NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED)
A. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Business Activities --
The Krystal Company ("Krystal") (a Tennessee corporation) is engaged primarily
in the development, operation and franchising of quick-service restaurants in
the Southeastern United States. The Company recognizes revenues from
restaurant sales upon delivery of the product to the customer.
Principles of Consolidation --
The accompanying consolidated financial statements include the accounts of
Krystal and its subsidiaries (hereinafter referred to collectively as "the
Company"). Certain advertising cooperatives in which the Company has a
controlling interest are consolidated with the Company. All significant
intercompany balances and transactions have been eliminated. The Company
is wholly-owned by Port Royal Holdings, Inc.
Cash and temporary investments --
The Company considers repurchase agreements and other temporary cash
investments with a maturity of three months or less to be temporary
investments.
Accounts Receivable and the Allowance for Doubtful Accounts --
The Company's accounts receivable consist primarily of amounts due from
franchisees for royalties, advertising and purchases. The Company monitors
the amounts due from franchisees continually and maintains an allowance for
doubtful accounts for estimated losses resulting from the inability of any of
the Company's franchisees to make required payments. This estimate is based
on the Company's assessment of the collectibility of specific accounts
as well as a general allowance based on historical trends, the financial
condition of the franchisees and the aging of the receivables. Accounts
are charged off when deemed uncollectible. The Company has good
relationships with its franchisees and high collection rates. The
Company generally does not require collateral. If the future financial
condition of the Company's franchisees were to deteriorate, resulting in
their inability to make their required payments, increases in the
allowance for doubtful accounts may be required. The allowance for doubtful
accounts was $754,000 at March 28, 2004 and $956,000 at March 30, 2003.
Franchise and License Agreements --
Franchise or license agreements are available for single Krystal restaurants
and multi-unit development agreements are available for the development of
several Krystal restaurants over a specified period of time. The multi-unit
development agreement establishes the number of restaurants the franchisee or
licensee is to construct and open in the franchised area during the term of
the agreement. At March 28, 2004, there were 177 franchised or licensed
restaurants and at March 30, 2003, there were 180 franchised or licensed
restaurants.
Franchisees and licensees are required to pay the Company an initial franchise
or license fee plus a weekly royalty and service fee of 4.5% to 6.0% of
the restaurants' gross receipts, depending on the duration of the franchise
agreement. The initial franchise and license fees are recorded as income when
the related restaurants begin operations. Royalty and service fees, which are
based on restaurant sales of franchisees and licensees, are recognized as
earned. Franchise fees received prior to the opening of the restaurant are
deferred and included in accrued liabilities on the consolidated balance
sheet. At March 28, 2004 and March 30, 2003, total deferred franchise
and license fees were approximately $681,000 and $1,006,000, respectively.
Advertising --
The Company incurs expenditures for television, radio and print advertising to
support its products. This advertising maintains the important brand
franchise with the consuming public. The Company allocates a
percentage of the necessary supporting advertising expenses to each dollar of
sales by charging a percentage of sales on an interim basis based upon
anticipated annual sales and advertising expenditures (in accordance with
Accounting Principles Board Opinion No. 28) and adjusting that accrual to
the actual expenses incurred at the end of the year.
Fair Market Value of Financial Instruments --
The carrying amount reflected in the consolidated balance sheets for cash and
temporary investments, accounts receivable and accounts payable approximate
their respective fair values based on the short-term nature of these
instruments.
Benefit Plans --
The determination of obligations and expenses under the Company's retirement
and postretirement benefit plans is dependent on the selection of certain
assumptions used by actuaries in calculating such amounts. Those assumptions
include among others, the discount rate, expected return on plan assets and the
expected rates of increase in employee compensation and health care costs. In
accordance with accounting principles generally accepted in the United States,
actual results that differ from assumptions are accumulated and amortized over
future periods and, therefore, generally affect our recognized expense and
the recorded obligation in such periods. Significant differences in actual
experience or significant changes in the assumptions used may materially
affect the pension and postretirement obligations and future expenses.
On September 30, 2003, the Company amended its retirement plan to eliminate
future accrual of additional pension benefits for active employees. The
amendment, resulted in a curtailment gain of $1.7 million. The curtailment
gain was recorded in the Company's fiscal fourth quarter ending
December 28, 2003.
Effective with the change in the retirement plan, the Company established a
defined contribution employee benefit plan subject to IRS code 401(k). This
plan covers substantially all employees of the Company. Participants may
contribute a percentage of their compensation as allowed under applicable
laws. The plan provides for a matching contribution of up to 3.0% of the
employees' salary by the Company. Participants are 100% vested in participant
contributions and become vested in Company matching contributions over a
period of six years.
The following table represents a summary of the components of net annual
pension cost for the three months ended March 28, 2004 (in thousands).
Three months ended
------------------
(a)March 28, March 30,
2004 2003
-------- --------
Service costs (net of employee
contribution) $ 0 $ 280
Interest cost 575 593
Expected return on assets (700) (656)
Amortization of unrecognized
prior service cost 0 ( 59)
Amortization of unrecognized
net loss (gain) 225 385
----- ------
Net annual pension cost $ 100 $ 543
===== ======
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(a) March 28, 2004 expense is an estimate based on prior year data. Actual
expense will be determined by June 30, 2004.
Accumulated Other Comprehensive Loss --
Accumulated other comprehensive loss is comprised of a minimum pension
liability of $6.6 million, net of taxes, at March 28, 2004 and
December 28, 2003.
Stock Compensation --
The Company has elected to follow the intrinsic value method of accounting
for stock-based compensation under APB Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB No. 25"), and related interpretations.
Because the exercise price on the date of grant was equal to the fair
market value of the stock, no compensation expense has been recognized
under ABP No. 25.
Had compensation cost been determined in accordance with SFAS No. 123,
the Company's net income (loss) would have been adjusted to the pro forma
amounts indicated below:
The three months ended
----------------------
March 28, March 30,
2004 2003
-------- --------
(In thousands)
Net Income (Loss):
As reported $ 1,443 $ ( 266)
Stock compensation expense ( 19) ( 19)
------- -------
Pro forma $ 1,424 $ ( 285)
======= =======
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Use of Estimates --
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates and the differences could be material.
B. RECENT ACCOUNTING PRONOUNCEMENTS -
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN 46 requires certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first
interim or annual period beginning after December 15, 2003. The Company
adopted FIN 46 as of March 28, 2004 and the adoption did not have any impact
on the Company's financial statements.
In December 2003, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 132R, "Employers' Disclosures about Pensions and Other
Postretirement Benefits." This statement retains the disclosure requirements
contained in SFAS No. 132, which it replaces. SFAS 132R also requires
additional disclosures about the assets, obligations, cash flows and net
periodic benefit cost of defined benefit pension plans and other defined
benefit postretirement plans. Those disclosures include information
describing the types of plan assets, investment strategy, measurement dates,
plan obligations, cash flows and components of net periodic benefit cost
recognized during interim periods. This statement is effective for financial
statements with fiscal years ending after December 15, 2003. The interim-
period disclosures required by this statement are effective for interim
periods beginning after December 15, 2003. The Company adopted the
disclosure provisions of SFAS 132R in fiscal 2003.
C. SEGMENT REPORTING
The Company operates in two defined reportable segments: restaurants and
franchising. The restaurant segment consists of the operations of all
Company-owned restaurants and derives its revenues from retail sales of food
products to the general public. The franchising segment consists of franchise
sales and support activities and derives its revenues from fees related to the
sales of franchise and development agreements and collection of royalties from
franchisees of the Krystal brand. All of the Company's revenues are derived
within the United States.
The accounting policies of the segments are the same as those described in the
Summary of Significant Accounting Policies.
Segment information is as follows:
For the Three Months Ended
------------------------------------------------------------------------------
March 28, March 30,
(in thousands) 2004 2003
------------------------------------------------------------------------------
Revenues:
Restaurants $ 61,968 $ 56,646
Franchising 1,812 1,932
-----------------------------------------------------------------------------
Total segment revenues $ 63,780 $ 58,578
=============================================================================
Depreciation and Amortization:
Restaurants $ 2,600 $ 2,751
Franchising 1 1
-----------------------------------------------------------------------------
Total segment depreciation and amortization $ 2,601 $ 2,752
=============================================================================
Interest expense:
Restaurant $ 1,819 $ 2,024
Franchising 0 0
-----------------------------------------------------------------------------
Total segment interest expense $ 1,819 $ 2,024
=============================================================================
Operating income:
Restaurant $ 2,604 $ 210
Franchising 1,247 1,335
----------------------------------------------------------------------------
Total segment operating income $ 3,851 $ 1,545
============================================================================
March 28, December 28,
2004 2003
-----------------------------------------------------------------------------
Capital Expenditures:
Restaurants $ 1,749 $ 10,760
Franchising 11 2
-----------------------------------------------------------------------------
Total segment capital expenditures $ 1,760 $ 10,762
=============================================================================
Total Assets:
Restaurants $146,532 $144,246
Franchising 1,005 1,130
-----------------------------------------------------------------------------
Total segment assets $147,537 $145,376
=============================================================================
A reconciliation of segment depreciation and
amortization to consolidated depreciation and
amortization is as follows:
-------------------------------------------------------------------------------
March 28, March 30,
2004 2003
-------------------------------------------------------------------------------
Segment depreciation and amortization $ 2,601 $ 2,752
Unreported segments (1) 12 40
-------------------------------------------------------------------------------
Total consolidated depreciation and amortization $ 2,613 $ 2,792
===============================================================================
A reconciliation of segment operating
income to total operating income is as follows:
Operating income:
Restaurant $ 2,604 $ 210
Franchising 1,247 1,335
Unreported segments (1) 140 123
----------------------------------------------------------------------------
Total operating income $ 3,991 $ 1,668
============================================================================
A reconciliation of segment total assets to
consolidated total assets is as follows:
-------------------------------------------------------------------------------
March 28, December 28,
2004 2003
-------------------------------------------------------------------------------
Total segment assets $147,537 $145,376
Unreported segments (1) 1,528 1,541
-------------------------------------------------------------------------------
Total consolidated assets $149,065 $146,917
===============================================================================
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(1) Unreported segments do not meet the quantitative thresholds for segment
reporting.
D. INDEBTEDNESS
Senior Secured Credit Agreement--
0n June 30,2003, the Company amended its existing $25.0 million credit
agreement (the "Credit Facility"). The amended Credit Facility,
which provides for borrowing up to $25.0 million, is made up of $19.85 million
in available credit and $5.15 million in outstanding letters of credit. The
amendment eliminated the term loan feature and modified certain other terms and
conditions. The existing term loan balance at September 28, 2003 was
repaid in full with an initial borrowing under the line of credit. The
prepayment of the $13.3 million term loan portion resulted in a prepayment
penalty of $533,000 and the retirement of $164,000 of deferred financing
costs, which were charged to expense in the quarter ended September 28, 2003.
There was no amount outstanding under the facility at March 28, 2004. The
amended Credit Facility matures June 29, 2004 and the Company expects to
refinance or renew the Credit Facility. See Note F below for subsequent events.
Borrowings under the amended Credit Facility bear interest rates, at the
option of the Company, and depending on the certain financial covenants,
equal to either (a) the greater of the prime rate, or the federal
funds rate plus 0.5%, plus a margin (which ranges from 0.00% to 1.0%) or
(b) the rate offered in the Eurodollar market for amounts and periods
comparable to the relevant loan, plus a margin (which ranges from 1.50%
to 2.75% and is determined by certain financial covenants.
The amended Credit Facility contains restrictive covenants including, but not
limited to (a) the Company's required maintenance of a minimum amount of
tangible net worth; (b) the Company's required maintenance of certain levels
of funded debt coverage; (c) limitations regarding additional indebtedness;
(d) the Company's required maintenance of a minimum amount of fixed charges
coverage; (e) limitations regarding consolidated capital expenditures and
(f) limitations regarding liens on assets. The Company was in compliance with
or has received waivers on all covenants at March 28, 2004.
Essentially all assets of the Company are pledged as collateral on the
Credit Facility. Additionally, the Credit Facility is guaranteed by Port
Royal through a secured pledge of all of the Company's common stock held by
Port Royal and the common stock of each existing and future subsidiary of the
Company.
Senior Notes--
In September 1997, the Company issued $100.0 million in unsecured 10.25% senior
notes ("the Notes") which mature on October 1, 2007. The Notes pay interest
semi-annually on April 1 and October 1 of each year. The Notes are redeemable
at the option of the Company at prices decreasing from 105 1/8% of the
principal amount on April 1, 2002 to 100% of the principal amount on
April 1, 2005. Additionally, upon a change of control of the Company, the
holders of the Notes will have the right to require the Company to purchase
all or a portion of the Notes at a price equal to 101% of the original
principal amount. The proceeds of the Notes were used to fund the acquisition
of the Company by Port Royal.
During fiscal 2002, the Company purchased and retired $39.0 million aggregate
par value of its Notes.
E. COMMITMENTS AND CONTINGENCIES
The Company is a party to various legal proceedings incidental to its
business. The ultimate disposition of these matters is not presently
determinable but will not, in the opinion of management and the Company's
legal counsel, have a material adverse effect on the Company's financial
condition or results of operations.
F. SUBSEQUENT EVENTS
On May 10, 2004, the Company announced it has commenced a tender offer for
all of its Notes and its intention to refinance its Credit Facility. The
funds for the tender offer and refinancing are expected to be obtained through
a new $90 million senior secured credit facility. The proposed transactions
are subject to the successful completion of syndication efforts, definitive
transaction documents and customary closing conditions. The closing of the
transaction is expected to occur during the second quarter of 2004. If the
foregoing refinancing transaction is completed, the Company would not have
any outstanding Notes and would seek to terminate its obligation to file
reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
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