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APPB > SEC Filings for APPB > Form 10-Q on 28-Jul-2005All Recent SEC Filings

Show all filings for APPLEBEES INTERNATIONAL INC

Form 10-Q for APPLEBEES INTERNATIONAL INC


28-Jul-2005

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Restatement of Financial Statements

The accompanying Management's Discussion and Analysis gives effect to the restatement of our condensed consolidated financial statements for quarterly and year-to-date information in 2004 to correct our accounting treatment for leases, depreciation of related leasehold improvements and for previously identified immaterial errors, primarily related to vacation and workers' compensation, as described in Note 2 to the condensed consolidated financial statements.

General

We operate on a 52 or 53 week fiscal year ending on the last Sunday in December.
Our fiscal years and fiscal periods are as follows:

                                                                    Number
          Fiscal Year                  Fiscal Year End             of Weeks
------------------------------      ---------------------      ----------------
             2004                     December 26, 2004               52
             2005                     December 25, 2005               52
             2006                     December 31, 2006               53

                                                                    Number
         Fiscal Period                Fiscal Period End            of Weeks
------------------------------      ---------------------      ----------------
         2004 Quarter                   June 27, 2004                 13
         2005 Quarter                   June 26, 2005                 13
   2004 Year-to-date period             June 27, 2004                 26
   2005 Year-to-date period             June 26, 2005                 26

Our revenues are generated from three primary sources:

o Company restaurant sales (food and beverage sales)
o Franchise royalties and fees
o Other franchise income

Beverage sales consist of sales of alcoholic beverages, while non-alcoholic beverages are included in food sales. Franchise royalties are generally 4% of each franchise restaurant's monthly gross sales. Franchise fees typically range from $30,000 to $35,000 for each restaurant opened. Other franchise income includes insurance premiums for the current year and premium audit adjustments for prior years from franchisee participation in our captive insurance program and revenue from information technology products and services provided to certain franchisees. In fiscal 2005, we have fewer franchisee participants in the captive insurance program due to the termination of one of our captive programs, which will result in a decrease in franchise premiums recognized in other franchise income of approximately $9,500,000.

Certain expenses relate only to company operated restaurants. These include:

o Food and beverage costs
o Labor costs
o Direct and occupancy costs
o Pre-opening expenses

Cost of other franchise income includes the costs related to franchisee participation in our captive insurance program and costs related to information technology products and services provided to certain franchisees. In fiscal 2005, we have fewer franchisee participants in the captive insurance program due to the termination of one of our captive programs, which will result in a decrease in franchise premiums expense in the cost of other franchise income of approximately $9,500,000.

Other expenses, such as general and administrative and amortization expenses, relate to both company operated restaurants and franchise operations.

Overview

Applebee's International, Inc. and our subsidiaries develop, franchise and operate casual dining restaurants under the name "Applebee's Neighborhood Grill & Bar" which is the largest casual dining concept in the world with over 1,700 system-wide restaurants open as of June 26, 2005. The casual dining segment of the restaurant industry is highly competitive and there are many factors that affect our profitability. Our industry is susceptible to changes in economic conditions, trends in lifestyles, fluctuating costs, government regulation, availability of resources and consumer perceptions. When evaluating and assessing our business, we believe there are five key factors:

o Development - the number of new company and franchise restaurants opened during the period. As the largest casual dining concept in the world, Applebee's has a unique opportunity to leverage our brand, system size and scale to optimize our future growth. Our expansion strategy has been to cluster restaurants in targeted markets, thereby increasing consumer awareness and convenience, and enabling us to take advantage of operational, distribution and advertising efficiencies. We currently expect that the Applebee's system will encompass at least 3,000 restaurants in the United States, as well as the potential for at least 1,000 restaurants internationally. In the 2005 quarter and the 2005 year-to-date period, we and our franchisees opened 30 and 56 restaurants, respectively. We have opened at least 100 restaurants system-wide each year for the past 12 fiscal years. In fiscal 2005, we currently expect to open at least 135 restaurants system-wide, comprised of 50 company and 85 franchise restaurants.

o Comparable restaurant sales - a year-over-year comparison of sales for restaurants open at least 18 months. Our revenues are generated primarily from company restaurant sales, franchise royalties and fees and other franchise income. Increases in company and franchise comparable restaurant sales will result in increases in company restaurant sales and franchise fees and royalties. In the 2005 quarter, company comparable sales decreased 1.2% while franchise and system-wide comparable sales were up 2.5% and 1.6%, respectively. For the 2005 year-to-date period, company comparable sales were down 0.4% while franchise and system-wide comparable sales were up 3.7% and 2.7%, respectively. We have had 28 consecutive quarters of positive system-wide comparable sales growth. We currently expect system-wide comparable restaurant sales to increase by at least 3% in fiscal 2005, with results expected to accelerate in the latter half of the year as comparisons

become easier. Comparable restaurant sales increases are driven by increases in the average guest check and/or increases in guest traffic. Average guest check increases result from menu price increases and/or a change in menu
mix. Although we may have increases in our average guest check from period to period, our main focus has been increasing guest traffic as we view this component to be more indicative of the long-term health of the Applebee's brand. We are constantly seeking to increase guest traffic by focusing on operations and improving our menu with semi-annual new menu rollouts and implementation of new programs such as Carside to Go(TM)and Weight Watchers(TM). Carside To Go(TM)is expected to be a driver of company, franchise and system-wide comparable sales growth in fiscal 2005.

o Company restaurant margin - company restaurant sales less food and beverage, labor, direct and occupancy restaurant costs and pre-opening expenses expressed as a percentage of company restaurant sales. Company restaurant margins were 13.8% and 14.8% in the 2005 quarter and 2005 year-to-date period, respectively. We currently expect full year fiscal 2005 company restaurant margins to be less than full year fiscal 2004 results and will be dependent on comparable sales performance at company restaurants. Company restaurant margins are susceptible to fluctuations in commodity costs, labor costs and other operating costs such as utilities costs. We attempt to negotiate contracts for the majority of our food products in order to mitigate the impact of rising commodity costs. We currently expect commodity costs for beef, poultry and other proteins to increase by approximately 1.5% in fiscal 2005. Labor costs are impacted by many factors, including minimum wage rate and other employment laws.

o General and administrative expenses - general and administrative expense expressed as a percentage of total operating revenues. General and administrative expense leverage is a key focus for us. We currently expect that revenues will grow faster than general and administrative expenses. In fiscal 2005, general and administrative expenses as a percent of total revenues are currently expected to be approximately 9%.

o Return on equity - net earnings expressed as a percent of average stockholders' equity. We believe this is an important indicator as it allows us to evaluate our ability to create value for our shareholders. We have exceeded our stated goal of at least 20% return on equity for the past six years and we are a leader in the casual dining industry in this category.

The above overview contains forward-looking statements. Please refer to "Forward-Looking Statements" later in this section.

Application of Critical Accounting Estimates

Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which were prepared in accordance with accounting principles generally accepted in the United States of America. These principles require us to make estimates and assumptions that affect the reported amounts in the condensed consolidated financial statements and notes thereto. Actual results may differ from these estimates, and such differences may be material to our condensed consolidated financial statements. We believe that the following significant accounting policies involve a significant degree of judgment or complexity.

Inventory valuation: We state inventories at the lower of cost, using the first-in, first-out method, or market. Market is determined based upon our estimates of the net realizable value.

We purchase and maintain inventories of certain specialty products to assure sufficient supplies to the system. We review and make quality control inspections of our inventories to determine obsolescence on an ongoing basis. These reviews require management to make certain estimates and judgments regarding projected usage which may change in the future and may require us to record an inventory impairment.

Property and equipment: We report property and equipment at historical cost less accumulated depreciation. Depreciation is provided on a straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of the lease term or the estimated useful life of the related asset. The useful lives of the assets are based upon management's expectations. We periodically review the assets for changes in circumstances which may impact their useful lives. If there are changes in circumstances that shorten an asset's useful life, we will recognize increased depreciation expense for that asset in future periods.

Impairment of long-lived assets: We periodically review restaurant property and equipment for impairment on a restaurant by restaurant basis using historical cash flows as well as current estimates of future cash flows and/or appraisals. We review other long-lived assets annually and when events or circumstances indicate that the carrying value of the asset may not be recoverable. The recoverability is assessed in most instances by comparing the carrying value to its undiscounted cash flows. This assessment process requires the use of estimates and assumptions regarding future cash flows and estimated useful lives which are subject to a significant degree of judgment. If these assumptions change in the future, we may be required to record impairment charges for these assets.

Income taxes: We record valuation allowances against our deferred tax assets, when necessary, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Realization of deferred tax assets is dependent on future taxable earnings and is therefore uncertain. We assess the likelihood that our deferred tax assets in each of the jurisdictions in which we operate will be recovered from future taxable income. Deferred tax assets do not include future tax benefits that we deem likely not to be realized.

We are periodically audited by foreign, state and local tax authorities for both income and sales and use taxes. We record accruals when we determine it is probable that we have an exposure in a matter relating to an audit. The accruals may change in the future due to new developments in each matter.

Legal and insurance reserves: We are periodically involved in various legal actions. We are required to assess the probability of any adverse judgments as well as the potential range of loss. We determine the required accruals after a review of the facts of each legal action.

We use estimates in the determination of the appropriate liabilities for general liability, workers' compensation and health insurance. The estimated liability is established based upon historical claims data and third-party actuarial estimates of settlement costs for incurred claims. Unanticipated changes in these factors may require us to revise our estimates.

We periodically reassess our assumptions and judgments and make adjustments when significant facts and circumstances dictate. A change in any of the above estimates could impact our consolidated statements of earnings and the related asset or liability recorded in our consolidated balance sheets would be adjusted accordingly. Historically, actual results have not been materially different than the estimates that are described above.

Acquisitions

All of our acquisitions below have been accounted for using the purchase method of accounting and, accordingly, our consolidated financial statements reflect the results of operations for each acquisition subsequent to the date of acquisition. The assets acquired and liabilities assumed are recorded at

estimates of fair values as determined by management based upon information available. We finalize the allocation of purchase price to the fair value of assets acquired and liabilities assumed when we obtain information sufficient to complete the allocation, but in each case, no longer than one year after the acquisition date.

In May 2005, we completed the acquisition of 12 Applebee's restaurants, which included one restaurant under construction, in Missouri, Kansas and Arkansas for approximately $39,500,000. Through June 2005, we have paid approximately $38,900,000, which has been allocated to the fair value of property and equipment of $16,800,000, goodwill of $21,900,000 and other net assets of approximately $200,000. In addition, we expect to pay the remaining $600,000 for property and equipment relating to the completion of construction of one restaurant in the third fiscal quarter of 2005.

The following table is comprised of actual company restaurant sales for the restaurant acquisition above, which are included in our condensed consolidated financial statements for each period presented and pro forma company restaurant sales assuming the acquisition above occurred at the beginning of each respective period (in thousands):

                                                               13 Weeks Ended                  26 Weeks Ended
                                                       ------------------------------- -------------------------------
                                                          June 26,        June 27,        June 26,        June 27,
                                                            2005            2004            2005            2004
                                                       --------------- --------------- --------------- ---------------

Actual acquired company restaurant sales.............    $     2,800     $      --       $     2,800     $      --
                                                       =============== =============== =============== ===============


Pro forma acquired company restaurant sales..........    $     7,300     $     6,700     $    14,400     $    13,400
                                                       =============== =============== =============== ===============

In April 2005, we finalized the acquisition of eight Applebee's restaurants that were closed in fiscal 2004 by a former franchisee for approximately $8,800,000 payable in cash. In connection with this acquisition, we paid approximately $800,000 in cash in the fourth quarter of fiscal 2004, approximately $5,700,000 in cash in the first quarter of fiscal 2005 and approximately $2,300,000 in cash in the second quarter of fiscal 2005. The purchase price of $8,800,000 has been allocated to the fair value of property and equipment of approximately $8,200,000 and goodwill of approximately $600,000. As of June 26, 2005, we have remodeled and opened six restaurants. Subsequent to June 26, 2005, one additional restaurant was opened and the remaining restaurant was sold to a third party for $1,300,000.

In April 2004, we completed our acquisition of the operations and assets of ten Applebee's restaurants located in Southern California for approximately $13,800,000 in cash. The purchase price was allocated to the fair value of property and equipment of $2,500,000, goodwill of $10,800,000 and other net assets of approximately $500,000. Company restaurant sales for these restaurants were $4,700,000 for both the 13 weeks ended and 26 weeks ended June 27, 2004. Proforma company restaurant sales for these restaurants would have been approximately $7,000,000 and $13,500,000 for the 13 weeks and 26 weeks ended June 27, 2004 had this acquisition been completed at the beginning of fiscal 2004.

Captive Insurance Subsidiary

In 2002, we formed Neighborhood Insurance, Inc., a Vermont corporation and a wholly-owned captive insurance subsidiary to provide Applebee's International, Inc. and qualified franchisees with workers' compensation and general liability insurance. Applebee's International, Inc. and covered franchisees make premium payments to the captive insurance company which pays administrative fees and insurance claims, subject to individual and aggregate maximum claim limits under the captive insurance company's reinsurance policies. Franchisee premium amounts billed by the captive insurance company are established based upon third-party actuarial estimates of settlement costs for incurred claims and administrative fees. The franchisee premiums are included in other franchise income ratably over the policy year. The related offsetting expenses are included in cost of other franchise income. Accordingly, we do not expect franchisee participation in the captive insurance company to have a material impact on our net earnings. In fiscal 2005, we reduced the types of insurance coverage plans which resulted in fewer franchisee participants in our captive insurance program. Our consolidated balance sheets include the following balances related to the captive insurance subsidiary:

o Franchise premium receivables of approximately $3,200,000 and $1,900,000 as of June 26, 2005 and December 26, 2004, respectively, included in receivables related to captive insurance subsidiary.
o Cash equivalent and other long-term investments restricted for the payment of claims of approximately $18,100,000 and $16,700,000 as of June 26, 2005 and December 26, 2004, respectively, included in restricted assets related to captive insurance subsidiary.
o Loss reserve and unearned premiums related to captive insurance subsidiary of approximately $21,400,000 and $19,600,000 as of June 26, 2005 and December 26, 2004, respectively. Approximately $7,400,000 and $7,500,000 as of June 26, 2005 and December 26, 2004, respectively, is included in other non-current liabilities.
o Other miscellaneous items, net, of approximately $100,000 and $1,000,000 as of June 26, 2005 and December 26, 2004, respectively, included in several line items in the consolidated balance sheets.

Results of Operations

The  following  table  contains   information   derived  from  our  consolidated
statements of earnings  expressed as a percentage of total  operating  revenues,
except where otherwise noted. Percentages may not add due to rounding.
                                                                     13 Weeks Ended            26 Weeks Ended
                                                                -------------------------  -------------------------
                                                                  June 26,     June 27,      June 26,     June 27
                                                                    2005         2004          2005         2004
                                                                ------------ ------------  ------------ ------------
                                                                                 (as                        (as
                                                                               restated)                  restated)
Revenues:
    Company restaurant sales..................................       88.9%        87.9%         88.9%        87.9%
    Franchise royalties and fees..............................       10.6         10.9          10.7         11.0
    Other franchise income....................................        0.5          1.2           0.4          1.2
                                                                ------------ ------------  ------------ ------------
         Total operating revenues.............................      100.0%       100.0%        100.0%       100.0%
                                                                ============ ============  ============ ============
Cost of sales (as a percentage of company restaurant sales):
    Food and beverage.........................................       26.6%        26.9%         26.5%        26.5%
    Labor.....................................................       33.0         32.6          32.9         32.6
    Direct and occupancy......................................       26.0         24.4          25.3         24.4
    Pre-opening expense.......................................        0.5          0.2           0.4          0.2
                                                                ------------ ------------  ------------ ------------
         Total cost of sales..................................       86.2%        84.1%         85.2%        83.7%
                                                                ============ ============  ============ ============

Cost of other franchise income (as a percentage of other
    franchise income).........................................       86.3%       148.1%         82.3%       122.4%
General and administrative expenses...........................        9.1          8.9           9.0          9.0
Amortization of intangible assets.............................        0.1          0.1           0.1           --
Loss on disposition of restaurants and equipment..............        0.2          0.2           0.1          0.2
                                                                ------------ ------------  ------------ ------------
Operating earnings............................................       13.6         15.2          14.7         15.8
                                                                ------------ ------------  ------------ ------------
Other income (expense):
    Investment income.........................................        0.1           --           0.1           --
    Interest expense..........................................       (0.2)        (0.1)         (0.2)        (0.1)
    Other income..............................................        0.2          0.2           0.2          0.2
                                                                ------------ ------------  ------------ ------------
         Total other income...................................        0.1          0.1           0.1          0.1
                                                                ------------ ------------  ------------ ------------
Earnings before income taxes..................................       13.7         15.3          14.8         15.9
Income taxes..................................................        4.7          5.3           5.1          5.5
                                                                ------------ ------------  ------------ ------------
Net earnings..................................................        9.0%        10.0%          9.7%        10.3%
                                                                ============ ============  ============ ============

The following table sets forth certain unaudited financial information and other restaurant data relating to company and franchise restaurants, as reported to us by franchisees:

                                                               13 Weeks Ended                     26 Weeks Ended
                                                       -------------------------------    -------------------------------
                                                         June 26,          June 27,          June 26,          June 27,
                                                           2005              2004              2005              2004
                                                       -------------     -------------    --------------    -------------
Number of restaurants:
    Company:
         Beginning of period.......................            437               391               424              383
         Restaurant openings.......................             14                 4                27               12
         Restaurants acquired from franchisees.....             11                10                11               10
                                                       -------------     -------------    --------------    -------------
         End of period.............................            462               405               462              405
                                                       -------------     -------------    --------------    -------------
    Franchise:
         Beginning of period.......................          1,257             1,212             1,247            1,202
         Restaurant openings.......................             16                 8                29               19
         Restaurants closed........................             (2)               (3)               (5)              (4)
         Restaurants acquired from franchisees.....            (11)              (10)              (11)             (10)
                                                       -------------     -------------    --------------    -------------
         End of period.............................          1,260             1,207             1,260            1,207
                                                       -------------     -------------    --------------    -------------
    Total:
         Beginning of period.......................          1,694             1,603             1,671            1,585
         Restaurant openings.......................             30                12                56               31
         Restaurants closed........................             (2)               (3)               (5)              (4)
                                                       -------------     -------------    --------------    -------------
         End of period.............................          1,722             1,612             1,722            1,612
                                                       =============     =============    ==============    =============

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