O'Charley's (CHUX)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

Commission file number 0-18629

O’CHARLEY’S INC.

(Exact name of registrant as specified in its charter)

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer o Accelerated filer x Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x

 

The aggregate market value of the voting stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $375.9 million. For purposes of this calculation, shares held by non-affiliates excludes only those shares beneficially owned by officers, directors and shareholders beneficially owning 10% or more of the outstanding common stock.

 

The number of shares of common stock outstanding on March 9, 2007 was 23,713,627.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

 

 

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INDEX

 

 

 

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O’CHARLEY’S INC.

 

PART I

 

 

We are a leading casual dining restaurant company headquartered in Nashville, Tennessee. We own and operate three restaurant concepts which operate under the “O’Charley’s,” “Ninety Nine Restaurants” and “Stoney River Legendary Steaks” trade names. As of December 31, 2006, we operated 227 O’Charley’s restaurants in 16 states in the Southeast and Midwest regions, 114 Ninety Nine restaurants in nine Northeastern states, and ten Stoney River restaurants in the Southeast and Midwest. As of December 31, 2006, we had six franchised O’Charley’s restaurants including five franchised O’Charley’s restaurants in Michigan and one franchised O'Charley's restaurant in Ohio. As of December 31, 2006, we had three joint venture O’Charley’s restaurants in Louisiana, and one joint venture O'Charley's restaurant in Wisconsin, in all of which we have an ownership interest.

 

Our Restaurant Concepts

 

O’Charley’s

 

We acquired the original O’Charley’s restaurant in Nashville, Tennessee in May 1984. O’Charley’s is a casual dining restaurant concept whose strategy is to differentiate its restaurants by serving high-quality, freshly prepared food at moderate prices and with attentive guest service. O’Charley’s restaurants are intended to appeal to a broad spectrum of guests from a diverse income base, including mainstream casual dining guests, as well as upscale casual dining and value oriented guests. The O’Charley’s menu is mainstream, but innovative and distinctive in taste. The O’Charley’s menu features a variety of items including USDA Choice hand-cut and aged steaks, baby-back ribs basted with our own tangy BBQ sauce, fresh salmon, a variety of seafood, salads with special recipe salad dressings and O’Charley’s signature caramel pie. All entrees are cooked to order and feature a selection of side items in addition to our hot, freshly baked yeast rolls. We believe the large number of freshly prepared items on the O’Charley’s menu helps differentiate our O’Charley’s concept from other casual dining restaurants.

 

O’Charley’s restaurants are open seven days a week and serve lunch, dinner and Sunday brunch and offer full bar service. Specialty menu items include “limited time only” promotions, O’Charley’s Lunch Club and a special kids menu with a “kids eat free” program in selected markets. We are continually developing new menu items for our O’Charley’s restaurants to respond to changing guest tastes and preferences. Lunch entrees range in price from $6.99 to $9.99, with dinner entrees ranging from $7.29 to $17.99. The average check per guest, including beverages, was $12.04 in 2006, $11.52 in 2005, and $11.52 in 2004.

 

We seek to create a casual, neighborhood atmosphere in our O’Charley’s restaurants through an open layout and exposed kitchen and by tailoring the decor of our restaurants to the local community. The exterior typically features bright red and green neon borders, multi-colored awnings and attractive landscaping. The interior typically is open, casual and well lighted and features warm woods, exposed brick, color prints and hand-painted murals depicting local history, people, places and events. The prototypical O’Charley’s restaurant is a free-standing building ranging in size from approximately 4,900 to 6,800 square feet with seating for approximately 163 to 275 guests, including approximately 60 bar seats. We periodically update the interior and exterior of our restaurants to reflect refinements in the concept and respond to changes in guest tastes and preferences.

 

Historically, we have grown the O’Charley’s concept through opening new restaurants. As part of the strategic planning process and our focus on improving results in existing restaurants, we decided to open fewer restaurants in 2006. We opened three new company-owned restaurants and closed one company-owned restaurant in 2006. In 2007, we plan on developing between four and six new company-owned restaurants and four new franchised or joint venture O’Charley’s restaurants. We also plan on rebranding approximately 20 to 30 restaurants in 2007 as part of our ‘Project Rev’Olution’ initiative. This initiative is focusing the concept on our overall brand design to enhance the guest experience as well as improve our profitability.

 

Ninety Nine Restaurants

 

In January 2003, we acquired Ninety Nine restaurants, (“Ninety Nine”) a Woburn, Massachusetts based casual dining concept that began in 1952 with its initial location at 99 State Street in downtown Boston. Ninety Nine restaurants are casual dining restaurants that we believe have earned a reputation as friendly, comfortable places to gather and enjoy great American food and drink at a terrific price. Ninety Nine restaurants are intended to appeal to mainstream casual dining and value oriented guests. The Ninety Nine menu features approximately 75 items, including a wide selection of appetizers, soups, salads, sandwiches, burgers, beef, chicken and seafood entrees and desserts. Ninety Nine restaurants offer full bar service, including a wide selection of imported and domestic beers, wines and specialty drinks.

 

Ninety Nine restaurants are open seven days a week and serve lunch and dinner. Lunch entrees range in price from $6.49 to $8.99 with dinner entrees ranging from $6.79 to $15.99. The average check per guest, including beverages, was $14.08 in 2006, $13.69 in 2005, and $13.86 in 2004.

 

Ninety Nine restaurants seek to provide a warm and friendly neighborhood pub atmosphere. Signature elements of the prototypical Ninety Nine restaurant include an open view kitchen, booth seating and a centrally located rectangular bar. The prototypical Ninety Nine restaurant is a free-standing building of approximately 5,800 square feet in size with seating for approximately 190 guests, including approximately 30 bar seats. Ninety Nine has grown through remodeling traditional and non-traditional restaurant locations as well as through developing new restaurants in the style of our prototype restaurant. During 2007, we plan to open between three and five new Ninety Nine restaurants. We also plan on rebranding approximately 30 restaurants in 2007 as part of our ‘Dressed to the Nines’ initiative.

 

 

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Stoney River Legendary Steaks

 

We acquired Stoney River in May 2000. Stoney River restaurants are upscale steakhouses that are intended to appeal to both upscale casual dining and fine dining guests by offering the high-quality food and attentive guest service typical of high-end steakhouses at more moderate prices. Stoney River restaurants have an upscale “mountain lodge” design with a large stone fireplace, plush sofas and rich woods that is intended to make the interior of the restaurant inviting and comfortable. The Stoney River menu features several offerings of premium Midwestern beef, fresh seafood and a variety of other gourmet entrees. An extensive assortment of freshly prepared salads and side dishes are available a la carte. The menu also includes several specialty appetizers and desserts. Stoney River restaurants offer full bar service, including an extensive selection of wines. The price range of entrees is $16.99 to $32.99. The average check per guest, including beverages, was $41.72 in 2006, $40.56 in 2005 and $39.53 in 2004.

 

We established a “managing partner program” for the general managers of our Stoney River restaurants pursuant to which each general manager had the opportunity to acquire a six percent interest in the limited liability company that owns the restaurant that the general manager manages in exchange for a capital contribution to that subsidiary. The general managers at four Stoney River restaurants each acquired a six percent interest in their restaurant for a capital contribution of $25,000. Upon the fifth anniversary of the managing partner’s capital contribution to the subsidiary, we have the option, but not the obligation, to purchase the managing partner’s six percent interest for fair market value. Under the terms of the agreements between us and each managing partner, fair market value would be determined by negotiations between the parties. If such negotiations did not result in an agreement on value, a third-party appraisal process would be used to determine fair market value. During 2006, we purchased two of our managing partner’s six percent interest. In addition, during 2006 we implemented a new “managing partner program” which is a five year operating agreement between us and the general manager that allows the general manager to receive five percent of their restaurant’s profit each quarter and one percent of the profit in all the restaurants participating under this new program. We also accrue an additional five percent of the restaurant’s profit and one percent of the participating restaurant’s profit in the program each quarter to be paid upon the fifth anniversary of the agreement in exchange for a $25,000 cash investment by the general manager. The cash investments made under the new managing partner program are recorded and shown in the consolidated balance sheet as an other liability. At December 31, 2006, we had two managing partners under our original “managing partner program” and five general managers under our new “managing partner program”. In 2007, we plan on opening one or two new Stoney River restaurants.

 

Support Operations

 

Quality Product Center (formerly known as our Commissary Operation). We operate an approximately 220,000 square foot quality product center in Nashville, Tennessee through which we manufacture, purchase and distribute a substantial majority of the food products and supplies for our O’Charley’s, Ninety Nine and Stoney River restaurants. To a lesser extent, the quality product center sells manufactured items to other customers, including retail grocery chains, mass merchandisers and wholesale clubs. In addition, our Nashville quality product center operates a USDA-approved and inspected facility where we process beef and chicken products for O’Charley’s, Ninety Nine and steaks for Stoney River restaurants. Additionally we operate a production facility where the signature yeast rolls and salad dressings served in our O’Charley’s restaurants are produced. We believe our Nashville quality product center has sufficient capacity to meet a substantial majority of the distribution needs of our existing and planned O’Charley’s and Stoney River restaurants for the next several years. We also operate a 20,000 square foot production facility located in Woburn, Massachusetts which is a USDA-approved and inspected facility where we cut beef tips, turkey tips, selected steaks, marinate chicken, and produce soups served in our Ninety Nine restaurants. We also operate a 79,000 square foot distribution facility in Bellingham, Massachusetts to supply our Ninety Nine concept. During 2006, we hired Larry Taylor, as our Chief Supply Chain Officer, and Roland Ornelas, as our Vice President of Strategic Sourcing. Larry and his team are aggressively pursuing cost saving opportunities, exploring ways to improve the quality of our products, and benchmarking all operations currently performed by the quality product center. Results of the benchmarking will be used to evaluate all options required to optimize O’Charley’s’ supply chain, including potential divestiture of our quality product center.

 

Human Resources. We maintain a human resources department that supports restaurant operations, the restaurant support center, the financial services center and quality product center through the design and implementation of policies, programs, procedures and benefits for our team members. The human resources department is responsible for the oversight of team member relations and enforces the alternative dispute resolution process. However, all team members are encouraged to first address any employment related issues or concerns through our open door policies or a toll free 800 number. This department also maintains our code of conduct and addresses possible compliance issues. The human resources area also administers the Team Member Survey and is responsible for identifying issues and developing action plans to resolve any issues that are identified. During 2006, we hired Dr. Steve McMillen as our Vice President of Human Resource Development. He has initiated a process designed to improve the quality of employees we hire, evaluate the strengths of our team, ensure we optimize the performance of our team members at all levels across the enterprise and ultimately improve the overall operating execution and performance of our restaurants.

 

Guest Relations. Our guests’ expectations and experiences are measured through the Guest Satisfaction Index (GSI). GSI is a survey-based tool designed to measure guest satisfaction levels at each O’Charley’s and Ninety Nine restaurant, providing immediate feedback to all levels of the organization. Guests are issued an invitation on a random basis through our point-of-sale system to take a telephone survey. Primary focus is placed on identification and improvement of top box predictors of a highly satisfied guest experience. Our ability to continuously monitor service levels and satisfaction at the restaurant level, while providing guests with a convenient, brief, unbiased, and user-friendly way to share their comments, allows us to focus on converting satisfied guests to highly satisfied or loyal guests. In addition to measuring and communicating guest satisfaction results, our guest relations team receives direct calls and written correspondence from our O’Charley’s and Ninety Nine guests, ensuring timely and accurate response to all communications.

 

Advertising and Marketing. We have an ongoing advertising and marketing plan for each of our restaurant concepts that utilize television, radio and print advertising. We also support our restaurants with point of purchase materials, menus and local restaurant marketing programs. We focus our marketing efforts on limited time promotional products, the quality and freshness of our products, the types of guests that typically visit us and the restaurant setting. We conduct or subscribe to studies of food trends, changes in guest tastes and preferences and are continually

 

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evaluating the quality of our menu offerings. In addition to advertising, we encourage restaurant level team members to become active in their communities through local charities and other organizations and sponsorships.

 

Restaurant Reporting. Our use of technology and management information systems is essential for the management oversight needed to improve our operating results. During 2006, we completed the implementation of a theoretical food cost system in our O’Charley’s restaurants through which we more closely monitor waste during the food preparation and execution stages of our operations. We maintain operational and financial controls in each restaurant, including management information systems that monitor sales, inventory, and labor and that provide reports and data to our restaurant support center. The management accounting system polls data from our restaurants and generates daily reports of sales, sales mix, guest counts, check average, cash, labor and food cost. Management utilizes this data to monitor the effectiveness of controls and to prepare periodic financial and management reports. We also utilize these systems for financial and budgetary analysis, including analysis of sales by restaurant, product mix and labor utilization. Our internal audit department audits a sample of our restaurants to measure compliance within our operational systems, procedures and controls. The Financial Services Center (FSC) is located in Brentwood, Tennessee and has been designed to consolidate and integrate our accounting functions. We believe that consolidating the accounting function of our three concepts provides a structure that creates consistency and provides more centralized control over our accounting and financial reporting function while also promoting continuous process improvement and savings.

 

Real Estate and Construction. We maintain an in-house real estate and construction department to assist in the site selection process, secure real estate, develop architectural and engineering plans, oversee new construction and remodel existing restaurants. We maintain a broad database of possible sites which we analyze against our site criteria in order to target the best possible locations. Once a site is selected, our real estate department oversees the acquisition process, while our construction department obtains zoning and all other required governmental approvals, develops detailed building plans and specifications and constructs and equips the restaurants.

 

Restaurant Locations

 

The following table sets forth the markets in which our company-owned O’Charley’s, Ninety Nine and Stoney River restaurants were located at December 31, 2006, including the number of restaurants in each market.

 

O’Charley’s Restaurants

 

 

 

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6

 

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Ninety Nine Restaurants

 

 

Stoney River Restaurants

 

 

In addition to the above company-owned locations, as of December 31, 2006, we had six franchised O’Charley’s restaurants including five franchised O’Charley’s restaurants in Michigan and one franchised O'Charley's restaurant in Ohio. Also at December 31, 2006 we had three joint venture O’Charley’s restaurants in Louisiana, and one joint venture O'Charley's restaurant in Wisconsin, in all of which we have an ownership interest. The locations of these restaurants are set forth below.

 

 

 

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Franchising

 

We seek franchising relationships with successful restaurant operators for the development of O’Charley’s restaurants in areas that are outside of our current growth plans for company-owned restaurants. We have entered into and continue to look to enter into, exclusive multi-unit development agreements with third party franchisees and joint venture partners to open and operate O’Charley’s restaurants. Franchisees and joint venture partners are required to comply with our specifications as to restaurant space, design and décor, menu items, principal food ingredients, team member training and day-to-day operations. The following table illustrates the various agreements that we have executed with our joint venture partners and franchisees along with the contracted markets, the current number of restaurants operated by each joint venture and franchisee and the number of restaurants that they are contractually required to develop and open:

 

 

Service Marks

 

The name “O’Charley’s” and its logo, the name “Stoney River Legendary Steaks,” and the Ninety Nine restaurants logo are registered service marks with the United States Patent and Trademark Office. We also have other service marks that are registered in the states in which we operate. We are aware of names and marks similar to our service marks used by third parties in certain limited geographical areas. Use of our service marks by third parties may prevent us from licensing the use of our service marks for restaurants in those areas. We intend to protect our service marks by appropriate legal action whenever necessary.

 

Government Regulation

 

We are subject to various federal, state and local laws affecting our business. Our quality product centers are licensed and subject to regulation by the USDA. In addition, each of our restaurants is subject to licensing and regulation by a number of governmental authorities, which may include alcoholic beverage control, health, safety, sanitation, building and fire agencies in the state or municipality in which the restaurant is located. Most municipalities in which our restaurants are located require local business licenses. Difficulties in obtaining or failures to obtain the required licenses or approvals could delay or prevent the development of a new restaurant in a particular area. We are also subject to federal and state environmental regulations, but those regulations have not had a material effect on our operations to date.

 

Approximately 12 percent of restaurant sales in 2006 were attributable to the sale of alcoholic beverages. Each restaurant, where permitted by local law, has appropriate licenses from regulatory authorities allowing it to sell liquor, beer and wine, and in some states or localities, to provide service for extended hours and on Sunday. Each restaurant has food service licenses from local health authorities. Similar licenses would be required for each new restaurant. The failure of a restaurant to obtain or retain liquor or food service licenses could adversely affect its operations or, in an extreme case, cause us to close the restaurant. We have established standardized procedures for our restaurants designed to assure compliance with applicable codes and regulations.

 

We are subject, in most states in which we operate restaurants, to “dram-shop” statutes or judicial interpretations, which generally provide a person injured by an intoxicated person the right to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person.

 

Many of our markets are seeing changes in laws regarding smoking inside of buildings. These laws can negatively affect our bar business, with ancillary effects on our dining room business.

 

The federal Americans with Disabilities Act prohibits discrimination on the basis of disability in public accommodations and employment. We design our restaurants to be accessible to the disabled and believe that we are in substantial compliance with all current applicable regulations relating to restaurant accommodations for the disabled.

 

The development and construction of additional restaurants will be subject to compliance with applicable zoning, land use and environmental regulations. Our restaurant operations are also subject to federal and state minimum wage laws and other laws governing matters such as working

 

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conditions, citizenship requirements, overtime and tip credits. In the event a proposal is adopted that materially increases the applicable minimum wage, the wage increase would likely result in an increase in payroll and benefits expense.

 

Team Members

 

As of December 31, 2006, we employed approximately 25,000 team members, approximately 22,500 of which represented our hourly workforce within our restaurants. None of our team members are covered by a collective bargaining agreement. We have an alternative dispute resolution program in which all team members are required to participate as a condition of employment. We consider our team member relations to be good.

 

Executive Officers of the Registrant

 

Our executive officers are elected by the board of directors and serve at the pleasure of the board of directors. The following table sets forth certain information regarding our executive officers.

 

 

The following is a brief summary of the business experience of each of our executive officers.

 

Gregory L. Burns has served as Chief Executive Officer and Chairman of the Board since February 1994. Mr. Burns, a director since 1990, served as President from September 1996 to May 1999 and from May 1993 to February 1994, as Chief Financial Officer from October 1983 to September 1996, and as Executive Vice President and Secretary from October 1983 to May 1993.

 

Lawrence E. Hyatt has served as Chief Financial Officer, Secretary and Treasurer since November 2004. Prior to joining our company, he was Executive Vice President and Chief Financial Officer of Cole National Corporation from 2002 to 2004. Mr. Hyatt was with PSINet, Inc. as Chief Financial and Restructuring Officer from 2000 to 2002; with HMS Host Corporation as Chief Financial Officer from 1999 to 2000; and with Sodexho Marriott Services, Inc. and its predecessor company as Chief Financial Officer from 1989 to 1999.

 

Randall C. Harris has served as Chief Human Resources Officer since October 2005. Prior to joining our company, he was Senior Vice President of Human Resources for Nextel Communications from 1999 to 2005. Mr. Harris was with Sodexho Marriott Services as Chief Human Resources Officer from 1997 to 1999. Mr. Harris’ earlier experience includes general management and human resource positions with Dun & Bradstreet, First Data Corporation, and American Express.

 

Lawrence D. Taylor has served as Chief Supply Chain Officer since May 2006. Prior to joining our company, he was the Chief Procurement Officer for Carlson Companies, Inc. from 2003 to 2006. Mr. Taylor was Vice President, Supply Chain Management for Carlson Restaurants from 2001 to 2003. Mr. Taylor’s earlier experience included senior procurement and supply chain management positions with Taco Bell Corporation, Burger King, Inc., and Perseco. Mr. Taylor was also an owner-operator of a franchised McDonald's restaurant.

Leon De Wet has served as Chief Information Officer since September 2006. Prior to joining our company he was with Brinker International from 1992 to 2006 and most recently served as the Vice President, Business Intelligence and Strategic Systems, from 2002 to 2006. His previous roles at Brinker International include Senior Member of Technical Staff, Director of Store Systems and as a Development Manager. Mr. De Wet’s earlier experiences included management and analyst roles in charge of retail systems at various companies including Michael’s Stores Inc.

Jeff D. Warne has served as Concept President-O’Charley’s since February 2006. Prior to joining our company he was with Carlson Companies, Inc. During his tenure at Carlson Companies, Inc. he served as the President and Chief Operating Officer of PickUp Stix from 2005 to 2006 and the Executive Vice President and Chief Operating Officer of TGI Friday’s International from 2002 to 2004. Mr. Warne’s earlier experience at Carlson includes serving as Chief Financial Officer of Carlson Restaurants Worldwide from 1998 to 2002, Vice President of Business Planning from 1994 to 1998, and Director of Corporate Audit from 1990 to 1994.

John R. Grady has served as Concept President-Ninety Nine restaurants since April 2004. Mr. Grady joined Ninety Nine restaurants in March 1975. Prior to being named President, Mr. Grady was Executive Vice President and has also served in various capacities in the Operations, Training and Real Estate Departments over the years.

 

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Anthony J. Halligan III was named Concept President - Stoney River Legendary Steaks in February 2006. Prior to being named President, Mr. Halligan served in the capacity of Vice-President from 2000 until 2006. Prior to his tenure with Stoney River, Mr. Halligan served in various capacities for companies in the restaurant and retail industries.

 

R. Jeffrey Williams has served as Chief Accounting Officer since February 2006 and as Corporate Controller since February 2003. Mr. Williams served as Controller for the O’Charley’s Concept from July 2001 to February 2003. Mr. Williams served as Controller of The Krystal Company from July 2000 to July 2001. Mr. Williams served as Director of Financial Planning and Analysis for Cracker Barrel Old Country Store from July 1999 to July 2000 and as Accounting Manager for Cracker Barrel Old Country Store from November 1996 to July 1999. Mr. Williams is a certified public accountant.

 

James K. Quackenbush has served as Corporate Vice-President of Development since December 2005. Mr. Quackenbush served as Executive Vice-President of Strategic Development for the Ninety Nine concept from May 2002 to November 2005. Prior to joining Ninety Nine he served in various management positions at McDonald’s Corporation for over fifteen years.

 

Available Information

 

We file reports with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We are an electronic filer and the SEC maintains an Internet site at http://www.sec.gov that contains the reports, proxy and information statements, and other information filed electronically. Our website address is www.ocharleysinc.com. Please note that our website address is provided as an inactive textual reference only. We make available free of charge through our website the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. The information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is specifically referenced elsewhere in this report.

 

We have posted our Corporate Governance Guidelines, Code of Conduct and Business Ethics Policy for directors, officers and team members, and the charters of our Audit, Compensation and Human Resources and Nominating and Corporate Governance Committees of the board of directors on our website at www.ocharleysinc.com. Copies of our corporate governance materials are available free of charge upon request by any shareholder to our Corporate Secretary, O’Charley’s Inc., 3038 Sidco Drive, Nashville, Tennessee 37204.

 

 

Risk Factors

 

Some of the statements we make in this Annual Report on Form 10-K are forward-looking. Forward-looking statements are generally identifiable by the use of the words “anticipate,” “will,” “believe,” “estimate,” “expect,” “plan,” “intend,” “seek” or similar expressions. These forward-looking statements include all statements that are not historical statements of fact and those regarding our intent, belief, plans or expectations including, but not limited to, the discussions of our operating and growth strategy, projections of revenue, income or loss, information regarding future restaurant openings and capital expenditures, potential increases in food and other operating costs, and our development, expansion, franchising and joint venture plans and future operations. Forward-looking statements involve known and unknown risks and uncertainties that may cause actual results in future periods to differ materially from those anticipated in the forward-looking statements. Those risks and uncertainties include, among others, the risks and uncertainties discussed below. Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of these assumptions could prove to be inaccurate, and, therefore, there can be no assurance that the forward-looking statements included in this Annual Report on Form 10-K will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, you should not regard the inclusion of such information as a representation by us or any other person that our objectives and plans will be achieved. We do not undertake any obligation to publicly release any revisions to any forward-looking statements contained herein to reflect events and circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

 

Our success depends on our ability to execute our turnaround strategy, including our rebranding initiatives.

We are implementing strategic initiatives to improve our management and employee team, improve our restaurant level economics and enhance guest loyalty. As part of these initiatives, since the end of 2004, we have hired a new Chief Financial Officer, Chief Human Resources Officer, Concept President – O'Charley's, Chief Supply Chain Officer, Chief Information Officer and other senior executives. Our successful implementation of our turnaround efforts will depend, in large part, upon the services of our senior management team. If we are unable to assimilate these new executives, if they fail to perform effectively or if we are unable to retain them, our turnaround efforts could be adversely impacted which could adversely affect our business, financial condition and result of operations.

Our turnaround efforts involve a number of initiatives intended to improve our restaurant level economics and enhance guest loyalty, including the development of new prototype restaurants and the rebranding of many of our existing O'Charley's and Ninety Nine restaurants. These rebranding efforts include substantial remodels. As of March 8, 2007, we have completed 11 rebrandings at O'Charley's restaurants and 14 rebrandings at Ninety Nine Restaurant restaurants. We are not yet able to determine whether these rebranding initiatives will meet our intended goals. We plan on rebranding an additional 20 to 30 O’Charley’s restaurants and 30 Ninety Nine restaurants in fiscal 2007. A failure to realize the benefits anticipated from these rebrandings could adversely affect our turnaround efforts.

 

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Changing consumer preferences and discretionary spending patterns could force us to modify our concepts and menus and could result in a reduction in our revenues.

 

Our O’Charley’s and Ninety Nine restaurants are casual dining restaurants that feature menus intended to appeal to a broad spectrum of guests. Our Stoney River restaurants are upscale steakhouses that feature steaks, fresh seafood and other gourmet entrees. Our continued success depends, in part, upon the popularity of these foods and these styles of dining. Shifts in consumer preferences away from this cuisine or dining style could materially adversely affect our future operating results. The restaurant industry is characterized by the continual introduction of new concepts and is subject to rapidly changing consumer preferences, tastes and eating and purchasing habits. Our success will depend in part on our ability to anticipate and respond to changing consumer preferences, tastes and eating and purchasing habits, as well as other factors affecting the restaurant industry, including new market entrants and demographic changes. We may be forced to make changes in our concepts and menus in order to respond to changes in consumer tastes or dining patterns. If we change a restaurant concept or menu, we may lose guests who do not prefer the new concept or menu, and may not be able to attract a sufficient new guest base to produce the revenue needed to make the restaurant profitable. In addition, consumer preferences could be affected by health concerns about the consumption of beef, the primary item on our Stoney River menu, or by specific events such as E. coli food poisoning or outbreaks of bovine spongiform encephalopathy (mad cow disease) or other diseases.

 

Our success is also dependent to a significant extent on numerous factors affecting discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce guest traffic or impose practical limits on pricing, either of which could harm our results of operations.

 

We may experience higher operating costs, which would adversely affect our operating results, if we cannot increase menu prices to cover them.

 

Our operating results are significantly dependent on our ability to anticipate and react to increases in food, labor, team member benefits, energy and other costs. Various factors beyond our control, including adverse weather conditions (including hurricanes), governmental regulation, production, availability, recalls of food products and seasonality may affect our food costs or cause a disruption in our supply chain. We cannot predict whether we will be able to anticipate and react to changing food costs by adjusting our purchasing practices and menu prices, and a failure to do so could adversely affect our operating results. In addition, because the pricing strategy at our O’Charley’s and Ninety Nine restaurants is intended to provide an attractive price-to-value relationship, we may not be able to pass along price increases to our guests without adversely impacting our guest counts.

 

We compete with other restaurants for experienced management personnel and hourly team members. Each of our concepts offers medical benefits to hourly team members. Increases in health care costs, changes in state or federal minimum wage laws, or changes in legal requirements relating to employee benefits would likely cause an increase in our labor costs. We cannot assure you that we will be able to offset increased wage and benefit costs through our purchasing and hiring practices or menu price increases, particularly over the short term. As a result, increases in wages and benefits could have a material adverse effect on our business.

 

Our continued growth depends on our ability to open new restaurants and operate our new restaurants profitably, which in turn depends upon our continued access to capital.

 

A significant portion of our historical growth has been due to opening new restaurants. We have substantially reduced our new restaurant growth pending the implementation of our strategic initiatives in our turnaround plan, but still opened three new company-owned O’Charley’s restaurants, five new Ninety Nine restaurants and three new Stoney River restaurants in 2006. We currently plan to open between four and six new company-owned O’Charley’s restaurants, between three and five new Ninety Nine restaurants, and one or two new Stoney River restaurants in 2007. Our ability to open new restaurants successfully depends on a number of factors, such as:

 

 

 

 

 

 

 

Many of these factors are beyond our control. In addition, we have historically generated insufficient cash flow from operations to fund our working capital and capital expenditures and, accordingly, our ability to open new restaurants and our ability to grow, as well as our ability to meet other anticipated capital needs, may be dependent on our continued access to external financing, including borrowings under our credit facility and financing obtained in the capital markets. Our ability to make borrowings under our credit facility will require, among other things, that we comply with certain financial and other covenants, and we cannot assure you that we will be able to do so. Accordingly, we cannot assure you that we will be successful in opening new restaurants in accordance with our current plans or otherwise. Furthermore, we cannot assure you that our new restaurants will generate revenues or profit margins consistent with those of our existing restaurants, or that the new restaurants will be operated profitably.

 

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Our growth may strain our management and infrastructure, which could slow our development of new restaurants and adversely affect our ability to manage existing restaurants.

 

Our growth has placed significant demands upon our management. We also face the risk that our existing systems and procedures, restaurant management systems, financial controls and information systems will be inadequate to support our planned growth. We cannot predict whether we will be able to respond on a timely basis to all of the changing demands that our turnaround effort and planned growth will impose on management and these systems and controls. If our management is unable to meet these demands or if we fail to continue to improve our information systems and financial controls or to manage other factors necessary for us to achieve our growth objectives, our operating results or cash flows could be materially adversely affected.

 

Unanticipated expenses and market acceptance could affect the results of restaurants we open in new and existing markets.

 

As part of our growth plans, we may open new restaurants in areas in which we have little or no operating experience and in which potential guests may not be familiar with our restaurants. As a result, we have incurred and may continue to incur costs related to the opening, operation, supervision and promotion of those new restaurants that are substantially greater than those incurred in other areas. Even though we may incur substantial additional costs with these new restaurants, they may attract fewer guests than our more established restaurants in existing markets. As a result, the results of operations at new restaurants may be inferior to those of our existing restaurants. The new restaurants may even operate at a loss.

 

Our primary growth plan is to open restaurants in or near markets in which we have existing restaurants. We may be unable to attract enough guests to the new restaurants for them to meet our objectives. Even if we are able to attract enough guests to the new restaurants to meet our objectives for that restaurant, those guests may be former guests of one of our existing restaurants in that market and the opening of a new restaurant in the existing market could reduce the revenue of our existing restaurants in that market.

 

We could face labor shortages that could adversely affect our results of operations.

 

Our success depends in part upon our ability to attract, motivate and retain a sufficient number of qualified team members, including restaurant managers, kitchen staff and servers, necessary to continue our operations and to keep pace with our growth. Qualified individuals of the requisite caliber and quantity needed to fill these positions are in short supply. Given the low unemployment rates in certain areas in which we operate, we may have difficulty hiring and retaining qualified management and other personnel. Any inability to recruit and retain sufficient qualified individuals may adversely affect operating results at existing restaurants and delay the planned openings of new restaurants. Any delays in opening new restaurants or any material increases in team member turnover rates in existing restaurants could have a material adverse effect on our business, financial condition, operating results or cash flows. Additionally, we have increased wages and benefits to attract a sufficient number of competent team members, resulting in higher labor costs.

 

Our restaurants are concentrated geographically; if any one of the regions in which our restaurants are located experiences an economic downturn, adverse weather or other material change, our business results may suffer.

 

Our O’Charley’s restaurants are located predominately in the Southeastern and Midwestern United States. Our Ninety Nine restaurants are located primarily in the Northeastern United States. As of December 31, 2006, we operated 37 of our 227 O’Charley’s restaurants in Tennessee and 61 of our 114 Ninety Nine restaurants in Massachusetts. As a result, our business and our financial or operating results may be materially adversely affected by adverse economic, weather or business conditions in these markets, as well as in other geographic regions in which we locate restaurants.

 

Our restaurants may not be able to compete successfully with other restaurants, which could adversely affect our results of operations.

 

The restaurant industry is intensely competitive with respect to price, service, location, nutritional and dietary trends and food quality, and there are many well-established competitors with substantially greater financial and other resources than us, including a large number of national and regional restaurant chains. Some of our competitors have been in existence for a substantially longer period than us and may be better established in the markets where our restaurants are or may be located. Additionally, we face increasing competition from the convergence of restaurant, deli and grocery services, as supermarkets and grocery stores offer “convenient meals” in the form of improved entrees and side dishes in their deli sections. If our restaurants are unable to compete successfully in new and existing markets, our results of operations will be adversely affected.

To the extent that we open restaurants in larger cities and metropolitan areas, we expect competition to be more intense in those markets. We also compete with other restaurants for experienced management personnel and hourly team members and with other restaurants and retail establishments for quality sites.

 

Any disruption in our manufacturing and distribution operations could adversely affect our ability to operate our restaurants.

 

We operate a quality product center in Nashville, Tennessee through which we manufacture, purchase and distribute a substantial majority of the food products and supplies for our O’Charley’s and Stoney River restaurants. We also operate similar type facilities in Woburn and Bellingham, Massachusetts, through which we manufacture, purchase and distribute a portion of the food products and supplies for our Ninety Nine restaurants. If the operations of our quality product centers are disrupted, we may not be able to deliver food and supplies to our restaurants. If our quality product centers are unable to deliver the food products and supplies required to run our restaurants, we may not be able to find other sources of food or supplies, or, if alternative sources of food or supplies are located, our operating costs may increase. Accordingly, any disruption in our manufacturing and distribution operations could adversely affect our ability to operate our restaurants and would adversely affect our results of operations.

 

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We may incur costs or liabilities and lose revenue as the result of government regulation.

 

Our restaurants are subject to extensive federal, state and local government regulation, including regulations related to the preparation and sale of food (such as regulations regarding labeling, allergens content, trans fat content and other menu information regarding nutrition), the sale of alcoholic beverages, zoning and building codes and other health, sanitation and safety matters. All of these regulations impact not only our current restaurant operations but also our ability to open new restaurants. We will be required to comply with applicable state and local regulations in new locations into which we expand. Any difficulties, delays or failures in obtaining licenses, permits or approvals in such new locations could delay or prevent the opening of a restaurant in a particular area or reduce operations at an existing location, either of which would materially and adversely affect our growth and results of operations. In addition, our quality product centers are licensed and subject to regulation by the United States Department of Agriculture and are subject to further regulation by state and local agencies. Our failure to obtain or retain federal, state or local licenses for our quality product centers or to comply with applicable regulations could adversely affect our quality product centers operations and disrupt delivery of food and other products to our restaurants. If one or more of our restaurants were unable to serve alcohol or food for even a short time period, we could experience a reduction in our overall revenue.

 

The costs of operating our restaurants may increase if there are changes in laws governing minimum hourly wages, workers’ compensation insurance rates, unemployment tax rates, sales taxes or other laws and regulations, such as the federal Americans with Disabilities Act, which governs access for the disabled. If any of the above costs increase, we cannot assure you that we will be able to offset the increase by increasing our menu prices or by other means, which would adversely affect our results of operations.

 

We may incur costs or liabilities as a result of litigation and publicity concerning food quality, health and other issues that can also cause guests to avoid our restaurants.

 

We are subject to complaints or litigation from time to time from guests alleging illness, injury or other food quality or health concerns. Litigation or adverse publicity resulting from these allegations may materially adversely affect us or our restaurants, regardless of whether the allegations are valid or whether we are liable. We were subject to numerous lawsuits arising out of the exposure in September 2003 of our guests and employees at one of our O’Charley’s restaurants located in Knoxville, Tennessee to the Hepatitis A virus. See “Item 3-Legal Proceedings.” In addition, we are subject to litigation under “dram shop’’ laws that allow a person to sue us based on any injury or death caused by an intoxicated person who was wrongfully served alcoholic beverages at one of our restaurants. While we maintain insurance for lawsuits under a dram shop law or alleging illness or injury from food, we have significant deductibles under such insurance and any such litigation may result in a verdict in excess of our liability insurance policy limits, which could result in substantial liability for us and may have a material adverse effect on our results of operations.

 

In addition, we are a defendant from time to time in various legal proceedings, including claims relating to workplace and employment matters, discrimination and similar matters; claims resulting from “slip and fall” accidents; claims with respect to insurance recoveries; claims relating to lease obligations and claims from guests or employees alleging illness, injury or other food quality, health or operational concerns. In recent years, a number of restaurant companies have been subject to lawsuits, including class action lawsuits, alleging violations of federal and state law regarding workplace and employment matters, discrimination and similar matters. A number of these lawsuits have resulted in the payment of substantial damages by the defendants. We do not believe that any of the legal proceedings pending against us as of the date of this report will have a material adverse effect on our liquidity or financial condition. We may incur or accrue expenses relating to legal proceedings, however, which may adversely affect our results of operations in a particular period.

 

Compliance with and any failure to comply with current regulatory requirements will result in additional expenses and may adversely affect us.

 

Keeping abreast of, and in compliance with, changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, Securities and Exchange Commission regulations and NASDAQ Stock Market rules, has required an increased amount of management attention and external resources. We remain committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards, and this investment has resulted in and we expect will continue to result in increased general and administrative expenses as well as management’s time and attention from revenue-generating activities to compliance activities.

 

We are dependent upon our senior management team to execute our business strategy.

 

Our operations and our ability to execute our business strategy are highly dependent on the efforts of our senior management team. Many of the members of our senior management team do not have long tenures with us, including, in particular, our Chief Financial Officer who joined us in November 2004, our Chief Human Resources Officer who joined us in October 2005, our Concept President-O’Charley’s who joined us in February 2006, our Chief Supply Chain Officer who joined us in May 2006, and our Chief Information Officer who joined us in September 2006.

 

Although certain of the members of our senior management team have employment agreements with us, these agreements may not provide sufficient incentives for these officers to continue employment with us. The loss of one or more of the members of our senior management team could adversely affect our business. We do not maintain key man insurance on any of the members of our senior management team.

 

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None.

 

 

As of December 31, 2006, we operated 227 O’Charley’s restaurants, 114 Ninety Nine restaurants and ten Stoney River Legendary Steak restaurants. As of that date, we owned the land and building at 96 of our O’Charley’s restaurants, leased the land and building at 44 of our O’Charley’s restaurants and leased the land only at 87 of our O’Charley’s restaurants. We lease the land and building at 87 of our Ninety Nine restaurants and lease the land only at 27 of our Ninety Nine restaurants. We own the land and building at four of our Stoney River restaurants, lease the land only at two Stoney River restaurants and lease the land and building at four Stoney River Restaurants. See “Item 1-Business-Restaurant Locations” above. Restaurant lease expirations range from 2007 to 2025, with the majority of the leases providing for an option to renew for additional terms ranging from five to 20 years. All of our restaurant leases provide for a specified annual rental, and some leases call for additional rental based on sales volume at the particular location over specified minimum levels. Generally, our restaurant leases are net leases, which require us to pay the cost of insurance and taxes.

 

Our primary quality product center and our corporate office are located in Nashville, Tennessee in a total of approximately 290,000 square feet of office, manufacturing and warehouse space. We own this facility. We also have administrative offices in Woburn, Massachusetts and a quality product center located in approximately 20,000 square feet of space. We lease these facilities. We also lease a distribution facility with approximately 79,000 square feet of space in Bellingham, Massachusetts for our Ninety Nine concept. We also lease approximately 16,000 square feet of office space in Brentwood, Tennessee which is used for the Financial Services Center (FSC).

 

 

In September 2003, we became aware that guests and employees at one of our O’Charley’s restaurants located in Knoxville, Tennessee were exposed to the Hepatitis A virus, which resulted in a number of our employees and guests becoming infected. As of the date of this filing, all of these cases have been settled and dismissed. We have insurance that provides coverage, subject to limitations, for lost income at our restaurants whose results of operations were adversely affected by the Hepatitis A incident. We submitted a claim pursuant to our insurance policy for this type of loss, but our carrier disagreed with our claim. On July 11, 2005, certain underwriters at Lloyd’s, our insurance carrier, filed suit against us in the Circuit Court for Knox County, Tennessee seeking declaration by the court regarding certain limits in this policy which would effectively limit our recovery under the policy to $100,000. During the first quarter of fiscal 2007, we entered into a release and settlement agreement with Lloyd’s, which will be included in our results of operations for the first fiscal quarter of 2007. As the settlement will result in a gain, it was not recognized until the settlement was certain, which was during the first fiscal quarter of 2007.

 

We have been involved in an arbitration in the matter of Ballantyne Village, LLC v. O’Charley’s Inc. filed in April 2005. Ballantyne Village, LLC has alleged that we breached a lease for retail space for a proposed Stoney River Legendary Steaks restaurant in Charlotte, North Carolina. During the first quarter of fiscal 2007, we entered into a settlement and release agreement with the plaintiff. The amount of our settlement was included in our results of operations for the fiscal year ended December 31, 2006.

 

On May 19, 2006, Meritage Hospitality Group, Inc. and certain of its affiliated entities (“Meritage”), which franchise five O’Charley’s restaurants in Michigan, filed suit against us in the United States District Court for the Western District of Michigan. The suit alleged that we engaged in fraud and violations of the Michigan Franchise Investment Law and Michigan Consumer Protection Act in connection with Meritage becoming a franchisee of our O’Charley’s restaurant concept. The suit sought rescission of the development agreement and five franchise agreements with us and related damages. During the first quarter of fiscal 2007, we entered into a general release with Meritage pursuant to which Meritage agreed to dismiss the litigation filed against us and we agreed to make certain future financial and other accommodations to Meritage under the terms of their development and franchise agreements.

 

In addition, we are defendants and plaintiffs from time to time in various other legal proceedings arising in the ordinary course of our business, including claims relating to injury or wrongful death under “dram shop” laws that allow a person to sue us based on any injury caused by an intoxicated person who was wrongfully served alcoholic beverages at one of our restaurants; claims relating to workplace and employment matters, discrimination and similar matters; claims resulting from “slip and fall” accidents; claims with respect to insurance recoveries; claims relating to lease obligations; and claims from our guests or employees alleging illness, injury or other food quality, health or operational concerns.

 

We do not believe that any of the legal proceedings pending against us as of the date of this report will have a material adverse effect on our liquidity or financial condition. We may incur liabilities or accrue expenses relating to future legal proceedings in a particular fiscal quarter which may adversely affect our results of operations.

 

 

No matters were submitted to a vote of shareholders during the fourth quarter ended December 31, 2006.

 

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PART II

 

 

Our common stock trades on the NASDAQ National Market under the symbol “CHUX.” As of March 9, 2007, there were approximately 3,134 shareholders of record of our common stock. The following table shows quarterly high and low bid prices for our common stock for the periods indicated, as reported by the NASDAQ National Market.

 

 

We have never paid a cash dividend on our common stock. Our credit facility limits the payment of cash dividends on our common stock without the consent of the participating banks.

 

On January 27, 2003, we issued 941,176 shares of common stock to the former owners of Ninety Nine as part of the purchase price of the acquisition of Ninety Nine Restaurants. We issued an additional 390,586 shares in January 2004, 407,843 shares in January 2005, 407,843 shares in January 2006, 94,118 in January 2007 and we are required to issue an additional 94,118 shares in January 2008. The issuance of the shares to the former owners of Ninety Nine was exempt from the registration requirements of the Securities Act of 1933 pursuant to Section 4(2) of the Securities Act of 1933.

 

 

The selected financial data presented below under the captions “Statement of Operations Data” and “Balance Sheet Data” for, and as of the end of, each of the fiscal years in the five-year period ended December 31, 2006, were derived from the consolidated financial statements of O’Charley’s Inc. and subsidiaries. The selected data should be read in conjunction with the consolidated financial statements as of December 31, 2006 and December 25, 2005 and for each of the years in the three-year period ended December 31, 2006, and the related notes thereto appearing in this Form 10-K. Certain prior year amounts have been reclassified to conform to the current year presentation.

 

When you read this financial data, it is important that you also read the consolidated financial statements and related notes included in this Form 10-K, as well as the section of this report entitled Management’s Discussion and Analysis of Financial Condition and Results of

Operations. Historical results are not necessarily indicative of future results.

 

 

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Overview

 

We are a leading casual dining restaurant company headquartered in Nashville, Tennessee. We own and operate three restaurant concepts under the “O’Charley’s,” “Ninety Nine” and “Stoney River Legendary Steaks” trade names. As of December 31, 2006, we operated 227 O’Charley’s restaurants in 16 states in the Southeast and Midwest regions, 114 Ninety Nine restaurants in nine Northeastern states, and ten Stoney River restaurants in the Southeast and Midwest. As of December 31, 2006, we had six franchised O’Charley’s restaurants including five franchised O’Charley’s restaurants in Michigan and one franchised O'Charley's restaurant in Ohio. As of December 31, 2006, we had three joint venture O’Charley’s restaurants in Louisiana, and one joint venture O'Charley's restaurant in Wisconsin, in all of which we have an ownership interest.

 

On February 8, 2007, we reported our fiscal 2006 earnings in our unaudited press release. Subsequently, we concluded that we needed to reclass share-based compensation expense associated with SFAS 123(R). Historically, we have classified all share-based compensation on our consolidated statements of earnings in the “General and Administrative Expense” line. On March 29, 2005 the Securities Exchange Commission issued Staff Accounting Bulletin 107 (SAB 107) to address the interaction of SFAS 123 (R) and certain Securities and Exchange Commission rules and regulations. One of the items addressed in SAB 107 in item F was the classification of share-based compensation expense on the income statement. Item F stated that companies should present the expense related to share-based payment arrangements in the same line or lines as cash compensation paid to the same employees. We therefore concluded that our past practice was incorrect and have made reclasses in the current and prior year presentations throughout this 10-K to reflect those reclasses. The following table sets forth the impact to each affected line item as a result of the reclassification adjustments:

 

 

strategy is focused on:

 

Strengthening the organization with a new core of talent and building a winning team. During 2006, we continued to build our core of executive talent as we hired a Concept President – O'Charley's, Chief Supply Chain Officer, Senior Corporate Counsel, Chief Information Officer, Vice President of Human Resource Development, Vice President of Communications and Vice President of Strategic Sourcing. We now believe that we have in place a management team that is substantially complete and that will be able to execute successfully our turnaround and transformation efforts. We have already benefited from the new ideas and strategies that our new team members have brought to O’Charley’s which we believe is reflected in the improvement in our fiscal 2006 consolidated operating margin. We are now working to optimize the performance of every member of our organization in order to achieve our long-term vision to be the Best of Class in food and service in our segments of the restaurant industry.

 

Improving the box economics through the execution of product and labor cost management and increasing same restaurant sales through new product offerings, new marketing, and a more analytical approach to menu pricing. . As a percentage of restaurant sales, cost of food and beverage and payroll and benefits costs in 2006 were both lower than in the prior-year on a consolidated basis. This was the result of a higher average check in all three of our concepts, the impact of our theoretical food cost system and our increased focus on team member and management labor productivity as well as changes we made to our restaurant-level incentive plans. We have also made the decision to gradually phase out our Kids-Eat-Free program by mid-2008 which we believe will in the short term decrease the number of our guest visits but will increase our average check and operating margin. Our intent is to increase same restaurant sales through new product offerings, our limited time or seasonal product offerings and increase in service levels.

 

Our ‘Project RevO’lution’ and ‘Project Dress to the Nines’ teams continue to focus on box economics by, among other initiatives, developing new team member selection and training tools, introducing new kitchen technology and engineering, capitalizing on dining room efficiencies and applying these improvements along with our rebrandings of our O’Charley’s and Ninety Nine restaurants. Another important aspect of our rebranding is the introduction of concept specific elements including new uniforms, plateware, menu designs, Curbside-To-Go service and new service standards. We have now completed 11 ‘Project RevO’lution’ rebrandings at our O’Charley’s restaurants, and 14 ‘Dressed to the Nines’ rebrandings at our Ninety Nine restaurants. We plan to complete an additional five rebrandings at O’Charley’s, and three rebrandings at Ninety Nine during the first quarter of 2007. While we still consider the rebrandings completed to date a test, we continue to be pleased with the increased sales volume following the reopening of these restaurants.

 

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We have also developed a new prototype restaurant which features new interior and exterior color schemes, new exterior signage and a number of interior changes designed to enhance the guest experience and improve operational efficiencies in both the dining room and kitchen. All of the planned new O’Charley’s and Ninety Nine restaurants for 2007 will feature this new prototype design.

 

Enhancing guest satisfaction and intent to return by instilling “A Passion to Serve” ^SM. In 2005, we adopted the vision statement: ‘A Passion to Serve’ ^SM. This statement describes our commitment to our guests, each other, our stakeholders and our communities. Our vision is to be the Best of Class in food and service in our segments of the restaurant industry. We are holding ourselves to higher standards as measured by our Guest Satisfaction Index or “GSI”. Our ‘Project Rev’Olution’ and ‘Project Dressed to the Nines’ initiatives are designed to improve the guest experience. Our senior management teams at Ninety Nine and O’Charley’s have followed this roll out with a combination of in-store and market focus groups designed to solicit feedback about how we can continue to improve our delivery of great food and service. We believe that an increase in the average check requires sustainable improvement in the guest experience. We believe that we are taking the appropriate steps to generate profitable and sustainable growth while enhancing shareholder value.

 

Fiscal years end on the last Sunday of the calendar year. Fiscal year 2006 consisted of a 53 week year while 2005 and 2004 each consisted of 52 weeks. We have one reportable segment.

 

Following is an explanation of certain items in our consolidated statements of operations:

 

Revenues consist of Company-operated and joint venture restaurant sales and, to a lesser extent, commissary sales and franchise revenue. Restaurant sales include food and beverage sales and are net of applicable state and local sales taxes and discounts. Commissary sales represent sales to outside parties consisting primarily of sales of O’Charley’s branded food items, primarily salad dressings, to retail grocery chains, mass merchandisers, wholesale clubs and franchisees. Franchise revenue consists of development fees and royalties on sales of franchised units. Our development fees for franchisees in which we do not have an ownership interest are generally $50,000 for the first two restaurants and $25,000 for each additional restaurant opened by the franchisee. The development fees are recognized during the reporting period in which the developed restaurant begins operation. The royalties are recognized in revenue in the period corresponding to the franchisees’ sales.

 

Cost of Food and Beverage primarily consists of the costs of beef, poultry, seafood, produce and alcoholic and non-alcoholic beverages net of vendor discounts and rebates. The two most significant commodities that may affect our cost of food and beverage are beef and seafood, which account for approximately 19 percent to 21 percent and eight percent to ten percent, respectively, of our overall cost of food and beverage. Generally, temporary increases in these costs are not passed on to guests; however, in the past, we have adjusted menu prices to compensate for increased costs of a more permanent nature.

 

Payroll and Benefits include payroll and related costs and expenses directly relating to restaurant level activities including restaurant management salaries, bonuses, share-based compensation, hourly wages for restaurant level team members, payroll taxes, workers’ compensation, various health, life and dental insurance programs, vacation expense and sick pay. We have various incentive bonus plans that compensate restaurant management for achieving certain restaurant level financial targets and performance goals.

 

Restaurant Operating Costs include occupancy and other expenses at the restaurant level, except property and equipment depreciation and amortization. In addition to occupancy costs, supplies, straight-line rent, supervisory salaries, bonuses, share-based compensation and related expenses, management training salaries, general liability and property insurance, property taxes, utilities, repairs and maintenance, outside services and credit card fees account for the major expenses in this category.

 

Advertising and Marketing Expenses include all advertising and marketing-related expenses for the various programs that we utilize to promote traffic and brand recognition for our three restaurant concepts. This category also includes the administrative costs of our marketing departments.

 

General and Administrative Expenses include the costs of restaurant support center administrative functions that support the existing restaurant base and provide the infrastructure for future growth. Executive management and support staff salaries, bonuses, share-based compensation and related expenses, data processing, legal and accounting expenses, and office expenses account for the major expenses in this category. This category also includes all recruiting, relocation and severance-related expenses.

 

Depreciation and Amortization Property and Equipment, primarily includes depreciation on property and equipment calculated on a straight-line basis over the estimated useful lives of the respective assets or the lease term plus one renewal term for leasehold improvements, if shorter.

 

Asset Impairment and Disposals includes costs associated with the impairment of land, buildings and equipment and certain other assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to the future undiscounted net cash flows expected to be generated by the assets. Impairment costs also include the write-off of certain assets at existing restaurants for remodels related to ‘Project Rev’Olution’ and ‘Dressed to the Nines’. Disposal costs include the costs incurred to prepare the asset or assets for sale including the following: repair and maintenance, clean up costs, broker commissions, independent appraisals, insurance deductibles and proceeds. Gains and/or losses associated with the sale of assets are also included in this category.

 

Pre-opening Costs represent costs associated with our store opening teams, as well as other costs associated with opening a new restaurant and are expensed as incurred. These costs also include straight-line rent related to leased properties from the period of time between when we have waived any contingencies regarding use of the leased property and the date on which the restaurant opens. The amount of pre-opening costs incurred in any one period includes costs incurred during the period for restaurants opened and under development. Our pre-opening costs may vary significantly from period to period primarily due to the timing of restaurant development and openings.

 

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Results of Operations

 

The following information should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and the related notes thereto included elsewhere herein. The following table reflects our operating results for fiscal years 2006, 2005, and 2004 as a percentage of total revenues unless otherwise indicated. Fiscal year 2006 was comprised of 53 weeks and fiscal years 2005 and 2004 comprised of 52 weeks.

 

 

 

 

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The following information should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and the related notes thereto included elsewhere herein. The following table reflects the margin performance of each of our concepts for fiscal years 2006, 2005, and 2004 as a percentage of restaurant sales for each respective concept. Fiscal year 2006 was comprised of 53 weeks and fiscal years 2005 and 2004 comprised of 52 weeks.

 

 

 

 

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The following tables set forth certain unaudited financial and other restaurant data relating to company-owned restaurants, unless otherwise specified:

 

 

 

 

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Fiscal Year 2006 Compared with Fiscal Year 2005

 

Revenues

 

During 2006, total revenues increased $59.3 million, or 6.4 percent, to $989.5 million from $930.2 million in 2005. In 2006, we increased average check at all of our concepts, partially offset by a decrease in guest visits at all of our concepts. The increase in check average and decrease in guest counts was primarily attributable to the partial phase out of the Kids-Eat-Free program at our O’Charley’s concept, the reduction of promotional coupons and a more analytical approach to menu pricing at all of our concepts in 2006. In 2006, we had 53 weeks as compared to 52 weeks in fiscal 2005 and the estimated revenue increase associated with the 53^rd week was $21.2 million. We also had a net addition of ten company-owned restaurants in 2006.

 

O’Charley’s company-operated restaurant sales increased $15.1 million, or 2.5 percent, to $626.3 million during 2006 as compared to $611.2 million in 2005, as a result of an increase in average check of 4.4 percent offset by a decrease in same restaurant guest visits of 5.0 percent. During 2006 we added three new and closed one company-operated O’Charley’s restaurants.

 

Ninety Nine restaurant sales increased $29.7 million, or 10.5 percent, to $311.9 million during 2006 as compared to $282.2 million in 2005. The year-over-year sales increase was primarily related to a same restaurant sales increase of 0.7 percent and the addition of five new restaurants during 2006. The same restaurant sales increase was comprised of a 3.0 percent increase in average check partially offset by a decrease in guest counts of 2.2 percent.

 

Stoney River restaurant sales increased $8.6 million, or 34.5 percent, to $33.5 million during 2006 as compared to $24.9 million in the same prior year period, as a result of same restaurant sales increases of 4.0 percent and the addition of three restaurants. The same restaurant sales increase was comprised of a 4.4 increase in average check partially offset by a decrease in guest visits of 0.3 percent.

 

Cost of Food and Beverage

 

During 2006, our cost of food and beverage was $291.8 million, or 29.8 percent of restaurant sales, compared with $277.4 million in the same prior year period, or 30.1 percent of restaurant sales, in 2005. This 30 basis point improvement in food and beverage cost as a percentage of sales in the year reflects the impact of higher average checks and lower costs for poultry, cheese and cooking oils and by a further narrowing of the gap between our theoretical and actual food costs at the O’Charley’s concept, partially offset by higher costs for beef and seafood, and higher fuel-related distribution costs.

 

Payroll and Benefits

 

During 2006, payroll and benefits were $328.8 million, or 33.6 percent of restaurant sales, compared to $318.5 million in the same prior year period, or 34.6 percent of restaurant sales, in 2005 reflecting an improvement of 100 basis points. Payroll and benefits costs as a percentage of restaurant sales were lower at the O’Charley’s concept when compared to the prior year. Reductions in employee benefits expense, management salaries, and restaurant-level bonus expense were partially offset by higher hourly wage expenses and share-based compensation. The reduction in management salaries reflects reductions in the average number of managers per restaurant in the O’Charley’s concept, while the reduction in bonus expense reflects the impact of our new performance focused bonus plans. The cost of our employee benefit plans was lower as a percentage of restaurant sales in 2006 than in 2005, reflecting reductions negotiated with certain health care plans earlier in 2006, and the implementation of our new benefit plans on September 1, 2006.

 

Restaurant Operating Costs

 

During 2006, restaurant operating costs were $185.9 million, or 19.0 percent of restaurant sales, compared to $172.4 million in the same prior year period, or 18.7 percent of restaurant sales, in the same prior year period. This 30 basis point increase is primarily the result of an increase in utility costs, and an increase in repair and maintenance.

 

Advertising and Marketing Expenses

 

During 2006, advertising and marketing expenditures increased 9.4 percent to $27.9 million from $25.5 million in 2005 and, as a percentage of total revenues, increased to 2.8 percent from 2.7 percent in prior-year. The ten basis point increase as a percentage of sales is primarily attributable to additional advertising and marketing expenditures to support our limited time menu offerings.

 

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General and Administrative Expenses

 

General and administrative expenses increased 22.0 percent to $52.2 million in 2006 from $42.8 million in 2005, and as a percentage of total revenues, increased to 5.3 percent from 4.6 percent in the prior-year. This 70 basis point increase in general and administrative expenses is primarily the result of severance, recruiting and relocation expenses related to our recent management changes, an increase in incentive compensation expense, an increase in share-based compensation expense and an increase in legal expenses, partially offset by decreases in other areas. The increase in legal expense is primarily attributable to previously disclosed legal proceedings. See footnote 19 in the Notes to the consolidated financial statements for a description of these legal proceedings. The increase in share-based compensation expense is primarily attributable to restricted share expense and also includes the expensing of stock options and the employee stock purchase plan discount as a result of the adoption of Financial Accounting Standards Board Statement No. 123R, “Share-Based Payment”.

 

Depreciation and Amortization

 

During 2006, depreciation and amortization expense was $46.6 million as compared to $43.8 million in 2005 and was flat as a percentage of total revenues at 4.7 percent. The increase in deprecation and amortization is primarily attributable to the Company’s capital expenditures in 2006 and 2005.

 

Asset Impairment and Disposals

 

Our results of operations for the year ended December 31, 2006 include net charges of $2.1 million for asset impairment and disposals. This amount includes an asset impairment charge of approximately $1.6 million related to the three planned O’Charley’s restaurant closures, $1.9 million relating to one O’Charley’s restaurant and two Ninety Nine restaurants that are impaired but will remain open, and $1.0 million relating to the impairment of purchased software and assets related to the Company’s rebranding efforts. The $4.5 million charge in 2006 was offset by a net gain of $2.4 million on assets held for sale and other assets that were sold or settled. In 2005, the Company recorded impairment and disposal charges of $7.3 million related to six restaurant closures, a corporate aircraft, two restaurants that remained open and other non-operating assets.

 

Pre-opening Costs

 

During 2006, our pre-opening costs decreased approximately $1.7 million to $4.6 million, or 0.5 percent of total revenues, compared with $6.3 million in the same prior year period, or 0.7 percent of total revenues, in 2005. The 27.0 percent decrease is due to 11 company-owned restaurant openings in 2006 as compared to 24 company-owned restaurant openings in 2005.

 

Interest Expense

 

Our interest costs were $14.4 million in 2006 as compared to $14.4 million in 2005. Interest expense during 2006 reflects $125.0 million of senior subordinated notes at a fixed rate of 9.0 percent; approximately $7.0 million weighted average debt outstanding on our $125.0 million revolving credit facility; and other debt including capitalized lease obligations and prepaid financing costs. Approximately $100.0 million of the 9.0 percent senior subordinated notes have been effectively converted through interest rate swap agreements into a variable interest rate obligation based on the six-month LIBOR rate in arrears plus 3.9 percent. On October 18, 2006, we entered into a five-year $125 million secured revolving credit facility, which amended and restated our $125 million secured revolving credit facility that was scheduled to mature on November 4, 2007. This new facility is less costly to us than the facility that it replaced, and we believe that it provides us with greater financial flexibility. At December 31, 2006, there were no amounts outstanding under the new credit facility.

 

Income Taxes

 

During 2006, our income tax expense increased $5.2 million to $7.2 million, or 0.7 percent of total revenues, compared with $2.0 million, or 0.2 percent of total revenues, in 2005. Our effective tax rate was 27.6 percent in 2006 compared to 14.3 percent in 2005. This increase was primarily attributable to higher 2006 pretax earnings.

 

 

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Fiscal Year 2005 Compared with Fiscal Year 2004

 

Revenues

 

During 2005, total revenues increased $58.8 million, or 6.7 percent, to $930.2 million from $871.4 million in 2004. In 2005, we averaged 337 restaurants in operation per quarter as compared to 317 restaurants in operation per quarter in 2004.

 

O’Charley’s company-operated restaurant sales increased $22.8 million, or 3.9 percent, to $611.2 million during 2005, as a result of the net addition of four new restaurants during 2005. Same restaurant sales were flat for the year.

 

Ninety Nine restaurant sales increased $30.3 million, or 12.0 percent, to $282.2 million during 2005. The year-over-year sales increase was primarily related to a same restaurant sales increase of 0.7 percent and the addition of ten new restaurants during 2005. The same restaurant sales increase was comprised of a 1.4 percent increase in guest counts offset by a decrease in check average of 0.8 percent.

 

Stoney River restaurant sales increased $1.4 million, or 6.0 percent, to $24.9 million during 2005, as a result of same restaurant sales increases of 3.7 percent. The 3.7 percent same restaurant sales increase was comprised of a 2.6 percent improvement in the average check and a 1.1 percent increase in guest counts.

 

Cost of Food and Beverage

 

While our cost of food and beverage in 2005 was lower than 2004 by 0.1 percent as a percentage of sales it was higher than we anticipated, due in part to our traffic-building promotions, higher distribution costs and higher costs associated with the opening of the Bellingham distribution center. Reductions in poultry costs were offset by increases in produce costs resulting from weather related crop damage, and increased seafood costs.

 

Payroll and Benefits

 

During 2005, payroll and benefits increased 90 basis points as a percentage of restaurant sales compared to the same prior-year period. Higher average wage and benefit rates and declines in productivity contributed to the increase as well as an increase in the hourly health care plans in 2005 as compared to 2004.

 

Restaurant Operating Costs

 

Restaurant operating costs as a percentage of restaurant sales increased 40 basis points during 2005. Increases in packaging costs, higher energy costs and repairs and maintenance costs resulted in the year-over-year increase. The higher packaging costs were the result of an increase in packaging material costs combined with increases in our to-go sales. The increase in energy costs were primarily associated with natural gas price increases.

 

Advertising and Marketing Expenses

 

During 2005, our advertising and marketing costs decreased $0.2 million to $25.5 million, or 2.7 percent of total revenues, compared with $25.7 million, or 2.9 percent of total revenues, in 2004. The decrease in advertising and marketing expenditures as a percentage of total revenues is primarily due to the use of the same promotional calendar on a year-over-year basis, enabling us to utilize some print and television media which were produced in the prior years.

 

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General and Administrative Expenses

 

During 2005, our general and administrative costs increased $4.4 million to $42.8 million, or 4.6 percent of total revenues, compared with $38.4 million, or 4.4 percent of total revenues, in 2004. General and administrative expenses increased in 2005 as compared to 2004 primarily because of $1.5 million in severance and consulting expenses associated with the financial system conversion project. We also incurred approximately $0.8 million in severance and recruiting expenses in 2005 associated with previously announced management changes. In 2004, we incurred severance and related costs of approximately $1.2 million associated with the organizational changes that were implemented during the third and fourth quarter of 2004.

 

Depreciation and Amortization

 

During 2005, our depreciation and amortization costs increased $4.0 million to $43.8 million, or 4.7 percent of total revenues, compared with $39.8 million, or 4.6 percent of total revenues, in 2004. The 10.1percent increase is primarily attributable to additions of long-lived assets of $68.8 million during 2005.

 

Asset Impairment and Disposals

 

During 2005, we recorded impairment and disposal charges of $7.3 million. The impairment and disposal charges consisted of a $4.9 million charge related to the planned closure of six under-performing O’Charley’s restaurants, $0.9 million for two O’Charley’s restaurants that remain open, $0.3 million for losses relating to the O’Charley’s store in Biloxi, Mississippi that was destroyed by Hurricane Katrina, and a $1.1 million impairment charge to write down the value of a corporate aircraft, which we intend to sell, to reflect the difference between its current book value and the estimated net sale proceeds. These charges also include net losses of approximately $0.1 million on asset sales.

 

Pre-opening Costs

 

During 2005, our pre-opening costs increased $0.4 million to $6.3 million, or 0.7 percent of total revenues, compared with $5.9 million, or 0.7 percent of total revenues, in 2004. The 6.1 percent increase is due to timing of restaurant openings and the increased costs incurred for opening the first Stoney River restaurant since 2002.

 

Interest Expense

 

During 2005, our interest costs increased $1.8 million to $14.4 million, or 1.5 percent of total revenues, compared with $12.6 million, or 1.4 percent of total revenues, in 2004. The 14.0 percent increase is due to higher short-term interest rates on our variable rate debt. Interest expense during 2005 reflects $125.0 million of senior subordinated notes at a fixed rate of 9.0 percent; approximately $15.7 million weighted average debt outstanding on our $125.0 million revolving credit facility at one-month LIBOR plus 1.25 percent; and other debt including capitalized lease obligations and prepaid financing costs. Approximately $100.0 million of the 9.0 percent senior subordinated notes have been effectively converted through interest rate swap agreements into a variable interest rate obligation based on the six-month LIBOR rate in arrears plus 3.9 percent.

 

Income Taxes

 

During 2005, our income tax expense decreased $7.4 million to $2.0 million, or 0.2 percent of total revenues, compared with $9.4 million, or 1.1 percent of total revenues, in 2004. Our effective tax rate of 28.6 percent in 2004 dropped to 14.3 percent in 2005. This decrease was primarily attributable to higher 2005 tax credits and lower 2005 pre-tax earnings.

 

 

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Outlook

 

We expect to report net earnings per diluted share of between $0.27 and $0.32 for the 16-week period ending April 22, 2007, and net earnings per diluted share of between $1.00 and $1.10 for the fiscal year ending December 30, 2007. Projected results for the quarter and the year are based upon anticipated same restaurant sales increases of less than 2 percent for the O’Charley’s and Ninety Nine concepts, and continued year-over-year improvement in restaurant-level margins. In 2007, we expect to open between four and six new O’Charley’s company-operated restaurants, between three and five new Ninety Nine restaurants, and one or two new Stoney River restaurants. Although we have not yet decided to proceed with a full roll-out of these projects, we anticipate between 20 and 30 ‘Project RevO’lution’ rebrandings at O’Charley’s. We also expect to complete approximately 30 ‘Dressed to the Nines’ rebrandings at Ninety Nine. The training expenses and asset write-offs associated with these rebrandings are expected to have a negative impact on net earnings in 2007. We have locked in our pricing for approximately 90 percent of our annual requirements for poultry and approximately 85 percent of our annual requirement for pork. Compared to 2006, our contracted pricing for 2007 is approximately flat for poultry and more than 10 percent lower for pork. Given the current conditions in the beef market we have only locked in pricing for most of the projected needs for the first quarter of 2007. Our guidance for the first quarter and full year 2007 does not reflect any impact for charges or expenses arising from decisions we may make during 2007 as part of our turnaround efforts.

Our earnings guidance for the 2007 fiscal year represents a reduction from the preliminary guidance that we offered on October 26, 2006 due to a more challenging sales environment, and the subsequent passage of minimum wage increases in a number of states. Adjusting for the impact of the 53^rd week, and the charges for asset impairments and disposals and severance and related costs in 2006, our full-year guidance for 2007 anticipates an increase in net earnings per diluted share of between 25 percent and 35 percent. We plan to continue to execute all elements of our plan, including improving the overall guest experience in our restaurants, managing our margins, and instilling ‘A Passion to Serve’™ throughout our organization.

 

Liquidity and Capital Resources

 

Our primary sources of capital have historically been cash provided by operations, borrowings under our credit facilities and capital leases. Our principal capital needs have historically arisen from property and equipment additions, acquisitions, and payments on long-term debt and capitalized lease obligations. In addition, we lease a substantial number of our restaurants under operating leases and have substantial operating lease obligations. Like many restaurant companies, our working capital has historically had current liabilities in excess of current assets due to the fact that most of our sales are received as cash or credit card charges, and we have reinvested our cash in new restaurant development. We do not believe this indicates a lack of liquidity. To the extent operations generate cash in excess of working capital and development needs, we have historically invested this cash in overnight repurchase agreements. As previously announced, we have slowed our restaurant development in order to focus on improving the performance of our existing restaurants. We opened three Company-owned O’Charley’s restaurants, five Ninety Nine restaurants and three Stoney River restaurant during 2006.

 

On October 18, 2006, we entered into a Second Amended and Restated Credit Agreement, dated as of October 18, 2006 (the “Credit Agreement”). The Credit Agreement amended and restated our existing senior secured credit facility entered into on November 4, 2003. The Credit Agreement provides for a five-year, $125.0 million revolving credit facility and permits us to request an increase in the principal amount of the facility of up to $25 million. At December 31, 2006, we had no amounts outstanding on the revolving credit facility except for approximately $9.3 million in letters of credit which reduced our available borrowings under the Credit Agreement.

 

The Credit Agreement includes certain customary representations and warranties, negative covenants and events of default. It requires us to comply with certain financial covenants, including adjusted debt to EBITDAR ratio, a senior secured leverage ratio, a fixed-charge coverage ratio and capital expenditures ratio. We were in compliance with such covenants at December 31, 2006.

 

The interest rates per annum applicable to loans outstanding under the Credit Agreement will, at our option, be equal to either a base rate or a LIBOR rate, in each case plus an applicable margin (0.0 percent to 0.5 percent in the case of base rate loans and 0.75 percent to 1.25 percent in the case of LIBOR rate loans), depending on our senior secured leverage ratio. At December 31, 2006, our margin applicable to LIBOR loans was 0.75 percent. In addition to the interest payments required under the Credit Agreement, we are required to pay a commitment fee on the aggregate average daily unused portion of the credit facility equal to 0.25 percent to 0.375 percent per annum, depending on our senior secured leverage ratio.

Our obligations under the Credit Agreement are secured by liens on substantially all of our assets, including a pledge of the capital stock of our material subsidiaries (but excluding real property acquired after November 3, 2003). Except as otherwise provided in the Credit Agreement, the Credit Agreement will mature on October 18, 2011. From time to time, we have entered into interest rate swap agreements with certain financial institutions. During the first quarter of 2004, we entered into interest rate swap agreements with a financial institution that effectively convert a portion of the fixed-rate indebtedness related to the $125 million aggregate principal amount of senior subordinated notes due 2013 into variable-rate obligations. The total notional amount of these swaps was $100.0 million and is based on the six-month LIBOR rate in arrears plus a specified margin, the average of which is 3.9 percent. The terms and conditions of these swaps mirror the interest terms and conditions on our 9.0 percent senior subordinated notes due 2013 and are accounted for as fair value hedges. These swap agreements expire in November 2013. Our weighted average interest rate for the years ended December 31, 2006 and December 25, 2005 was 8.7 percent and 7.8 percent, respectively.

 

In October 2003, we announced an authorization to repurchase up to $25.0 million of our common stock. Any repurchases will be made from time to time in open market transactions or privately negotiated transactions at our discretion. To date, we have not repurchased any shares of our common stock under this authorization. Any repurchases will be funded by cash provided by operations or proceeds from short-term borrowings under our credit facility and will be reported in the Company’s quarterly reports on Form 10-Q or annual report on Form 10-K for the period in which any such repurchase occurs in accordance with applicable SEC rules.

 

In 2006, net cash flows used by investing activities included capital expenditures incurred principally for building new restaurants, improvements to existing restaurants, new equipment and improvements at our Quality Product Center, and technological improvements at our restaurant support center. The Company did not finance any capital expenditures during the year ended December 31, 2006. During the year

 

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ended December 25, 2005, new equipment financed through capitalized lease obligations was $4.5 million. Capital expenditures for the years ended December 31, 2006 and December 25, 2005 were as follows:

 

 

We expect capital expenditures in 2007 to be between $55.0 million and $60.0 million. As part of our focus on improving results in our existing restaurants, we plan to develop and open fewer restaurants in 2007 than we have developed prior to 2006. We expect to open between four and six new company-owned O’Charley’s restaurants, between three and five new Ninety Nine restaurants, and one or two new Stoney River restaurants in 2007. Our capital expenditure projections for 2007 include between 20 and 30 ‘Project Rev’Olution’ rebrandings for our O’Charley’s concept and approximately 30 ‘Dressed to the Nines’ rebrandings for our Ninety Nine concept.

 

The following tables set forth our capital structure and certain financial ratios and financial data at and for the fiscal years ended December 31, 2006 and December 25, 2005:

 

 

 

 

 

 

 

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Based upon the current level of operations and anticipated growth for our restaurant concepts, we believe that cash flow from operations and borrowings under our Credit Agreement are sufficient to fund our working capital needs over at least the next 12 months. There can be no assurances that such sources of financing will be available to us or that any such financing would not negatively impact our earnings. Contractual Obligations and Commercial Commitments

 

The following tables set forth our contractual obligations and commercial commitments at December 31, 2006.

 

 

 

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Joint Ventures and Franchise Arrangements

 

In connection with our franchising initiative, we may from time to time enter into joint venture arrangements to develop and operate O’Charley’s restaurants. For any franchisee in which we have an ownership interest, we may make loans to the joint venture entity and/or guarantee certain of its debt and obligations.

 

To date, we have invested in two joint ventures for the development of O’Charley’s restaurants. On August 20, 2004, we invested in a joint venture for the development of three O’Charley’s restaurants in certain markets in Southern Louisiana. On November 8, 2004, we invested in a joint venture for the development of three O’Charley’s restaurants in Wisconsin. Under the terms of the Limited Liability Company Agreements for both of the joint ventures, ownership of the joint venture entity is shared equally between us and our joint venture partner. The joint venture entity is managed by a Board of Managers composed of two individuals designated by the joint venture partner and two individuals designated by us. The joint venture partner was required to make capital contributions in the aggregate amount of $500,000 to the joint venture entity and we agreed to make initial loans to the joint venture entity in the maximum principal amount of $750,000. The loans are secured by substantially all of the assets of the joint venture entity and are partially guaranteed by the joint venture partner.

 

In order to assist this first joint venture (JFC Enterprises, LLC) to open its restaurants, we decided to make additional loans to the joint venture, and as of December 31, 2006, we had advanced a total of approximately $8.4 million to the joint venture. In addition, the joint venture has been given access to a $1.2 million loan through GE Capital Franchise Finance Corporation which we guarantee. These loans funded most of the investment in the building and equipment, and the start-up and operating losses incurred in the joint venture’s restaurants. Although we are not obligated to do so, we are likely to fund future operating losses.

 

In similar fashion to our first joint venture, in order to assist our second joint venture (WI-Tenn Restaurants, LLC) to open its restaurants, we decided to make additional loans to the joint venture, and as of December 31, 2006, we had advanced a total of approximately $3.5 million to the joint venture. This loan funded most of the investment in the building and equipment, and the start-up and operating losses incurred in the joint venture’s restaurants.

 

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Under FIN 46(R), both joint ventures are variable interest entities, as we do not anticipate them having sufficient equity to fund their operations. Since we bear a disproportionate share of the financial risk associated with the joint ventures, we are deemed to be the primary beneficiary of the joint ventures, and in accordance with FIN 46(R), we consolidate the joint ventures in our consolidated financial statements.

 

On December 30, 2003, we entered into a multi-unit franchise agreement with Meritage Hospitality Group, Inc. (“Meritage”) a franchisee, to develop and operate O’Charley’s restaurants in Michigan. The agreement specifies the franchisee will develop 15 new O’Charley’s restaurants.

 

The franchising arrangement required us to provide access to certain contractual arrangements that we have with our vendors in order for the franchisee to benefit from those contracts. The development fees for the franchisee were $50,000 each for the first two restaurants and $25,000 each for the remaining 13 restaurants. The franchisee is also required to pay a franchise fee and marketing fund fee that are based on a percentage of sales. Pursuant to the arrangement, the franchisee was required to pay $212,500 as development fees at the closing of the agreement, which represents half of the fees associated with the 15 restaurants agreed upon. The franchisee is required to pay the other half of the development fee to us as each new restaurant opens. We recognized in income $25,000, $100,000 and $50,000 in development fees in fiscal 2006, 2005 and 2004 related to the opening of franchised restaurants. The remaining development fees paid have been deferred and will be recognized in income as each restaurant opens.

 

On May 19, 2006, Meritage and certain of its affiliated entities, which franchise five O’Charley’s restaurants in Michigan, filed suit against us in the United States District Court for the Western District of Michigan. The suit alleged that we engaged in fraud and violations of the Michigan Franchise Investment Law and Michigan Consumer Protection Act in connection with Meritage becoming a franchisee of our O’Charley’s restaurant concept. The suit sought rescission of the development agreement and five franchise agreements with us and related damages. During the first quarter of fiscal 2007, we entered into a general release with Meritage pursuant to which Meritage agreed to dismiss the litigation filed by them and we agreed to make certain financial and other accommodations to Meritage under the terms of their development and franchise agreements.

 

On March 28, 2005, we entered into a Development Agreement with Four Star Restaurant Group, LLC and Michael R. Johnson. Under the terms of the agreement, Four Star Restaurant Group, LLC has the right to develop and operate up to ten new O’Charley’s restaurants over the next six years in certain markets in Iowa, Nebraska, and parts of Topeka, Kansas and Eastern South Dakota.

 

The franchising arrangement requires us to provide access to certain contractual arrangements that we have with our vendors in order for the franchisee to benefit from those contracts. The development fees for the franchisee are $50,000 each for the first two restaurants and $25,000 each for the remaining eight restaurants. The franchisee is also required to pay a franchise fee and marketing fund fee that are based on a percentage of sales. Pursuant to the arrangement, the franchisee was required to pay $100,000 as development fees at the closing of the agreement, which represents a portion of the fees associated with the ten restaurants agreed upon. The franchisee is required to pay the remaining amount of the development fees to us as each new restaurant opens. The development fees paid have been deferred and will be recognized in income as each restaurant opens.

 

On May 18, 2005, we entered into a Development Agreement with O’Candall Group, Inc. and Sam Covelli. Under the terms of the agreement, O’Candall Group, Inc. and/or certain of its affiliates have the right to develop and operate up to 50 new O’Charley’s restaurants over the next eight years, with a minimum of three new O’Charley’s restaurants expected to be open by the end of 2007. The initial development plans are expected to focus on the Tampa, Florida, Orlando, Florida, Western Pennsylvania and Northern Ohio markets.

 

The franchising arrangement requires us to provide access to certain contractual arrangements that we have with our vendors in order for the franchisee to benefit from those contracts. The development fees for the franchisee are $50,000 each for the first two restaurants and $25,000 each for the remaining restaurants in each of its four granted areas. The franchisee is also required to pay a franchise fee and marketing fund fee that are based on a percentage of sales. Pursuant to the arrangement, the franchisee was required to pay $500,000 as development fees at the closing of the agreement, which represents a portion of the fees associated with the 50 restaurants agreed upon. The franchisee is required to pay the remaining amount of the development fees to us as each new restaurant opens. The Company recognized in income $50,000 in development fees in fiscal 2006 related to the opening of a franchised restaurant. The remaining development fees paid have been deferred and will be recognized in income as each restaurant opens.

 

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Critical Accounting Policies

 

We prepare our consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP). The preparation of these financial statements requires us 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 (see Note 1 to our consolidated financial statements). Actual results could differ from those estimates. Critical accounting policies are those that management believes are both most important to the portrayal of our financial condition and operating results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We base our estimates on historical experience, outside advice from parties believed to be experts in such matters, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. We consider the following policies to be most critical in understanding the judgments that are involved in preparing our consolidated financial statements.

 

Our critical accounting policies are as follows:

 

 

 

 

 

 

 

Lease Accounting

 

On February 7, 2005, the Office of the Chief Accountant of the SEC issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain accounting principles relating to three aspects of lease accounting: the period of time used for the amortization of leasehold improvements; the recognition of rent expense when the lease term in an operating lease contains a period of free or reduced rents commonly referred to as a “rent holiday”; and accounting for landlord improvement incentives to tenants. In October 2005, the FASB issued FASB Staff Position (FSP) FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period.” The FASB concludes in this FSP that rental costs associated with ground or building operating leases that are incurred during a construction period should be expensed.

 

Our policy for lease accounting involves recognizing rent on a straight-line basis from the time we are committed to a leased property, which is when all contingencies associated with the delivery of the property by the landlord are taken care of, to the end of the lease term, inclusive of one renewal period. The term, for purposes of straight-line rent calculations and the useful life over which leasehold improvements are depreciated, is the shorter of the estimated useful life of the leased property or the base lease term, inclusive of one renewal period. We also recognize tenant allowances as a deferred rent liability and amortize them over the lease term, inclusive of one renewal period.

 

Share-Based Compensation

 

Prior to the adoption of SFAS 123R, we did not record stock option expense and presented a proforma disclosure. We did however record the expense of restricted (non-vested) awards.  Effective December 26, 2005, the Company adopted SFAS No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS 123R”), which requires the measurement and recognition of compensation cost at fair value for all share-based payments including stock options. We have adopted the provisions of SFAS 123R using the modified prospective method of adoption.  As a result, share-based compensation for fiscal 2006 includes compensation expense, recognized over the applicable vesting periods, for share-based awards granted prior to, but not vested as of December 25, 2005, as well as compensation cost for new share-based awards granted during 2006.

 

Under the Black-Scholes Merton option-pricing model we estimated volatility using only historical share price performance over the expected life of the option. Results of prior periods do not reflect any restated amounts upon adoption of SFAS No. 123R under the modified prospective method. The Company’s policy is to recognize compensation cost for restricted awards with only service conditions and a graded vesting schedule on a straight-line basis over the requisite service period for the entire award. In addition, SFAS No. 123R also requires that compensation expense be recognized for only the portion of options and restricted awards that are expected to vest. Therefore, an estimated forfeiture rate derived from historical employee terminations is applied against share-based compensation expense. The forfeiture rate is applied on a straight-line basis over the service (vesting) period for each separately vesting portion of the award as if the award was in-substance, multiple awards. We have retained a third party to estimate our forfeiture rate. In addition, upon the adoption of SFAS No. 123R we began expensing the discount associated with our employee stock purchase plan based on the actual discount received.

 

Property and Equipment

 

The Company has $464.1 million of property and equipment net of accumulated depreciation at December 31, 2006. As discussed in Note 1 to the consolidated financial statements, our property and equipment are stated at cost and depreciated on a straight-line basis over the following estimated useful lives: building and improvements-30 years; furniture, fixtures and equipment-3 to 10 years. Leasehold improvements are amortized over the lesser of the asset’s estimated useful life or the expected lease term, inclusive of one renewal period. Equipment under capital

 

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leases is amortized to its expected value at the end of the lease term. Gains or losses are recognized upon the disposal of property and equipment, and the asset and related accumulated depreciation and amortization are removed from the accounts. Maintenance, repairs and betterments that do not enhance the value of or increase the life of the assets are expensed as incurred.

 

Inherent in the policies regarding property and equipment are certain significant management judgments and estimates, including useful life, residual va