MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
For an understanding of the significant factors that influenced our performance during the past three fiscal years, the following discussion should be read in conjunction with the consolidated financial statements and related notes found elsewhere in this annual report.
We have a 52/53 week fiscal year ending on the last Wednesday in June. Fiscal years 2006 and 2005, which ended on June 28, 2006 and June 29, 2005, respectively, contained 52 weeks, while fiscal year 2004, which ended on June 30, 2004, contained 53 weeks.
RESULTS OF OPERATIONS FOR FISCAL YEARS 2006, 2005, and 2004
The following table sets forth income and expense items as a percentage of total revenues for the periods indicated:
| Percentage of Total Revenues Fiscal Years |
|||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2006 | 2005 | 2004 | |||||||||
| Revenues | 100.0 | % | 100.0 | % | 100.0 | % | |||||
| Operating Costs and Expenses: Cost of sales |
28.0 | % | 28.3 | % | 27.7 | % | |||||
| Restaurant expenses | 54.5 | % | 55.4 | % | 54.3 | % | |||||
| Depreciation and amortization | 4.6 | % | 4.8 | % | 4.7 | % | |||||
| General and administrative | 5.0 | % | 4.1 | % | 4.3 | % | |||||
| Restructure charges and other impairments | 0.0 | % | 1.6 | % | 2.0 | % | |||||
| Total operating costs and expenses | 92.1 | % | 94.2 | % | 93.0 | % | |||||
| Operating income | 7.9 | % | 5.8 | % | 7.0 | % | |||||
| Interest expense | 0.5 | % | 0.7 | % | 0.3 | % | |||||
| Other, net | 0.0 | % | 0.0 | % | 0.1 | % | |||||
| Income before provision for income taxes | 7.4 | % | 5.1 | % | 6.6 | % | |||||
| Provision for income taxes | 2.2 | % | 0.9 | % | 2.3 | % | |||||
| Income from continuing operations | 5.2 | % | 4.2 | % | 4.3 | % | |||||
| (Loss) income from discontinued operations, net of taxes | (0.1 | )% | 0.1 | % | 0.0 | % | |||||
| Net income | 5.1 | % | 4.3 | % | 4.3 | % | |||||
OVERVIEW
We are principally engaged in the ownership, operation, development, and franchising of the Chili’s Grill & Bar (“Chili’s”), Romano’s Macaroni Grill (“Macaroni Grill”), Maggiano’s Little Italy (“Maggiano’s”), and On The Border Mexican Grill & Cantina (“On The Border”) restaurant brands. At June 28, 2006, we owned, operated, or franchised 1,622 restaurants. In September 2005, we entered into an agreement to sell Corner Bakery Cafe (“Corner Bakery”). The sale of the brand was completed in February 2006. As a result, Corner Bakery is presented as discontinued operations in the accompanying consolidated financial statements.
We intend to continue the expansion of our restaurant brands by opening units in strategically desirable markets. The restaurant site selection process is critical to our long-term success and we devote significant effort to the investigation of new locations utilizing a variety of sophisticated analytical techniques. We intend to concentrate on the development of certain identified markets to achieve penetration levels deemed desirable in order to improve competitive position, marketing potential and profitability. Expansion efforts will be focused not only on major metropolitan areas, but also on smaller market areas and non-traditional locations (such as airports and food courts) that can adequately support any of our restaurant brands. In addition, we intend to pursue domestic and international franchise expansion to achieve our goal of increasing franchise ownership of our brands from 20% to approximately 30% through an active program of franchising company-owned restaurants and accelerated development commitments from franchisees. Future franchise development agreements are expected to remain limited to enterprises having significant restaurant or enterprise management experience and proven financial ability to develop multi-unit operations. The specific rate at which we are able to open new restaurants is determined by our success in locating satisfactory sites, negotiating acceptable lease or purchase terms, securing appropriate local governmental permits and approvals, and by our capacity to supervise construction and recruit and train management personnel.
The restaurant industry is a highly competitive business, which is sensitive to changes in economic conditions, trends in lifestyles and fluctuating costs. Operating margins for restaurants are susceptible to fluctuations in prices of commodities, which include among other things, beef, pork, chicken, seafood, dairy, cheese, produce, energy and other necessities to operate a restaurant. Additionally, the restaurant industry is characterized by a high initial capital investment, coupled with high labor costs.
REVENUES
Revenues for fiscal 2006 increased to $4,151.3 million, 10.7% over the $3,749.5 million generated for fiscal 2005. Revenues for fiscal 2005 increased 5.9% from fiscal 2004 revenues of $3,541.0 million (8.0% excluding revenues of $70.3 million for the additional week in fiscal 2004). The increases were primarily attributable to a net increase of 109 and 70 company-owned restaurants (excluding Corner Bakery) in fiscal 2006 and 2005, respectively, and an increase in comparable store sales. Revenues for fiscal 2006 increased primarily due to a 7.2% increase in capacity (as measured by average-weighted sales weeks) and a 1.5% increase in comparable store sales. Revenues for fiscal 2005 increased primarily due to a 1.9% increase in capacity and a 2.5% increase in comparable store sales. Capacity increased 3.9% for fiscal 2005 on a comparable 52-week basis. Menu prices in the aggregate increased 3.0% and 2.7% in fiscal 2006 and 2005, respectively.
COSTS AND EXPENSES
Cost of sales, as a percent of revenues, decreased 0.3% in fiscal 2006 due primarily to a 0.7% increase in menu prices, a 0.2% favorable price change in bread and dairy, and a 0.2% favorable product mix shift for poultry, partially offset by a 0.7% unfavorable product mix shift for meat and a 0.1% price increase in poultry. Cost of sales, as a percent of revenues, increased 0.6% in fiscal 2005 due primarily to a 0.9% increase in commodity prices for meat, poultry and produce and a 0.6% unfavorable product mix shift for meat and seafood, partially offset by a 0.9% increase in menu prices.
Restaurant expenses, as a percent of revenues, decreased 0.9% in fiscal 2006. The decrease was primarily due to gains recorded in fiscal 2006 related to the sale of company-owned restaurants to franchisees and the sale of real estate totaling $19.3 million, increases in sales leverage and productivity, and a reduction in repair and maintenance expenses. The decrease was also due to a $23.3 million increase in utility and vacation costs recorded in fiscal 2005 resulting from the correction of accounting policies and the $17.3 million FICA tax assessment recorded in fiscal 2005. The decrease was partially offset by an increase in stock-based compensation of $9.4 million and an increase in advertising. Restaurant expenses, as a percent of revenues, increased 1.1% in fiscal 2005. The increase was primarily due to the utility and vacation costs and the FICA tax assessment previously mentioned, increases in labor costs related to new product rollouts and service initiatives, and increases in repair and maintenance expenses. These increases were partially offset by gains related to the sale of company-owned restaurants to franchisees and the sale of real estate totaling $9.1 million and a decrease in advertising costs.
Depreciation and amortization increased $10.3 million and $12.1 million in fiscal 2006 and 2005, respectively. The increases were due to new unit construction and ongoing remodel costs, partially offset by a decrease in depreciation related to the disposition of stores and a declining depreciable asset base for older units.
General and administrative expenses increased $54.0 million and $2.6 million in fiscal 2006 and 2005, respectively. The increase in fiscal 2006 was due primarily to an increase of $23.6 million in performance based compensation that was not paid out in the prior year, $20.7 million in stock-based compensation expense, and payroll costs resulting from an increase in headcount. The increase in fiscal 2005 was due primarily to increased costs related to consumer research and an increase in payroll costs resulting from an increase in headcount, partially offset by a decrease in performance based compensation.
Restructure charges and other impairments recorded during fiscal 2006 consist of $3.1 million in net charges associated with closed restaurants and asset impairments, partially offset by a $1.1 million gain related to the final disposition of our interest in Rockfish Seafood Grill (“Rockfish”). Restructure charges and other impairments recorded during fiscal 2005 consist of a $36.4 million charge related to the disposition of the remaining Big Bowl Asian Kitchen (“Big Bowl”) restaurants, a $16.9 million charge to fully impair the investment and notes receivable associated with Rockfish, and a $8.6 million charge related primarily to restaurant closures.
Interest expense decreased by $2.4 million in fiscal 2006 due primarily to the redemption of the convertible senior debentures in January 2005 and the final scheduled payment of the remaining principal balance on the senior notes in April 2005, partially offset by increased average borrowings and interest rates on our lines of credit. Interest expense increased by $13.8 million in fiscal 2005 due primarily to interest related to the 5.75% notes (the “Notes”) issued in May 2004 and increased average borrowings on our lines of credit. These increases were partially offset by a decrease in interest expense due to the redemption of the convertible senior debentures and the final scheduled repayment of the senior notes.
Other, net decreased $3.2 million in fiscal 2006 due to fully impairing our investment in Rockfish during fiscal 2005 and a decrease in expense related to our net savings plan obligations as a result of partially terminating one of our savings plans and distributing $31.8 million to participants.
INCOME TAXES
The effective income tax rate related to continuing operations was 29.9%, 17.3%, and 35.3% in fiscal 2006, 2005, and 2004, respectively. The increase in fiscal 2006 and the decrease in 2005 were primarily due to the income tax benefit of $16.9 million, consisting primarily of federal income tax credits related to the additional FICA taxes paid as a result of the Internal Revenue Service (“IRS”) resolution in fiscal 2005, the disposition of Big Bowl in fiscal 2005, which allowed us to take tax deductions for goodwill impairment charges totaling $48.6 million, and a $6.6 million tax benefit related to the correction of deferred tax liabilities as a result of an analysis of the tax basis of certain property and equipment balances in fiscal 2005. The increase in fiscal 2006 was also due to stock-based compensation related to incentive stock options. The increase in fiscal 2006 was partially offset by an income tax benefit totaling $8.1 million associated with the favorable settlement of certain IRS audits and a decrease in the effective tax rate for state income taxes.
IMPACT OF INFLATION
We have not experienced a significant overall impact from inflation. To the extent permitted by competition, increased costs are recovered through a combination of menu price increases and reviewing, then implementing, alternative products or processes.