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MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
IMPACT OF INFLATION
The Company has not experienced a significant overall impact from inflation. As operating expenses increase, the Company, to the extent permitted by competition, recovers increased costs through a combination of menu price increases and reviewing, then implementing, alternative products or processes.
LIQUIDITY AND CAPITAL RESOURCES
The working capital deficit increased from $110.0 million at June 27, 2001 to $160.3 million at June 26, 2002, and net cash provided by operating activities increased from $246.8 million for fiscal 2001 to $390.0 million for fiscal 2002 due primarily to the timing of operational receipts and payments. The Company believes that its various sources of capital, including availability under existing credit facilities and cash flow from operating activities, are adequate to finance operations as well as the repayment of current debt obligations.
Long-term debt outstanding at June 26, 2002 consisted of $255.0 million of zero coupon convertible senior debentures ($431.7 million principal less $176.7 million representing an unamortized debt discount), $46.0 million of unsecured senior notes ($42.8 million principal plus $3.2 million representing the effect of changes in interest rates on the fair value of the debt), $43.5 million in assumed debt related to the acquisition of restaurants from a former franchise partner ($38.8 million principal plus $4.7 million representing a debt premium), $35.0 million in assumed capital lease obligations related to the acquisition of restaurants from a former franchise partner ($19.5 million principal plus $15.5 million representing a debt premium), $63.5 million of borrowings on credit facilities, and obligations under other capital leases. The Company has credit facilities totaling $375.0 million. At June 26, 2002, the Company had $311.5 million in available funds from these facilities.
In October 2001, the Company issued $431.7 million of zero coupon convertible senior debentures and received proceeds totaling approximately $250.0 million. The Company used the proceeds for repayment of existing indebtedness, restaurant acquisitions, purchases of outstanding common stock under the Company's stock repurchase plan and for general corporate purposes.
In July 2001, the Company made a $12.3 million capital contribution to Rockfish Seafood Grill ("Rockfish") in exchange for an approximate 40% ownership interest in the legal entities owning and developing Rockfish. Additionally, in June and November 2001, the Company acquired three On The Border and thirty-nine Chili's restaurants from its franchise partners Hal Smith and Sydran, respectively, for $60.5 million. The Company financed these acquisitions through existing credit facilities, the zero coupon convertible senior debentures and cash provided by operations.
In February 2002, the Company acquired the remaining assets leased under its $80.0 million equipment leasing facilities and $75.0 million real estate leasing facility for $36.2 million and $56.8 million, respectively, and terminated the leasing arrangements. The acquisitions were primarily funded by utilizing amounts available under existing credit facilities.
Capital expenditures consist of purchases of land for future restaurant sites, the cost of new restaurant construction, purchases of new and replacement restaurant furniture and equipment, the acquisition of previously leased equipment and real estate assets, and ongoing remodeling programs. Capital expenditures, net of amounts funded under the respective equipment and real estate leasing facilities, were $371.1 million for fiscal 2002 compared to $205.2 million for fiscal 2001. The increase is due primarily to the acquisition of the remaining assets leased under the equipment and real estate leasing facilities and an increase in the number of new store openings. The Company estimates that its fiscal 2003 capital expenditures will approximate $335.0 million. These capital expenditures will be funded primarily from operations and existing credit facilities.
The Board of Directors authorized an increase in the stock repurchase plan of $100.0 million in August 2001 and an additional $100.0 million in April 2002, bringing the Company's total share repurchase program to $410.0 million. Pursuant to the Company's stock repurchase plan, approximately 5.1 million shares of its common stock were repurchased for $136.1 million during fiscal 2002. As of June 26, 2002, approximately 16.0 million shares had been repurchased for $327.6 million under the stock repurchase plan. The Company repurchases common stock to offset the dilutive effect of stock option exercises, satisfy obligations under its savings plans, and for other corporate purposes. The repurchased common stock is reflected as a reduction of shareholders' equity. The Company financed the repurchase program through a combination of cash provided by operations, drawdowns on its available credit facilities and the issuance of the zero coupon convertible senior debentures.
In August 2002, the Company entered into a letter of intent with Philip J. Romano and Eatzi's Corporation to divest its interest in the Eatzi's concept. As a result, an approximate $8.7 million impairment charge was recorded reducing the Eatzi's notes receivable to $11.0 million. The Company expects to collect the remaining balance of the notes in the second quarter of fiscal 2003.
The Company is not aware of any other event or trend which would potentially affect its liquidity. In the event such a trend develops, the Company believes that there are sufficient funds available under its credit facilities and from its strong internal cash generating capabilities to adequately manage the expansion of the business.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk from changes in interest rates on debt and certain leasing facilities and from changes in commodity prices. A discussion of the Company's accounting policies for derivative instruments is included in the summary of significant accounting policies in the notes to the consolidated financial statements.
The Company may from time to time utilize interest rate swaps to manage overall borrowing costs and reduce exposure to adverse fluctuations in interest rates. The Company does not use derivative instruments for trading purposes and has procedures in place to monitor and control derivative use.
The Company is exposed to interest rate risk on short-term and long-term financial instruments carrying variable interest rates. The Company's variable rate financial instruments, including the outstanding borrowings of credit facilities and notional amounts of interest rate swaps, totaled $224.1 million at June 26, 2002. The impact on the Company's annual results of operations of a one-point interest rate change on the outstanding balance of these variable rate financial instruments as of June 26, 2002 would be approximately $2.2 million.
The Company purchases certain commodities such as beef, chicken, flour, and cooking oil. These commodities are generally purchased based upon market prices established with vendors. These purchase arrangements may contain contractual features that limit the price paid by establishing certain price floors or caps. The Company does not use financial instruments to hedge commodity prices because these purchase arrangements help control the ultimate cost paid and any commodity price aberrations are generally short term in nature.
This market risk discussion contains forward-looking statements. Actual results may differ materially from this discussion based upon general market conditions and changes in domestic and global financial markets.
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are disclosed in Note 1 to our consolidated financial statements. The following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results, and that require significant judgment.
Property and Equipment
Property and equipment are depreciated on a straight-line basis over the estimated useful lives of the assets. The useful lives of the assets are based upon the Company's expectations for the period of time that the asset will be used to generate revenue. The Company periodically reviews the assets for changes in circumstances which may impact their useful lives.
Impairment of Long-Lived Assets
The Company reviews property and equipment for impairment when events or circumstances indicate it might be impaired. The Company tests impairment using historical cash flows and other relevant facts and circumstances as the primary basis for its estimates of future cash flows. This process requires the use of estimates and assumptions which are subject to a high degree of judgment. In addition, at least annually the Company assesses the recoverability of goodwill and other intangible assets related to its restaurant concepts. These impairment tests require the Company to estimate fair values of its restaurant concepts by making assumptions regarding future cash flows and other factors. If these assumptions change in the future, the Company may be required to record impairment charges for these assets.
Financial Instruments
The Company enters into interest rate swaps to manage fluctuations in interest expense and to maintain the value of fixed-rate debt. The fair value of these swaps is estimated using widely accepted valuation methods. The valuation of derivatives involves considerable judgment, including estimates of future interest rate curves. Changes in those estimates may materially affect the value of the Company's derivatives.
Self-Insurance
The Company is self-insured for certain losses related to general liability and workers' compensation. The Company maintains stop loss coverage with third party insurers to limit its total exposure. The self-insurance liability represents an estimate of the ultimate cost of claims incurred as of the balance sheet date. The estimated liability is not discounted and is established based upon analysis of historical data and actuarial estimates, and is reviewed by the Company on a quarterly basis to ensure that the liability is appropriate. If actual trends, including the severity or frequency of claims, differ from our estimates, our financial results could be impacted.
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