First, comparable sales in the second and third quarters were below expectations. We also incurred significant increases in input costs, including beef price increases of approximately 12%. We were able to partially offset the impact of this increase by changes in operational procedures and a price increase on our steak and prime rib products; however, the price increase lowered demand for our beef products and reduced sales as guests switched to lower priced alternatives. Finally, we incurred significant increases in utility costs and insurance premiums. Because we did not believe it was prudent to continue raising prices, we were unable to fully offset the negative impact of all those increases in input costs. Our business is slightly seasonal, with the first and fourth quarters having higher sales averages than the second and third, and the combination of poor same store sales performance and higher input costs in those quarters produced a cascading negative effect from about March until mid-August (more on this below; for the moment suffice it to say that we are dedicated to doing whatever is necessary to prevent a recurrence).
| We were very happy with our fourth quarter financial performance, especially when contrasted with our dissatisfaction with our second and third quarters . |
During the summer of 2001, we focused all of our attention on limiting and reversing those negative effects. We launched a combination of menu and product initiatives to reduce our cost of sales and improve our comparable sales performance. These programs had started to kick in a little while before September 11, after which sales softened for a few weeks before starting a solid build during the fourth quarter. We were very happy with our fourth quarter financial performance, especially when contrasted with our dissatisfaction with our second and third quarters. We exceeded our business plan for the fourth quarter, but that improvement paled in comparison to the shortfall for the second and third quarters, and we were unable to make any significant profitability improvements over 2000. We believe, and are dedicated to proving to you in 2002, that 2001 was a negative aberration.
One of the most important financial measures we use to monitor our performance is what we refer to as "running the business profit," which we compute by adding pre-opening expenses to consolidated operating income. Our running the business profit for 2001 was $3,055,000 compared to $2,870,000 in 2000. Our original expectations were to improve this measure by over $800,000. We are very disappointed with only the modest improvement in this area.
For the year, our same store sales were flat. Our cost of sales increased from 32.0% of sales to 32.4% due in part to the beef cost issue mentioned above. Restaurant labor and related labor costs declined slightly from 33.8% of sales to 33.5%. We were able to reduce general and administrative expenses from 8.2% of sales to 7.9%. As revenues have increased and we have added new restaurants, we have not needed to increase our head count or general and administrative expenses significantly.
We expect 2002 to be back on track from a financial performance point of view. Our new beef contract was effective on March 1 and provides us an approximate 9% reduction for this year. We also believe input costs will be favorable in most other food categories, and that energy costs will be down or flat for the year.
Our same store sales performance would certainly have been better with stronger economic conditions, but we expect the favorable trends in the fourth quarter of 2001 to continue, and as the economy improves our expectations will increase. No business is recession proof, but we believe that our niche in the restaurant business is a resilient one.
We are very pleased with our two new restaurant openings in 2001: Boca Raton, Florida, and Peachtree Parkway in Norcross, Georgia. Both are in affluent upscale markets with good population densities supported by very high median household incomes. Over the last few years, our new opening systems have improved dramatically, and both these restaurants posted under-roof profits within 90 days of opening. We expect this kind of performance in our new locations. We expect our four newest restaurants to contribute significantly to improved profitability performance this year. We plan to open one new restaurant in the fourth quarter of this year, which is a revision of our original plan to open two. Depending on the availability of sites and overall market conditions, we would like to add two restaurants in 2003.
Our future development plan will be limited largely by our insistence upon locations with excellent, not merely good, potential. When we are unable to secure excellent locations at rational prices, we will seek other ways to increase value, including buying our stock, if available at favorable prices. While our preference, of course, is to expand by building additional J. Alexander’s restaurants in excellent locations, we will not be averse to considering other business opportunities.
| Our two new restaurants posted under-roof profits within 90 days of opening. |
In the 2000 and 1999 Annual Reports, we shared significant information about our business strategies, market selection issues, guest check averages and menu management. We continue to focus much of management’s attention on our smaller and mid-market restaurants where we have experienced more resistance to pricing our menu to reflect adequately the quality of our products and the corresponding level of service. We have worked hard to improve sales performance in these restaurants and have made real progress, but much remains to be done. We will retain our focus on improving sales in these restaurants. The small and mid-market restaurants are a significant key to substantially improving financial performance in our existing restaurant base.
We have successfully competed our way through a lot of new upscale restaurant openings in our mid-markets during the past year and a half. Those new competitors have had a short-term impact on our business, but none seem to have had a long-term negative effect. Our Franklin, Tennessee restaurant, located in a market that is a magnet for chain restaurants, had a pretty severe sales slump in the first half of 2001 but by fall had fully recovered. Despite the setbacks mentioned in 2001, we have made considerable progress in improving the market positioning of our restaurants.
We have a strong culture, and our entire management team and all of our restaurant champions are dedicated to providing intense professional service and high quality products to our guests every day. We recently completed an extensive marketing research project led by an independent research company, The Marketing Workshop, Inc. in Atlanta, with which we have had a long-term relationship. We were quite pleased with the results of the research, which included almost half of our restaurants, with a mix of older and newer restaurants, including small, mid-market and large market locations. In the aggregate, we outdistanced all upscale competition in the samples by a wide margin, especially in the area of food quality and professional service. As we have said, ad nauseam, these are the two key business drivers for an upscale casual dining concept. We were also delighted to observe that in some of our more mature markets, we have the same top-of-mind awareness as some of the national chains. They spend incredible amounts of money on advertising, while we spend virtually nothing and depend instead on our reputation to build awareness. These strong results confirm our beliefs that we are building a very strong brand (even though I hate that word — it reminds me of toilet paper or soap powder) in the upscale casual dining industry. Our strategy of high quality products, professional service and a comfortable contemporary restaurant environment seems to be meeting the high demands of the upscale restaurant guest.
We are in the process of sourcing long-term financing, which we expect to close in the second quarter. For the last several years we have used our credit facility as needed to fund new restaurant development. We are now approaching a point (a year or two away) where we expect to be able to fund our future restaurants from our cash flows. We do not see any significant needs for additional long-term capital, after this permanent financing is completed, to meet our current business objectives.
Accounting matters and policies seem to be at the top of investors’ minds this year. The Enron affair and other accounting related scandals have certainly increased awareness, which is a good thing. We have always done our best to be a full disclosure-oriented company and, given my accounting background and experience, I am personally glad that the Securities and Exchange Commission appears to be taking a strong stance in this area. We are proud of the depth of our disclosures in our Management’s Discussion and Analysis. I hope you take time to read this very important part of our Annual Report along with all of the Notes to the Financial Statements.
Restaurant companies do not normally engage in exotic financial instruments, such as derivatives, or have any significant trading activities. This is a pretty straightforward business. We do enter into purchasing agreements that give us price protection (principally beef and certain seafood contracts), and we have recently entered into a similar agreement for purchasing produce in the upcoming year. Those agreements do not obligate us to purchase a specific amount of product, but typically require us to give 100% of our business to a supplier, in exchange for a fixed price on a commodity product. Some of our contracts give us a 30-day out provision. As we have grown, we have been able to take advantage of economies of scale. We believe we have protection against wide variances in commodity prices; however, evaluating future commodity pricing most times is just sophisticated guessing.
We spend a considerable amount of time on the decision whether to lease or buy our restaurant locations. We prefer to own the land if we can acquire a prime site for a rational price, but in very upscale markets it is now extremely difficult to buy suitable property. Some restaurant companies prefer to lease land, which obviously requires less cash. If you have read many annual reports, you may note that some companies talk about their "cash on cash returns." However, this metric omits one important factor in financial evaluation, namely the analysis of commitments for future rental payments under leases. I believe equal attention should be paid to the future minimum lease schedules of non-cancelable operating leases. Virtually all land leases are operating leases and thus constitute perhaps the most basic form of "off balance sheet financings."
We have two important footnotes to our financial statements that deal with leases, "Note E" (Long-Term Debt and Obligations Under Capital Leases) and "Note F" (Leases). The latter schedules our future minimum lease payments under capital leases, as well as future rental payments under non-cancelable operating leases. We have over $42 million of operating lease obligations. A good upscale restaurant site today could easily have a ground lease cost of $250,000 per year, so that a 20-year non-cancelable primary lease term will create a $5 million liability for future rental payments. The net present value would be much less; however, if a location failed, the landlord will not be taking the present value of future minimum rentals in satisfaction of a current lease obligation. Additionally, most ground leases today have automatic "bumps" factored into the lease, generally a 5% increase in the base minimum rental every 5 years, which increase the obligation by a significant amount over time.
Even simple lease accounting is very interesting — and I am not going to mention how transactions that economically are not really leases can be engineered into accounting parameters to "qualify" as leases. Under some circumstances, earnings under generally accepted accounting principles can be significantly improved in the early years by entering into sale and leaseback or an operating lease transaction. Eventually, however, this "benefit" turns around and earnings are penalized in later years (perhaps for another owner). With many public companies focused on short-term results, some are tempted to pursue an operating lease strategy for the purpose of reporting higher earnings during the rapid expansion phase of a restaurant concept.
I do not want to give the impression that there is anything structurally wrong with sale and leaseback type financing. We are actually considering sale and leaseback financing as one of our long-term financing options, in addition to standard mortgage financing. We believe that the decision of the best alternative should be based on the cost of capital. If sale and leaseback financing has a more favorable cost, then I believe it is proper to pursue. However, if the cost of money were exactly the same, then we believe that retaining ownership of the property is the best way to enhance shareholder value in the long term. Leasing is a perfectly acceptable financial alternative as long as the rationale behind the decision is solid.
Our financial philosophy is always to try to make the same decision as if we were acquiring assets personally. We try to make sure we are making rational and prudent financial decisions that will improve value over time, for example, by owning real estate which is likely to increase significantly in value over the years. We will continue to decline short-term improvements in reported earnings at the expense of long-term value creation. We have always adhered to this philosophy, which was well taught to us by our Chairman and Founder, Jack Massey.
| Our financial philosophy is always to try to make the same decision as if we were acquiring assets personally. |
Restaurant companies sometimes differ from one another in some of their significant accounting policies, which are disclosed in our "Note A" of the financial statements. Depreciation lives in the restaurant industry are generally pretty standard and do not vary much for similar assets. However, one very real cost which is not disclosed in financial statements is the cost of not maintaining those assets properly. Some companies are very aggressive about maintaining their assets and others sometimes are tempted to "defer" maintenance costs, either because of cash shortages or to improve short-term earnings. Our policy, while not specified in the notes, is a simple one: If it’s broken, fix it. But, first, spend to maintain it so it won’t break.
We believe in spending the money necessary to maintain our buildings and equipment. We are convinced that this will enhance the value of the assets and increase their future earnings potential. All of us see this same principle every day in residential real estate. A homeowner who keeps her house in good repair, paints it on a regular basis and maintains its exterior, generally has a more valuable asset and does not incur major repair costs in the future. Conversely, a homeowner who neglects his home and does not paint the trim and otherwise maintain the asset will occasionally incur very large costs to refurbish the asset and usually realizes a much poorer return when he chooses to sell the home. Asset maintenance is an important cost in our business.
Finally, I would like to comment on one last financial item, commitments and contingencies. All companies have contingent liabilities. Ours are disclosed in "Note K" to the financial statements. While I do not believe that our contingencies are any more likely to materialize this year than they were last year or will be next year, it is prudent for an investor to be aware that they exist. Much of our contingent liability relates to Wendy’s restaurants that we sold many years ago where we remain secondarily liable on the lease obligations. In many cases, we have a strong indemnitor (Wendy’s International) protecting us from liability. However, in some cases we have a lower net worth entity standing between the landlord and us; our aggregate contingent liability, which is not protected by Wendy’s International, was estimated to be approximately $2.1 million at December 30, 2001.
As you have surely noticed if you have read our past press releases, we very much dislike the federal Alternative Minimum Tax (AMT) and the negative impact it has had on our 2001 earnings. Because of the effect of AMT we are currently unable to take advantage of the sizable tax carryforwards which have been accumulated by the Company, whereas we would be able to use some of these carryforwards if we were a higher income taxpayer. The effect of timing differences in book and tax depreciation calculations and other timing differences also directly affect the Company’s tax provision at the present time because of management’s conservative posture of providing a 100% valuation allowance for all of its deferred tax assets. Congress enacted AMT principally to close loopholes used by some large corporations because of the generosity of other tax legislation, specifically in the oil and gas industry. Apparently, little thought was given by the lawmakers to other businesses involved in capital intense, depreciation heavy industries such as the restaurant industry.
| Last year was a tough year. We recognized our problems and issues. We believe we dealt with them forcefully. Our team is extremely motivated and energized. |
We believe the provisions of AMT impose an extremely harsh penalty for a small, growing company like ours, but there is little we can do about it other than explain the facts. As we become more profitable, we will be subject to more "normal" federal income tax rates which will reduce our effective tax rate considerably. Maybe I am missing something, but I continue to think our 70% effective tax rate last year was not fair, especially given our location in the business development cycle. More reason for us to be as aggressive as possible in improving our financial performance.
In summary, last year was a tough year. We recognized our problems and issues. We believe we dealt with them forcefully. Our team is extremely motivated and energized. As noted earlier, we are uniformly dedicated to showing you that last year was an aberration.
We ourselves are substantial investors in this Company in addition to being the managers of your assets. We commit to you that we will stay focused on the issue of making the Company’s investors as satisfied as we have been able to make our guests.
Sincerely,
Lonnie J. Stout II
Chairman, President and Chief Executive Officer
