Another important benchmark by which we measure ourselves compares the sales in our same store restaurant base, which in 2003 included 24 restaurants. Their average weekly sales improved 3.9 percent in 2003, compared with a 1.4 percent increase for 22 restaurants in 2002. Gross margins are another important measure of efficiency and are calculated by subtracting from sales the cost of sales and direct labor costs and dividing the result by net sales. Direct labor costs deducted in determining gross margins were $24,895,000, $26,410,000 and $27,483,000 for 2001, 2002 and 2003, respectively. Gross margins improved from 40.3 percent in 2001 to 41.6 percent in 2002 and 2003. Our restaurant level margins (restaurant operating income divided by net sales) improved from 11.2 percent of sales in 2001 to 12.0 percent of sales in 2002 and 12.5 percent in 2003. The improvement in restaurant level operating income is another example of why we are pleased with our restaurant performance. Our mature restaurants continue to operate better.
As I mentioned earlier, we met most of our business plan objectives for 2003. One reason was solid sales performance. While our goal was to post a same store sales increase of 2.0 percent, the actual increase was 3.9 percent. (That was a good thing, because our food costs also increased a lot more than expected.) We believe our positive same store sales growth was attributable to several factors, the most important of which was our continuing improvement in the quality of service during the last two years. We also have benefitted from stable menu pricing, having taken only a very modest 1 percent price increase late in 2003. Additionally, some of our restaurants in small and middle markets posted incredibly strong sales performance as we have continued to build our reputation as a great restaurant in those markets.
While we have avoided developing new restaurants in smaller markets for several years, we already have several restaurants in such markets, and in 2003 many of our same store sales leaders came from this group. We have also benefi ted from our restaurants having matured, developing a reputation as the best restaurants in their markets. Intentionally sounding like a stuck record, we believe that the combination of consistent execution, attention to detail, high quality food, and seamless professional service is a successful formula for building same store sales.
One of our goals is to be the best service provider in the casual dining industry at the “four-top” table. Because our restaurants have few areas that will accommodate large parties, we can concentrate on four-party groups, which we believe is the dominant configuration for dining out. We refuse to be distracted by “to go” sales and we do everything possible to limit that business, in contrast to many restaurant groups today. We have concluded that “to go” business puts an excessive burden on our kitchen and service staff and causes dining room service to decline; that is simply not acceptable. “To go” business also presents a variety of opportunities, which are completely beyond our control, for an inferior dining experience; that is neither in our guests’ interest nor our own. In any event, our same store sales increases in 2003 were driven almost entirely by guest count increases.
Each of our new restaurants is a mystery for us when it comes to building sales. Success results when our guests place us on their list of favorites. Repeat visits and the experience of consistent execution on our part are prerequisites to that designation. Our marketing research suggests that when we meet our high service and food quality expectations, guest loyalty will develop within a reasonable period of time, but in some markets that time period has been painfully long. Each of our four Florida restaurants almost gave me an ulcer a year or so after opening because all were very slow to build sales, but today all four are outstanding performers by any yardstick. Last year we opened three restaurants, which is a lot for us. Our business plan called for two, one in the Chicago suburb of Northbrook early in the year (originally scheduled to open in late 2002) and another late in the year in the “Clybourn Corridor” of Chicago, adjacent to Lincoln Park. In mid-year we were presented the opportunity at a reasonable price to open a restaurant in an existing, well-located facility in Houston, Texas, which required very little capital improvement or equipment to convert to a J. Alexander’s. Our Board of Directors and management team seized the opportunity, knowing full well (and caring not a whit) that this would have negative short-term financial implications. The Houston market is a new one for J. Alexander’s.
The Northbrook restaurant had a relatively quick ramp-up to profitability. Because we are new to the Houston market (we are pretty sure that is the reason since our restaurant itself is excellent), that restaurant’s ramp-up has been much slower, and it is still not profitable. Our third restaurant, which opened late in the year in Chicago’s Clybourn Corridor, has been painfully slow to build its sales. We have no doubt that, like all of our restaurants, these last two will eventually become excellent performers, but it may take longer for them than some of our other restaurants. In large metropolitan areas, which definitely have the highest sales potential for our restaurants, it sometimes takes longer than we like to be recognized as a service and food quality leader and be added to our guests’ list of favorite restaurants. As we remind each other (we prefer it when this isn’t necessary), we are building a true business franchise to stand the test of time for decades.
Opening three restaurants was a significant achievement last year. Because we are working hard to develop a successful operation in each, we are in no rush to open any new restaurants this year. Although there are some potential opportunities that might play out later in the year, our goal is to open two in 2005. We are more interested in being in good locations in the right markets than in meeting a numerical development objective. However, we are quite confident we will have two 2005 openings, most likely in existing market areas. We continue to evaluate other large metropolitan market areas for future expansion.
Rather than cover the same ground as last year about our income taxes, I will merely recommend that you read last year’s letter. Our tax credit carryforwards are available to offset future federal income taxes. As required by GAAP, each year we must evaluate the likelihood of realizing these and other tax assets and determine whether to make adjustments in our net deferred tax assets. In both 2002 and 2003 we increased our net deferred tax assets with a corresponding reduction in the income tax provisions. Our income tax provision was reduced (and our GAAP earnings increased) by $1.2 million in 2002 and by $1.5 million in 2003 because of this adjustment. This credit increases retained earnings but – and this is what’s really important – does not generate any cash. The adjustment is made because we expect there will be a future cash savings to the Company, but neither that expectation nor the resulting increase in GAAP earnings will buy a single tenderloin or pay a utility bill.
Our outlook for 2004 is positive, because our 2003 sales momentum has continued into 2004. On the negative side, as mentioned above, we experienced several significant increases in food costs last year. The largest increase occurred this year on March 8, when our new pricing agreement with our major beef purveyor became effective, raising the average price we pay for beef over the next twelve months by about 13 percent. This alone will increase our cost of sales by about $1.5 million during the term of the agreement. To offset at least some of our increased food costs, in addition to a 1 percent price increase last November, we implemented another 3 percent increase on March 1. Our competitors are also raising their prices, and we believe our price increase can be effective without having a significant adverse effect on guest counts; but only time will tell.
We nevertheless expect our cost of sales in 2004 to average about 50 basis points higher than last year, but it could be more in light of continuing food cost pressures. What makes this worse is that 2003’s cost of sales averaged about 100 basis points higher than our long-term business model. We will of course work hard to improve our cost of sales performance, but sometimes we are just a cork in the ocean. Because of our sales momentum and outlook for guest count growth, we prefer not to be very aggressive in increasing prices this year, but we cannot rule out another price increase in our restaurants.
Because we are not likely to open a new restaurant in 2004, we expect pre-opening costs in 2004 to be about $700,000 less than in 2003. (If next year I try to attribute this reduction to management brilliance, remember the Wizard of Oz.). Because our long-term mortgage financing was in place throughout 2003, we do not expect a significant increase in interest expense for 2004.
Every year we expect improvement in our “running the business profit." and 2004 is no exception. We assure you, however, that we will post a much lower percentage improvement than in 2003. We don’t make public earnings projections or announce growth expectations at J. Alexander’s. But as we assess all the pluses and minuses for 2004, we believe our pre-tax earnings should increase significantly and that 2004 will be a good year for the Company. Businesses do not operate in a vacuum. As I have shared with you in the past, reaching business objectives is sometimes like driving down a bumpy road, with many ups and downs; and business progress (or the lack of it) often cannot be best measured in any discrete time period. While we believe our outlook for 2004 is favorable, I would never try to predict what our net income will be for the year. Even though I’m writing this letter in mid-March, I’m not sure what our earnings are going to be for the first quarter, though I believe they will be quite good. All I can promise is that our management team will work hard to achieve our Business Plan objectives this year.
As an example, I will share with you how we intend to offset the increase in our beef costs in 2004. Our best guess (while we think our analysis is pretty sophisticated, it is still a guess) is that this increase will be about $1.25 million for the ten months the new prices will be effective this year. This estimate was developed independently by Mark Parkey (our controller), Greg Lewis (our chief financial officer), and myself. Then we compared notes. Each of our computations was in the area of $1.25 million, so that was the assumption we used in developing our Business Plan. As noted above, we instituted a 3 percent price increase in March. This is in addition to the 1 percent increase in the fourth quarter of 2003, so that we will have an effective price increase of about 4 percent from March through November. We also believe that some of our guests will migrate to different products, which may lower our check averages. We increased prices 5 to 8 percent on most of our beef items, but some of our prices did not increase at all. A particular guest may simply reject our price increase and purchase an item whose price did not go up. It is of course possible some guests may just decide to dine somewhere else, but we don’t believe that many will, and we expect our guest counts will grow this year by at least 1 percent.
The preceding paragraph contains four guesses: an estimate of the beef input cost increase, our price increase and product migration, a potential check average decline, and a guest count increase. We believe each is a good estimate, but they are neither rocket science nor poetry. We simply will not know for a few months. If we are wrong, we certainly will respond.
This leads to an example of how we manage your Company. Entering 2003, we knew that interest expense and pre-opening costs would increase significantly, which would likely result in only a modest increase in our pre-tax earnings. (Although that was in fact the result, the year was actually better than we expected because we absorbed $568,000 in unanticipated pre-opening expenses and start-up losses of the new restaurant in Houston.) I recommended the 2003 Business Plan to our Board, and the Board endorsed it. However, because it included only a modest increase in pre-tax income, considering the interests of our shareholders, none of us believed that simply meeting the Business Plan would merit a “full bonus payout.” And ultimately, even though we were pleased with meeting the Business Plan (exceeding it, when Houston is factored in) and delighted in our restaurant level financial performance, we paid bonuses aggregating only about one-third of a full payout.
Compare the thinking of our Board with that of some of the better-known companies in our own industry. I recently read last year’s annual report of one of the leading companies in the restaurant industry. Its 2002 results were down from 2001 as a percent of revenues in all significant categories: operating income, pre-tax earnings, etc. While overall earnings improved modestly because of restaurant expansion, the efficiencies of the business did not improve. However, bonuses for the senior management team were the same as those of the prior year, which appeared to me to be a much better year. You will not see that here.
We have had two consecutive years of solid service improvements in our restaurants. We continue to be very much a food-driven concept, with over 50 feature products that we rotate depending on the individual restaurant’s marketing strategy. We have highlighted several new products in our Annual Report this year. We believe we have an arsenal of strong competitive products and the ability to separate J. Alexander’s from the competition in upscale casual dining.
If you read many restaurant reviews, you will notice the great majority engage in “chain bashing.” Most restaurant critics consider only independent or chef-owned restaurants to be worthy of high marks for food and service. Ruth Reichl recently wrote an obituary on Lutèce, which closed its doors in February, in The New York Times. She said that “When Mr. André Soltner walked out the door, Lutèce went with him,” referring to his sale of the restaurant in 1994. The restaurant had lived on its reputation for a decade and then closed. Her implication was that the restaurant’s closing had less to do with food than with hospitality. Not only was Soltner a great chef (one of my favorites), he knew how to make people happy. At J. Alexander’s we do our best to adopt that philosophy wholeheartedly. We are in the business of making people happy, with great food and exceptional service. We are also in the business of making them feel they are valued partners in a great dining experience, in contrast to the critics’ general belief that chain restaurants are indifferent to their guests.
We have made progress with restaurant critics over the years, but the opening line in most reviews of a J. Alexander’s restaurant is still to the effect that “you will not believe this is a chain” or “the food and service are really good even though it is a chain restaurant.” Left-handed compliments, of course, but we will take them nonetheless. As we continue to expand nationally, we are starting to receive national recognition for our efforts to provide outstanding food quality and service.
Last year a leading consumer publication (one that sues you if you mention its name in any promotional or marketing materials) disclosed that its readers had rated us the number one restaurant in the “American Traditional” category (whatever that is). As best as I could determine from reviewing the article, we were rated first by a very small margin, but we were certainly glad to have the honor. More broadly relevant perhaps was that, of the 88 restaurants rated in all classifications, we were in the top 7 and most of the others are privately owned.
Our business philosophy is that a public restaurant company can compete with anyone as long as it combines high quality food and superior service. We believe that this approach can earn a fair return on investment and build a true business franchise. In the last couple of years, we have produced solid evidence supporting our views. One reason is that we have a group of committed owners who understand our business strategy and are willing to make a long-term commitment to the Company. For this we are grateful; our success is truly an owner-management team effort.
Sarbanes-Oxley and new SEC and American Stock Exchange rules have had a significant impact on corporate governance matters. While these rule changes have not necessitated any changes in the way we conduct our business, they have caused a disproportionate amount of senior management’s time to be devoted to making sure we comply with each of the new rules. In a small company like ours, with four corporate officers, we have attempted to keep our overhead costs as low as possible by being actively engaged in running the business and focusing essentially all of our attention on revenue-generating and profit improvement activities.
However, corporate governance issues have certainly created a considerable diversion from our normal management activity recently and it has been necessary for our senior management’s focus to include compliance activities. It is especially disheartening for us when nothing was broken in our company, but our small management team and shareholders must now pay their portion of the price for the scandals at Enron, HealthSouth and the telecommunications industry.
One important area of corporate governance is the role of the audit committee. As your CEO, I have only attended two audit committee meetings, these at the request of the committee, since the committee was formed years ago. The committee meets with our accountants independently of management at every meeting. In many companies, the auditors have historically worked for the CEO. In ours, we have made sure they work for the shareholders. That kind of governance has been the rule at J. Alexander’s for many years. We nevertheless do expect to spend a considerable amount of time and resources beginning this year in connection with Section 404 (internal control documentation) of Sarbanes-Oxley.
We have implemented a written policy concerning business ethics that all of our officers will sign. That document will require no change in behavior.
Our business strategy is simple. We compete in the casual dining industry on a platform of operational excellence. We offer our guests higher quality food than we believe is provided by just about any of our competitors. We back that up with seamless professional service in an upscale restaurant environment. As I have repeated numerous times, our strategic aim is to become, over time, an “institution” in each of our markets. Our goal is simply to be the best high quality service provider in our segment of the restaurant industry and to become the benchmark restaurant in our markets, thereby creating a business franchise that can endure and maintain its leadership position indefinitely.
I want to thank our investors for their continued support and positive long-term outlook for our Company. I want to especially thank our coaches, champions, and support center staff who have never wavered in their belief in our Company and its mission.
Sincerely,
Lonnie J. Stout II
Chairman, President and Chief Executive Officer
March 17, 2004
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The new caption “Restaurant operating income” represents the actual income from our restaurants before the deduction of any general and administrative expenses, pre-opening costs, interest expense, or other items not directly related to the under-roof profitability of the restaurants. Depreciation is one of the restaurant operating expenses and, consequently, deducted in calculating restaurant operating income.