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CEC ENTERTAINMENT INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide the readers of our Consolidated Financial Statements with a narrative from the perspective of our management on our consolidated financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A should be read in conjunction with our Consolidated Financial Statements and related notes included in Part II, Item 8. "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. Our MD&A includes the following sections: • Executive Summary; • Overview of Operations; • Results of Operations; • Financial Condition, Liquidity and Capital Resources; • Off-Balance Sheet Arrangements and Contractual Obligations; • Inflation; • Critical Accounting Policies and Estimates; and • Recently Issued Accounting Guidance. Fiscal Year We operate on a 52 or 53 week fiscal year that ends on the Sunday nearest to December 31. Each quarterly period has 13 weeks, except for a 53 week year when the fourth quarter has 14 weeks. References to 2013, 2012 and 2011 are for the fiscal years ended December 29, 2013, December 30, 2012, and January 1, 2012, respectively, which each consisted of 52 weeks. Executive Summary Our Strategic Plan As previously disclosed, we implemented an updated strategic plan with the primary objective of increasing guest traffic and ultimately improving our consolidated sales and operating results. As part of this plan, we implemented a number of strategic changes over the last two years. We introduced an updated Chuck E. Cheese character, launched a multi-faceted advertising campaign, launched our redesigned website, began implementing and communicating our value proposition to our guests and began providing a significantly improved and targeted operational plan focused on enhancing the service level and experience for all guests. Our value proposition includes changes in our pricing strategy to ensure that we continue to provide our guests with what we believe is a great value. Based on market research and testing, we changed our pricing structure during 2012, including reducing price points for our package deals, reducing pizza prices, decreasing the number of tokens included in various token packages, reducing discounts included in certain coupons and reducing the number of "token only" coupons. In addition, a standardized menu and pricing for domestic Company-owned stores was included on our redesigned website and in all of our stores by November 2012. We believe that these changes to our pricing strategy will increase the attractiveness of our everyday menu offerings, while continuing to provide our guests with a great value proposition. We continue to refine our strategic plan and have implemented several enhancements, including changes to our capital spending initiatives, the mix of our advertising spend and our methods for obtaining and measuring customer satisfaction. Beginning in the second quarter of 2013, we reduced the cost of game enhancements by utilizing more transferred games and rides, which will allow us to perform game enhancements at a store more frequently and for approximately half the cost on a per store basis. See further discussion of our capital spending initiatives in "Financial Condition, Liquidity and Capital Resources - Capital Expenditures." In the third and fourth quarters of 2013, we reduced spend on our digital brand advertising and are using a portion of national television airtime for new birthday commercials. In the third quarter, we implemented a new guest survey tool that allows the guest to provide real-time, meaningful and actionable feedback to ensure our service is delivered in accordance with our operational plan. We continuously look for opportunities to improve overall communication with our guests through our television advertising and website. We continue to communicate our value and entertainment offerings, including package deals, coupons, all games are one token and the Chuck E. Cheese live performances and ticket giveaway every hour on the half-hour. We believe these enhancements to our strategic plan will improve our sales and operating results. See Part I, Item 1. "Business - Our Strategic Plan - Marketing Plan and Value Proposition" for more information regarding our revised marketing strategy. 25-------------------------------------------------------------------------------- Table of Contents Merger Agreement On January 15, 2014, the Company entered into the Merger Agreement. Pursuant to the terms of the Merger Agreement, and on the terms and subject to the conditions thereof, among other things, Parent and Merger Sub have commenced the Tender Offer. If the Merger is completed, the Company will cease to be a publicly traded company. See further discussion of the Merger in Part I, Item 1. "Business - Merger Agreement" and Part II, Item 8. "Financial Statements and Supplementary Data - Note 13. Subsequent Events" of this Annual Report on Form 10-K. Overview of 2013 • Net income increased to $47.8 million, or $2.78 per share, for 2013 compared to net income of $43.6 million, or $2.47 per share, for 2012. Results included the following: • Total revenues increased $18.2 million, or 2.3%, primarily due to a 0.4% increase in comparable store sales and additional revenues from eight net new stores opened in 2013. • Company store operating costs decreased 70 basis points, as a percentage of Company store sales, primarily due to a 90 basis point decrease in the cost of food, beverage, entertainment and merchandise, partially offset by a 10 basis point increase in labor costs. • Other costs and expenses increased $5.7 million, due to an increase in advertising and general and administrative expenses, partially offset by a decrease in asset impairments. • Our effective income tax rate for 2013 decreased to 37.1% from 37.4% in 2012. • Cash provided by operations remained relatively flat at $138.7 million in 2013 compared to $137.1 million in the prior year. • We repurchased $18.1 million of our common stock in 2013. • During 2013, we completed 175 capital initiatives, including 150 game enhancements, six major remodels, six expansions and opened 13 new Company-owned store locations, including one relocated store. • During 2013, we declared dividends of $17.4 million, or $0.99 per share. 26 -------------------------------------------------------------------------------- Table of Contents Overview of Operations We develop, operate and franchise family dining and entertainment centers under the name "Chuck E. Cheese's" in 47 states and ten foreign countries and territories. Our stores offer wholesome family dining, distinctive musical and comic entertainment by computer-controlled robotic characters, family-oriented arcade-style and skill-oriented games, video games, rides and other activities, all of which are intended to uniquely appeal to our primary customer base of families with children between two and 12 years of age. All of our stores offer dining selections consisting of a variety of pizzas, sandwiches, wings, appetizers, a salad bar, beverages and desserts. The following table summarizes information regarding the number of Company-owned and franchised stores for the periods presented: Fiscal Year 2013 2012 2011 Number of Company-owned stores: Beginning of period 514 507 507 New (1) 13 12 4 Acquired from franchisees - 1 - Closed (1) (5 ) (6 ) (4 ) End of period 522 514 507 Number of franchised stores: Beginning of period 51 49 47 New (2) 6 3 3 Acquired by the Company - (1 ) - Closed (2) (2 ) - (1 ) End of period 55 51 49 _______________________(1) The number of new and closed Company-owned stores during 2013 included one store that was relocated. The number of new and closed Company-owned stores during 2012 included three stores that were relocated. The number of new and closed Company-owned stores during 2011 included two stores that were relocated. (2) The number of new and closed franchise stores during 2013 included one store that was relocated. We are focusing on growing our concept both domestically and internationally. We currently plan to open 12 to 15 domestic Company-owned stores, including relocations and franchise acquisitions, in 2014. We are also targeting franchising our concept internationally in certain countries located in Asia, Eastern Europe, Latin America and the Middle East. During 2013, we opened five new stores, of which one was located in Mexico, Panama and Peru and two were located in Saudi Arabia. We currently expect franchisees to open a total of seven to nine additional international franchise stores in 2014. Comparable store sales. We define comparable store sales as the percentage change in sales for our domestic Company-owned stores that have been open for at least 18 months as of the beginning of each respective fiscal year or operated by us for at least 12 months for acquired stores (our "comparable store base"). Comparable store sales is a key performance indicator used within our industry and is a critical factor when evaluating our performance, as it is indicative of acceptance of our strategic initiatives and local economic and consumer trends. The following table summarizes information regarding our average annual comparable store sales and comparable store base: Fiscal Year 2013 2012 2011 (in thousands, except store number amounts) Average annual sales per comparable store (1) $ 1,573 $ 1,553 $ 1,596 Number of stores included in our comparable store base 485 480 475 _______________________ (1) Average annual sales per comparable store is calculated based on the average weekly sales of our comparable store base. The amount of average annual sales per comparable store cannot be used to compute year-over-year comparable store sales increases or decreases due to the change in comparable store base. 27-------------------------------------------------------------------------------- Table of Contents Revenues. Our primary source of revenues is sales at our Company-owned stores ("Company store sales"), which consists of the sale of food, beverages, game-play tokens and merchandise. A portion of our Company store sales are from sales of value-priced combination packages generally comprised of food, beverage and game tokens ("Package Deals"), which we promote through in-store menu pricing or coupon offerings. We allocate the revenues recognized from the sale of our Package Deals and coupons between "Food and beverage sales" and "Entertainment and merchandise sales" based upon the price charged for each component when it is sold separately, or in limited circumstances, our best estimate of selling price if a component is not sold on a stand-alone basis, which we believe approximates each component's fair value. Food and beverage sales include all revenues recognized with respect to stand-alone food and beverage sales, as well as the portion of revenues allocated from Package Deals and coupons that relate to food and beverage sales. Entertainment and merchandise sales include all revenues recognized with respect to stand-alone game token and merchandise sales, as well as a portion of revenues allocated from Package Deals and coupons that relate to entertainment and merchandise. Another source of revenues is from franchise fees and royalties. We earn monthly royalties from our franchisees based on a percentage of each franchised store's monthly sales. We also receive development and initial franchise fees to establish new franchised stores, as well as earn revenues from the sale of equipment and other items or services to franchisees. We recognize development and initial franchise fees as revenue when the franchise store has opened and we have substantially completed our obligations to the franchisee relating to the opening of a store. Company store operating costs. Certain costs and expenses relate only to the operation of our Company-owned stores and are as follows: • Cost of food and beverage includes all direct costs of food, beverages and costs of related paper and birthday supplies, less rebates from suppliers; • Cost of entertainment and merchandise includes all direct costs of prizes provided and merchandise sold to our customers, as well as the cost of tickets dispensed to customers; • Labor expenses consist of salaries and wages, bonuses, related payroll taxes and benefits for store personnel; • Depreciation and amortization includes expenses that are directly related to our Company-owned stores' property and equipment, including leasehold improvements, game and ride equipment, furniture, fixtures and other equipment; • Rent expense includes lease costs for Company-owned stores, excluding common occupancy costs (e.g., common area maintenance ("CAM") charges and property taxes); and • Other store operating expenses primarily include utilities, repair and maintenance costs, liability and property insurance, CAM charges, property taxes, credit card processing fees, licenses, preopening expenses, store asset disposal gains and losses and all other costs directly related to the operation of a store. The "Cost of food and beverage" and the "Cost of entertainment and merchandise" mentioned above excludes any allocation of (a) store employee payroll, related payroll taxes and benefit costs; (b) rent expense; (c) depreciation and amortization expense; or (d) other direct store operating expenses associated with the operation of our Company-owned stores. We believe that presenting store-level labor costs, rent expense, depreciation and amortization expense and other store operating expenses in the aggregate provides the most informative financial reporting presentation. Our rationale for excluding such costs is as follows: • our store employees are trained to sell and attend to both our dining and entertainment operations. We believe it would be difficult and potentially misleading to allocate labor costs between "Food and beverage sales" and "Entertainment and merchandise sales"; and • while certain assets are individually dedicated to either our food service operations or game activities, we also have significant capital investments in shared depreciating assets, such as leasehold improvements, point-of-sale systems, computer-controlled robotic characters and showroom fixtures.Therefore, we believe it would be difficult and potentially misleading to allocate depreciation and amortization expense or rent expense between "Food and beverage sales" and "Entertainment and merchandise sales." "Cost of food and beverage" and "Cost of entertainment and merchandise", as a percentage of Company store sales, are influenced by both the cost of products, as well as the overall mix of our Package Deals and coupon offerings. "Entertainment and merchandise sales" have higher margins than "Food and beverage sales." 28-------------------------------------------------------------------------------- Table of Contents Advertising expense. Advertising expense includes production costs for television commercials, newspaper inserts, Internet advertising, coupons, media expenses for national and local advertising and consulting fees, partially offset by contributions from our franchisees. General and administrative expenses. General and administrative expenses represent all costs associated with operating our corporate office, including regional and district management and corporate personnel payroll and benefits, depreciation and amortization of corporate assets, back-office support systems and other administrative costs not directly related to the operation of our Company-owned stores. Asset impairments. Asset impairments represent non-cash charges for the estimated write down or write-off of the carrying amount of certain long-lived assets within our stores to their estimated fair value, which are incurred when a store's operation is not expected to generate sufficient projected future cash flows to recover the current net book value of the long-lived assets within the store. We believe our assumptions in calculating the fair value of our long-lived assets is similar to those used by other marketplace participants. Results of Operations Historical Results The following table summarizes our principal sources of Total Company store sales expressed in dollars and as a percentage of Total Company store sales for the periods presented: Fiscal Year 2013 2012 2011 (in thousands, except percentages) Food and beverage sales $ 368,584 45.1 % $ 372,948 46.7 % $ 388,908 47.7 % Entertainment and merchandise sales 448,155 54.9 % 425,989 53.3 % 426,986 52.3 % Total Company store sales $ 816,739 100.0 % $ 798,937 100.0 % $ 815,894 100.0 % 29-------------------------------------------------------------------------------- Table of Contents The following table summarizes our revenues and expenses expressed in dollars and as a percentage of Total revenues (except as otherwise noted) for the periods presented: Fiscal Year 2013 2012 2011 (in thousands, except percentages) Total Company store sales $ 816,739 99.4 % $ 798,937 99.4 % $ 815,894 99.4 % Franchising fees and royalties 4,982 0.6 % 4,543 0.6 % 5,284 0.6 % Total revenues 821,721 100.0 % 803,480 100.0 % 821,178 100.0 % Company store operating costs: Cost of food and beverage (1) 90,363 24.5 % 93,417 25.0 % 95,989 24.7 % Cost of entertainment and merchandise (2) 29,775 6.6 % 30,855 7.2 % 32,362 7.6 % Total cost of food, beverage, entertainment and merchandise (3) 120,138 14.7 % 124,272 15.6 % 128,351 15.7 % Labor expenses (3) 229,172 28.1 % 223,605 28.0 % 222,596 27.3 % Depreciation and amortization (3) 78,167 9.6 % 78,769 9.9 % 80,826 9.9 % Rent expense (3) 78,463 9.6 % 75,312 9.4 % 74,992 9.2 % Other store operating expenses (3) 131,035 16.0 % 126,855 15.9 % 126,847 15.5 % Total Company store operating costs (3) 636,975 78.0 % 628,813 78.7 % 633,612 77.7 % Other costs and expenses: Advertising expense 41,217 5.0 % 35,407 4.4 % 34,989 4.3 % General and administrative expenses 57,007 6.9 % 53,437 6.7 % 51,859 6.3 % Asset impairments 3,051 0.4 % 6,752 0.8 % 2,739 0.3 % Total operating costs and expenses 738,250 89.8 % 724,409 90.2 % 723,199 88.1 % Operating income 83,471 10.2 % 79,071 9.8 % 97,979 11.9 % Interest expense 7,453 0.9 % 9,401 1.2 % 8,875 1.1 % Income before income taxes $ 76,018 9.3 % $ 69,670 8.7 % $ 89,104 10.9 % _______________________ (1) Percent amount expressed as a percentage of Food and beverage sales. (2) Percent amount expressed as a percentage of Entertainment and merchandise sales. (3) Percent amount expressed as a percentage of Total Company store sales. Due to rounding, percentages presented in the table above may not sum to total. The percentage amounts for the components of Cost of food and beverage and the Cost of entertainment and merchandise may not sum to total due to the fact that Cost of food and beverage and Cost of entertainment and merchandise are expressed as a percentage of related Food and beverage sales and Entertainment and merchandise sales, as opposed to Total Company store sales. 30-------------------------------------------------------------------------------- Table of Contents Fiscal Year 2013 Compared to Fiscal Year 2012 Revenues Company store sales increased $17.8 million, or 2.2%, to $816.7 million in 2013 compared to $798.9 million in 2012. The increase in Company store sales is primarily due to a 0.4% increase in comparable store sales and additional revenues from 13 new stores opened, net of five closed stores, since the end of 2012. Comparable store sales were favorably impacted by record warm weather in the Midwest and Northeast in March 2012, which negatively impacted our prior year results. This benefit was partially offset by severe winter weather in December 2013, which negatively impacted comparable store sales in the fourth quarter of 2013. We also believe 2013 benefited from certain components of our strategy; however, this benefit was partially offset by an approximate 7% decline in birthday party sales during the current year, which have historically generated 15% to 20% of Company store sales. In addition, we believe our comparable store sales have been negatively impacted by overall political and economic uncertainties. Our Company store sales mix consisted of food and beverage sales totaling 45.1% and entertainment and merchandise sales totaling 54.9% in 2013 compared to 46.7% and 53.3%, respectively, in 2012. We believe that this shift in our sales mix is primarily due to the following: (a) repricing of certain components of our offerings; (b) changing the mix of items included in Packaged Deals and coupons; and (c) modification of our various token offers. These changes were part of our continued effort to rebalance our menu pricing between food and games. We believe that the rebalancing of our menu pricing and our ongoing investment in our games has resulted in more of our guests' average check being allocated to games. Company Store Operating Costs Overall, the Cost of food, beverage, entertainment and merchandise, as a percentage of Total Company store sales, decreased 90 basis points to 14.7% in 2013 from 15.6% in 2012. We believe the decrease was primarily attributable to the changes in our pricing strategy that were fully implemented in the fourth quarter of 2012 and our cost savings initiatives that were fully implemented in the second quarter of 2013. Cost of food and beverage, as a percentage of Food and beverage sales, decreased 50 basis points to 24.5% in 2013 from 25.0% in 2012. The decrease primarily related to an approximate 15% reduction in dough usage as a result of our new thinner, more crispy pizza crust implemented in stores in March 2013 and a 20 basis point decrease related to changes in the product mix of paper and birthday supplies, partially offset by an increase of $0.05 per pound, or 2.9%, in the average cost per pound of cheese. Cost of entertainment and merchandise, as a percentage of Entertainment and merchandise sales, decreased 60 basis points to 6.6% in 2013 from 7.2% in 2012. The percentage of Cost of entertainment and merchandise was favorably impacted by the modification of our prize and merchandise categories, as well as the shift in the sales mix to entertainment and merchandise. Labor expenses, as a percentage of Total Company store sales, increased 10 basis points to 28.1% in 2013 from 28.0% in 2012, primarily related to higher sales and performance bonuses, partially offset by a decrease in workers' compensation and health insurance costs during 2013. Advertising Expenses Advertising expenses increased $5.8 million to $41.2 million in 2013 from $35.4 million in 2012. In accordance with our updated strategic plan, we increased our expenditures for television advertising and our digital advertising campaign in 2013. General and Administrative Expenses General and administrative expenses increased $3.6 million to $57.0 million in 2013 from $53.4 million in 2012, primarily due to higher corporate compensation costs, including operational management bonuses, and increases in certain professional fees related to the modernization of various information technology platforms. 31-------------------------------------------------------------------------------- Table of Contents Asset Impairments In 2013, we recognized an asset impairment charge of $3.1 million primarily related to seven stores, of which three stores were previously impaired. In 2012, we recognized an asset impairment charge of $6.8 million for 18 stores, of which seven were previously impaired. We continue to operate all but two of these impaired stores. The impairment charge was based on the determination that these stores were adversely impacted by various economic factors in the markets in which they are located. Management determined that the estimated fair value of certain long-lived assets at these stores (determined from discounted future projected operating cash flows of the stores over their remaining lease term) had declined below their carrying amount. As a result, we recorded an impairment charge to write down the carrying amount of certain property and equipment at these stores to the estimated fair value. For additional information about these impairment charges, refer to Note 4 "Property and Equipment - Asset Impairments" in our Consolidated Financial Statements included in Part II, Item 8. "Financial Statements and Supplementary Data." Interest Expense Interest expense decreased $1.9 million to $7.5 million in 2013 from $9.4 million in 2012, primarily as a result of favorable settlements and the expiration of statutes of limitations relating to uncertain tax positions and a decrease in the average outstanding debt balance on our revolving credit facility. Income Taxes Our effective income tax rate decreased to 37.1% in 2013 as compared to 37.4% in 2012. The decrease primarily related to an increase in federal Work Opportunity Tax Credits related to our 2012 fiscal year, which was accounted for in the first quarter of 2013 due to the retroactive reinstatement of the credit program enacted January 2, 2013. In addition, the 2013, and to a greater extent 2012, effective tax rates were favorably impacted by the recognition of uncertain tax positions resulting from audit settlements and the expirations of statutes of limitations, net of increases related to uncertain tax positions taken in the current and prior years. Diluted Earnings Per Share Diluted earnings per share increased $0.31, or 12.6%, to $2.78 per share in 2013 compared to $2.47 per share in 2012. The increase was primarily due to the increase in net income and a decrease in the number of weighted average diluted shares outstanding in 2013 as compared to 2012. The decrease in the weighted average diluted shares outstanding was impacted by our repurchase of 0.9 million shares of our common stock since the beginning of the 2012 fiscal year. We estimate stock repurchases benefited our earnings per share in 2013 by approximately $0.07. Our estimate is based on the weighted average number of shares repurchased since the beginning of the 2012 fiscal year and includes consideration of the estimated additional interest expense attributable to increased borrowings under our revolving credit facility to finance any repurchases. Our computation does not include the effect of share repurchases prior to the 2012 fiscal year, or the effect of the issuance of restricted stock subsequent to the beginning of the 2012 fiscal year. Fiscal Year 2012 Compared to Fiscal Year 2011 Revenues Company store sales decreased $17.0 million, or 2.1%, to $798.9 million in 2012 compared to $815.9 million in 2011. The decrease in Company store sales is primarily due to a 2.9% decrease in comparable store sales. This decrease was partially offset by additional revenues from 13 new stores opened or acquired, net of six closed stores, since the end of 2011. We believe the decrease in comparable store sales is primarily attributable to the following: (a) a significant decrease in national television advertising to children as compared to the prior year; and (b) our messaging in new commercials being focused primarily on our new brand, without complementary messaging related to our value propositions and reasons to visit Chuck E. Cheese's. We continue to believe that families' concerns about unemployment levels and costs of non-discretionary items cause our customers to be more cautious about how they spend their discretionary income. Competition for families' food and entertainment dollars continues to increase. Additionally, our sales may have been impacted by certain changes in our pricing strategy, including a reduction in the circulation of certain coupons, a reduction in the discounts offered on certain coupons and changes in the types of coupons issued. Lastly, we believe the decrease in comparable store sales may be attributed, in part, to the impact of record warm weather in the Midwest and Northeast, in March 2012, which falls in our most significant quarter. We have refined our strategic plan with the objective of increasing customer traffic in the future, as discussed earlier in Part I, Item 1. "Business - Our Strategic Plan." 32-------------------------------------------------------------------------------- Table of Contents Our Company store sales mix consisted of food and beverage sales totaling 46.7% and entertainment and merchandise sales totaling 53.3% in 2012 compared to 47.7% and 52.3%, respectively, in 2011. We believe that this shift in our sales mix is primarily due to the following: (a) repricing of certain components of our offerings; (b) changing the mix of items included in Packaged Deals and coupons; and (c) modification of our various token offers. These changes were part of our continued effort to rebalance our menu pricing between food and games. We believe that the rebalancing of our menu pricing and our ongoing investment in our games has resulted in more of our guests' average check being allocated to games. Company Store Operating Costs Overall, the Cost of food, beverage, entertainment and merchandise, as a percentage of Total Company store sales, decreased 10 basis points to 15.6% in 2012 from 15.7% in 2011. The decrease primarily related to a decrease in certain commodity costs and price changes, as well as a shift in sales mix from food and beverage sales to entertainment and merchandise sales. Cost of food and beverage, as a percentage of Food and beverage sales, increased 30 basis points to 25.0% in 2012 from 24.7% in 2011. The increase primarily related to a 40 basis point increase in the cost of paper and birthday supplies, partially offset by a reduction of $0.10 per pound, or 5.6%, in the average cost per pound of cheese and a reduction of $0.02, or 4.4%, in the average cost per pound of dough. The total Cost of food and beverage, as a percentage of Food and beverage sales, was also influenced by a shift in sales mix from food and beverage sales to entertainment and merchandise sales related to component and price changes in our Package Deals and tokens. Cost of entertainment and merchandise, as a percentage of Entertainment and merchandise sales, decreased 40 basis points to 7.2% in 2012 from 7.6% in 2011. The percentage of Cost of entertainment and merchandise was favorably impacted by the shift in the sales mix to entertainment and merchandise related to component and price changes in our Package Deals and tokens. Labor expenses, as a percentage of Total Company store sales, increased 70 basis points to 28.0% in 2012 from 27.3% in 2011. The increase primarily related to a 1.2% increase in labor hours and a 0.6% increase in average hourly wage rate, partially offset by a reduction in store incentive compensation attributable to our sales decline. Depreciation and amortization expense for Company-owned stores decreased $2.0 million to $78.8 million in 2012 from $80.8 million in 2011. The decrease primarily related to a reduction in depreciation and amortization expense of approximately $3.0 million associated with our change in the estimated useful lives of certain games, leasehold improvements and various pieces of equipment utilized in our stores implemented at the beginning of the third quarter of 2011. The change in accounting estimate is discussed further in Note 1 "Description of Business and Summary of Significant Accounting Policies" to our Consolidated Financial Statements included in Part II, Item 8. "Financial Statements and Supplementary Data." Advertising Expenses Advertising expenses, as a percentage of Total revenues, increased 10 basis points to 4.4% in 2012 from 4.3% in 2011. The increase is due to increases in production costs for new commercials, costs associated with our new advertising agency and new digital advertising costs, partially offset by a reduction in the frequency of national television advertising to children and frequency of free standing inserts. General and Administrative Expenses General and administrative expenses increased $1.5 million to $53.4 million in 2012 from $51.9 million in 2011. The increase primarily related to investments to modernize our various information technology platforms and infrastructure. Asset Impairments In 2012, we recognized an asset impairment charge of $6.8 million for 18 stores, of which seven stores were previously impaired. In 2011, we recognized an asset impairment charge of $2.7 million for six stores, none of which were previously impaired. We continue to operate all but two of these impaired stores. The impairment charge was based on the determination that these stores were adversely impacted by various economic factors in the markets in which they are located. Management determined that the estimated fair value of certain long-lived assets at these stores (determined from discounted future projected operating cash flows of the stores over their remaining lease term) had declined below their carrying amount. As a result, we recorded an impairment charge to write down the carrying amount of certain property and equipment at these stores to the estimated fair value. For additional information about these impairment charges, refer to Note 4 "Property and Equipment - Asset Impairments" in our Consolidated Financial Statements included in Part II, Item 8. "Financial Statements and Supplementary Data." 33-------------------------------------------------------------------------------- Table of Contents Interest Expense Interest expense increased $0.5 million to $9.4 million in 2012 from $8.9 million in 2011. The increase is primarily due to interest related to new capital leases and an increase in the average outstanding debt balance on our revolving credit facility to $373.9 million in 2012 from $358.9 million in 2011, partially offset by the reduction in our weighted average effective interest rate. Our weighted average interest rate was 1.7% in 2012 compared to 2.0% in 2011, which decreased as a result of the expiration of our interest rate swap contract in May 2011. Income Taxes Our 2012 effective income tax rate decreased to 37.4% in 2012 as compared to 38.3% in 2011. The decrease primarily related to the recognition of uncertain tax positions resulting from favorable settlements and the expirations of statutes of limitations, refund claims filed in connection with prior year federal and state income tax returns, as well as the true-up of prior year's estimated tax provision. The favorable impact of these adjustments was partially offset by an increase in other uncertain tax positions and a decrease in employment related federal income tax credits, as a result of the expiration of certain credits in 2012. Diluted Earnings Per Share Diluted earnings per share decreased to $2.47 per share in 2012 compared to $2.88 per share in 2011. The decrease was primarily due to an $11.4 million, or 20.7%, decrease in net income, significantly offset by the decrease in the number of weighted average diluted shares outstanding in 2012 as compared to 2011. The decrease in the weighted average diluted shares outstanding was impacted by our repurchase of 2.7 million shares of our common stock since the beginning of the 2011 fiscal year. We estimate stock repurchases benefited our earnings per share in 2012 by approximately $0.17. Our estimate is based on the weighted average number of shares repurchased since the beginning of the 2011 fiscal year and includes consideration of the estimated additional interest expense attributable to increased borrowings under our revolving credit facility to finance any repurchases. Our computation does not include the effect of share repurchases prior to the 2011 fiscal year, or the effect of the issuance of restricted stock subsequent to the beginning of the 2011 fiscal year. 34-------------------------------------------------------------------------------- Table of Contents Financial Condition, Liquidity and Capital Resources Overview of Liquidity We finance our business activities through cash flows provided by our operations and, as necessary, from borrowings under our revolving credit facility. The primary components of working capital are as follows: • Our store customers pay for their purchases in cash or credit cards at the time of the sale, and the cash from these sales is typically received before our related accounts payable to suppliers and employee payroll becomes due; • Frequent inventory turnover results in a limited investment required in inventories; and • Our accounts payable are generally due within five to 30 days. As a result of these factors, our requirement for working capital is not significant and we are able to operate with a net working capital deficit (current liabilities in excess of current assets). The following tables present summarized consolidated financial information that we believe is helpful in evaluating our liquidity and capital resources: Fiscal Year 2013 2012 2011 (in thousands) Net cash provided by operating activities $ 138,664 $ 137,092 $ 177,233 Net cash used for investing activities (70,942 ) (98,903 ) (94,652 ) Net cash used for financing activities (66,031 ) (37,285 ) (82,973 ) Effect of foreign exchange rate changes on cash (641 ) 59 (204 ) Change in cash and cash equivalents $ 1,050 $ 963 $ (596 ) Interest paid $ 7,798 $ 9,419 $ 9,081 Income taxes paid, net $ 31,614 $ 27,598 $ 6,592 At Year End 2013 2012 (in thousands) Cash and cash equivalents $ 20,686 $ 19,636 Revolving credit facility borrowings $ 361,500 $ 389,500 Available unused commitments under revolving credit facility $ 127,600 $ 100,100 Funds generated by our operating activities, available cash and cash equivalents and, as necessary, borrowings from our revolving credit facility continue to be our primary sources of liquidity. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to finance our strategic plan and capital initiatives for the next year. Our revolving credit facility is also available for additional working capital needs and investment opportunities. However, in the event of a material decline in our sales trends or operating margins, there can be no assurance that we will generate sufficient cash flows at or above our current levels. Although we are in compliance with the debt covenants associated with our revolving credit facility, our ability to access our revolving credit facility is subject to our continued compliance with the terms and conditions of the credit facility agreement, including our compliance with certain prescribed financial ratio covenants, as more fully described below. Our primary uses for cash provided by operating activities relate to funding our ongoing business activities, planned capital expenditures and servicing our debt. Our cash and cash equivalents totaled $20.7 million and $19.6 million as of December 29, 2013 and December 30, 2012, respectively. Cash and cash equivalents as of December 29, 2013 and December 30, 2012 includes $8.2 million and $7.8 million, respectively, of undistributed income from our Canadian subsidiary that we consider to be permanently invested. 35-------------------------------------------------------------------------------- Table of Contents Our strategic plan does not require that we enter into any material development or contractual purchase obligations. Therefore, we have the flexibility necessary to manage our liquidity by promptly deferring or curtailing any planned capital spending. In 2014, our planned capital spending includes new store development, existing store improvements, improvements to our various information technologies platforms and other capital initiatives. Sources and Uses of Cash - Fiscal Year 2013 Compared to Fiscal Year 2012 Net cash provided by operating activities was relatively flat at $138.7 million in 2013 compared to $137.1 million in 2012. During 2013 and 2012, we benefitted from federal bonus tax depreciation for qualifying capital additions and the federal Work Opportunity Tax Credit, which both expired at the end of 2013. As a result, our cash payments for income taxes will increase in future years barring a retroactive extension of these provisions. Net cash used in investing activities decreased $28.0 million to $70.9 million in 2013 from $98.9 million in 2012. The decrease primarily related to a reduction in the number of store expansions and other capital initiatives completed, as well as recognizing cash proceeds from the sale of a property. Net cash used in financing activities increased $28.7 million to $66.0 million in 2013 from $37.3 million in 2012. The increase primarily related to net repayments of $28.0 million on our revolving credit facility in 2013 compared to net repayments of $0.1 million on our revolving credit facility in 2012 and a $3.7 million increase in repurchases of our common stock, partially offset by a $2.7 million decrease in dividend payments. Sources and Uses of Cash - Fiscal Year 2012 Compared to Fiscal Year 2011 Net cash provided by operating activities decreased $40.1 million to $137.1 million in 2012 from $177.2 million in 2011. The decrease was primarily attributable to a $9.0 million refund of federal income tax reported on our 2010 income tax return received in the first quarter of 2011 and an increase in the amount of estimated tax payments required for 2012 income taxes. The remaining decrease in cash provided by operating activities related to a decrease in net income and changes in our working capital. Our cash interest payments increased $0.3 million to $9.4 million in 2012 from $9.1 million in 2011. The increase primarily related to higher average outstanding debt balances on our revolving credit facility of $373.9 million in fiscal 2012 as compared to $358.9 in fiscal 2011, partially offset by a decrease in the weighted average interest rate incurred from 2.0% to 1.7% on our borrowings under our revolving credit facility. The decrease in the weighted average interest rate was associated with the expiration of the interest rate swap agreement in May 2011. Our cash payments for income taxes, net of refunds received, increased $21.0 million to $27.6 million in 2012 from $6.6 million in 2011. The increase primarily related to the receipt in 2011 of refunds of $9.0 million in federal income taxes related to our 2010 tax year and a $15.0 million increase of estimated tax payments required for 2012 federal income taxes, partially offset by a $3.0 million reduction in the amount of other income tax payments. The reduced amount of tax payments and the increase in refunds related to our 2010 and 2011 tax years largely resulted from more favorable bonus tax depreciation rules in effect from September 2010 through December 2011. Bonus depreciation for qualifying capital additions placed in service in 2012 was less favorable and was scheduled to expire at the end of 2012. However in January 2013, bonus depreciation for qualifying capital additions placed in service in 2013 was extended, and thus, we will continue to benefit from bonus depreciation through 2013. Net cash used in investing activities increased $4.2 million to $98.9 million in 2012 from $94.7 million in 2011. The increase primarily related to an increase in the number of new or relocated stores opened or acquired in 2012 compared to 2011, partially offset by a reduction of $24.7 million in spending on existing stores in 2012. Capital spending for our existing stores affected 125 stores during 2012 compared to 181 stores during 2011. Additionally, during 2012 we opened 13 new stores, including three relocated stores and one acquired from a franchisee, while in 2011 we opened four new stores, including two relocations. Net cash used in financing activities decreased $45.7 million to $37.3 million in 2012 from $83.0 million in 2011. The decrease primarily related to a $65.4 million decrease in repurchases of our common stock, partially offset by an $8.4 million increase in dividend payments and net repayments of $0.1 million on our revolving credit facility in 2012 compared to net proceeds of $12.6 million on our revolving credit facility in 2011. 36-------------------------------------------------------------------------------- Table of Contents Debt Financing We maintain a $500.0 million revolving credit facility under a credit agreement dated October 28, 2011, with a syndicate of lenders. The revolving credit facility is a senior unsecured credit commitment, which matures in October 2016. The revolving credit facility includes an accordion feature allowing us, subject to meeting certain conditions and lender approval, to request an increase to the revolving commitment of up to $200.0 million in borrowings at any time. Based on the type of borrowing, the revolving credit facility bears interest at the one month London Interbank Offered Rate ("LIBOR") plus an applicable margin of 0.875% to 1.625%, determined based on our financial performance and debt levels, or alternatively, the highest of (a) the Prime Rate, (b) the Federal Funds rate plus 0.50%, or (c) one-month LIBOR plus 1.0%; plus an applicable margin of up to 0.625%, determined based on our financial performance and debt levels. During 2013, the Prime Rate was 3.25% and the one-month LIBOR rate ranged from 0.16% to 0.24%. The revolving credit facility also requires us to pay a commitment fee on a quarterly basis ranging from 0.15% to 0.30%, depending on our financial performance and debt levels on any unused portion of our revolving credit facility. All borrowings under our revolving credit facility are unsecured, but we agreed not to pledge any of our existing assets to secure any other future indebtedness. We have the unrestricted ability to pay dividends and repurchase shares of our common stock under our revolving credit facility, provided that our consolidated leverage ratio, as defined in the revolving credit facility, does not exceed 2.75 to 1.0 on a proforma basis, for the four fiscal quarters then most recently ended, immediately after giving effect to such payments or repurchases. As of December 29, 2013, we had $361.5 million of borrowings outstanding and $10.9 million of letters of credit, issued but undrawn, under our revolving credit facility. The weighted average effective interest rate incurred on our borrowings under our credit facilities was 1.7% for the year ended December 29, 2013. Our revolving credit facility contains a number of covenants that, among other things, require us to comply with the following financial ratios as of the end of any fiscal quarter: • a consolidated fixed charge coverage ratio of not less than 1.5 to 1.0, based upon the ratio of (a) consolidated earnings before interest, income taxes and rents ("EBITR") for the last four fiscal quarters to (b) the sum of consolidated interest charges plus consolidated rent expense during such period. Consolidated EBITR, as defined in the revolving credit facility, equals net income plus consolidated interest charges, income taxes, stock-based compensation expense, rent expense and other non-cash charges, reduced by non-cash income. • a consolidated leverage ratio of not greater than 3.0 to 1.0, based upon the ratio of (a) the quarter-end consolidated funded indebtedness (as defined in the revolving credit facility) to (b) consolidated EBITDA for the last four fiscal quarters. Consolidated EBITDA, as defined in the revolving credit facility, equals our consolidated EBITR adjusted to exclude the cash portion of rent expense plus depreciation and amortization. Our revolving credit facility is the primary source of committed funding from which we finance our planned capital expenditures, repurchase our common stock and provide for our working capital needs. Non-compliance with the financial covenant ratios could prevent us from being able to access further borrowings under our revolving credit facility, require us to immediately repay all amounts outstanding under the revolving credit facility and increase our cost of borrowing. As of December 29, 2013, we were in compliance with these covenant ratios, with a consolidated fixed charge coverage ratio of 2.05 to 1.0 and a consolidated leverage ratio of 2.23 to 1.0, and we expect to remain in compliance for the next twelve months. For information on the proposed financing related to our pending Merger, see our Solicitation/Recommendation Statement on Schedule 14D-9 (as may be amended) filed with the SEC on January 22, 2014. Such financing will not occur if the Merger is not completed. 37-------------------------------------------------------------------------------- Table of Contents Cash Dividends The table below presents dividends declared during 2013 and 2012: Dividend Dividend Payable Payable Per Total Amount of Declaration Date Record Date Date Share Dividends Declared (in millions) February 19, 2013 March 21, 2013 April 18, 2013 $ 0.24 $ 4.3 April 30, 2013 June 6, 2013 July 2, 2013 0.24 4.2 July 29, 2013 September 5, 2013 October 3, 2013 0.24 4.2 October 29, 2013 December 5, 2013 December 27, 2013 0.27 4.7 $ 0.99 $ 17.4 Dividend Dividend Payable Payable Per Total Amount of Declaration Date Record Date Date Share Dividends Declared (in millions) February 21, 2012 March 22, 2012 April 19, 2012 $ 0.22 $ 4.0 May 1, 2012 June 7, 2012 July 5, 2012 0.22 3.9 July 31, 2012 September 6, 2012 October 4, 2012 0.22 4.0 October 30, 2012 December 6, 2012 December 27, 2012 0.24 4.3 $ 0.90 $ 16.2 In accordance with the Merger Agreement, our ability to declare dividends is restricted. If the Merger is not completed, we will continue to base future dividend decisions on a number of factors, including our consolidated operating results, financial condition and debt covenants that affect our ability to pay dividends. See further discussion of the Merger in Part I, Item 1. "Business - Merger Agreement" and Part II, Item 8. "Financial Statements and Supplementary Data - Note 13. Subsequent Events" of this Annual Report on Form 10-K. Pursuant to our current revolving credit facility agreement, there are restrictions on the amount of cash dividends that we may pay on our common stock. See the discussion of our current revolving credit facility agreement included above in "Debt Financing." See Part I, Item 1A. "Risk Factors" for a discussion of factors that might affect our financial performance and compliance with debt covenants, including covenants that affect our ability to pay dividends. 38-------------------------------------------------------------------------------- Table of Contents Capital Expenditures Capital expenditures for 2013 totaled $74 million, including $19 million related to capital initiatives for our existing stores, $32 million related to new store development and the remainder of $23 million related to other store initiatives, general store requirements and corporate capital expenditures. The following table summarizes information regarding the number of completed capital spending initiatives and the approximate total capital spend for those completed initiatives for the periods presented: Fiscal Year 2013 2012 2011 Investment in existing Company-owned stores: Game enhancements 150 94 137 Major remodels 6 6 11 Store expansions 6 25 33 Total completed 162 125 181 Total capital spend on completed existing Company-owned stores (in millions) $ 19 $ 40 $ 65 Company-owned stores added (1) 13 13 4 Total capital spend on completed new Company-owned stores (in millions) $ 32 $ 35 $ 10 _______________________(1) Company-owned stores added during 2013 included one store we relocated. Company-owned stores added during 2012 included three stores we relocated and one store acquired from a franchisee. Company-owned stores added during 2011 included two stores we relocated. New Company store development. Our plan for new store development is primarily focused on opening high sales volume stores in densely populated areas. We expect the cost of opening a new store will vary depending upon many factors, including the existing real estate market, the size of the store, whether we acquire land and whether the store is located in an in-line or freestanding building. Existing stores. We believe that in order to maintain consumer demand and the appeal of our concept, we must continue to reinvest in our existing stores. For our existing stores, we utilize the following capital initiatives: (a) game enhancements; (b) major remodels; and (c) store expansions. Game enhancements. Game enhancements include replacing a portion of a store's games and rides with new and refurbished equipment. We believe game enhancements are necessary to maintain the relevance and appeal of our games and rides. In addition, game enhancements counteract general wear and tear on the equipment and incorporate improvements in game ride technology. During the second quarter of 2013, we enhanced our existing store capital strategy to reduce the cost of game enhancements by utilizing more used and transferred games and rides in combination with new games and rides. This revised plan will allow us to perform a game enhancement at a store, generally, every two years for approximately half the cost of our historical game enhancements on a per store basis. We are testing a number of major attractions that will be incorporated into game enhancements, which we expect will add approximately $3 million to $4 million to the total cost of game enhancements in 2014. Major remodels. We undertake periodic major remodels when there is a need to improve the overall appearance or layout of a store or when we introduce concept changes or enhancements in our stores. A major remodel initiative typically includes interior design modifications that allow us to more effectively utilize space allocated to the gameroom area of the store, increase the number of games and rides and modify or develop a new exterior and interior identity. Store expansions. We believe store expansions improve the quality of our guests' experience because the additional square footage allows us to increase the number and variety of games, rides and other entertainment offerings in the expanded stores. In addition to expanding the square footage of a store, store expansions typically include all components of a major remodel and result in an increase in the store's seat count. We consider our investments in store expansions generally to be discretionary in nature. In undertaking store expansions, our objective is to improve the appeal of our stores and to capture sales growth opportunities as they arise. 39-------------------------------------------------------------------------------- Table of Contents Since the lifecycles of our store format and our games are largely driven by changes in consumer behaviors and preferences, we believe that our capital initiatives involving major remodels and game enhancements are strategic investments required in order to keep pace with consumer entertainment expectations. As a result, we view our major remodel and game enhancement initiatives as a means to maintaining and protecting our existing sales and cash flows over the long-term. While we are hopeful that our major remodels and game enhancements will contribute to incremental sales growth, we believe that our capital spending with respect to expansions of existing stores will more directly lead to growth in our comparable store sales and cash flow. We typically invest in expansions when we believe there is a potential for sales growth and, in some instances, in order to maintain sales in stores that have competitors in their market. We believe that expanding the square footage and entertainment space of a store increases our customer traffic and enhances the overall customer experience, which we believe will contribute to the growth of our long-term comparable store sales. The objective of an expansion or remodel that increases space available for entertainment is not intended to exclusively improve our entertainment sales, but rather is focused on impacting overall Company store sales through increased customer traffic and satisfaction. Fiscal 2014 Capital Plan We have funded and expect to continue to fund our capital expenditures through existing cash flows from operations and, if necessary, borrowings under our revolving credit facility. We currently estimate that total capital expenditures for 2014 will be approximately $75 million to $80 million, including (a) approximately $37 million related to new store development; (b) approximately $29 million related to capital initiatives for our existing stores; and (c) the remainder for other store initiatives, general store requirements and other corporate capital expenditures. As discussed above, we currently plan to open 12 to 15 new stores in 2014 at an average cost of approximately $2.47 million per store. New store growth will include a combination of opening new stores, acquiring franchise stores and relocating existing stores. We continually reassess the need for capital investment in our existing stores in light of each store's current condition. The following tables summarize information regarding the expected number of, and estimated average cost for, our projected capital expenditures activities in fiscal 2014: Projected Estimated Completions Average Projected In Cost Total Costs Fiscal 2014 Per Project In Fiscal 2014 (in millions, except projected completions) Investment in existing Company-owned stores: Game enhancements 250 $ 0.06 $ 15 Major remodels 8 $ 0.65 $ 5 Store expansions 5 $ 1.00 $ 5 Major attractions - - $ 4 Total 263 $ 29 New Company store development (1) 15 $ 2.47 $ 37 _______________________ (1) New Company store development projected for fiscal year 2014 includes three store relocations and one franchise acquisition. As described in Part I, Item 1. "Business", on January 15, 2014, the Company entered into the Merger Agreement. The above 2014 capital plan presumes the Company's continuation as an independent company, which may not be the case if the Company is acquired. If the Company is acquired, plans for the Company may differ from those set forth above. See Part I. Item 1. "Business" for a description of the Merger Agreement. 40-------------------------------------------------------------------------------- Table of Contents Share Repurchases On April 30, 2013, our Board authorized a $100 million increase to our existing Board approved stock repurchase program. During 2013, we repurchased 526,246 shares of our common stock at an average purchase price of $34.42 per share for an aggregate purchase price of $18.1 million. As of December 29, 2013, $128.9 million remained available for us to repurchase shares of our common stock in the future, under our approved stock repurchase program. In accordance with the Merger Agreement, our ability to repurchase shares of our common stock is restricted. If the Merger is not completed, we will continue to base future stock repurchase decisions on a number of factors, including our working capital needs, our debt repayment obligations, the market price of our common stock and economic and market conditions. Our stock repurchase program does not have an expiration date, and repurchases may be effected from time to time through open market purchases, accelerated share repurchases or in privately negotiated transactions. Although there are no current plans to modify the implementation of our stock repurchase program, our Board may elect to accelerate, expand, suspend, delay or discontinue the program at any time. See further discussion of the Merger in Part I, Item 1. "Business - Merger Agreement" and Part II, Item 8. "Financial Statements and Supplementary Data - Note 13. Subsequent Events" of this Annual Report on Form 10-K. Pursuant to our current revolving credit facility agreement, there are restrictions on the amount of our common stock we may repurchase. See the discussion of our current revolving credit facility included above in "Debt Financing." 41-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements and Contractual Obligations As of December 29, 2013, we had no off-balance sheet financing arrangements as described in Regulation S-K Item 303(a)(4)(ii). The following table summarizes our contractual cash obligations as of December 29, 2013: Payments Due by Period Less than 1 - 3 3 - 5 More than Total 1 Year Years Years 5 Years (in thousands) Operating leases (1) $ 1,125,862 $ 82,055 $ 165,047 $ 162,674 $ 716,086 Capital leases 37,243 2,634 5,039 5,367 24,203 Purchase obligations (2) 28,365 24,056 1,359 1,459 1,491 Revolving credit facility 361,500 - 361,500 - - Interest obligations (3) 17,036 5,997 11,039 - - Uncertain tax positions (4) 645 645 - - - $ 1,570,651 $ 115,387 $ 543,984 $ 169,500 $ 741,780 _______________________(1) Includes the initial non-cancelable term plus renewal option periods provided for in the lease that can be reasonably assured but excludes contingent rent obligations and obligations to pay property taxes, insurance and maintenance on the leased assets. (2) A "purchase obligation" is defined as an agreement to purchase goods or services that is enforceable and legally binding on us and that specifies all significant terms, including (a) fixed or minimum quantities to be purchased; (b) fixed, minimum or variable price provisions; and (c) the approximate timing of the transaction. Our purchase obligations primarily consist of obligations for the purchase of merchandise and entertainment inventory and obligations associated with the modernization of various information technology platforms. The above purchase obligations exclude agreements that are cancelable without significant penalty. (3) Interest obligations represent an estimate of future interest payments under our revolving credit facility. We calculated the estimate based on (a) terms of the revolving credit facility agreement and (b) using a 1.7% weighted average interest rate incurred on outstanding borrowings as of December 29, 2013. Our estimate assumes that we will maintain the same levels of indebtedness and financial performance through the credit facility's maturity in October 2016. (4) Due to the uncertainty related to the settlement of uncertain tax positions, only the current portion of the liability for unrecognized tax benefits has been provided in the table above. The noncurrent portion of $2.0 million is excluded from the table above. As of December 29, 2013, capital expenditures totaling $5.5 million were outstanding and included in accounts payable. These amounts are expected to be paid in less than one year. The total estimate of accrued liabilities for our self-insurance programs was $20.2 million as of December 29, 2013. We estimate that $7.0 million of these liabilities will be paid in fiscal 2014 and the remainder paid in fiscal 2015 and beyond. Due to the nature of the underlying liabilities and the extended period of time often experienced in resolving insurance claims, we cannot make reliable estimates of the timing of cash payments to be made in the future for our obligations related to our insurance liabilities. Therefore, no amounts for such liabilities have been included in the table above. As of December 29, 2013, there were $10.9 million of letters of credit issued but undrawn under our revolving credit facility. We utilize standby letters of credit primarily for our self-insurance programs. These letters of credit do not represent additional obligations of the Company since the underlying liabilities are already recorded in accrued liabilities. However, if we were unable to pay insurance claims when due, our insurance carrier could make demand for payment pursuant to these letters of credit. As of December 29, 2013, we had dividends payable of $0.9 million, which will be paid when the restricted stock associated with the declared cash dividends vest, which is generally over four years. Pursuant to the Merger Agreement, the Company agreed that shares of restricted stock subject to vesting requirements will automatically vest in connection with the Merger and, at the effective time of the Merger, each such share of restricted stock shall be cancelled and converted into the right to receive an amount equal to the Offer Price plus an amount in cash equal to all accrued but unpaid dividends relating to such shares, without interest and less any withholding required by applicable tax laws. For information on the proposed financing related to our pending Merger, see our Solicitation/Recommendation Statement on Schedule 14D-9 (as may be amended) filed with the SEC on January 22, 2014. Such financing will not occur if the Merger is not completed. We enter into various purchase agreements in the ordinary course of business and have fixed price agreements and contracts with "spot" market prices primarily relating to food and beverage products. Other than the purchase obligation included in the above table, we do not have any material contracts (either individually or in the aggregate) in place committing us to a minimum or fixed level of purchases or that are cancelable subject to significant penalty. 42-------------------------------------------------------------------------------- Table of Contents Inflation Our cost of operations, including but not limited to labor, food products, supplies, utilities, financing and rental costs, can be significantly affected by inflationary factors. Critical Accounting Policies and Estimates Our Consolidated Financial Statements are prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amount of our assets and liabilities at the date of our Consolidated Financial Statements, the reported amount of revenues and expenses during the reporting period and the related disclosures of contingent assets and liabilities. The use of estimates is pervasive throughout our Consolidated Financial Statements and is affected by management judgment and uncertainties. Our estimates, assumptions and judgments are based on historical experience, current market trends and other factors that we believe to be relevant and reasonable at the time our Consolidated Financial Statements were prepared. We continually evaluate the information used to make these estimates as our business and the economic environment change. Actual results could differ materially from these estimates under different assumptions or conditions. The significant accounting policies used in the preparation of our Consolidated Financial Statements are described in Note 1 "Description of Business and Summary of Significant Accounting Policies" included in Part II, Item 8. "Financial Statements and Supplementary Data." We consider an accounting policy or estimate to be critical if it requires difficult, subjective or complex judgments and is material to the portrayal of our consolidated financial condition, changes in financial condition or results of operations. The selection, application and disclosure of the critical accounting policies and estimates have been reviewed by the Audit Committee of our Board of Directors. Our accounting policies and estimates that our management considers most critical are as follows: Estimation of Reserves The amount of liability we record for claims related to insurance and tax reserves requires us to make judgments about the amount of expenses that will ultimately be incurred. We use history and experience, as well as other specific circumstances surrounding these contingencies, in evaluating the amount of liability that should be recorded. As additional information becomes available, we assess the potential liability related to various claims and revise our estimates as appropriate. These revisions could materially impact our consolidated results of operations, financial position or liquidity. Self-Insurance reserves. We are self-insured for certain losses related to workers' compensation, general liability, property, and company-sponsored employee health plans. Liabilities associated with risks retained by the Company are estimated primarily using historical claims experience, current claims data, demographic and severity factors, other factors deem relevant by us, as well as information provided by independent third-party actuaries. To limit our exposure for certain losses, we purchase stop-loss or high-deductible insurance coverage through third-party insurers. Our stop-loss limit or deductibles for workers' compensation, general liability, property, and company-sponsored employee health plans, generally range from $0.2 million to $0.5 million per occurrence. As of December 29, 2013, our total estimate of accrued liabilities for our self-insurance and high deductible plan programs was $20.2 million. We estimate $7.0 million of these liabilities will be paid in fiscal 2014 and the remainder paid in fiscal 2015 and beyond. If actual claims trends or other factors differ from our estimates, our financial results could be significantly impacted. 43-------------------------------------------------------------------------------- Table of Contents Income tax reserves. We are subject to audits from multiple domestic and foreign tax authorities. We maintain reserves for federal, state and foreign income taxes when we believe a position may not be fully sustained upon review by taxing authorities. Although we believe that our tax positions are fully supported by the applicable tax laws and regulations, there are matters for which the ultimate outcome is uncertain. We recognize the benefit from an uncertain tax position in our Consolidated Financial Statements when the position is more-likely-than-not (a greater than 50 percent chance of being sustained). The amount recognized is measured using a probability weighted approach and is the largest amount of benefit that is greater than 50 percent likelihood of being realized upon settlement or ultimate resolution with the taxing authority. We routinely assess the adequacy of the estimated liability for unrecognized tax benefits, which may be affected by changing interpretations of laws, rulings by tax authorities and administrative policies, certain changes and/or developments with respect to audits and expirations of the statute of limitations. Depending on the nature of the tax issue, the ultimate resolution of an uncertain tax position may not be known for a number of years; therefore, the estimated reserve balances could be included on our Consolidated Balance Sheets for multiple years. To the extent that new information becomes available that causes us to change our judgment regarding the adequacy of a reserve balance, such a change will affect our income tax expense in the period in which the determination is made and the reserve is adjusted. Significant judgment is required to estimate our provision for income taxes and liability for unrecognized tax benefits. At December 29, 2013, the reserve for uncertain tax positions (unrecognized tax benefits) was $2.6 million. Although we believe our approach is appropriate, there can be no assurance that the final outcome resulting from a tax authority's review will not be materially different than the amounts reflected in our estimated tax provision and tax reserves. If the results of any audit materially differ from the liabilities we have established for taxes, there would be a corresponding impact to our Consolidated Financial Statements, including the liability for unrecognized tax benefits, current tax provision, effective tax rate, net after tax earnings and cash flows, in the period of resolution. Impairment of Long-Lived Assets We review our property and equipment for indicators of impairment on an ongoing basis at the lowest reporting unit level, which is on a store-by-store basis, to assess if the carrying amount may not be recoverable. Such events or changes may include a significant change in the business climate in a particular market area (for example, due to economic downturn or natural disaster), historical negative cash flows or plans to dispose of or sell the property and equipment before the end of its previously estimated useful life. If an event or change in circumstances occurs, we estimate the future cash flows expected to result from the use of the property and equipment and its eventual disposition. If the sum of the expected future cash flows, undiscounted and without interest, is less than the asset carrying amount (an indication that the carrying amount may not be recoverable), we may be required to recognize an impairment loss. We estimate the fair value of a store's property and equipment by discounting the expected future cash flows of the store over its remaining lease term using a weighted average cost of capital commensurate with the risk. The following estimates and assumptions used in the discounted cash flow analysis impact the fair value of a store's long-lived assets: • Discount rate based on our weighted average cost of capital and the risk-free rate of return; • Sales growth rates and cash flow margins over the expected remaining lease terms; • Strategic plans, including projected capital spending and intent to exercise renewal options, for the store; • Salvage values; and • Other risks and qualitative factors specific to the asset or conditions in the market in which the asset is located at the time the assessment was made. During 2013, the average discount rate, average sales growth rate and average cash flow margin rate used were 8%, 0.2% and 11%, respectively. We believe our assumptions in calculating the fair value of our long-lived assets are similar to those used by other marketplace participants. If actual results are not consistent with our estimates and assumptions, we may be exposed to additional impairment charges, which could be material to our Consolidated Statements of Earnings. 44-------------------------------------------------------------------------------- Table of Contents Accounting for Leases The majority of our stores are leased. The terms of our store leases vary in length from lease to lease, although a typical lease provides for an initial primary term of 10 years with two additional five year options to renew. We estimate the expected term of a lease by assuming the exercise of renewal options, in addition to the initial non-cancelable lease term, if the renewal is reasonably assured. Generally, reasonably assured relates to our contractual right to renew and the existence of an economic penalty that would preclude the abandonment of the lease at the end of the initial non-cancelable lease term. The expected term is used in the determination of whether a lease is a capital or operating lease and in the calculation of straight-line rent expense. Additionally, the useful life of leasehold improvements is limited by the expected lease term or the economic life of the asset, whichever is shorter. If significant expenditures are made for leasehold improvements late in the expected term of a lease and renewal is reasonably assured, the useful life of the leasehold improvement is limited to the end of the reasonably assured renewal period or economic life of the asset. The determination of the expected term of a lease requires us to apply judgment and estimates concerning the number of renewal periods that are reasonably assured. If a lease is terminated prior to reaching the end of the expected term, this may result in the acceleration of depreciation or impairment of a store's long-lived assets, and it may result in the accelerated recognition of landlord contributions and the reversal of deferred rent balances that assumed higher rent payments in renewal periods that were never ultimately exercised by us. Recently Issued Accounting Guidance See Note 1 "Description of Business and Summary of Significant Accounting Policies" to our Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" for a description of new accounting standards and their anticipated effects on our Consolidated Financial Statements. ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. We are exposed to various types of market risk in the normal course of business, including the impact of interest rates, commodity price changes and foreign currency fluctuations. Interest Rate Risk We are exposed to market risk from changes in the variable interest rates (primarily LIBOR) related to borrowings from our revolving credit facility. Our borrowings outstanding as of December 29, 2013 of $361.5 million are variable rate debt that is exposed to market risk. A hypothetical increase of 100 basis points in variable interest rates, assuming no change in our outstanding debt balance, would have increased annual interest expense by approximately $3.6 million for the year ended December 29, 2013. Commodity Price Risk We are exposed to commodity price changes related to certain food products that we purchase, primarily related to the prices of cheese and dough, which can vary throughout the year due to changes in supply, demand and other factors. We have not entered into any hedging arrangements to reduce our exposure to commodity price volatility associated with such commodity prices; however, we typically enter into short-term cancellable purchasing contracts, which may contain pricing arrangements designed to minimize the impact of commodity price fluctuations. For 2013, the weighted average cost of a block of cheese was $1.75. The estimated increase in our food costs from a hypothetical 10% increase in the average cost of a block of cheese would have been approximately $1.3 million for the year ended December 29, 2013. For 2013, the weighted average cost of dough per pound was $0.41. The estimated increase in our food costs from a hypothetical 10% increase in the average price of dough per pound would have been approximately $0.4 million for the year ended December 29, 2013. Foreign Currency Risk We are exposed to foreign currency fluctuation risk associated with changes in the value of the Canadian dollar relative to the United States dollar, as we operate a total of 14 Company-owned stores in Canada. For the year ended December 29, 2013, our Canadian stores represented less than 0.1% of our consolidated operating income. Changes in the currency exchange rate result in cumulative translation adjustments and are included in "Accumulated other comprehensive income" and potentially result in transaction gains or losses, which are included in our earnings. The low and high currency exchange rates for a Canadian dollar into a United States dollar for the year ended December 29, 2013 were $0.9336 and $1.0166, respectively. A hypothetical 10% devaluation in the average quoted United States dollar-equivalent of the Canadian dollar exchange rate during the year ended December 29, 2013 would have reduced our reported consolidated operating income by less than $0.1 million. 45-------------------------------------------------------------------------------- Table of Contents |