Our Corporate Chef Jim Filaroski (“Chef Jim” to us inmates) describes some of his creations as “stellar.” That is a fitting description for our fourth quarter, which really helped to drive our performance for the year. We saw earnings for that quarter increase by 74 percent. Much of this improvement was the result of very strong operating performance, but we also received a nice gift from Mother Nature in the form of an almost non-existent hurricane season. You may recall that our results in the fourth quarter of 2005 were significantly hurt by severe storms in our South Florida market, which we estimated to have cost us sales of about $365,000 and earnings of $0.02 per share. Our fourth quarter and full year 2006 earnings comparisons were also aided by pre-opening expenses in 2005, including $296,000 in the fourth quarter and $411,000 for the full year, compared to none in 2006. On the other hand, in 2006 we recorded $385,000 less income associated with gift cards and certificates in the fourth quarter than in 2005, and $566,000 less for the full year.

While I do not want to take away from the hard work of our dedicated employees and management team, when we compare our 2006 performance to 2005 we are acutely aware that in 2005 we posted almost no improvement in pre-tax income over 2004. If you look at the two-year period beginning January 3, 2005, then we were really no better at the end of 2006 than about where we should have been. So, last year was a good year, but someday (soon!) I hope to describe our long-term performance as stellar. We will need to string together several years of performance like 2006 before we break out the good champagne.

The table below includes two non-GAAP captions (in bold face) that are not included on our income statements but that we think are quite helpful in analyzing our performance.

For those reviewing your first J.Alexander’s Annual Report, “restaurant operating income” excludes the following expenses: general and administrative, pre-opening, net interest and all other items not directly related to the “under roof” performance of our restaurants. In 2006, on a net sales increase of 8.7 percent, our restaurant operating income increased $1,725,000, or 11.1 percent. This pleasant outcome reflected improved margins in our “same store” base, as well as a full year of operations from our newest restaurant, which opened in October 2005.

Our “running the business profit” is composed of our operating income before pre-opening expense and any involuntary property conversion gains. This is our most important internal yardstick; it does not include net interest expense, pre-opening expense or income taxes. In 2006 our “running the business profit” increased about 18 percent. Because we usually target an improvement of about 15 percent, we were certainly pleased with the solid progress in this area, although I note again that in 2005 we failed to post meaningful improvement in this metric. We believe the 18 percent improvement in “running the business profit” was a better measure of our improved business performance than was our 33 percent improvement in net income. If we ever improve “running the business profit” by 30 percent in one year, I will break out that good champagne (unless I had been fired for a disastrous preceding year).

A host of factors influence our performance every year. Managing our 28 restaurants is in effect running 28 separate but related businesses.

Eighteen of our “businesses” posted improvements in restaurant operating income last year, some quite remarkable. Fourteen of our restaurants posted in excess of 5 percent sales growth, including one of our mature restaurants whose sales increased by over 20 percent, which is quite impressive. (I wish that the only reason was our own terrific operations but feel compelled to note that an outstanding competitor left that market, opening the door for us to gain a lot of new guests.)

On the other hand, seven restaurants, discussed in more detail below, had fairly significant declines in restaurant operating income. Had we just held our own in these markets, I would have described our 2006 performance as stellar. Our major problem area last year was central and northern Ohio, where we operate four restaurants. A host of issues contributed to our woes there. While in general the Ohio economy is diverse, some markets are still very dependent on the automotive industry for their economic health. As the major automakers in Detroit try to squeeze every nickel out of their costs, there is a trickle-down (recently more of a cascade-down) effect on their original equipment manufacturers and other suppliers. Many of those companies are located in Ohio and have had a difficult time. We are among those who hope they enjoy better times SOON. Two of these Ohio restaurants are also in price sensitive markets, and two others have had a host of competitive difficulties. We are responding, as is our wont, by working harder to make our execution as good as it can possibly be. We are optimistic we will see improved results in 2007.

Our original restaurant in Nashville had tough competition from our new West End Avenue restaurant and posted a sizable decline in restaurant operating income. However, it now seems to have weathered the competition from its new sibling and has regained its sea legs. It started building sales in the fourth quarter of last year, and we have renewed its lease for another five years. We are optimistic it will continue to post improvements. Please cross your fingers at this point.

Finally, we had expected a decline in the financial performance of one under-performing restaurant, because we intentionally invested a lot of money retraining its staff and making operational improvements to benefit us in the future—we don’t throw in the towel easily—but its performance for 2006 still fell below our expectations.

Last year I made special mention of the disappointing results of two of the restaurants we opened in 2003. I am pleased to report that both experienced major improvements in 2006, even if they still have a long way to go. We expect significant contributions from them going forward.

Overall, our 2006 consolidated performance was satisfactory in most categories. Our weekly average same store sales increase of 5.2 percent exceeded our expectations.

Operating expenses, which had increased significantly in 2005 and 2004, stabilized as a percentage of net sales in 2006. We experienced only modest increases in most items in this category, and the increase in our utility costs was much less than expected. We did see substantial increases in the operating supply accounts of some individual restaurants and continue to monitor these closely.

One area that was mildly disappointing in 2006 was our cost of sales. While we did make some improvement, lowering cost of sales from 32.9 percent of net sales in 2005 to 32.7 percent in 2006, we wanted to drop it about 20 more basis points. We did make considerable progress in the fourth quarter, when our cost of sales was 32.1 percent, down 80 basis points from the 2005 quarter.

Our experience indicates that there was more inflation in the economy than suggested by some of the published indexes. Since food items and energy costs are excluded from the “core” index (that is a story in itself—and not one featuring rationality), it makes it difficult to assess what inflation really was last year. I am convinced it was much higher than is being commonly reported when food and energy costs are included.

Over the last two years, our input costs have risen significantly in almost all categories. I am especially concerned about beef costs. The table to the left shows what has happened to our beef costs over the last five years.

Beef prices historically have experienced relatively long price cycles (from low to average to high prices over a 12 to 15 year period). We think that we have been at the high end of the cycle for a couple of years now. As I have told you in past years, the quality of our beef has always been at the high end of USDA Choice. The last two years, we have used almost exclusively Certified Angus Beef® (CAB), a high-end branded USDA Choice product, in all but five of our restaurants. Branded beef is more expensive than unbranded USDA Choice and only slightly less than USDA Prime. We obviously believe it is worth the additional cost. There are other good Choice brands, which we from time to time evaluate, and we would not hesitate to use another branded product if we concluded it was as good as CAB.

The cost of all grades of USDA beef has increased significantly during the last two years.

The current price spike in the beef market (also at the high end of the long-term price cycle—not good news) is mostly the result of feed costs. Cows eat corn and now so do many cars. Everyone knows that crude oil prices have shot up significantly, from around $30 a barrel in 2000 to as high as $75 last year. The current price is above $60 per barrel. The search for alternative fuels has intensified, and corn ethanol is currently one of the most popular alternative fuels. (Of course, those of us who live in the South know a lot about corn ethanol, whose historical name is “moonshine.”) The corn used to produce ethanol is the same corn used to feed beef cattle, which is sort of a frightening thought. As long as crude oil prices stay around current levels, we expect more and more corn production to be diverted toward ethanol. Questions about the availability of corn for feeding beef cattle have caused beef prices to spike, because packers are afraid of long-term pricing commitments when they do not know the availability and price of corn for feed.

For the first time in several years, we have been unable to obtain in 2007 what we believe to be a reasonable twelve-month fixed-priced contract for all of our beef requirements. As I write this in late-March, we have contracted for about two-thirds of our requirements for the next twelve months, and for all our requirements through mid-June. We are hopeful we will contract for the remainder of the year by late Spring. We currently estimate that our beef input costs will increase approximately $1.1 million in 2007. This is a significant increase, about 8 to 9 percent, over what we paid in 2006.

We do not have a contract for beef tenderloin (from which we cut for our filets) for the last half of this year. If we are unable to obtain a satisfactory long-term contract and have to buy at “spot” market prices, we could be in for an ugly fourth quarter in regard to beef input costs. The premium branded Choice tenderloin is currently about $10.75 per pound. That could easily spike to $14 or $15 in the heavy demand period from around November 1 through year-end. We will work very hard in the next two to three months to obtain a satisfactory contract for our tenderloin requirements for at least the rest of 2007.

In March we increased prices on each of our beef entrées, except sandwiches, by $1 to offset the increase in our input cost. As you might anticipate from the foregoing we may need another $1 increase later in the year.

 Produce prices are currently high because of severe winter weather in California last year. We hope they are back to normal by mid-summer. We believe that recent increases in poultry prices are, like beef prices, related to the cost of corn; in any event, they also concern us. Most other input categories are stable at this time, but things can change quickly.

We are very pleased with our fresh seafood program and are selling a lot more seafood in our restaurants. Because of Chef Jim’s stellar creations, we continue to expand our feature product offerings of high quality fresh seafood, presented with an array of upscale sauces and presentations, and have added several sautéed fish products to our feature program. All these excellent offerings help to differentiate us in the casual dining industry.

We are one of the very few upscale casual dining restaurants that offer a wide selection of high quality beef items. Our sales mix, especially during the heavy dining out season (the fourth and first quarters), is more like a steakhouse than other upscale casual dining restaurants. Our prime rib and filet continue to be two of our best selling menu items.

We completed our rollout of French rotisseries in all our restaurants last year, and our rotisserie chicken has done well. We continue to investigate additional items that feature rotisserie cooking.

For the last several years, we have achieved consistent, impressive increases in wine sales, and 2006 was no exception. We have a truly excellent wine program at J. Alexander’s, with a wide selection by both the glass and bottle. This program also differentiates us in the marketplace, and we plan to keep it that way.

We are not planning any special new product or operations initiatives for 2007. We will rely upon our continued emphasis on fresh products, especially seafood, and our broad array of lunch and dinner features to maintain our separation from other upscale casual dining restaurants. We are encouraged in that regard by very positive guest feedback.

We will have many challenges in 2007. We intend to improve sales and profitability in virtually all of our 28 chef-driven restaurants. We will continue to focus on improving execution in every one.

Regulatory Issues
Public health is important to everyone, and both federal and state governments are taking an increasingly active role in this area. Heart disease, obesity and diabetes are three of the biggest health issues in America and are in many cases related to each other. One current focus is on reducing trans fats in our diets. (Sometimes trans fats are referred to as trans fatty acids.) These are formed when liquid vegetable oils go through a chemical process called hydrogenation, which in general makes oils more solid. Hydrogenated vegetable fats are used by food processors because they extend the shelf life of products and give processed food a more desirable taste, shape and texture. Trans fats appear in products like shortenings, hard margarine, cookies, crackers, virtually all snack foods, fried foods, pastries and baked goods. Some trans fats appear naturally, in very small amounts, in meat and dairy products.

There is strong health evidence that high levels of trans fat consumption increase the LDL, which some people refer to as “bad” cholesterol, and lower the HDL or “good” cholesterol. As almost everyone knows, high levels of cholesterol are associated with heart disease and stroke. Some state and local governments are calling for the outright ban of all trans fats and others are calling for increased disclosure of products that contain trans fats.

We use very few prepared products at J. Alexander’s. However, we do have some trans fat in the oils we use for frying and in a few other products. Like many others, we are looking for alternatives. We will soon be moving to a cooking oil that is free of trans fat and believe this will provide a good long-term solution to reducing trans fat usage in our restaurants. We have other products, however, like our traditional signature croissant from which it would be more difficult to remove 100 percent of the trans fats.

Of  course, the solution to America’s health problems ultimately requires making responsible eating choices and getting regular exercise. We need to eat more complex carbohydrates and watch our total calorie intake. (By the way, we think our broccoli will be the best you have ever tasted.) For most of us—and, after all, this challenge is met on the ground, one by one—this is easier said than done. We can eliminate 100 percent of trans fats and still be plagued with obesity, heart disease and diabetes unless we eat healthier and exercise more.

At J. Alexander’s, our system is built for maximum flexibility in providing guests with a host of choices of products and their preparation. Nevertheless, the final choice of whether to eat healthy is up to our guests.

Another area where the government is currently taking a more active role at both the state and local levels involves the minimum wage. The federal minimum wage was first passed by Congress in 1938 and set at $0.25 an hour. It is currently $5.15 per hour. (For our non-mathematicians that represents a 4.6 percent compounding.) Virtually all of our employees earn significantly more than minimum wage. Servers who are paid minimum wage during their training are about the only exception.

Employers must pay tipped employees a minimum cash wage of at least $2.13 per hour under Federal law. If an employee’s tips and cash wages combined do not equal at least $5.15 per hour, the employer must make up the difference, which is obviously fair. However, minimum wage laws fail to take into account the employee who receives high tip income; for example, if a tipped employee, say at a white tablecloth restaurant, makes $50 per hour in tips alone, she/he must nevertheless be paid the minimum cash wage of $2.13 per hour.

In our restaurants, tipped employees make, from tips alone, much more than the minimum wage. For example, in October 2006 just before Colorado voted to increase its minimum wage, our tipped employees (we refer to them as Champions) in our Denver area restaurant averaged almost $17 an hour from tips alone. By that vote, Colorado’s minimum cash wage for all tipped employees was increased from $2.13 per hour to $3.83. We believe many voters had the impression that they were increasing the wages of employees who were making only the federal minimum wage of $5.15 per hour. However, our Champions’ wages in Denver will increase from $19 to $20.70 per hour as a result of this change. We leave any further comment to you.

Ohio, Florida and Illinois passed similar legislation last year. (Recall that I earlier mentioned our price-sensitive restaurants in two Ohio markets, as well as other Ohio markets that are experiencing economic difficulties.) Our estimates are that servers’ wages from our Company—no matter what their incomes—will increase by about $600,000 in 2007 because of state minimum wage amendments. Because our servers were already making well above the minimum wage, these increases are in practical effect a tax on our guests, because we realistically have no choice but to respond with price increases in those states.

It appears Congress is likely to take some action on the federal minimum wage in 2007. If they do not pass an automatic change in the required minimum cash wage for tipped employees, it will have virtually no impact on us because our culinary professionals make three to four times the federal minimum wage and our Champions also earn substantially in excess of the minimum wage.

Expansion—New Restaurants
Last year I told you that our goal was to have three openings per year by 2008. We originally targeted two openings for 2007, but currently plan to open only one new restaurant. However, we are confident that we will meet, and occasionally exceed, our goal of opening three a year starting in 2008.

I also mentioned last year some of the difficulties in locating suitable real estate and told you we had hired a seasoned veteran, Rick Carson, to get us back on a solid track. I did not want to brag on Rick too much last year, because he was new; but I will brag on him this year, because he has done an outstanding job for us. He has increased our deal flow and has gotten us in front of a lot of national developers. The most important thing Rick has done, however, is to focus his attention on the right kinds of markets and the right kinds of sites. We are really pleased with what he has accomplished in a relatively short period.

In the fall of 2007, we will open in Palm Beach Gardens, Florida, in the Main Street at Midtown development on PGA West Boulevard, close to Interstate 95. Palm Beach County is an excellent growth area and the demographics line up well for our concept. In 2008 we will be open at The Rialto in Orlando. This is a development on Sand Lake Road near Interstate 4. Sand Lake Road is a high traffic area on the south side of Orlando that is in close proximity to new high-income residential growth areas. The huge resort hotel corridor, where many of the visitors to Orlando stay, is only a few miles away.

We plan to open a restaurant in one of Simon Property Group’s developments, St. John’s Towne Center, in Jacksonville, Florida. This is an upscale lifestyle center that is becoming the premier address for upscale retailers in Duval County, Florida.

We are very excited about developing a restaurant at the Borgata in Scottsdale, Arizona.

For years we have been evaluating opportunities in the Phoenix/Scottsdale area. The Borgata, located on Scottsdale Road, is a well-established location in Scottsdale that is undergoing a facelift by Macerich/Westcor Company. Scottsdale is another growing community that has the retail and demographic components to support our concept. (I am going somewhat out on a limb discussing Scottsdale and Jacksonville. We do not have executed contracts on either location but are confident we will. However, we do not want to jinx ourselves—they could still “blow up”!)

We are also working on 2009 and 2010 opportunities, including several upscale trade areas around the country. Our goal is to build a predictable deal flow over the next five to seven years. We intend to achieve this objective, and believe we can effectively manage a 10 percent physical expansion rate for the foreseeable future.

Leadership
It is hardly a secret that the upscale segment of the casual dining industry is highly competitive, because it includes a host of outstanding restaurateurs and restaurant groups. Our success is dependent on our team’s ability to execute our strategy of providing our guests with the highest quality food, supported by outstanding levels of consistent, seamless professional service.

While our vision of quality and service leadership has been unchanged since we started J. Alexander’s, it is the execution of that vision that is the key.

To be successful, we must have outstanding leaders that can share and communicate the vision. They must be dedicated to execution every day, for every guest. We are only as good as the last meal we served.

We are extremely fortunate to have a team of really outstanding leaders. Our Chief Financial Officer, Greg Lewis, and our Vice President and Controller, Mark Parkey, are simply outstanding in the financial area. Both are involved in developing systems to aid us in improving the financial performance in each of our restaurants. They also deal with a variety of regulatory issues that consume more and more time each year.

I want to thank Mike Moore, our Vice President of Administration and Human Resources, for the good job he has done not only this year, but since he assumed that role several years ago. Mike has an operations background. Beginning five years ago Mike helped Derek Gordon, our Head Coach in Denver, turn around a restaurant in a location that presented greater challenges than we expected. Today our Denver restaurant is a star contributor, and Mike is passing operational responsibilities for Denver back to our operations group—but we are looking for another operations project for him.

We have a great team of operational leaders led by Ralph Carnevale. They are very aggressive. They inspire their respective teams. They lead by example. They exemplify our philosophy and style of “coaching.” It is easy to bark orders at people, but much harder to lead, inspire, teach and train them.

We also have an outstanding team of forward-thinking leaders in our restaurants. Our general managers (Head Coaches) and their culinary and service leadership teams in the restaurants provide outstanding leadership. The outstanding support team in our corporate office is always ready to jump in and support our restaurant teams.

One area of major accomplishments, in which we obviously take great pride, is the culinary area. Chef Jim has in fact developed many “stellar” menu and feature items in the twelve years he has been our head chef. However, an even greater talent is his ability to work with our entire team to execute these products in all of our restaurants.

Our success is dependent on great leadership at all levels of our organization. I enjoy every day I spend working (granted, some more than others) with our team. In a business with many challenges, it is a great comfort to be able to rely on this group of great leaders.

Summary
We are excited about our business prospects for 2007 and plan to build on the progress we made in 2006. A core value of our company is our dedication to continuous improvement. That will be our major focus this year. All of us at J. Alexander’s have an unwavering commitment to providing our guests the highest quality food and most professional service in the casual dining industry.
We are most grateful for the support we have received from our owners over the years. On behalf of our entire team I thank you.

Sincerely,

 

Lonnie J. Stout II
Chairman, President and
Chief Executive Officer
March 23, 2007