J. Alexander's Corporation Historical Results (000's omitted)
	Fiscal Years
	1998	1999	2000	2001	2002
Operating profit	$499	$1,198	$2,487	$2,205	$3,964
Add pre-opening expense	660	264	383	850	134
Deduct gain on Wendy's disposition	(264)
"Running the business profit"	$895	$1,462	$2,870	$3,055	$4,098
Pre tax income (loss)	$(1,485)	$(299)	$891	$902	$2,608

Another important benchmark is performance in our same store restaurant base, which in 2002 included 22 restaurants. Revenues in these restaurants improved 1.2% in 2002, gross margins (sales minus cost of sales and direct labor costs) improved from 40.5% to 41.8% of sales, and our restaurant level margins improved from 11.6% to 12.3% of sales. Additionally, our two new restaurants which opened in the last half of 2001, performed well and quickly ramped up to profitability.

We also benefited in the first ten months of 2002 from extremely low interest rates under our short-term credit facility. In October we completed our long term financing, a $25 million 20-year mortgage loan with a fixed effective interest rate of 8.2%. Although we are pleased with the overall cost of the financing, long-term money is currently much more expensive than short term, and our new financing will increase our hurdle rate for 2003.

While 2002 was a very good year for our Company, it was by no means perfect — nor will any year ever be. Our weekly average same store sales increase of 1.4% was below our goal of 2%. It is common practice to blame sales misses on the economy, but I do not believe that was true for us, even if it might be for some businesses. In our case, a few of our mature restaurants did not achieve the sales results we expected because of internal operational issues. Additionally, our two new restaurants ramped up their sales more slowly than we anticipated. As I have discussed more than once in the past, we have a difficult time estimating sales ramp up. Some of our new restaurants come out of the gate like a Ferrari and others like a Mini Cooper (the non-turbocharged model). Fortunately, we have demonstrated that, over time, good consistent execution, attention to detail, high quality food and seamless professional service will build sales in virtually any location. But some take longer (occasionally, agonizingly) than others to achieve our goals.

Our development focus will continue to be on major metropolitan market areas.

Our development focus will continue to be on major metropolitan market areas. Nevertheless, most of our smaller market restaurants continue to post solid sales gains. Baton Rouge was the Company's leader in sales growth last year, up almost 12%. We believe that our financial returns will ultimately be quite acceptable in almost all of these locations. However, we have not changed our opinion about avoiding middle and smaller markets in the future. Their ramp up time has been hard on both our management team and investors. Further evidence supporting our current strategy is the fact that in 2002 our large markets (Metropolitan Statistical Areas with population above 1.5 million) averaged approximately $4,300,000 per unit compared to approximately $3,900,000 for our units in markets with a population of less than 1.5 million. The average of our four restaurants in our two largest Metropolitan Statistical Areas (Chicago and Detroit) was over $5,000,000.

We had originally planned to open our Northbrook (metropolitan Chicago) restaurant late in the fourth quarter of 2002, but construction delays caused by the regulatory approval process pushed the opening to March 2003. I am pleased to report that the opening went extremely well by almost all measures.

With so much emphasis on the country's accounting woes, I want to comment on my favorite accounting pronouncement, Financial Accounting Standards Board (FASB) Statement No. 109, "Accounting for Income Taxes." We currently have approximately $4.5 million of tax credit carryforwards available to reduce future federal income taxes. About 11 years ago, accounting for income taxes under generally accepted accounting principles (GAAP) was changed, and companies are now required to make a good faith estimate of the likelihood of utilizing future tax benefits to determine whether to record them on the balance sheet as an asset. One of the final determinants is the "more likely than not" test. If management believes it is more likely than not, perhaps defined as anything greater than a 50% chance, that the Company will utilize tax benefits in the future, then it must currently record them on the balance sheet. (As some of you are aware, in an earlier life I practiced accounting and am now an inactive certified public accountant. It may be that I dislike anything that makes accountants sound like lawyers.)

When I started practicing accounting a little over 30 years ago, the income statement "ruled." Prior to the establishment of the Financial Accounting Standards Board, the purpose of the income statement was fairly clear to all accountants and other interested users. Income was measured by matching the costs incurred against the revenue realized. The basic purpose of the income statement was to report the results of the accounting process of matching the revenue of a specific period with the costs reasonably assignable to that revenue, thus deriving the net results, or income, of the business activities for the period. Income was even defined by a famous Supreme Court case as "the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets..."

I will discuss the considerable impact which FASB Statement No. 109 has on 2002's reported net income.

I am not sure anyone can give you a very good definition of income today. The financial world is more complex, somewhat consumed by derivative transactions and many other financial instruments that certainly do not relate to this traditional definition of income. However, keeping the old definition in mind, I will discuss the considerable impact which FASB Statement No. 109 had on 2002's reported net income, which was significantly greater than would have been reported under the old rules that I liked so much. The theory then held by most accountants was that the income statement should be a very pure measure of an entity's financial performance (or results of operations) between the two balance sheet dates. While many accountants generally supported this theory, financial analysts and some financial executives detested it. They wanted the balance sheet to reflect numerous current estimates of value and changes in valuation — but this caused a problem: How to account for numerous changes in balance sheet valuations that did not relate to the current period of operations. It is elementary that these adjustments must flow either through the income statement or directly to shareholders' equity. Adjustments directly to shareholders' equity have been rare in accounting, for which we should all be thankful. This unfortunately leaves only one place — the income statement — through which to run all those desired valuation account adjustments. This tends to make the income statement a less "pure" measure of an entity's operating results for a given period.

Consequently, in modern accounting the balance sheet reflects many items, previously disclosed in the notes to financial statements, that are sometimes referred to as "soft" assets. The income statement is not really a true measure of the results of operations for the year, because it is required to reflect virtually all changes in balance sheet valuation accounts, which may or may not have anything to do with the actual economic results for the period. In other words, a lot of estimates go into what constitutes reported earnings.

Because of these rules, in 2002 we were required to report a large positive adjustment to our earnings. That adjustment caused our after tax earnings to exceed our income before taxes, because we were required to record a $1.2 million deferred tax asset on our balance sheet, which in turn was required to be run through our income statement. We now have had pre-tax income in each of the last three years that was substantial enough, and our forecast is optimistic enough, that we simply could not reasonably not conclude that it is "more likely than not" that we will in fact utilize some of our tax credit carryforwards. (Anyone can use a double negative, but the opportunity for a triple is rare.) But that is not all: That decision still left us with the question of how much of the $4.5 million asset to book in 2002. Trying to be true to accounting's historical conservative roots (as opposed to many of its recent liberal branches), we believe it would not comply with GAAP to book the entire amount. We made our best estimate using the "more likely than not" test and determined an adjustment of $1.2 million was appropriate.

I believe the old accounting rules presented this type of item in a more appropriate manner. The requirement that we run this very large positive adjustment through the income statement might be misleading to a casual user of the financial statements. However, FASB Statement No. 109 requires the treatment that we are using. The practice mandated today certainly makes any forecasting based on net earnings impossible and puts an asset on the balance sheet that you cannot "fix, paint, feed or sell" (the definition of a "good asset" used by one of my accounting professors).

Please excuse my extended excursion into accounting, but in light of the justifiable criticism about manipulation of earnings in today's business world, I thought you might find it interesting to review the accounting theory that allows — or in our case, requires — a company to make optimistic adjustments. We prefer that accounting be more pessimistic.

Our current outlook for 2003 is generally quite good. We believe we can continue to build same store sales and expect to continue to post operating improvements that will drive our "running the business profit." We plan to open two new restaurants this year. In addition to our Northbrook, Illinois unit, which opened on March 3, we have executed a lease to develop another restaurant in Chicago, near Lincoln Park, in the fourth quarter. However, as we learned in Northbrook, the regulatory process can and often does take different turns and twists. It is quite easy for a fourth quarter opening to turn into a first quarter one. My best guess is that we will open the Chicago restaurant in November of 2003, but it could certainly be pushed into 2004. In any event, we are excited about the project. There are over 130,000 people within a one-mile radius of the "Clybourn Corridor" where the restaurant will be located. We will have access to a large market of guests whose demographics are ideally suited for our concept.

Pre-opening expenses are expected to increase significantly in 2003 because we plan two openings.

Pre-opening expenses are expected to increase significantly in 2003 because we plan two openings. These include the cost of training seven coaches, which approximates 20% to 30% of the total. The remainder consists primarily of the food, training labor, and the costs of employee travel and other expenses necessary to prepare our new employees for managing and operating the new restaurant. Since this expense can have a significant impact on earnings in any given period, we present it as a separate disclosure item on our income statement. We estimate our 2003 pre-opening costs will increase by $600,000 to $700,000 over 2002.

Because we have now closed our $25,000,000 mortgage financing transaction, we project that our total interest cost in 2003 will increase approximately $700,000 to $800,000 over the interest expense incurred in 2002. We expect operating expenses to increase modestly during 2003; the only one we know will increase significantly is our workers' compensation expense, principally in Ohio, where we have five restaurants. We also have some concerns about energy costs as natural gas prices have risen recently. While we simply are unable to estimate at this time the additional impact that military conflict or other dislocations in the Middle East may have on energy costs, significant increases are a very real possibility. We have finalized our beef pricing agreement for 2003, which will continue the favorable pricing from our 2002 agreement. Thus, one of our biggest variables is under control, and we expect only modest increases in our beef input costs for the year.

As I indicated earlier, we expect continued improvements in same store sales and are consequently expecting solid improvements in our "running the business profit." However, because we already know of significant increases in the categories mentioned above, we will be surprised if our pre-tax earnings for 2003 exceed those of 2002 by more than a modest amount. But we promise you we will do our best.

Our conservative development strategy and our strict adherence to opening restaurants with a view to long-term earnings performance, instead of short-term results, can cause large swings in pre-tax earnings. We nevertheless obviously believe this is the best approach to maximizing the value of our business for our owners. We will make no attempt to time openings to meet any short-term earnings criterion.

As we have shared with you in the past, our business strategy is to compete in the upscale segment of the casual dining industry on a platform of operational excellence. We offer our guests higher food quality than we believe is provided by just about all of our competitors. Providing seamless professional service in an upscale environment in our restaurants, appropriate to the level of our food quality, is the basis of our execution strategy.

The goal is simply to be the best high-quality service provider in our segment of the restaurant industry.

Our strategic aim is to become, over time, an "institution" in each of our markets. The goal is simply to be the best high-quality service provider in our segment of the restaurant industry, thus becoming the benchmark restaurant in our markets and creating a business franchise that can endure and maintain its leadership position indefinitely. We believe a long-term benefit to this strategy is that its success does not require exponential expansion, which we believe to be a pipe-dream strategy that will be recognized as such only after a disaster. Over time our need for external capital will be minimal and our assets, even after capital maintenance costs (which are substantial in this business), should produce superior cashflow, which can further benefit our owners. A stable business with predictable cashflows that does not require heavy media or marketing expenses to grow, support or maintain its market share should leave us with the pleasant problem of surplus cash. While we are certainly not yet in that position, we are definitely making progress. We developed J. Alexander's simply because we saw an opportunity for a restaurant to position itself in this manner in upscale casual dining. We realize this is not "aggressive growth" or "controlled growth" or any other buzz term restaurant consultants often use.

I have often used the experience of our Franklin, Tennessee restaurant to demonstrate the long-term benefits of our strategy. Its market constantly absorbs more and more competition, most of it very upscale. Many national chains have opened in the market, and several have closed. As soon as one concept leaves a building, another takes over. That is the very nature of casual dining. Bob Emerson years ago in Fast Food, The Endless Shake Out, noted that quick-service concepts come and go. A similar book could well be written today and titled Upscale Casual Dining, The Endless Shake Out. We believe J. Alexander's is built to last. We are not going to be shaken out.

Our Franklin restaurant posted approximately $5.1 million in sales last year, a 4.7% increase over 2001. There was more competition in its market last year than ever before, and more is coming this year. The restaurant, as it has over the last nine years, posts a dip in sales when new competition enters the market, when the curiosity factor among casual dining customers is high. They will try anything. However, not too long after a new restaurant opens we generally get our guests back, sometimes with an increased loyalty factor, as they realize the high value we provide in terms of quality and service.

Last year we took a quantum leap, with service improvements in every one of our restaurants.

Within our three-legged strategy of food quality, seamless professional service, and ambiance, it is the service leg that needs the most improvement. This sometimes comes as a shock to people who admire the level of execution in our restaurants, but our execution is inconsistent against our very high standards. Two years ago we identified this as our number one business issue, and last year we took a quantum leap, with service improvements in every one of our restaurants. In our operational assessments at the beginning of 2003, we concluded for the first time that each of our locations was executing better in the service area than a year earlier. Nevertheless, we want similar improvement in execution this year. If we can continue raising the service bar in our restaurants, we can fortify our position and become without doubt the best casual dining restaurant in each of our markets. Sure, that's a lofty goal, but it is one that every one of us at J. Alexander's is dedicated to achieving.

In summary, we are pleased with our 2002 results and are convinced our business strategy is working. We believe the Company will continue to improve in all key areas. We will cross the $100 million sales threshold this year. We have a business with excellent prospects, the ability to grow modestly with minimal increases in corporate overhead and the potential for significant profitability improvement in our existing restaurant base.

As always, I want to thank our investors for their patience, support and appreciation for what we believe is a very positive long-term outlook for their Company. I especially want to thank all of our coaches, champions and support center staff for their dedication and hard work that made last year's performance so gratifying.

We are excited about our future prospects and look forward to reporting more good results next year.

 

Sincerely,

Lonnie J. Stout II
Chairman, President and Chief Executive Officer

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