $18.4 million in additional tax benefit recorded in 2009.
Reconciliation of Non-GAAP Measures to GAAP Measures
EINSTEIN NOAH RESTAURANT GROUP, INC.
NON-GAAP FINANCIAL INFORMATION
Results of Operations for 2009 as compared to 2008
System-wide comparable store sales decreased 2.4% in 2009. When the year began, we had negative 3.4% system-wide comparable store sales comprised of negative 8.1% in transactions and positive 5.2% for the average check related to a prior year price increase. By December of 2009 our system-wide comparable store sales were virtually flat at a negative 0.4% and negative 0.2% in both transactions and average check. We achieved this improvement through our increased marketing initiatives, focused around our core breakfast product offerings as well as other value-oriented initiatives aimed at increasing transactions and the frequency of guest visits. We believe that the difficult economic climate also put pressure on our catering sales as demand from our business customers declined.
Our gross profit margins in 2009 were pressured due primarily to the unfavorable deleveraging of certain operating expenses, higher health care benefit costs and the impact of increased investments in marketing initiatives. During periods of lower sales, we typically experience deleveraging in those cost elements that are not fully variable to changes in sales. These costs include other operating expenses, rent and related costs, and to a lesser extent, labor costs. Our health care benefit costs increased $1.9 million in 2009. We also continued to support our focus around our core breakfast offerings and other value-oriented initiatives by increasing our investments in marketing by $2.3 million in 2009.
While our revenues declined in 2009 and our cost of sales reflected a $1.9 million increase in health care benefit costs, our focus on our cost initiatives resulted in our Adjusted EBITDA being virtually flat in 2009 compared to 2008.
Company-Owned Restaurant Operations
Our company-owned restaurants vary in their unit volume, profitability and recent comparable store sales performance. As of December 29, 2009, we had 110 restaurants that generated an average unit volume in excess of $1 million. These 110 restaurants had an average unit volume of approximately $1.2 million. In the aggregate, these restaurants contribute approximately 36% of total restaurant sales.
Company-owned restaurant sales for 2009 decreased, which was primarily related to the decline in our 2009 company-owned restaurant comparable store sales to a negative 3.4%. This was due to a decrease in the number of transactions, and a slight decrease in our average check mostly due to greater coupon redemptions associated with our initiatives and a slightly unfavorable change in the mix of products sold. This was partially offset by the modest price increases in 2009 at our Einstein Bros. and Noahs company-owned restaurants, compared to the price increases taken during 2008 and, on average, the company-owned restaurants that were opened since late in 2008 until the end of 2009 had higher volumes than those that were closed over the same period, which positively contributed to our sales.
Comparable store sales for our company-owned restaurants for each quarter in 2008 and 2009, compared to the same periods in the previous year were as follows:
Although we had a 1.7% decrease in company-owned revenues, we were able to control and lower our variable cost of goods sold by 4.1% to cause our cost of goods sold to decline from 29.9% to 29.2% as a percent of company-owned restaurant revenues.
Most of our commodity-based food costs decreased in 2009. Wheat represents the most significant raw ingredient we purchase. To mitigate the risk of increasing market prices, we have 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 2009. We will continue to work with our third party advisor to strategically
source our wheat purchases. However, there can be no assurance that we will benefit from a decline in the cost of any of the commodity-based products that we purchase.
Although our staffing costs declined in response to decreased traffic, our health care benefit costs increased and we added new catering personnel throughout 2009. In the fourth quarter of 2009 we implemented a new on-line ordering system which allowed us to reduce our catering sales force at the end of the year. Total labor costs increased 1.0% as a percentage of company-owned restaurant sales in 2009.
During 2009, we doubled our investment in marketing to $4.6 million from $2.3 million in 2008. The increase was principally attributable to an investment in our marketing initiatives that we started early in 2009, which were aimed at increasing transactions and launching of our new products.
In 2009 we had additional rent expense associated with the net opening of two restaurants over the last twelve months and the eight new restaurants that opened towards the end of 2008. During the year, we negotiated more favorable lease terms with many of our landlords. These lease modifications will result in lower future rent expense compared to the prior terms.
Manufacturing and Commissary Operations
Manufacturing and commissary revenues for 2009 were relatively flat compared to 2008. Manufacturing and commissary costs decreased substantially in 2009 as a result of substantial productivity improvements in 2009 at our bagel manufacturing facility. In addition, we experienced lower prices of our raw ingredient costs as a result of the decrease of most of our commodity-based food costs.
Franchise and License Operations
Overall, franchise and license revenue improvement was driven by strong royalty streams resulting from the net opening of 26 license locations and six franchise locations over the last twelve months. Comparable store sales for the franchisees and licensees of the Manhattan Bagel and Einstein Bros. brands increased 1.1% in 2009.
During 2009 we revised a development agreement with one of our franchisees to modify the number of franchise restaurants to be built under the development agreement from 21 to four.
Our general and administrative expenses decreased $0.9 million in 2009 compared to 2008 as a result of our cost reduction initiatives that were put into place throughout the year.
In 2008, we recorded $1.9 million in operating expenses to satisfy two California wage and hour settlements. These were fully paid in the second quarter of 2009. Late in 2008 we also experienced turnover at the senior management level, and hired our new CEO, which resulted in $0.9 million in severance charges and $0.4 million in recruiting and other costs.
Depreciation and amortization expenses increased 17.9% in 2009 compared to 2008 due to the additional assets invested in the company-owned restaurants that were added or upgraded in late 2008 and in 2009.
Interest expense, net increased in 2009 primarily due to the additional redemption amounts on our Series Z included in interest expense for the period of July 1 through December 29, 2009, partially offset by lower interest rates on our credit facility, inclusive of our interest rate swap.
We recorded current income tax expense of $1.1 million and $0.2 million in 2008 and 2009, respectively. Utilization of our net operating loss carryforwards reduced our federal and state income tax liability incurred in 2008 and 2009. Additionally, we completed several studies related to the timing and deductibility of property and equipment costs. The new estimates of the timing and deductibility of our property and equipment costs have reduced the expected current expense and the related liability for 2009.
The components of our income tax provision are as follows:
In 2009, we had recorded a net deferred tax benefit of $71.8 million, as restated, comprised of a $79.3 million reversal of substantially all of our valuation allowance, as restated, partially offset by deferred tax expense of $7.6 million. In the third quarter of 2009, we reduced our $84.3 million valuation allowance by $79.3 million, as restated, to $4.9 million after concluding the likelihood for realization of the benefits of our deferred tax assets is more likely than not.
The following table summarizes the amounts of payments due under specified contractual obligations as of December 28, 2010:
Financial Condition, Liquidity and Capital Resources
The restaurant industry is predominantly a cash business where cash is received at the time of the transaction. Our inventory turns frequently and our investment in inventory is minimal. 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 operations, specifically the gross margin from our company-owned restaurants. Therefore, we focus on the elements of those operations including comparable store sales and cash flows 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 in 2010, depending 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. Starting in 2010, we reduced the size of our new restaurants and we renegotiated other costs that resulted in a $30,000 decrease in the average cost of each restaurant. We anticipate that our tenant improvement allowances will average
approximately $50,000 per restaurant which also reduces the cash cost of our restaurants. However, the amount of the allowance can vary widely depending on the location of the restaurant and other terms of the lease. In 2011, 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, the continued roll-out of our new coffee program and continuing with our kitchen display ordering system (KDS) installations. In 2010, we continued to roll out KDS and it is now in 82% of our company-owned restaurants. 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 2011 will be focused on the addition of 10 to 14 new company-owned restaurants and the relocation of an additional 10 to 14 restaurants.
The following is information on our restaurant economics as of December 28, 2010 and represents the average company-owned restaurant that has been open longer than one year:
Mandatorily redeemable Series Z Preferred Stock (Series Z)
On May 28, 2009, the Company and the Halpern Denny Fund III, L.P. (Halpern Denny) agreed that the Company would redeem Halpern Dennys remaining shares of Series Z in accordance with a designated schedule
with the final payment occurring June 30, 2010. The first payment was made on June 30, 2009. All subsequent redemption payments included an additional redemption price per share based on a rate that was 250 bps higher than the highest rate paid on the Companys funded indebtedness, as provided in the Certificate of Designations for the Series Z.
As of December 29, 2009, the Company had redeemed $24.8 million of Series Z and incurred $0.2 million of additional redemption expense. As of December 29, 2009, $1.3 million of additional redemption was included in accrued expenses and other liabilities on the balance sheet and included within interest expense on the statements of operations. The fair value of the Series Z was estimated to be $31.0 million as of December 29, 2009.
On March 17, 2010, the Company and Halpern Denny amended their previous agreement dated May 28, 2009 to extend the redemption date to June 30, 2011, and allow the Company to redeem any amount of Series Z at any time through that date. In addition, beginning July 1, 2010, Halpern Denny received a one year option to exchange up to $7.0 million of the outstanding Series Z and accrued additional redemption amounts for shares of freely tradable common stock at a price of $11.50 per share. All additional redemption amounts that accrue after June 30, 2010 would be waived with respect to the shares of Series Z exchanged, if any. To the extent that Halpern Dennys exchange option remained unexercised, the Company had the right to redeem the shares subject to the exchange option after the Company redeemed the shares of the Series Z that were not subject to the exchange option.
The Company recorded this agreement on its balance sheet at fair value during the first quarter of 2010. The fair value was recorded at a premium with a non-cash charge to our net income of $0.9 million.
On October 25, 2010, the Company redeemed an additional 3,240 shares of Series Z for $3.6 million, including accrued additional redemption amounts. Halpern Denny did not exercise its exchange option and pursuant to the terms of the agreement, the exchange option expired. After this redemption, 3,240 shares of Series Z remained outstanding. On December 20, 2010, the Company redeemed all remaining outstanding shares of the Companys Series Z preferred stock for $3.6 million in cash.
During fiscal year 2010, the Company redeemed $32.2 million of Series Z shares and accrued additional redemption amounts of approximately $2.6 million.
New senior credit facility
In December 2010, we entered into a new senior $125 million credit facility with Bank of America, N.A., as administrative agent (the Administrative Agent) and other lenders party thereto (the New Credit Facility).
Our New 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, all of the revolver is available for letters of credit, which reduce the availability on the line. As of December 28, 2010, our availability under the revolver was $30.0 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 improved by $30.9 million in 2010. We began 2010 with a deficit of $25.3 million and we ended 2010 with a working capital surplus of $5.6 million.
Our working capital position improved in 2010 due primarily to the generation of $28.0 million in free cash flow, or net cash provided by operating activities less net cash used in investing activities, and the redemption payment of $32.2 million relating to the Series Z. We began 2010 with $9.9 million of unrestricted cash. We generated $43.8 million in cash from operating activities and received $1.0 million from the exercise of stock options. We used a portion of this aggregate $54.7 million in cash to invest $16.6 million in property and equipment, and to redeem $32.2 million of our Series Z and $2.6 million of accrued additional redemption. As of December 28, 2010, we had unrestricted cash of $11.8 million, representing an increase in unrestricted cash of $1.9 million during 2010. In addition to changes in unrestricted cash, and redemption payments on our Series Z, other elements of working capital fluctuated in the normal course of business.
Our working capital position improved by $25.9 million in 2009. We began 2009 with a deficit of $51.2 million and we ended 2009 with a deficit of $25.3 million.
Our working capital deficit position improved in 2009 by $25.9 million due primarily to the generation of $16.8 million in free cash flow, or net cash provided by operating activities less net cash used in investing activities, and the recognition of $9.6 million in current deferred tax assets. We began 2009 with $24.2 million of unrestricted cash and generated $33.7 million in cash from operating activities and received $1.8 million from the exercise of stock options. We used a portion of this aggregate $59.7 million in cash to invest $16.9 million in property and equipment, to redeem $24.8 million of our Series Z, to repay $8.1 million of debt and to pay $3.2 million for the two California wage and hour settlements and the payment of senior management transition costs. As of December 29, 2009, we had unrestricted cash of $9.9 million, representing a decline in unrestricted cash of $14.3 million during 2009. In addition to changes in unrestricted cash, current deferred tax assets, current maturities of our Series Z and our debt, and the payment of $3.2 million of certain accrued liabilities, other elements of working capital fluctuated in the normal course of business.
Based upon our projections for 2011, we believe our various sources of capital, including availability under our existing credit facility, and cash flow from operating activities of continuing operations, 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
Our company-owned restaurant sales and franchise and license related revenue increased overall in 2010 compared to 2009. 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. Net cash generated by operating activities was $43.8 million for 2010 compared to $33.7 million for 2009, a 29.9% increase.
Cash Used in Investing Activities
During 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:
During 2009, we used approximately $16.9 million of cash to purchase additional property and equipment as follows:
Cash Used in Financing Activities
During 2010, we made payments on our June 2007 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 our New 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 primarily from former employees.
During 2009, we made payments on our debt totaling $8.1 million and redeemed $24.8 million of our Series Z. We received $1.8 million in proceeds from stock option exercises primarily from former employees.
Off-Balance Sheet Arrangements
Prior to 2001, we would occasionally guarantee leases for the benefit of certain of our franchisees. None of the guarantees have been modified since their inception and we have since discontinued this practice. Current franchisees are the primary lessees under the vast majority of these leases. Under the lease guarantees, we may be required by the lessor to make all of the remaining monthly rental payments or property tax and common area maintenance payments if the franchisee does not make the required payments in a timely manner. However, we believe that most, if not all, of the franchised restaurants could be subleased to third parties, reducing our potential exposure. Additionally, we have indemnification agreements with our franchisees under which the franchisees would be obligated to reimburse us for any amounts paid under such guarantees. Historically, we have not been required to make such payments in significant amounts. As of December 28, 2010, we do not have a liability recorded for our exposure, following a probability related approach. Minimum future rental payments for all remaining guaranteed leases that expire on various dates through July 2012 were approximately $0.2 million as of December 28, 2010. We believe the ultimate disposition of these matters will not have a material adverse effect on our financial position or results of operations.
Letters of Credit
We have $7.3 million in letters of credit outstanding under our New Credit Facility with Bank of America. The letters of credit expire on various dates during 2011, 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. In particular, the effects of changing energy and food costs, and increasing interest rates, among other things, may impact discretionary consumer spending in restaurants. Accordingly, we believe we experience declines in comparable store sales during economic downturns or during periods of economic uncertainty. Any material decline in the amount of discretionary spending could have a material adverse effect on our sales and income.
We have experienced only a modest impact from inflation. However, the impact of inflation on labor, food 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. We believe our current strategy, which is to seek 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 inflation.
Impact of Agricultural Commodities
Our cost of sales consist of cost of goods sold, which is made up of food and product costs, compensation costs and other operating costs. Wheat, butter and cheese are our primary agricultural commodities and in addition, coffee, chicken and turkey are the other major agricultural commodities which are included in our cost of goods sold. For the last few years, cost increases in one or more of our agricultural commodities were generally modest in relation to our total cost of sales.
Recent Accounting Pronouncements
In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 revises two disclosure requirements concerning fair value measurements and clarifies two others. It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It will also require the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. The Companys disclosures about fair value measurements, including the new disclosures which were applicable to the Company beginning in 2010, are presented in Note 2 and Note 9. The disclosures concerning gross presentation of Level 3 activity are effective for fiscal years beginning after December 15, 2010 and the Company does not anticipate an impact on its consolidated financial statements.
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 accounting principles generally accepted in the United States of America (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 report.
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 among 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.
Deferred tax asset valuation allowances and our liability for unrecognized tax benefits require significant management judgment regarding applicable statutes and their related interpretation, 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 review property and equipment and amortizing intangible assets for impairment when events or circumstances indicate that the carrying amount of a restaurants assets may not be recoverable. We test for impairment using historical cash flows and other relevant facts and circumstances as the primary basis for our estimate of 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 a restaurants assets is measured by a comparison of the carrying amount of the assets to the estimated undiscounted future cash flows expected to be generated by the restaurant. This process requires the use of estimates and assumptions, which are subject to a high degree of judgment. If the carrying amount of a restaurants assets exceeds its estimated undiscounted future cash flows, an impairment charge is recognized as the amount by which the carrying amount of the assets exceeds its fair value. Absent other available information, we use discounted future cash flows as an estimate of fair value. During 2010, we did not record an impairment charge related to our company-owned restaurants. During 2009, we recorded an impairment charge of $0.8 million related to seven of our company-owned restaurants.
At least annually, we assess the recoverability of goodwill and other intangible assets not subject to amortization related to our restaurant concepts. These impairment tests require us to estimate the fair values of our restaurant concepts by making assumptions regarding future profits and cash flows, expected growth rates, terminal values, discount rates and other factors. As of December 28, 2010, 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.
The Company uses a combination of insurance and self-insurance mechanisms to provide for the potential liabilities for 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. We have not historically paid any dividends and were precluded from doing so under our old debt covenants. We anticipate paying dividends in the future.
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 Securities and Exchange Commissions 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.
Estimates of share-based compensation expenses do have an impact on our financial statements, but these expenses are based on the aforementioned option valuation model and will never result in the payment of cash by us. For this reason, and because we do not view share-based compensation as being related to our operational performance, we exclude estimated share-based compensation expense when evaluating our performance.
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. For 2009 and 2010, we recognized $0.2 million in gift card breakage in each year. The Company 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, the Company has 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.
During 2009 and 2010, our results of operations, financial position and cash flows have not been 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, and invoiced and paid in U.S. dollars, there are no international risks of loss or foreign exchange currency issues.
Our debt as of December 28, 2010 was composed of the New 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 New Credit Facility, interest rate changes generally do not affect the fair market value of such debt, but do impact future earnings and cash flows, assuming other factors are held constant.
On May 7, 2008, we entered into an interest rate swap agreement, to fix our rate on $60 million of our debt to 3.52% plus an applicable margin for the next two years, effective August 2008. This agreement expired in August 2010 and was not renewed.
Assuming no change in the size or composition of debt as of December 28, 2010, and presuming 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 our interest expense on our New Credit Facility by approximately $0.9 million annually. Currently, the interest rates on our New 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 for our company-owned production facility. In addition to wheat, we have established contracts and entered into commitments with our vendors for turkey, butter, cheese and coffee.
This 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.
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 December 28, 2010 and December 29, 2009, and the related consolidated statements of operations, stockholders(deficit) equity, and cash flows for each of the three years in the period ended December 28, 2010. Our audits of the basic financial statements include the financial statement schedule listing 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 as of December 28, 2010 and December 29, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 28, 2010 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.
As discussed in Note 3 to the consolidated financial statements, the Company has restated its consolidated financial statements as of December 29, 2009 and for the years ended December 29, 2009 and December 30, 2008 due to errors in its income taxes.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Einstein Noahs internal control over financial reporting as of December 28, 2010, 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 15, 2011 expressed an adverse opinion.
/s/ GRANT THORNTON LLP
March 15, 2011
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 December 28, 2010, 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.
A material weakness is a deficiency, or combination of control deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the companys annual or interim financial statements will not be prevented or detected on a timely basis.
The following material weakness has been identified and included in managements assessment.
The Companys controls related to financial reporting were not effective to ensure that amounts related to certain deferred tax balances and deferred income tax expense were recorded in accordance with U.S. generally accepted accounting principles. Specifically, the Company did not maintain effective controls over the preparation and review of the income tax provision. Control activities related to the income tax provision were not properly designed and operating effectively related to indefinite lived intangible assets when establishing a valuation allowance on deferred tax assets, as well as properly recognizing certain deferred tax assets and liabilities related to state income tax rates, workers compensation, deferred rent and an alternative minimum tax credit carryover. As a result, there was a material error in the aforementioned tax accounts in the preliminary consolidated financial statements that was corrected prior to issuance of the Companys consolidated financial statements.
In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Einstein Noah has not maintained effective internal control over financial reporting as of December 28, 2010, based on criteria established in Internal ControlIntegrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Einstein Noah as of December 28, 2010 and December 29, 2009, and the related consolidated statements of operations, stockholders(deficit) equity, and cash flows for each of the three years in the period ended December 28, 2010. The material weakness identified above was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2010 financial statements, and this report does not affect our report dated March 15, 2011, which expressed an unqualified opinion on those financial statements.
/s/ GRANT THORNTON LLP
March 15, 2011
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 STATEMENT OF CHANGES IN STOCKHOLDERS' (DEFICIT) EQUITY
(in thousands, except share information)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS