Every year I look for a word or a sentence that best describes my views about the year on which I am reporting. The word for 2007 is “yuk.”

I suppose we did have a few bright spots (low wattage) in 2007. We managed a 1.6% increase in same store sales for the year and held general and administrative expenses to under the 2006 level – unfortunately, due mostly to elimination of bonuses for our corporate staff. Net income would have been slightly higher in 2007 than 2006 except for our $939,000 of pre-opening expense incurred in 2007 for our two new restaurants, which should be good for longer term results but had a negative impact on current profits. However, all of this is overshadowed when we look at our “running the business profit” performance, which our long-term shareholders know we consider to be our most important internal yardstick. “Running the business profit” is a non-GAAP financial measure composed of our operating income before pre-opening expense and any involuntary property conversion gains. It is included in the table below, along with “restaurant operating income”, another non-GAAP measure which excludes general and administrative expenses, pre-opening expense, interest expense, investment income and all other items not directly related to the “under roof” performance of our restaurants. We generally target an improvement of about 15% in “running the business profit” each year, and in 2007 we achieved an increase of only 1.4%.

 

J. Alexander’s Corporation Historical Results
(Dollars in 000’s)			Fiscal Years
	2003	2004	2005	2006	2007	2007 vs. 2006
						+/–%
Net Sales	$ 107,059	$ 122,918	$ 126,617	$ 137,658	$ 141,268	2.6%
Restaurant operating expenses	93,751	107,985	111,044	120,360	123,878	2.9%
Restaurant operating income	13,308	14,933	15,573	17,298	17,390	.5%
General and administrative expenses	8,220	8,568	9,081	9,641	9,625	-.2%
Operating income before   pre-opening expense and involuntary conversion gain (“running the business profit”)	5,088	6,365	6,492	7,657	7,765	1.4%
Pre-opening expense	897	—	411	—	939	—
Involuntary property conversion gain	—	117	—	—	—	—
Operating income	4,191	6,482	6,081	7,657	6,826	-10.9%
Total other expense (principally interest)	2,033	2,104	1,656	1,472	1,132	-23.1%
Income before income taxes	2,158	4,378	4,425	6,185	5,694	-7.9%
Income tax provision (benefit)	(1,122)	(444)	865	1,468	1,140	-22.3%
Net income	$ 3,280	$ 4,822	$ 3,560	$ 4,717	$ 4,554	-3.5%
Note: Fiscal year 2004 includes 53 weeks of operations compared to 52 weeks for all other years presented. Captions in bold above represent non-GAAP financial measures.

 

We operate 30 restaurants, and we view them as 30 separate businesses. We started the year with 28 restaurants, 21 of which posted declines in restaurant level profitability in the fourth quarter. Never before have we had 75 percent of our businesses post performance declines. Many of those whose performances declined in 2007 are among the best operated restaurants in our company. You should be very suspicious about what I say next. We believe most of our problems are related to the serious economic issues affecting many aspects of our national economy. Inflation, credit crunch, mortgage crisis and price at the gas pump are cutting into consumers’ disposable income and psyches, even those of upscale consumers. Many letters to shareholders of retail companies will sound this theme: Last year was not a good year; this year may not be any better, and it’s all the economy’s fault. Even if true, this is a great big rock to hide behind. Later in this letter I will share in more detail some considerations that are specific to our business. First, I want to comment on several non-specific factors currently affecting us.

Inflation in our view is already clearly a problem, which hurts both us and our guests. Our input costs have escalated significantly. We can try to pass them along, or we can absorb them and accept lower margins. Neither option will produce a happy result. Not only have our input costs increased, they have also increased significantly for consumers, especially at the grocery store and gas pump. Those increases are reducing discretionary spending (while we are doing everything we can to make the experiences of our guests addictive, we have not yet attained that goal.) Crude oil is now above $100 a barrel on a fairly consistent basis, and gas may be close to $4.00 a gallon by mid-summer. These will feed the inflation monster in myriad ways.

I began my business career as a cost accountant with an original equipment supplier in the automotive industry. Richard Nixon was President, and Arthur Burns was Chairman of the Federal Reserve Board. The central economic issue was how to manage the trade-off between inflation and a hike in unemployment, to bring down inflation without significantly slowing the economy and raising unemployment. It was sort of a political game. Unemployment had risen to an alarming 5 percent and the annualized inflation rate (as measured by the “old” index, including food and gas prices) had also risen to 5 percent. The brilliant solution to this combination was wage and price controls, which were supposed to last about 90 days, but continued for nearly 1000 and proved to be a total debacle. Since that time I have lived through a few recessions, but I have not seen today’s level of real inflation since the post wage-and-price-controls era, when inflation drove the misery index (determined by adding the unemployment rate to the inflation rate) to its all-time high in June 1980. We do not measure inflation the same way today, but it feels pretty miserable. Inflation, and the impact it is having on the consumer, is one of the reasons for the decline in retail sales in the U.S. retail economy.

The casual dining industry is relatively new. By today’s definition, most would probably say that Steak and Ale, which began in 1966, was the first casual dining group. Chili’s Grill and Bar, one of the brand icons in casual dining, was established in 1975 but really did not start to expand until Norman Brinker acquired the group in 1983. The industry’s major growth occurred in the 80’s.

Our company started evaluating the casual dining industry in 1990, focusing on the “upscale segment,” when there were very few upscale brands in the marketplace. We define upscale today as restaurants with check averages, including alcoholic beverages, in excess of $20. There still are relatively few groups in this category. Virtually all started in the 1990’s or obtained critical mass in that decade. The exception is the Hillstone Restaurant Group, which owns Houston’s Restaurants and was the first true upscale casual dining group. This segment of the industry is still heavily populated by numerous privately held restaurant groups, so data is very difficult to obtain.

We have not experienced a serious economic downturn since most of the upscale casual dining groups reached critical mass. This is certainly true for J. Alexander’s. There have been numerous theories about the effect of a recession (or whatever one chooses to call our current economic situation) on upscale casual dining restaurants. We now know that virtually every upscale retail business and upscale casual dining restaurant have been negatively affected by the current economic environment. No business appears to be exempt, certainly not ours.

We build restaurants in markets where we can target consumerswith household incomes in excess of $75,000. That represents approximately 32 percent of the U.S. population, or about 36 million households. Thus, we target the upper third of the disposable income in the United States; this group tends to have a high frequency of use for our restaurants. Additionally, we have a broader market reach, and have found that many people below that income level use J. Alexander’s as a special occasion restaurant, lunch experience or an occasional dining-out treat. It is clear to us that many households in both categories are currently feeling significant pressure to cut back on spending.

In the fourth quarter of 2007 we experienced a sharp decline in volume in both the earliest and latest portions of the dining hours. Our early diners tend to be older consumers with lower disposable incomes, and our late night guests tend to be younger consumers with lower disposable incomes. Households in the bottom third of the U.S. demographics appear to be under severe pressure to reduce spending. These guests are not our heaviest users, but they do dine with us occasionally. We have not observed much decline in our special occasion usage. However, we may be observing some decline in frequency of visit even by our higher income guests (I am excluding our Ohio market from this discussion and will address it later in this letter.)

Our traffic was down prior to the fourth quarter, but price increases had more than made up for the decline. Starting about three years ago we have been fine tuning many of the upscale components of our concept. You may recall that we went to à la carte menu pricing and also upgraded our beef program to the Certified Angus Beef® (CAB) brand. This was a major format change and in effect resulted in a significant price increase. We realized this would have some negative impact on traffic but were willing to struggle through that. In fact, we did experience the anticipated traffic loss, but our check averages increased far more than our price increases. In other words, our core guests spent much more, which more than offset our traffic loss.

However, starting late in the third quarter of 2007, all of this changed. Our traffic loss began to exceed our gains in check average, and for the first time in our history we experienced significant declines in same store sales. Making matters worse, our input costs increased significantly (more on this later); but because of our large losses in guest counts, we decided not to pass along much of that cost increase, which penalized our margins about 100 basis points during the fourth quarter.

In difficult economic times it is extremely important to do everything feasible to maintain, and not do anything to damage, the equity we have built in our concept over the last fifteen years. We believe the best way is to make sure, every day, that we take the best possible care of our guests. Over time this will increase frequency. When the conditions impeding consumer spending improve, we believe our other guests will return to us and increase their frequency. In this Annual Report, we feature several members of our Service Team. I hope you will develop a feel for the commitment our front line employees have to provide outstanding professional service to each of our guests. Consumers are increasingly discerning about where to spend their resources, and in difficult economic times they become even more selective.

The best way to maintain guest loyalty is to re-earn it at every opportunity. We also focus on hospitality leadership and want our guests to understand that we appreciate their spending of their discretionary dollars with us. We believe the combination of high quality food, professional service, and great hospitality will allow us to generate positive sales momentum. I think you will enjoy reading the employees’ views on service and hospitality at J. Alexander’s.

Historically, I have been very pleased with how we managed our beef program. Beef prices sometimes fluctuate significantly on a week- to-week basis, due to a host of variables, such as product demand, herd adjustments and plant capacity. The highest prices for beef are usually during the Christmas season and around other holidays when consumers tend to purchase more beef. They are generally at their lowest after the Valentine’s holiday through spring. Consumer demand for beef in some years increases in the summer when more beef is purchased for cookouts, and restaurant demand usually drops in the summer. In most years, we see the highest market price for beef from around Thanksgiving through the middle of February. We observe spikes in the market during the year, but nothing significant.

We have previously noted that our business is somewhat seasonal, with the fourth and first quarters being those where we sell the most steaks, prime ribs and other beef products. Of course, we always want to ensure availability of high quality beef in our restaurants. When we were smaller, our beef purchases were “at the market”, but several years ago we elected to negotiate fixed pricing contracts for our beef. Until last year, most of those contracts proved beneficial when compared to the market, occasionally very beneficial. Last year, however, we blew it. We were very concerned about the availability of quality beef and entered into a fixed pricing agreement for CAB beef that was based on the market forecast that looked to be high, but reasonable. The demand for beef in restaurants dropped significantly and prices for beef dropped, so that we were contracted above the market price. To make a long story short, we paid about $420,000 more for beef last year than we would have had we not opted for a fixed price contract.

As I write this in mid-March 2008, the beef market is lower than this time last year, but the cost of a fixed price beef contract carries a high premium, in our judgment too high. In any event, we have opted to go “at the market” this year and forego any fixed price contract. We read the tea leaves about the economy on a weekly basis. If we conclude the market is going to change radically (up or down), we will have the option to write a fixed price contract. At the moment, we think it is prudent to take the market risk. We hope we are right.

I mentioned earlier that I would comment separately on our Ohio restaurants. We have five and three of them have performed very poorly over the last two to three years. These three are either in locations or markets that do not meet our current demographic criteria, but the current unhappy state of Ohio’s economy has certainly been a factor. Unfortunately, Ohio has also been raising the cost of doing business there. Workers’ compensation insurance is much more expensive in Ohio than in our other states, including Michigan. Also, Ohio, like some other states, increased the minimum cash wage required to be paid to tipped employees in 2007 and again in 2008, even though tipped employees may already earn much more than the federal or state minimum wage, as most of ours do. We would have to charge higher prices in Ohio than in Atlanta or Houston to maintain the same margins – and that is just not going to happen. (Indeed, at least four of our Ohio restaurants cannot support even our standard pricing structure.) In some Ohio locations we have reduced prices on some items and have reformatted our menus to add lower priced items. We are hopeful these actions will help us restore sales momentum. However, we will never achieve the sales volume in our small Ohio markets that we have in metropolitan Detroit or south Florida. We do believe we can rebuild sales in these restaurants to an acceptable level.

In last year’s Annual Report I told you that we planned to open only one restaurant in 2007. Shortly after the ink dried on my letter, we acquired an existing restaurant site for conversion in the metropolitan Atlanta area. It opened in 2007, along with our originally planned location in Palm Beach Gardens, Florida. This year we plan to open three restaurants, including The Rialto in Orlando, Florida on Sand Lake Road; St. Johns Town Center in Jacksonville, Florida; and The Borgata in Scottsdale, Arizona.

We are always cautious about development, even more so in these current times of economic uncertainty. We have a good, predictable deal flow on sites. As mentioned in last year’s report, we believe we can maintain an approximate 10% physical expansion rate. For 2009, however, we will not be concerned if we open only one or two restaurants. In 2010, we will probably open two or three.

We will enter 2009 with five new restaurants having been opened in the previous eighteen months, all in excellent upscale markets. The current slow down in consumer spending will not last forever. As the economy improves, we intend to be positioned for solid earnings growth, not only in our existing restaurant base, but especially in these five new locations.

Our stock is currently trading at a discount to book value (as determined by generally accepted accounting principles) and is down substantially from its price level a year ago. Depressed stock prices tend not to make CEO’s happy, and I am no exception. The subject of stock buybacks usually comes up – and should – when stock prices are depressed and the long term business view is still positive. Our Board has discussed stock buybacks and will continue to do so. Our only objection at the present time is that all our surplus capital is committed to our restaurant development program. If we had surplus funds, I expect that our Board would seriously consider a stock buyback; but to do so now would require that we use borrowed money. Every day there is a new story about the imprudent use of financial leverage by (supposedly) very sophisticated hedge funds or investment banking institutions (such as the recently deceased Bear Stearns). We do not intend to add our name to that list. 

We expect 2008 to be a difficult year. We believe same store sales will be down two-to-three percent in the first quarter, and our earnings will be significantly below those in the first quarter of last year. Restaurants utilize a high degree of operating leverage or fixed cost in the business, which is why same store sales growth is so important. Relatively small increases in same store sales, combined with efficient
management, can produce impressive earnings improvements. However, the opposite is true when same store sales decline. Our only true variable costs are food and beverage costs. We need our full complement of coaches, servers, and support team members to provide the level of outstanding professional service required to keep guests coming back. While we will always strive to be as efficient as possible, we believe that cutting back on our service hours, kitchen hours or restaurant management will in the long run damage our business. In any event, our first quarter results will not be pleasant.

We expect a positive impact during the second quarter from changing our beef program from our fixed price contract to our “at the market” program. However, forecasting same store sales for this year is a daunting task. We simply do not have much confidence in our ability to make an accurate forecast. Our best guess at this time is that same store sales will be down to flat for the rest of the year because of the current economic environment. Robust sales growth cannot occur until the conditions that have caused the major cutback in consumer spending improve. In the interim, we will provide our guests outstanding service and hospitality and continually re-earn their loyalty. We are extremely appreciative of the efforts of our management team and our outstanding culinary and service professionals who are committed to giving our guests the best experience in upscale casual dining.

We are committed to improving performance in spite of economic overhang. We are not happy with current results. We promise to work hard to improve sales and profitability in each one of our restaurants and to increase value for our shareholders. As always, we thank our shareholders for their loyal support.

 Sincerely,

 

 

Lonnie J. Stout II
Chairman, President and
Chief Executive Officer
March 18, 2008