Item 1. Business
General
Stater Bros. Holdings Inc. was incorporated in Delaware in 1989 and together with its wholly-owned subsidiaries, Stater Bros. Markets (“Markets”) and Stater Bros. Development, Inc. (“Development”), (collectively “Stater Bros.” or the “Company”) were founded in 1936 when the first Stater Bros. Market opened in Yucaipa, California. The Company is a leading supermarket chain in Southern California and operates 158 supermarkets under the Stater Bros. Markets name. The Company acquired controlling interest of Santee Dairies, Inc. (“Santee”) effective February 6, 2004. Santee is a subsidiary of Markets.
The Company has grown, primarily by constructing supermarkets in its primary trading areas, through the enlargement of existing supermarkets and through a strategic acquisition in August 1999 of 43 supermarkets in Southern California. Stater Bros.’ supermarkets consist of approximately 5.3 million total square feet including approximately 3.8 million selling square feet. The Company’s supermarkets offer its customers a high level of customer service, broad selections of grocery, meat, produce, liquor and general merchandise. All of the Company’s supermarkets have expanded selections of produce and full-service meat departments. Nearly all of the supermarkets have hot service delicatessens and many have bakery departments.
The Company utilizes centralized distribution facilities that provide the Company’s supermarkets with approximately 78% of the volume of the merchandise they offer for sale. The Company’s distribution facilities encompass approximately 1.7 million square feet and include facilities for grocery, grocery deli, produce, meat, meat deli, frozen, bakery, health and beauty care, and general merchandise products.
Ownership of the Company
La Cadena Investments (“La Cadena”) is the sole shareholder of the Company and holds all of the shares of the Company’s Class A Common Stock. La Cadena is a California General Partnership whose partners include Jack H. Brown, Chairman of the Board, President and Chief Executive Officer of the Company and a former member of the senior management of the Company. Jack H. Brown has a majority interest in La Cadena and is the Managing General Partner with the power to vote the shares of the Company held by La Cadena.
Stock Redemption
During fiscal 2002, the Company obtained consent of the holders of its 10.75% Senior Notes due 2006 (the “10.75% Notes”) to make a distribution and payment to stockholders consisting of $25.0 million in cash and a subordinated note in the principal amount of $20.0 million. On January 22, 2002, the Company redeemed 11,699 shares of the Company’s stock previously held by La Cadena and made a cash payment of $20.0 million and executed a $20.0 million subordinated note due March 31, 2007 to a former partner of La Cadena. The subordinated note bore interest at a rate of 5.0% per annum, payable semi-annually. On February 1, 2002, the Company paid a $4.5 million dividend to La Cadena. Fees for consent of the holders of its 10.75% Senior Notes and fees and expenses of the transaction, including a $500,000 financial advisory service fee to La Cadena, amounted to approximately $5.0 million.
Issuance of New Debt and Early Extinguishment of Debt
On June 17, 2004, the Company issued $525.0 million of unregistered 8.125% Senior Notes due June 15, 2012 and $175.0 million of unregistered Floating Rate Senior Notes due June 15, 2010. On October 4, 2004, subsequent to year-end, the Company exchanged the unregistered 8.125% Senior Notes due June 15, 2012 and unregistered Floating Rate Senior Notes due June 15, 2010 for substantially identical registered 8.125% Senior Notes due June 15, 2012 and registered Floating Rate Senior Notes due June 15, 2010 collectively, (the “Notes”). The Company incurred $22.7 million of debt issuance cost related to the issuance of the Notes which will be amortized over the term of the respective Notes.
Item 1. Business (contd.)
Business Strategy
Issuance of New Debt and Early Extinguishment of Debt (contd.)
On June 17, 2004 the Company used part of the proceeds from the issuance of these notes for the purchase of $397.8 million of the 10.75% Senior Notes due August 2006, the payment of $16.9 million for tender premium and fees on the purchased 10.75% Senior Notes, the early retirement of the $20.0 million 5.0% Subordinated Note due March 2007 and to pay accrued interest on the purchased 10.75% Senior Notes and the retired 5.0% Subordinated Note. On August 16, 2004, the Company redeemed the remaining outstanding $41.0 million 10.75% Notes and paid a make whole fee on the redemption of $1.1 million.
Store Profile and Locations
The Company’s supermarkets have well-established locations and low overhead expenses, including fixed rent payments in most supermarkets. In addition, the Company believes that its existing supermarkets are well maintained and generally require capital expenditures only for customary maintenance. An average supermarket is approximately 33,200 square feet, while newly constructed supermarkets range from approximately 40,000 square feet to 46,000 square feet. Stater Bros. supermarkets typically utilize approximately 72% of total square feet for retail selling space. The Company operates its supermarkets with minimal back-room storage space because of the close proximity of its distribution facility to its store locations. Generally, all Stater Bros. supermarkets are similarly designed and stocked thereby allowing Stater Bros.’ customers to find items easily in any of the Company’s supermarkets.
Substantially all of the Company’s 158 supermarkets are located in neighborhood shopping centers in well-populated residential areas. The Company endeavors to locate its supermarkets in growing areas that will be convenient to potential customers and will accommodate future supermarket expansion.
Management actively pursues the acquisition of sites for new supermarkets. In an effort to determine sales potential, new supermarket sites are carefully researched and analyzed by management for population shifts, zoning changes, traffic patterns, nearby new construction and competitive locations. Stater Bros. works with developers to attain the Company’s criteria for potential supermarket sites, and to insure adequate parking and a complementary co-tenant mix.
Store Expansion and Remodeling
The Company has historically focused its expansion in the San Bernardino, Riverside, Orange, Los Angeles, San Diego and Kern counties of Southern California. Such expansion has been accomplished through improving and remodeling existing stores, constructing new supermarkets, and the acquisition of other supermarket operations. The number of supermarkets operated by the Company was 158 as of September 26, 2004. The Company intends to continue to expand its existing supermarket operations by enlarging and remodeling existing supermarkets and constructing new supermarkets. The Company may also make strategic acquisitions of existing supermarkets, if such opportunities arise.
Item 1. Business (contd.)
Store Expansion and Remodeling (contd.)
The Company monitors sales and profitability of its operations on a store-by-store basis and enlarges, remodels or replaces stores in light of their performance and management’s assessment of their future potential. Approximately 87% of the Company’s supermarkets have been either newly constructed or remodeled within the last five years. Minor remodels cost between $100,000 and $500,000 and typically include new fixtures and may include a change in decor. Major remodels cost in excess of $500,000 and typically involve more extensive refurbishment of the store’s interior and may include the addition of one or more specialty service departments such as a hot service delicatessen or a bakery. Expansions entail enlargement of the store building and typically includes breaking through an exterior wall. The primary objectives of remodeling and expansions are to improve the attractiveness of supermarkets, increase sales of higher margin product categories and, where feasible, to increase selling area. The Company conducts all of its new construction and most of its remodeling through its wholly owned subsidiary Development which serves as the general contractor for all Company construction projects.
The following table sets forth certain statistical information with respect to the Company’s supermarket expansion and remodeling for the periods indicated.
Beyond 2004, the Company plans to open approximately three to six new stores per year, based upon a number of factors, including customer demand, market conditions, profitability, costs of opening, and availability of financing for such new stores. The Company’s plans with respect to major and minor remodels, expansion and new construction are reviewed continually and are revised, if appropriate, to take advantage of marketing opportunities. The Company finances its new store construction primarily from cash provided by operating activities and short-term borrowings under its credit facilities. Long-term financing of new stores generally will be obtained through either sale and leaseback transactions or secured long-term financings. However, no assurances can be made as to the availability of such financings.
Corporate Office and Distribution Facilities
The Company’s corporate office and distribution facilities are located in Colton, California, and encompass approximately 1.7 million square feet. The facilities include distribution facilities for grocery, grocery deli, produce, meat, meat deli, frozen, bakery, health and beauty care, and general merchandise products. Approximately 78% of the volume of the products offered for sale in the Company’s supermarkets are processed through the Company’s distribution facilities.
The Company’s distribution facilities are centrally located and are an average distance of approximately 39 miles from its supermarkets. Most supermarkets can be reached without using the most congested portions of the Southern California freeway system.
The Company’s transportation fleet consists of modern well-maintained vehicles. As of September 26, 2004, the Company operated approximately 145 tractors, 108 which were owned and 37 which were leased and 446 trailers, all of which were owned.
Item 1. Business (contd.)
Corporate Office and Distribution Facilities (contd.)
Markets plans to build new corporate office and distribution facilities on approximately 160 acres of real property located on the former Norton Air Force Base (“NAFB”) in the City of San Bernardino, California. Markets has entered into an Owner Participation Agreement with the Inland Valley Development Agency, a joint powers agency (“IVDA”), which is the entity responsible for the redevelopment of NAFB, to acquire approximately 93 acres of the project property owned by IVDA. As a component of this Agreement, IVDA is completing an agreement with a sister governmental agency for an additional 51 acres that would be transferred or leased to Markets with a purchase option. Of the 160 acre project site, 16 acres are privately owned. Markets has acquired one of these parcels and is negotiating the acquisition of the three remaining privately held parcels consisting of approximately 13.5 acres. The Agreement with IVDA requires Markets to acquire those parcels not owned by IVDA, to relocate all tenants and other business owners occupying buildings on the project property, to construct and complete the corporate office and distribution facilities and to obtain all City of San Bernardino building permits and entitlements required for construction of the project. Markets also has entered into an agreement with Hillwood/San Bernardino LLC (“Hillwood”), the master developer of NAFB, for infrastructure improvements. Under the Hillwood Agreement, Markets will share costs associated with the infrastructure improvements including water, sewer, streets and utilities, which will be required by the City of San Bernardino for the project. Markets, after completion of the acquisition of the project property, will secure its commitment with Hillwood for infrastructure improvements by the posting of either cash or letters of credits in the amount of $10.8 million. The agreements with IVDA and Hillwood are contingent upon Markets successfully completing acquisition of all the privately owned property.
The NAFB site will be used to relocate and consolidate Markets’ corporate office and all distribution facilities to a single integrated facility from the 13 distribution buildings at 7 different locations currently in use. The site is located within eight miles of the main distribution facility in Colton, so there will be no change in the average distance between the new facility and Markets retail supermarkets. The facility will consist of approximately 2.1 million square feet and will include Markets’ corporate office, truck maintenance and other support facilities required for consolidation of all of its Southern California office, distribution and maintenance operations. Taking into account the increased cost of raw materials including steel, concrete and asphalt, the projected net cost of the facility is approximately $220 million and completion of the construction is planned for the winter of 2006.
Purchasing and Marketing
The Company uses an “Aggressive Everyday Low Price” (“AEDLP”) format supported heavily by radio, TV, newspaper and direct mail advertising programs as an integral part of its purchasing and marketing strategy to provide its customers with the best overall supermarket value in its primary market areas. The Company supplements its everyday low price structure with chain-wide temporary price reductions (“Stater Savers”) on selected food and non-food merchandise. The geographic location of the Company’s supermarkets allows it to reach its target consumers through a variety of media and the Company aggressively advertises its everyday low prices through local and regional newspapers, direct mail and printed circulars as well as extensive advertisements on radio and television.
A key factor in the Company’s business strategy is to provide its customers with a variety of quality brand-name merchandise as well as alternative selections of high-quality private label merchandise. To meet the needs of customers, most supermarkets are stocked with approximately 35,000 items. The Company places particular emphasis on the freshness and quality of its meat and produce merchandise and maintains high standards for these perishables by distributing the merchandise through its perishable distribution facilities.
Item 1. Business (contd.)
Retail Operations
The Company’s supermarkets are well maintained, have sufficient off-street parking and generally are open from 6:00 a.m. or 7:00 a.m. until 10:00 p.m. or 11:00 p.m., seven days a week, including all holidays with the exception of Christmas Day. Because Stater Bros. operates its supermarkets under similar formats, management believes it is able to achieve certain operating economies.
Store Management. Each supermarket is managed by a store manager and an assistant manager, each of whom receives a base salary and may receive a bonus based on the individual supermarket’s overall performance and management of labor costs within the supermarket. The store manager and assistant manager are supported by their store management staff who have the training and skills necessary to provide proper customer service, operate the store and manage personnel in each department. Each store has individual department managers for grocery, meat, produce, and where applicable, bakeries, hot service delicatessens and seafood. Store managers report to one of nine district managers, each of whom is responsible for an average of 18 supermarkets. District managers report to one of three Regional Vice Presidents.
Customer Service. The Company considers customer service and customer confidence to be critical to the success of its business strategy. This strategy, to provide courteous and efficient customer service through specific programs and training, is a focus of the Senior Management and is implemented by employees at all levels of the Company. Each store is staffed with a Customer Service Manager who coordinates all customer service issues in the store. The Company maintains an intensive checker training school to train prospective checkers and to provide a refresher program for existing checkers. All of the Company’s supermarkets provide customers with carry-out service and have express checkout lanes.
Santee Dairies, LLC
Pursuant to a settlement agreement reached among Markets, Hughes Markets, Inc. (“Hughes”), Quality Food Centers, Inc., Ralphs Grocery Company (“Ralphs”), Fred Meyer, Inc., and the Kroger Co., Hughes relinquished to Markets its ownership in Santee Dairies, Inc. (“Santee”), giving Markets 100% ownership of Santee. Santee had been jointly owned by Hughes and Markets since 1986. Prior to the settlement agreement, the Company accounted for its investment in Santee using the equity method of accounting. Santee has been included in the consolidated financial statements of the Company as a wholly-owned subsidiary of Markets as of February 6, 2004, the effective date of the settlement agreement.
Santee operates one of the largest dairy plants in California, based on fluid production, and provides fluid milk products to Stater Bros., Ralphs, and other customers in Southern California. Santee processes, packages and distributes whole, low-fat and non-fat milk, as well as orange juice, fruit drinks and certain other cultured milk products under the Knudsen®, Foremost® and certain other brand names, as well as store brand names. Santee is the exclusive licensee of the Knudsen® trademark from Kraft Foods, Inc. for fluid milk, juices and certain other cultured milk products in the Southern California market. In addition, Santee is the exclusive licensee for Foremost Farms USA, cooperative of the Foremost® trademark for fluid milk in Southern California. From February 6, 2004 to September 26, 2004, Santee processed approximately 46.2 million gallons of fluid products, including 38.7 million gallons of fluid milk. During this time period, Markets purchased 23.8 million gallons of fluid products. Santee’s total revenue from February 6, 2004 through September 26, 2004, excluding related party sales, was $75.6 million. Ralphs has agreed to purchase fluid milk and certain other products from Santee in declining volumes through July 31, 2007. Santee also sells to unaffiliated supermarkets, independent food distributors, military bases and foodservice providers in Southern California.
The dairy’s capacity to process milk is approximately 250,000 to 350,000 gallons per day, with the ability to expand capacity to approximately 500,000 gallons per day.
Item 1. Business (contd.)
Management Information Systems
The Company’s management information systems and point-of-sale scanning technology reduce the labor costs attributable to product pricing and customer checkout, and provide management with information that facilitates purchasing, receiving and management of inventory and accounts payable. The Company has point-of-sale scanning checkout technology in all of its stores. All stores use electronic systems for employee time and attendance records, inventory orderings, and labor scheduling, which assist store management in developing a more efficient and customer-sensitive work schedule.
The Company uses the Stater Express system in all of the Company’s supermarkets. Stater Express is a combined supermarket technology platform that includes enhanced systems for check verification and acceptance and provides alternative pay choices such as most nationally recognized financial institution debit and credit cards. Stater Express also provides each supermarket with the technology required to print in-store-advertising signs and connects each supermarket to the Company’s host computer which provides certain efficiencies in data transfers between the supermarkets and the Company’s main office.
Employees
The Company has approximately 15,700 employees, approximately 900 of whom are management and administrative employees and approximately 14,800 of whom are hourly union employees. Substantially all of the Company’s hourly employees are members of either the United Food and Commercial Workers (“UFCW”) or International Brotherhood of Teamsters (“Teamsters”) labor unions and are represented by several different collective bargaining agreements.
The UFCW’s collective bargaining agreements were ratified on February 29, 2004 and expire in March of 2007. The Teamsters’ collective bargaining agreement was renewed in September 2002 and expires in September 2005.
The Company values its employees and believes its relationship with them is good and that employee loyalty and enthusiasm are key elements of its operating performance.
Southern California Labor Dispute
A major labor dispute involving three of Stater Bros.’ principal competitors lasted from October 11, 2003 through February 29, 2004. On October 11, 2003, the United Food and Commercial Workers Union (the “UFCW”), declared a strike against Safeway, Inc. (“Vons”); in turn, Albertson’s, Inc. (“Albertson’s”) and Ralphs locked out all of their UFCW employees (the “labor dispute”). The UFCW did not strike against Stater Bros. as a result of an agreement that Stater Bros. would accept the same contract terms that the UFCW negotiated with Vons, Albertson’s and Ralphs.
On February 29, 2004, members of the UFCW in Southern California ratified new collective bargaining agreements and ended their strike. Under the new collective bargaining agreements, Stater Bros. made special contributions to the UFCW’s health and welfare fund and made strike ratification bonus payments to its employees.
The labor dispute had a materially positive effect on Stater Bros.’ results of operations for fiscal 2004. The impact of the labor dispute on Stater Bros. was unprecedented and is not expected to be repeated in the future. Following the settlement of the labor dispute, management has taken steps through price promotions, customer service and attention to detail to retain as much of the increased volume as possible. However, the ultimate amount of increased volume retained, if any, cannot be forecast with any degree of certainty.
Item 1. Business (contd.)
Competition
The Company operates in a highly competitive industry characterized by narrow profit margins. Competitive factors include price, quality and variety of products, customer service, and store location and condition. The Company believes that its competitive strengths include its specialty services, everyday low prices, breadth of product selection, high product quality, one-stop shopping convenience, attention to customer service, convenient store locations, a long history of community involvement, established long-term customer base in the Inland Empire (consisting of San Bernardino and Riverside counties) and a growing customer awareness in the counties of Orange, San Diego and Los Angeles.
Given the wide assortment of products it offers, the Company competes with various types of retailers, including local, regional and national supermarket retailers, convenience stores, retail drug stores, national general merchandisers and discount retailers, membership clubs and warehouse stores. The Company’s primary competitors include Vons, Albertson’s, Ralphs, and a number of independent supermarket operators. The Company, and its competitors, will be faced with additional competitive pressures with the entry in the geographic market area of Wal-Mart’s Super Center format stores. Wal-Mart currently has a number of Wal-Mart discount locations and Sam’s Clubs within the Company’s marketing area selling a variety of grocery products. The Company believes that its everyday low prices, breadth of product offering, specialty service departments and long-term customer relationships will help it withstand the increased competitive environment.
Government Regulation
The Company is subject to regulation by a variety of governmental authorities, including federal, state and local agencies that regulate trade practices, building standards, labor, health, safety and environmental matters. The Company is also subject to agencies that regulate the distribution and sale of alcoholic beverages, tobacco products, milk and other agricultural products and other food items.
Santee is subject to periodic inspections by personnel from the California Department of Food and Agriculture, as well as the United States Food and Drug Administration, who test, among other things, Santee’s pasteurization and homogenization equipment, storage tanks, and bottling apparatuses to ensure compliance with applicable health and safety regulations. The price of raw milk is regulated by the federal government through federal market orders and price support programs, and by the State of California. The price of raw milk can fluctuate widely.
Environmental
Environmental remediation costs incurred over the past five years were approximately $1.7 million, in the aggregate, including remediation costs of approximately $198,000 in 2000, $495,000 in 2001, $324,000 in 2002, $395,000 in 2003 and $260,000 in 2004. Management believes that any such future remediation costs will not have a material adverse effect on the financial condition or results of operations of the Company.
Item 2.
Item 2. Properties
The Company leases its distribution facilities located in Colton, California, and management believes that its distribution facilities are well maintained and are adequate to meet its current volume.
The following schedule presents the Company’s distribution facilities by product classification and the size of each facility as of September 26, 2004.
The following schedule shows the size of Santee’s production, storage and administrative facilities:
As of September 26, 2004, the Company owned 44 of its supermarkets and leased the remaining 114 supermarkets. Management believes that its supermarkets are well maintained and adequately meet the expectations of its customers. The Company operates 158 supermarkets in the Southern California counties of San Bernardino, Riverside, Orange, Los Angeles, San Diego and Kern. The following schedule reflects the Company’s store count by size and county, and the number of stores that are either leased or owned as of September 26, 2004.
The total size of the Company’s supermarkets is approximately 5.3 million square feet, of which 3.8 million square feet is selling area.
Item 3.
Item 3. Legal Proceedings
In the ordinary course of its business, the Company is party to various legal actions which the Company believes are incidental to the operation of the business of the Company and its subsidiaries. The Company records an appropriate provision when the occurrence of loss is probable and can be reasonably estimated. The Company believes that the outcome of such legal proceedings to which the Company is currently a party will not have a material adverse effect upon its results of operations or its consolidated financial condition.
On July 9, 2003, the Company’s principal operating subsidiary Markets agreed to a settlement of two lawsuits which had been filed on behalf of certain of Markets’ existing and former store managers and assistant managers which alleged that such workers are non-exempt under California labor laws and are therefore entitled to overtime wages. Markets admitted no wrong doing under the settlement and it believes it has appropriately followed California law in the classification and payment of its employees. Markets believes that the store managers and assistant managers are highly compensated employees with duties and responsibilities which place them in the exempt category under California law and that such employees are not entitled to overtime wages. Markets continues to feel the case was without merit; however, because of escalating litigation expenses, Markets determined a settlement was the best solution. The amount of the settlement was $3.2 million. Of the $3.2 million, $1.2 million of the settlement was recognized as expense in fiscal 2003 and the remainder was expensed in prior years.
In July of 2002, Markets initiated litigation on its own behalf and derivatively on behalf of Santee in the Superior Court for the State of California, County of Los Angeles, against Hughes, Ralphs, Fred Meyer, Inc. and The Kroger Company (“Defendants”). In July of 2003, Defendants filed a cross-complaint against Markets, Santee and others. In order to settle the resulting litigation, Markets, Hughes, Santee and Santee Dairies, LLC. (“SDL”) entered into three separate but interconnected agreements “Settlement Agreement and Release of all Claims”, “Dissolution and Transfer Agreement” and “Assignment and Assumption Agreement” all three agreements collectively known as the “Settlement Agreement”. Under the Settlement Agreement, the Ralphs Guaranty was terminated, a new purchase of products schedule for Ralphs was established, Hughes agreed to pay $1,550,000 to Markets, SDL was dissolved and the shares of Santee, previously held by SDL, were transferred equally to Markets and Hughes. Concurrently with this transfer, Hughes immediately transferred Hughes’ Santee shares to Santee for cancellation and retirement.
Through the Settlement Agreement, Hughes relinquished its interest in Santee to Markets. The consideration received by Markets under the Settlement Agreement was $1,550,000 in cash and the value of the additional 50% ownership interest in Santee. The value assigned to the additional 50% interest in Santee was $21.8 million which was determined by management based upon the net present value of the most probable future cash flows. The Settlement Agreement’s effective date was the close of business on February 6, 2004. In fiscal 2004, the Company incurred legal fees of $500,000 related to the Settlement Agreement. In addition, the Company, through Santee, made payments, aggregating $500,000, to four Directors of Santee who had been named by Hughes as defendants in litigation settled by the Settlement Agreement. Three of the four Directors are related parties to the Company. The net consideration received by the Company under the Settlement Agreements was $22.4 million which was recorded as a gain in fiscal 2004 in the Consolidated Statements of Income under the line item “Selling, general and administrative expenses.”
Environmental Matters
Environmental remediation costs incurred during the last five years were approximately $1.7 million, in the aggregate, including remediation costs of approximately $198,000 in 2000, $495,000 in 2001, $324,000 in 2002, $395,000 in 2003 and $260,000 in 2004. Management believes that any such future remediation costs will not have a material adverse effect on the financial condition or results of operations of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters
(a) Market Information
There is no established public trading market for the Company’s common equity.
(b) Holders
La Cadena holds 38,301 shares, or 100% of the Company’s Class A Common Stock.
(c) Dividends
The New Credit Facility, as amended and restated on June 17, 2004, limits the Company’s ability to pay dividends. The Company may declare and pay dividends after June 27, 2004, but the aggregate amount of the dividend may not exceed, as of any date of determination, an amount equal to the sum of $25.0 million plus 50% of the Company’s consolidated net income for the period then ending following June 27, 2004. The New Credit Facility specifically allowed for the payment to La Cadena of a dividend in an amount not to exceed $45.0 million substantially concurrently with the issuance of the 8.125% Senior Notes Due 2012 and the Floating Rate Senior Notes due 2010.
Dividends of $45.0 million were paid in fiscal 2004. No dividends were paid in fiscal 2003. Dividends of $4.5 million were paid in fiscal 2002. The Company does not intend to pay dividends on its common equity in the foreseeable future.
Item 6.
Item 6. Selected Financial Data
The following table sets forth historical financial data derived from the audited consolidated financial statements of the Company as of and for the fiscal years ended September 24, 2000, September 30, 2001, September 29, 2002, September 28, 2003 and September 26, 2004. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Audited Consolidated Financial Statements of the Company and related notes thereto contained elsewhere herein. The information included in “Other Operating and Financial Data” and “Store Data” is unaudited.
(footnotes on following page)
Item 6. Selected Financial Data (contd.)
(1)
Like store sales are calculated by comparing year-to-year sales for stores that are opened in both years. For stores that were not opened for the entire previous year, only the current year’s weekly sales that correspond to the weeks the stores were open in the previous year are used. For replacement store sales, sales for the entire year are included in the like store sales calculation. A store in Hemet, California was closed on the last day of fiscal 2004. Accordingly, all of this store’s sales for fiscal 2003 and fiscal 2004 were included in the like store sales calculation.
(footnotes continued on following page)
Item 6. Selected Financial Data (contd.)
(2)
For the purpose of determining the ratio of earnings to fixed charges, earnings consist of income before income taxes and amortization of previously capitalized interest. Fixed charges consist of interest expense whether expensed or capitalized, amortization of debt issuance costs, and such portion of rental expense as can be deemed by management to be representative of the interest factor in the particular case. Included in earnings and fixed charges is the Company’s 50% share of Santee. For fiscal 2004, included in earnings and fixed charges is the Company’s 50% share of fixed charges and earnings of Santee through February 6, 2004. Santee has been consolidated into the Company’s consolidated results since that date.
(3)
Average sales per store, sales per total square feet and sales per selling square feet are calculated by prorating the number of stores, total square feet and selling square feet by the period of time the store was opened, for new stores, or the period of time the expanded square footage was in service, for expanded stores.
(4)
The fiscal year 2001 was a 53-week year, whereas fiscal years 2000, 2002, 2003 and 2004 were 52-week years.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Critical Accounting Policies
The Company’s discussion and analysis of financial condition and results of operations are based upon the Company’s audited consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States. The preparation of the financial statements requires the use of estimates and judgments on the part of management. The Company based
its estimates on the Company’s historical experience combined with management’s understanding of current facts and circumstances. The Company believes that the following critical accounting policies are the most important to the Company’s financial statement presentation and require the most difficult, subjective and complex judgments on the part of management.
Self-Insurance Reserves
The Company is primarily self-insured, subject to certain retention levels for workers’ compensation, automobile and general liability costs. The Company is covered by umbrella insurance policies for catastrophic events. The Company records its self-insurance liability based on the claims filed and an estimate of claims incurred but not yet reported. The estimates used by management are based on the Company’s historical experiences as well as current facts and circumstances. The Company uses third party actuarial analysis in making its estimates. Actuarial projections and the Company’s estimate of ultimate losses are subject to a high degree of variability. The variability in the projections and estimates are subject to, but not limited to, such factors as judicial and administrative rulings, legislative actions, and changes in compensation benefits structure. In recent years, the Company and employers within the State of California as a whole have seen significant increases in the severity of workers’ compensation claims. While the Company has factored these increases into its estimates of ultimate loss, no assurance can be given that future events will not require a change in these estimates. The Company discounted its workers’ compensation, automobile and general liability insurance reserves at a discount rate of 7.5% in fiscal 2002 and fiscal 2003 and 5.5% in fiscal 2004. The analysis of self-insurance liability is sensitive to the rate used to discount the anticipated future cash flows for the workers’ compensation, automobile and general liability insurance reserves. For fiscal 2004, if a rate of 4.5% was used to discount the reserves, the reserves for self insurance would have been $1.3 million higher then the reserves calculated at a 5.5% discount rate. If a rate of 6.5% was used in fiscal 2004 to discount the reserves, the reserves for self insurance would have been $1.2 million lower then the reserves calculated at a 5.5% discount rate.
Advertising Allowances
The Company receives co-operative advertising allowances from vendors for advertising specific vendor products over specific periods of time. Effective September 30, 2002, the Company adopted EITF Issue No. 02-16 “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” The adoption of EITF Issue No. 02-16 effects the classification of allowances received between cost of goods sold and advertising expense but has no net effect on the profitability of the Company. EITF Issue No. 02-16 requires the Company to perform an analysis of the amount of co-operative advertising allowances received from its vendors compared to the cost of running the corresponding advertisement. Any amount of co-operative funds received in excess of the cost of advertising is recorded as a reduction in cost of goods sold. Determining the amount of advertising cost that corresponds to the co-operative advertising allowances received requires judgment on the part of management.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Critical Accounting Policies (contd.)
Advertising Allowances (contd.)
A significant portion of the Company’s advertising expenditures is in the form of twice weekly print advertisements. The Company distributes its print ads through inserts in local newspapers, in direct mailers and as handouts distributed in its stores. On a monthly basis, management estimates the cost of advertisements related to co-operative advertising allowances by dividing the direct out-of-pocket costs for printing and distributing its print ads by the product of total number of print ad pages run during the month and the number of individual ads in a typical twice weekly advertisement. The dollar amount determined is deemed to be the fair value of advertising costs. The fair value of advertising cost is then compared to the amount of co-operative adverting allowances received during the month and any allowances received in excess of cost are recorded as a reduction in cost of goods sold. In fiscal 2003 and fiscal 2004, the amount of co-operative advertising allowances in excess of the direct fair value of the advertising was recognized as a reduction in cost of goods sold. In fiscal 2002, all co-operative advertising allowances were recognized as reductions in advertising expense.
Significant Accounting Policies
In addition to the critical accounting policies disclosed above, there are certain accounting policies that the Company has adopted that may differ from policies of other companies within the same industry. Such differences in the treatment of these policies may be important to the readers of the Company’s Form 10-K and the Company’s Consolidated Financial Statements contained herein. For further information regarding the Company’s accounting policies, refer to the significant accounting policies included in the Notes to the Consolidated Financial Statements contained here-in.
Ownership of the Company
La Cadena is the sole shareholder of the Company and holds all of the shares of the Company’s Class A Common Stock. La Cadena is a California General Partnership whose partners include Jack H. Brown, Chairman of the Board, President and Chief Executive Officer of the Company, and a former member of senior management of the Company. Jack H. Brown has a majority interest in La Cadena and is the Managing General Partner with the power to vote the shares of the Company held by La Cadena.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Results of Operations
The following table sets forth certain income statement components expressed as a percent of sales for the fiscal years ended September 29, 2002, September 28, 2003 and September 26, 2004.
As of February 6, 2004, the results of Santee, previously accounted for under the equity method of accounting, have been consolidated in the Company’s results of operations and all inter-company transactions have been eliminated.
The labor dispute involving three of the Company’s principal competitors from October 11, 2003 through February 29, 2004, had a materially positive effect on the Company’s results of operations in fiscal 2004. On October 11, 2003, the UFCW declared a strike against Vons; in turn, Albertson’s and Ralphs locked out all of their UFCW employees. The UFCW did not strike against the Company as a result of an agreement whereby the Company agreed to accept the same contract terms that the UFCW negotiated with Vons, Albertson’s and Ralphs.
On February 29, 2004, members of the UFCW in Southern California ratified new collective bargaining agreements and ended their strike. Under the new collective bargaining agreements, the Company made special contributions to the UFCW’s health and welfare fund totaling $29.3 million, and made strike ratification bonus payments to its employees totaling $4.7 million.
During the labor dispute, many of the former Vons, Albertson’s and Ralphs customers chose to honor the picket lines and took their business to the Company’s markets and other grocery retailers. Subsequent to the labor dispute, the Company has been able to retain some of these additional customers. The labor dispute had both a significant and material effect on the Company’s sales volume, results of operations and financial position.
The increased sales volume has had a positive effect on results of operations as the Company has been able to realize some economics of scale from the increased sales volume. As a result, gross profit, as a percentage of sales, has increased and operating expenses, as a percentage of sales, have decreased for the fiscal year 2004 when compared to fiscal 2003.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Results of Operations (contd.)
The impact of the labor dispute on the Company was unprecedented and is not expected to be repeated in the future. As of September 26, 2004, the Company has been able to retain some of the increased volume gained during the labor dispute. Management has taken steps through price promotions, customer service and attention to detail to retain as much of the increased volume as possible. Management anticipates that some of the retained volume realized to date will be lost as its major competitors take continued marketing steps of their own to win back the business lost during the labor dispute. The ultimate amount of increased volume retained, if any, cannot be forecast with any degree of certainty.
Like store sales are calculated by comparing year-to-year sales for stores that are opened in both years. For stores that were not opened for the entire previous year periods, only the current year’s weekly sales that correspond to the weeks the stores were opened in the previous year are used. For replacement store sales, sales for the entire year are included in the like store sales calculation.
Total sales amounted to $3.7 billion in 2004 compared to $2.8 billion in 2003 and $2.7 billion in 2002. The consolidation of Santee in fiscal 2004 increased sales by $75.6 million or 2.75% over prior year sales. Like-store sales increased $834.8 million or 30.3% in fiscal 2004, compared to $74.1 million or 2.78% in fiscal 2003 and $133.6 million or 5.30% in fiscal 2002. The increase in like store sales for fiscal 2004 is due primarily to the increased sales volume during the labor dispute and to the Company’s ability to retain some of the increased sales volume after the labor dispute. For the portion of the fiscal year during the labor dispute, like store sales increased $576.2 million or 54.52% over the same time frame of fiscal 2003. For the portion of fiscal year after the labor dispute, like store sales increased $253.9 million or 15.85% over the same time frame of fiscal 2003. The remaining increase in sales is due to the opening of a new store in Corona, California in June of 2003, the opening of a new store in Moreno Valley, California in March of 2004 and the opening of an additional new store in Corona, California in July of 2004. The increase in sales during fiscal 2003 was due to favorable customer response to the Company’s marketing plan and to the addition of a new store in Corona, California.
Gross profit increased to $1.1 billion or 28.40% of sales in 2004 compared to $754.4 million or 27.40% of sales in 2003 and $708.8 million or 26.58% of sales in 2002. Gross profit, as a percentage of sales, for the fiscal 2004 increased 1.00% compared to the prior year. The increase in gross profit, as a percentage of sales, in fiscal 2004 over the prior fiscal year is comprised of increased store gross profit of 0.55% attributed primarily to reduced shrink in the perishable departments during the labor dispute, a reduction, as a percentage of sales, of 0.80% in distribution and transportation costs attributed to the leveraging of fixed costs over the increased sales volume offset by the consolidation of Santee in fiscal 2004 which created a reduction in gross profit, as a percentage of sales, for the fiscal year of 0.32%. The increase in gross profit, as a percent of sales, during fiscal 2003 was due in large part to the introduction of higher gross margin products achieved through the Company’s merchandising expansion and upgrading programs including significant investments in product display fixtures. Also contributing to the increased gross profit in fiscal 2003 over fiscal 2002 was a $4.6 million reduction in cost of goods sold caused by the reclassification of the amount of vendor co-operative advertising allowances in excess of the fair value of advertising. This reclassification resulted from the Company’s adoption in fiscal 2003 of EITF Issue No. 02-16 “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” Fiscal 2002 cost of goods sold were not reclassified. The Company adjusts its pricing strategy as necessary to retain its aggressive every day low price market position.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Results of Operations (contd.)
Operating expenses include selling, general and administrative expenses, and depreciation and amortization. In fiscal year 2004, selling, general and administrative expenses amounted to $820.5 million or 22.15% of sales compared to $659.7 million or 23.96% of sales in 2003 and $615.5 million or 23.08% of sales in 2002.
Included in selling, general and administrative expenses for fiscal 2004 is $34.0 million for special payments related to the labor dispute and contract ratification. These special payments, as a percentage of sales, were 0.92% of sales in fiscal 2004. The Company made special payments of approximately $29.3 million to UFCW union trust funds to bring the funds up to levels negotiated during collective bargaining contract negotiations. Under the new negotiated collective bargaining agreement, future union insurance payments by the Company are proscribed at specified hourly rates. In addition, the Company paid approximately $4.7 million to UFCW union members as a contract ratification bonus. Also, included in selling, general and administrative expenses for fiscal 2004 is a $22.4 million gain from a settlement agreement
reached with Ralphs. The gain from litigation settlement reduced selling, general and administrative expenses, as a percentage of sales, by 0.62% for fiscal 2004. The consolidation of Santee in fiscal 2004 caused a reduction in selling general and administrative expenses, as a percentage of sales, of 0.29% for fiscal 2004.
After removing the effect of the special union payments, the gain from a settlement agreement and the consolidation of Santee, selling general and administrative expenses, as a percentage of sales, decreased 1.82% in the current fiscal year over the previous fiscal year. Most of the remaining reductions in the selling, general and administrative expenses, as a percentage of sales, are attributed to the Company being able to leverage fixed cost and operating more efficiently during the labor dispute. The reductions in selling, general and administrative expenses, as a percentage of sales, include a 0.97% reduction in payroll related expenses, 0.23% reduction in workers’ compensation expense, a 0.39% reduction in utility expenses and a 0.23% in rent expense. These savings were offset by a 0.44%, as a percentage of sales, increase in phantom stock expense.
The increase in selling, general and administrative expenses in fiscal 2003 over fiscal 2002 was due primarily to an increase of approximately $14.0 million in union insurance costs, an increase of approximately $6.3 million in union pension cost and to the reclassification of $4.6 million of vendor co-operative advertising allowances that were in excess of the fair value of advertising from selling, general and administrative expenses to cost of goods sold.
Depreciation and amortization expenses amounted to $32.5 million in 2004 compared to $26.9 million in 2003 and $24.3 million in 2002. Depreciation and amortization expense, as a percentage of sales, was 0.88%, 0.98% and 0.91% for fiscal years 2004, 2003 and 2002, respectively. The changes in depreciation expense from year-to-year are due primarily to store additions and remodels and corporate expenditures.
Operating profit amounted to $199.1 million or 5.37% of sales in 2004 compared to $67.8 million or 2.46% of sales in 2003 and $69.0 million or 2.59% of sales in 2002.
Interest expense amounted to $54.0 million, $53.3 million and $52.8 million for the 2004, 2003 and 2002 fiscal years, respectively. The increase in interest expense in fiscal 2004 compared to fiscal 2003 is due primarily to the increase in outstanding debt by the Company offset by the reduction in average interest rates of its long term debt. The increase in interest expense in fiscal 2003 compared to fiscal 2002 is primarily twelve months of interest expense on the 5.0% Subordinated Note in fiscal 2003 versus nine months in fiscal 2002.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Results of Operations (contd.)
For fiscal 2004, interest expense related to debt purchase was $35.6 million and included a $16.9 million payment for tender premium and fees on the purchase of $397.8 million of the 10.75% Notes, an $8.5 million make whole payment by Santee related to Santee’s redemption of all outstanding Santee Notes, a $1.1 million make whole payment on the redemption of the remaining $41.0 million 10.75% Senior Notes, and a $9.1 million charge for the write-off of the remaining debt issuance costs related to (i) the purchase of $397.8 million of the 10.75% Notes, (ii) the redemption of the remaining $41.0 million 10.75% Senior Notes, (iii) the early retirement of the $20.0 million 5.0% Subordinated Note due 2007 and (iv) the redemption of the Santee Notes. For fiscal 2003 and fiscal 2002, there was no interest expense related to debt purchase.
Equity in income from unconsolidated affiliate amounted to $0.9 million in fiscal 2004 compared to $1.3 million in 2003 and $2.9 million in 2002. The decrease in equity in income from unconsolidated affiliate in fiscal 2004 is due to Santee being consolidated as a wholly-owned subsidiary as of February 6, 2004, the effective date of the settlement agreement. The decrease in income from unconsolidated affiliate in fiscal 2003 was due primarily from a $1.1 million deferred tax revaluation, by Santee, in fiscal 2002 that was not present in fiscal 2003. Also, Santee’s net sales and operating profits decreased in fiscal 2003 versus fiscal 2002.
Income before income taxes amounted to $111.3 million, $15.9 million and $19.3 million in fiscal 2004, fiscal 2003 and fiscal 2002, respectively.
Net income, for fiscal 2004, amounted to $71.8 million, compared to $10.1 million in fiscal 2003 and $11.8 million in fiscal 2002.
Liquidity and Capital Resources
The Company historically has funded its daily cash flow requirements through funds provided by operations and through borrowings from short-term revolving credit facilities. The Company’s credit agreement, as amended and restated on June 17, 2004 expires in May 2007 and consists of a revolving loan facility for working capital and letters of credit of $75.0 million. As of September 26, 2004, the Company had $46.9 million of outstanding letters of credit and had $28.1 million available under the revolving loan facility. The letter of credit facility is maintained pursuant to the Company’s workers’ compensation and general liability self-insurance requirements.
In November 2004, Santee entered into a revolving line of credit with Bank of America (“the Revolver”). Under the Revolver, Santee may borrow up to $5.0 million of which $2.0 million may be used to secure letters of credit issued to support workers’ compensation liabilities. Borrowings under the Revolver are secured by the receivables of Santee. The Revolver is scheduled to expire on May 31, 2007. Advances under the revolver bear interest at Bank of America’s prime rate plus 0.5% with interest due monthly or, if elected by Santee, at the Interbank Offered Rate plus 1.75%. The outstanding undrawn portion of the workers’ compensation letter of credit is subject to an annual commitment fee of 1.25%. As of September 26, 2004, Santee had $1.4 million of outstanding letters of credit and had $3.6 million available under the revolving loan facility.
The Company had no short-term borrowings outstanding at the end of fiscal years 2004, 2003 and 2002, and the Company did not incur short-term borrowings during fiscal years 2004, 2003 and 2002.
Working capital amounted to $319.9 million at September 26, 2004, $124.5 million at September 28, 2003 and $119.6 million at September 29, 2002. The Company’s current ratios were 2.22:1, 1.60:1 and 1.62:1, respectively. Fluctuations in working capital and current ratios are not unusual in the industry.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Liquidity and Capital Resources (contd.)
Net cash provided by operating activities amounted to $150.5 million in 2004, $83.0 million in 2003 and $51.2 million in 2002. Net cash provided by operating activities in fiscal 2004 improved significantly over fiscal 2003 primarily as a result of the increase in net income attributable mainly to the labor dispute. In addition to the substantial increase in net income to $71.8 million in the current year compared to $10.1 million in the prior year, cash provided by operating activities in fiscal 2004 of $150.5 million reflected a $70.4 million increase in accrued liabilities, self-insurance reserves and other liabilities, an increase of $22.0 million in accounts payable, a $13.7 million decrease in other assets and $43.0 million of depreciation and amortization; partially offset by a $20.0 million increase in restricted cash, an increase of $16.8 million in deferred income taxes, a $10.6 million increase in inventory and a $22.4 million gain from litigation settlement. Net cash provided by operating activities in fiscal 2003 consisted primarily of depreciation and amortization, increases in accrued liabilities and self-insurance reserves, increases in accounts payable and decreases in receivables. Net cash provided by operating activities in fiscal 2002 consisted primarily of depreciation and amortization, increases in accrued liabilities and self-insurance reserves and decreases in accounts receivables and other assets offset by increases in income tax receivables and inventories and decreases in accounts payable.
Net cash provided by financing activities in fiscal 2004 amounted to $102.1 million. In fiscal 2004, the Company issued $525.0 million of 8.125% Senior Notes due June 2012, issued $175.0 million of Floating Rate Senior Notes due June 2010, purchased $397.8 million of 10.75% Senior Notes due June 2006, redeemed the remaining $41.0 million of 10.75% Senior Notes due June 2006, retired the $20.0 million 5.0% Subordinated Note due March 2007, redeemed $53.5 million of outstanding Santee Notes, paid $16.9 million in tender premium and fees for the purchase of the 10.75% Senior Notes, paid a make-whole payment of $1.1 million on the redemption of the remaining outstanding 10.75% Senior Notes, paid a make-whole payment of $8.5 million for the redemption of the Santee Notes, paid a dividend of $45.0 million to La Cadena, incurred fees of $22.7 million associated with the issuance of the 8.125% Senior Notes and Floating Rate Senior Notes and amortized the remaining debt issuance costs of $9.1 million related to (i) the purchase of the 10.75% Senior Notes, (ii) the redemption of the remaining outstanding 10.75% Senior Notes, (iii) the early retirement of the 5.0% Subordinated Note and (iv) the redemption of the Santee Notes, executed a new capital lease for $0.7 million and had payments on capitalized leases of $1.3 million. Net cash used in financing activities in fiscal 2003 amounted to $1.1 million and consisted of principal payments on capital lease obligations. Net cash used in financing activities in fiscal 2002 amounted to $31.2 million and consisted of the redemption of 11,699 shares of the Company’s stock previously held by La Cadena, for $20.0 million in cash and the issuance of a $20.0 million subordinated note, which bears interest at a rate of 5.0% per annum, payable semi-annually; $4.5 million for the payment of a dividend to La Cadena; and fees of approximately $5.0 million for the consent of the holders of its 10.75% Senior Notes and fees and expenses of the transaction, including a $500,000 financial advisory service fee to La Cadena. Also in 2002, the Company redeemed $250,000 of its 10.75% Senior Notes due 2006 for $250,000 plus accrued interest. These Notes were restricted and unregistered. The remaining financial activities in fiscal 2002 were for principal payment on capital lease obligations.
Net cash used in investing activities for 2004 amounted to $61.8 million and consisted primarily of the purchase of property and equipment of $62.0 million. Net cash used in investing activities for 2003 amounted to $51.7 million and consisted primarily of the purchase of property and equipment of $51.9 million. Net cash used in investing activities in fiscal 2002 amounted to $40.5 million and consisted primarily of the purchase of property and equipment of $40.7 million.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Liquidity and Capital Resources (contd.)
Management believes that capital expenditures for fiscal 2005 will be approximately $139.0 million and are expected to be financed by cash on hand and cash from operating activities. The following table sets forth the major components of expected fiscal 2005 capital expenditures.
Expected Capital Expenditures Fiscal 2005
(In thousands)
Management believes that operating cash flows and current cash reserves will be sufficient to meet the Company’s currently identified operating needs and scheduled capital expenditures. However, some expenditures may be funded through operating leases or from debt financing. There can be no assurance that such debt and lease financing will be available to the Company in the future.
The Company operated 158 supermarkets at September 26, 2004, 157 supermarkets at September 28, 2003 and 156 supermarkets at September 29, 2002.
The Company’s supermarkets had approximately 5.3 million total square feet at September 26, 2004 and 5.2 million total square feet at September 28, 2003 and September 29, 2002.
Credit Facilities
On June 17, 2004, the Company entered into an amended and restated credit facility (the “New Credit Facility”) with Bank of America N.A. (“Bank of America”) as sole and exclusive administrative agent, and sole initial lender, consisting of a three-year revolving credit facility in a principal amount of up to $75.0 million, with the right to increase, under certain circumstances, the size of the New Credit Facility to an aggregate principal amount of $100.0 million. The New Credit Facility amended and restated the existing credit facility in its entirety. Subject to certain restrictions, the entire amount of the New Credit Facility may be used for loans, letters of credit, or a combination thereof. Borrowings under the New Credit Facility are unsecured and will be used for certain working capital, capital expenditures and other corporate purposes. Letters of credit under the letter of credit facility are expected to be used to support obligations incurred in connection with the construction of stores, construction of the new corporate office and distribution facilities and workers’ compensation insurance obligations. The availability of the loans and letters of credit are subject to certain borrowing restrictions.
The New Credit Facility is guaranteed by the Company and all of its existing and future material subsidiaries, including Development and Santee (subject, in the case of Santee, to termination upon certain specified events).
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Liquidity and Capital Resources (contd.)
Credit Facilities (contd.)
Loans under the New Credit Facility bear interest at a rate based upon either (i) the “Base Rate” (defined as the higher of (a) the federal funds rate plus 0.50% and (b) the rate of interest publicly announced by Bank of America as its “reference rate”), plus 1.00%, or (ii) the “Offshore Rate” (defined as the average British Bankers Association Interest Settlement Rate for deposits in dollars, adjusted for the maximum reserve requirement for Eurocurrency funding), plus 1.75%. For Offshore Rate Loans, the Offshore Rate will be applied in consecutive periods of the earlier of (a) the maturity date of the loan or (b) periods, as selected by Markets of one, two, three or six months.
The New Credit Facility will cease to be available and will be payable in full on May 31, 2007. Notwithstanding such maturity date, at any time prior thereto Markets shall be entitled to request the issuance of standby letters of credit having a term which is up to one year following such maturity date, and commercial letters of credit having a term which is up to six months following such maturity date. Loans under the New Credit Facility must be repaid for a period of ten consecutive days semi-annually.
Loans under the New Credit Facility may be repaid and re-borrowed. The loans under the New Credit Facility may be prepaid at any time without penalty, subject to certain minimums and payment of any breakage and re-deployment costs in the case of loans based on the offshore rate. The commitments under the New Credit Facility may be reduced by Markets. Markets will be required to pay a commitment fee equal to 0.25% per annum on the actual daily unused portion of the revolving loan facility and the letter of credit facility, payable quarterly in arrears. Outstanding letters of credit under the credit facility are subject to a fee of 1.25% per annum on the face amount of such letters of credit, payable quarterly in arrears. Markets will be required to pay standard fees charged by Bank of America with respect to the issuance, negotiation, and amendment of commercial letters of credit issued under the letter of credit facility. The New Credit Facility requires Markets to meet certain financial tests, including minimum net worth and other tests. The New Credit Facility contains covenants which, among other things, limit the ability of Markets and its subsidiaries to (i) incur indebtedness, grant liens and guarantee obligations, (ii) enter into mergers, consolidations, liquidations and dissolutions, asset sales, investments, leases and transactions with affiliates, and (iii) make restricted payments. The New Credit Facility also contains covenants that apply to the Company and its subsidiaries, and the Company is a party to the New Credit Facility for purposes of these covenants. These covenants, among other things, limit the ability of the Company and its subsidiaries to incur indebtedness, make restricted payments, enter into transactions with affiliates, and make amendments to the Indenture governing the 8.125% Senior Notes due June 15, 2012 and the Floating Rate Senior Notes due June 15, 2010.
The New Credit Facility contains customary events of default, including payment defaults; material inaccuracies in representations and warranties; covenant defaults; cross-defaults to certain other indebtedness; certain bankruptcy events; certain ERISA events; judgment defaults; invalidity of any guaranty; and change of control.
In November 2004, Santee entered into a revolving line of credit with Bank of America (“the Revolver”). Under the Revolver, Santee may borrow up to $5.0 million of which $2.0 million may be used to secure letters of credit issued to support workers’ compensation liabilities. Borrowings under the Revolver are secured by the receivables of Santee. The Revolver is scheduled to expire on May 31, 2007.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Liquidity and Capital Resources (contd.)
Credit Facilities (contd.)
Advances under the Revolver bear interest at Bank of America’s prime rate plus 0.5% with interest due monthly or, if elected by Santee, at the Interbank Offered Rate plus 1.75%. The outstanding undrawn portion of the workers’ compensation letter of credit is subject to an annual commitment fee of 1.25%.
Under the Revolver, Santee is required to comply with certain financial covenants, which include certain financial ratios.
As of September 26, 2004, for purposes of the credit facilities with Bank of America, Santee, Markets and the Company were in compliance with all restrictive covenants. The Company is also subject to certain covenants associated with its 8.125% Senior Notes due 2012 and its Floating Rate Senior Notes due 2010. As of September 26, 2004, the Company was in compliance with all such covenants. However, there can be no assurance that Santee, Markets or the Company will be able to achieve the expected operating results or implement the capital expenditure strategy upon which future compliance with such covenants is based.
Labor Relations
The UFCW’s collective bargaining agreements were ratified on February 29, 2004 and expire in March 2007. The Teamsters’ collective bargaining agreement was renewed in September 2002 and expires in September 2005. Santee’s collective bargaining agreement with the Teamsters was renewed in March 2004 and expires in March 2007.
The Company values its employees and believes its relationship with them is good and that employee loyalty and enthusiasm are key elements of its operating performance.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements, other than stand-by letters of credit, as discussed under the caption “Liquidity and Capital Resources” in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report and operating leases as disclosed in Note 7 - Leases of the Audited Consolidated Financial Statements, that would have or are reasonably likely to have material current or future effect on the registrant’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Tabular Disclosure of Contractual Cash Obligations
The following table sets forth the Company’s contractual cash obligations and commercial commitments as of September 26, 2004.
(1)
The Company leases the majority of its retail stores, offices and distribution facilities. Certain of the Company’s operating leases provide for minimum annual payments that change over the primary term of the lease. For purposes of contractual cash obligations shown here, contractual step increases or decreases are shown in the period they are due. Primary lease terms range from 3 to 55 years and substantially all leases provide for renewal options.
(2)
Standby letters of credit are committed as security for workers’ compensation obligations and as security for current rent obligations. Outstanding letters of credit expire between December 31, 2004 and October 1, 2005.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Recent Accounting Pronouncements
In November 2004, the FASB issued Statement 151, “Inventory Costs”, an amendment of APB 43, Statement 151 clarifies what amount of expenses should be recognized as current period charges. The Company does not expect the adoption to of this pronouncement to have a material impact on the results of its operations.
Effect of Inflation and Competition
The Company’s performance is affected by inflation. In recent years the impact of inflation on the operations of the Company has been moderate. As inflation has increased expenses, the Company has recovered, to the extent permitted by competition, the increase in expenses by increasing prices over time. However, the economic and competitive environment in Southern California continues to challenge the Company to become more cost efficient as its ability to recover increases in expenses through price increases is diminished. The future results of operations of the Company will depend upon the ability of the Company to adapt to the current economic environment as well as to the current competitive conditions.
The Company conducts business in one industry segment, the operation of retail food supermarkets, which offer for sale to the public most merchandise typically found in supermarkets. The Company operates in the highly competitive supermarket industry which is characterized by low profit margins. Competitive factors include price, quality and variety of products, customer service, and store location and condition. The Company believes that its competitive strengths include its specialty services, everyday low prices, breadth of product selection, high product quality, one-stop shopping convenience, attention to customer service, convenient store locations, a long history of community involvement, established long-term customer base in the Inland Empire (consisting of San Bernardino and Riverside counties) and a growing customer awareness in the counties of Orange, San Diego and Los Angeles.
Given the wide assortment of products it offers, the Company competes with various types of retailers, including local, regional and national supermarket retailers, convenience store, retail drug stores, national general merchandisers and discount retailers, membership clubs and warehouse stores. The Company’s primary competitors include Vons, Albertson’s, Ralphs, and a number of independent supermarket operators. The Company, and its competitors, will be faced with additional competitive pressures with the entry in the geographic market area of Wal-Mart’s Super Center format stores. Wal-Mart currently has a number of Wal-Mart discount locations and Sam’s Clubs within the Company’s marketing area selling a variety of grocery products. Recent events have increased competitive pressures. Wal-Mart has begun to open their Super Center format stores in the Company’s market area and Von’s, Albertson’s and Ralphs, post labor dispute, continue to apply pricing pressures as they attempt to win back customers lost during the labor dispute. The Company believes that its everyday low prices, breadth of product offering, specialty service department and long-term customer relationships will help it withstand the increased competitive environment. The Company monitors competitive activity of its major competitors and Senior Management regularly reviews the Company’s marketing and business strategy and periodically adjusts them to adapt to changes in the Company’s primary trading area.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (contd.)
Cautionary Statement
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Certain information contained in the Company’s filings with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) includes statements that are forward-looking, such as statements relating to plans for future activities. Such forward-looking information involves important risks and uncertainties that could significantly affect results in the future and, accordingly, such results may differ from those expressed in any forward-looking statements made by or on behalf of the Company. These risks and uncertainties include, but are not limited to, those relating to domestic economic conditions, seasonal and weather fluctuations, labor unrest, expansion and other activities of competitors, changes in federal or state laws and the administration of such laws and the general condition of the economy.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure about Market Risk
The Company is subject to interest rate risk on its fixed interest rate debt obligations and floating rate debt obligations. The Company’s fixed rate debt obligations are comprised of the 8.125% Senior Notes due June 2012 and capital lease obligations. In general, the fair value of fixed rate debt will increase as the market rate of interest decreases and will decrease as the market rate of interest increases. The Company floating rate debt obligations are the Floating Rate Senior Notes due June 2010. The fair values of the 8.125% Senior Notes due June 2012 and Floating Rate Senior Notes due June 2010 are based upon quoted market prices. Although quoted market prices are not readily available on the Company’s capital lease obligations, the Company believes that stated values approximate the fair value of these obligations. The Company has not engaged in any interest rate swap agreements, derivative financial instruments or other type of financial transactions to manage interest rate risk. The following table provides the future principal cash flows and weighted-average interest rates expected on the Company’s fixed rate and floating rate debt obligations. The fair value shown here is based upon the quoted market price of the 8.125% Senior Notes and Floating Rate Senior Notes and the stated value of the capital leases as of September 26, 2004.
Expected Year of Maturity
(In thousands)
Item 8.
Item 8. Financial Statements and Supplementary Data
Information called for by this item is set forth in the Company’s audited consolidated financial statements and supplementary data contained in this report. Specific financial statements and supplementary data can be found on the pages listed in the following index.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
As of the year ended September 26, 2004, the Company carried out an evaluation, under the supervision of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have each concluded that those controls and procedures were effective in making known to them, on a timely basis, the material information needed for the preparation of this Report on Form 10-K. During the quarter and fiscal year ended September 26, 2004, there were no significant changes in the Company’s internal control over financial reporting or in other factors that could significantly affect the internal control over financial reporting since the date of their evaluation, nor did they find any significant deficiencies or material weaknesses that would have required corrective actions to be taken.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The following table sets forth certain information with respect to the current executive officers and directors of the Company, their ages and principal occupations for at least the past five years. Directors of the Company each serve for a term of one year, or until their successors are elected. The officers serve at the discretion of the Board of Directors of the Company.
Name
Age
Position
Jack H. Brown
Chairman of the Board, President and Chief Executive Officer
Donald I. Baker
Executive Vice President and Chief Operating Officer
Phillip J. Smith
Senior Vice President and Chief Financial Officer
Dennis L. McIntyre
Group Senior Vice President of Marketing
James W. Lee
Group Senior Vice President of Retail Operations
Edward A. Stater
Senior Vice President of Retail Operations
Bruce D. Varner
Director and Secretary
Thomas W. Field, Jr.
Vice Chairman of the Board of Directors
C. Dale Warman
Director
Background of Directors and Executive Officers
Jack H. Brown has been President and Chief Executive Officer of the Company since June 1981 and Chairman of the Board since 1986. From September 1978 to June 1981, Mr. Brown served as President of Pantry Food Markets, Inc. and American Community Stores Corporation, Inc., both wholly owned subsidiaries of Cullum Companies, Inc., a publicly held corporation. From 1972 to 1978, Mr. Brown served as Corporate Vice President of Marsh Supermarkets, Inc., a publicly held corporation. Mr. Brown has been employed in various capacities in the supermarket industry for 52 years. Mr. Brown has a majority interest and is the managing general partner of La Cadena. Mr. Brown serves as a Director for the Automobile Club of Southern California.
Donald I. Baker was promoted to President of Markets in September 2004 and has been Executive Vice President and Chief Operating Officer since November 2001 and Executive Vice President of the Company since October 1998. Mr. Baker joined the Company in November 1983 as Vice President-Warehouse and Transportation and was Group Senior Vice President-Administration from July 1996 to October 1998. From July 1992 to July 1996, Mr. Baker was Group Senior Vice President-Human Resources and Distribution. From August 1986 to July 1992, Mr. Baker was Senior Vice President-Human Resources and Distribution. Mr. Baker has approximately 38 years of experience in the supermarket industry. Prior to joining the Company, Mr. Baker was employed by American Community Stores Corporation, Inc., a subsidiary of Cullum Companies, Inc., a publicly held corporation, from 1972 to 1983 in various capacities including Vice President of Retail Operations, and was also employed by The Kroger Co. from 1966 to 1972.
Item 10. Directors and Executive Officers of the Registrant (contd.)
Background of Directors and Executive Officers (contd.)
Phillip J. Smith has been Senior Vice President and Chief Financial Officer since November 2000, and was Vice President and Controller from April 1998 until November 2000. Mr. Smith joined the Company in 1987 as Controller. Mr. Smith has approximately 29 years experience in the supermarket industry. Prior to joining the Company, Mr. Smith was employed by Market Basket Foodstores as Vice President and Chief Financial Officer from 1985 to 1987. From 1975 until 1985, Mr. Smith was employed by various divisions of Cullum Companies, Inc., a publicly held corporation, in various financial capacities.
Dennis L. McIntyre has been Group Senior Vice President of Marketing since August 2002. Mr. McIntyre has served the Company for 26 years in various capacities including Courtesy Clerk, Assistant Manager, Buyer, Assistance Vice President of Marketing from 1994 until 1999, Vice President of Marketing from 1999 to 2000 and Senior Vice President of Marketing from 2000 to 2002.
James W. Lee joined the Company in August 2002 as Group Senior Vice President of Retail Operations. Mr. Lee has over 32 years experience in the supermarket industry. Prior to joining the Company, Mr. Lee was with Wild Oats Markets, Inc. between 1997 and 2001 as Chief Operating Officer. Mr. Lee was employed in various operating capacities with Ralphs Grocery Company, a division of Kroger Co., from 1972 until 1996.
Edward A. Stater has been Senior Vice President of Retail Operations since April 2000. Mr. Stater has served the Company for 36 years in various capacities including Clerk, Produce Buyer, Assistant Warehouse Supervisor, New Store Set-up Manager, Grocery Supervisor, District Manager and Regional Vice President from 1986 until 2000.
Bruce D. Varner has been a Director of Stater Bros. Markets since September 1985 and a Director of Stater Bros. Holdings Inc. since May 1989. Since February 1997, Mr. Varner has been a partner in the law firm of Varner, Saleson & Brandt LLP. From 1967 to February 1997, Mr. Varner was a partner in the law firm of Gresham, Varner, Savage, Nolan & Tilden. Mr. Varner specializes in business and corporate matters. Mr. Varner and the law firm of Varner, Saleson & Brandt LLP have performed legal services in the past for the Company and the Company expects such services to continue in the future.
Thomas W. Field, Jr. has been Vice Chairman of the Board of Directors of the Company since May 1998 and a Director of the Company since 1994. Mr. Field has been President of Field and Associates since 1989. From 1988 to 1989, Mr. Field was Chairman of the Board, President and Chief Executive Officer of McKesson Corporation and was its President since 1984, and President and Chief Executive Officer from 1986 to 1988. Mr. Field was President of American Stores Company from 1981 to 1984 and was President of Alpha Beta Company from 1976 to 1984. Mr. Field was a Director of American Stores Company from 1979 to 1984. Mr. Field is a nationally recognized and highly regarded supermarket executive. Mr. Field has held various positions in the Supermarket Industry for over 45 years and serves as a Director for the Campbell Soup Company.
C. Dale Warman has been a Director of the Company since 2000. Mr. Warman served the Fred Meyer Company for over 43 years. Mr. Warman served as a Director of Fred Meyer from 1975 to 1990, Mr. Warman served as President from 1982 to 1990 and was its Executive Vice President from 1981 to 1990. Mr. Warman was Executive Vice President of Allied Foods from 1972 to 1975. Mr. Warman served as a Director of Big Bear Stores from 1987 to 1989 and as a Director of Allied Stores from 1973 to 1975. Mr. Warman is considered one of the supermarket industry’s outstanding executives.
Item 11.
Item 11. Executive Compensation
The following table summarizes the compensation for services rendered during the prior three fiscal years paid to the CEO and the four most highly compensated executive officers other than the CEO of the Company:
Stock Options and SARs
None
Item 11. Executive Compensation (contd.)
Pension Plan
The Company’s Pension Plan for Salaried Employees (the “Pension Plan”) is a non-contributory, defined benefit plan which applies to all salaried employees who have completed one year of qualified service, including Directors who are employees. For each year of credited service, the annual pension to which an employee is entitled under the Pension Plan upon normal retirement at age 65 is an amount equal to three quarters of one percent of the employee’s compensation for each year up to the social security wage base, plus 2.15 percent of the employee’s compensation for each year in excess of the social security wage base. The Named Executive Officers have the following years of credited service under the Pension Plan as of September 26, 2004: Jack H. Brown - 23 years, Donald I. Baker - 21 years, Phillip J. Smith - 17 years, Dennis L. McIntyre - 26 years and James W. Lee - 2 years.
The amounts shown in the following table are estimated annual retirement benefits under the Pension Plan (assuming payments are made on the normal life annuity and not under any of the various survivor forms of benefits) based upon retirement at age 65, after various years of service at selected salary levels. Benefits under the Pension Plan do not become fully vested until the employee has five years of credited service with the Company. The Internal Revenue Code of 1986, as amended, places certain limitations on pension benefits that can be paid from a tax-qualified pension plan and trust, as well as the compensation that may be taken into account in determining such benefits. Such limitations are not reflected in the table below. The maximum annual benefit for 2004 retirees with ten or more years of service at retirement is $160,000. The maximum annual compensation that may be considered for 2004 retirees is $200,000.
Pension Plan Table
Board of Directors
Directors of the Company are paid an annual fee of $50,000 plus $500 for each board meeting attended. The Board had two standing committees during fiscal 2004.
The Audit Committee recommends the appointment or removal of the Company’s independent auditors, reviews the scope and results of the independent audit of the Company, reviews audit fees and reviews changes in accounting policies that have a significant effect on the Company’s financial statements. The Audit Committee members are Mr. Warman and Mr. Field. Mr. Field is the Audit Committee’s Financial Expert and is an independent member of the Board.
The Compensation Committee approves compensation and annual performance bonuses paid to the Chief Executive Officer and the Senior Management of the Company. The Compensation Committee members are Mr. Varner and Mr. Field.
Code of Ethics
The Company has adopted a Financial Code of Ethics which has been signed by the CEO, CFO and Controllers of the Company. A copy of the Code of Ethics has been provided as an exhibit to this Report on Form 10-K.
Item 11. Executive Compensation (contd.)
Employment and Severance Agreements
In June of 2000, the Company’s principal operating subsidiary, Stater Bros. Markets, entered into Employment Agreements (“Agreements”) with Messrs. Brown, Baker, Smith and McIntyre. In August of 2002, a similar agreement was entered into with Mr. Lee. Under each of the Agreements, the employee is employed to serve as an officer of the Company and with certain exceptions the Agreements prohibit the employee from employment in any other business except for a parent or subsidiary of the Company. Each of the Agreements may be terminated by the Company with cause and by either party without cause upon ninety (90) days written notice. If the employment is terminated without cause, the employee’s compensation continues through the expiration of the term of the Agreement then in effect, except in the event of termination of any of the Agreements of Messrs. Baker, Smith, McIntyre and Lee by Mr. Brown or by the Board of Directors with the consent of Mr. Brown. If the employee is terminated as a result of a change of control, he is entitled to receive all salary and benefits provided under the Agreement for the original term notwithstanding termination of his employment. Each Agreement provides for annual base compensation at the employee’s current level with annual increases plus employee benefits and incentive bonus calculated in accordance with a formula based on the Company’s earnings. Mr. Brown’s Agreement has an original term of five (5) years which is automatically renewed on July 1 of each year for a five (5) year term unless ninety (90) days notice of termination is given by either party. Mr. Baker’s Agreement has an original term of four (4) years and unless sooner terminated is renewed automatically through April 20, 2006, the date of Mr. Baker’s sixty-fifth (65th) birthday, the Company’s normal retirement age. Mr. Smith’s, Mr. McIntyre’s and Mr. Lee’s Agreements have an original term of three (3) years, which is automatically renewed for an additional term of three (3) years unless sooner terminated.
In addition, the Company’s operating entity, Stater Bros. Markets has entered into employment contracts with 43 additional key members of Management.
The Company’s severance policies generally provide for two weeks of severance pay to full-time, non-bargaining unit employees for every year of service to the Company, up to a maximum of twelve weeks.
Phantom Stock Plan
The Company maintains a phantom stock plan to provide additional incentive compensation to certain executives of Markets whose performance is considered especially critical to the Company’s business. Under the plan, grants may be made by the Compensation Committee and Board of Directors to persons recommended by the Chairman of the Board or Chief Executive Officer. Existing stockholders and partners of La Cadena are not eligible to receive awards. Awards under the plan are for units that have an assigned value. The value of the units awarded under the plan will increase or decrease in accordance with net profits of the Company. Subject to vesting provisions of the plan, units are paid in cash either (i) in a lump sum upon a change in control of the Company; or (ii) if sooner, in either a lump sum or installments (with interest) over a five-year period (as the Company may determine) following termination of the participant’s employment by reason of retirement, permanent total disability or death. Awards under the plan vest after five years, except that upon a participant’s early retirement, permanent total disability or death, awards are considered partially vested at the rate of 20% for each year of employment following the grant. If a participant voluntarily terminates his or her employment, or is terminated for cause, any unvested awards under the plan will terminate and no payment will be made thereunder. As of September 29, 2002, September 28, 2003 and September 26, 2004, there were 668,000, 693,000 and 702,000 units outstanding, respectively.
Payments pursuant to units awarded under the plan are based upon the value of a unit at the date of retirement, permanent total disability or death, except that if such date occurs within two years of the grant the amount of payment, per unit, is limited to the appreciated value of the units during the period. Upon a change of control, the payment on all units is equal to the full value of the units.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth, as of December 21, 2004, the number and percentage of outstanding shares of Class A Common Stock beneficially owned by (a) each person known by the Company to beneficially own more than 5% of such stock, (b) each Director of the Company, (c) each of the Named Executive Officers, and (d) all Directors and executive officers of the Company as a group:
Change of Control Arrangements
None
Item 13.
Item 13. Certain Relationships and Related Transactions
Mr. Bruce D. Varner and the law firm of Varner, Saleson & Brandt LLP, of which Mr. Varner is a partner, have performed legal services in the past for the Company. The total cost of such legal services incurred by the Company during fiscal 2004 was approximately $4.8 million. Mr. Varner was one of the named defendants in the legal proceedings between Markets, Santee and Hughes and Mr. Varner received $100,000 as part of litigation settlement between Markets and Hughes. In addition Mr. Varner was paid Director fees of approximately $52,000. The Company believes that the terms and costs of such legal services provided by Mr. Varner and the law firm of Varner, Saleson & Brandt LLP were at least as fair to the Company as could have been obtained from unaffiliated law firms. The Company expects such services to continue in the future.
Effective January 2002, the Company redeemed 11,699 shares of the Company’s stock previously held by La Cadena and made a cash payment of $20.0 million and executed a $20.0 million subordinated note due March 31, 2007 to Mr. H. Harrison Lightfoot, a former partner of La Cadena. The subordinated note bears interest at a rate of 5.0% per annum, payable semi-annually. Effective February 2002, the Company paid a $4.5 million dividend and a $500,000 financial advisory service fee to La Cadena.
On June 17, 2004, the Company paid a $45.0 million dividend to La Cadena.
The 38,301 outstanding shares of the Company’s Class A Common Stock are owned by La Cadena and may be deemed to be beneficially owned by the partners of La Cadena. The general partners of La Cadena are Jack H. Brown and Richard C. Moseley. Mr. Brown has a majority interest and is the Managing General Partner. Mr. Brown is a Director of the Company and a Named Executive Officer of the Company. Mr. Brown has the power to vote the shares of the Company owned by La Cadena. Mr. Moseley served the Company for over 44 years in many executive capacities, most recently and from September 1995 until his retirement from the Company in January 1996, Mr. Moseley served as Executive Vice President of the Company.
Item 14.
Item 14. Principal Accounting Fees and Services
Audit Fees
Ernst & Young LLP fees for audit services aggregated $868,000 in fiscal 2004 and $308,000 in fiscal 2003 for services associated with the annual audit and reviews of the Company’s quarterly reports on Form 10-Q. Fees for fiscal 2004 also included consent services related to an offering memorandum for purchase of the Company’s 10.75% Senior Notes due 2006 and the issuance and registration of the Company’s 8.125% Senior Notes due 2012 and Floating Rate Senior Notes due 2010.
Audit Related Fees
Ernst & Young LLP billed the Company in aggregate $30,000 in fiscal 2004 and $31,000 in fiscal 2003 for audits of the Company’s pension and profit sharing plans.
Tax Fees
Ernst & Young LLP billed the Company in aggregate $27,000 in fiscal 2004 and $177,000 in fiscal 2003 for tax compliance, tax advice and tax planning services.
All Other Fees
There were no fees billed by Ernst & Young LLP for other services in either fiscal 2004 or fiscal 2003.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(1)
Financial Statements
See Financial Statement Index included in Item 8 of Part II of this Form 10-K.
(2)
Financial Statement Schedules
The Financial Statement Schedules required by Item 15(d) for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission, are not required under the related instructions or are inapplicable and therefore, have been omitted.
(3)
Exhibits
Exhibits as required by Item 15(c) are as follows:
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (contd.)
(a)(3)
Exhibits (contd.)
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (contd.)
(a)(3)
Exhibits (contd.)
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (contd.)
(a)(3)
Exhibits (contd.)
(1)
Previously filed with the Securities and Exchange Commission as an exhibit to the Registration Statement S-4 No. 33-77296 dated July 21, 1994.
(2)
Previously filed with the Securities and Exchange Commission as an exhibit to the Registration Statement S-4 No. 333-85723 dated August 20, 1999
(3)
Previously filed with the Securities and Exchange Commission as exhibits to Registrant’s Quarterly Report on Form 10-Q dated June 25, 2000 and filed on August 9, 2000.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (contd.)
(a)(3)
Exhibits (contd.)
STATER BROS. HOLDINGS INC.
FOR THE FISCAL YEAR ENDED SEPTEMBER 26, 2004
FORM 10-K
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
F - 1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors of
Stater Bros. Holdings Inc.
We have audited the accompanying consolidated balance sheets of Stater Bros. Holdings Inc. as of September 29, 2002, September 28, 2003 and September 26, 2004, and the related consolidated statements of income, stockholder’s deficit, and cash flows for the 52-week periods ended September 29, 2002, September 28, 2003, and September 26, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Stater Bros. Holdings Inc. at September 29, 2002, September 28, 2003 and September 26, 2004, and the consolidated results of their operations and their cash flows for the 52-week periods ended September 29, 2002, September 28, 2003, and September 26, 2004, in conformity with U.S. generally accepted accounting principles.
Irvine, California
/s/ Ernst &Young LLP
December 20, 2004
F - 2
STATER BROS. HOLDINGS INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
ASSETS
See accompanying notes to consolidated financial statements.
F - 3
STATER BROS. HOLDINGS INC.
CONSOLIDATED BALANCE SHEETS (contd.)
(In thousands, except share amounts)
LIABILITIES AND STOCKHOLDER’S DEFICIT
See accompanying notes to consolidated financial statements.
F - 4
STATER BROS. HOLDINGS INC.
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share and share amounts)
See accompanying notes to consolidated financial statements.
F - 5
STATER BROS. HOLDINGS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying notes to consolidated financial statements.
F - 6
STATER BROS. HOLDINGS INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDER’S DEFICIT
(In thousands)
See accompanying notes to consolidated financial statements.
F - 7
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 26, 2004
Note 1 - The Company and Summary of Significant Accounting Policies
Description of Business
Stater Bros. Holdings Inc. (the “Company”) is engaged primarily in the operation of retail supermarkets. As of September 26, 2004, the Company operated 158 retail grocery supermarkets under the name “Stater Bros. Markets.” The Company’s supermarkets are located in Southern California’s San Bernardino, Riverside, Los Angeles, Orange, San Diego and Kern counties. The Company and its predecessor companies have operated retail grocery stores under the “Stater Bros. Markets” name in the Inland Empire of Southern California since 1936.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Stater Bros. Markets (“Markets”) and Stater Bros. Development, Inc (“Development”). Santee Dairies, Inc. (“Santee”) is a wholly-owned subsidiary of Markets since February 6, 2004. Prior to February 6, 2004, Markets owned 50% of Santee and accounted for Santee under the equity method of accounting. All significant inter-company transactions have been eliminated in consolidation.
Reclassifications
Certain amounts in the prior periods have been reclassified to conform to the current period financial statement presentation.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Fiscal Year
The Company’s fiscal year ends on the last Sunday in September.
Cash and Cash Equivalents
Cash and cash equivalents are reflected at cost, which approximates their fair value, and consist primarily of overnight repurchase agreements, certificates of deposit and money market funds with maturities of less than three months when purchased.
Restricted Cash
Restricted cash represents cash that has been set aside as collateral on certain workers’ compensation and general liability reserves. Interest earned on the restricted cash is controlled by the Company and is included in cash and cash equivalents.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market.
Receivables
Receivables represent amounts expected to be received during the next operating cycle of the Company. The carrying amount reported in the balance sheet for receivables approximates their fair value.
Long-Lived Assets
The Company reviews the recoverability of its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. If the estimated future, undiscounted cash flows from the use of an asset are less than its carrying value, a write-down is recorded to reduce the related asset to estimated fair value.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 1 - The Company and Summary of Significant Accounting Policies (contd.)
Property and Equipment
Property and equipment are stated at cost and are depreciated or amortized, principally on the straight-line basis over the estimated useful lives of the assets, and for capitalized leases over the initial lease term or the estimated economic life of the asset.
The average estimated economic lives are as follows:
Deferred Debt Issuance Costs
Direct costs incurred as a result of financing transactions are capitalized and amortized to interest expense over the terms of the applicable debt agreements.
Phantom Stock Plan
It is the Company’s policy to expense phantom stock units to the extent that they vest and appreciate during the accounting period.
Self-Insurance Reserves
The Company is primarily self-insured, subject to certain retention levels for workers’ compensation, automobile and general liability costs. The Company is covered by umbrella insurance policies for catastrophic events. The Company records its self-insurance liability based on the claims filed and an estimate of claims incurred but not yet reported. The estimates used by management are based on the Company’s historical experiences as well as current facts and circumstances. The Company uses third party actuarial analysis in making its estimates. Actuarial projections and the Company’s estimate of ultimate losses are subject to a high degree of variability. The variability in the projections and estimates are subject to, but not limited to, such factors as judicial and administrative rulings, legislative actions, and changes in compensation benefits structure. In recent years, the Company and employers within the State of California as a whole have seen significant increases in the severity of workers’ compensation claims. The Company discounted its workers’ compensation, automobile and general liability insurance reserves at a discount rate of 7.5% in fiscal 2002 and fiscal 2003 and 5.5% in fiscal 2004. The Company is self-insured, subject to certain retention levels, for health care costs of eligible non-bargaining unit employees. Such health care reserves are not discounted.
Income Taxes
The Company provides for deferred income taxes as timing differences arise between income and expenses recorded for financial and income tax reporting purposes.
Revenue Recognition
The Company recognizes revenue from the sale of its products at the point of sale to the customer. Sales are recognized net of any discounts given to the customer. Santee recognizes revenue as shipments are received by its customers. Sales are recognized net of promotional discounts.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 1 - The Company and Summary of Significant Accounting Policies (contd.)
Cost of Goods Sold
Included in cost of goods sold are direct product purchase costs, all in-bound freight costs, all direct receiving and inspection costs, all quality assurance costs, all warehousing costs and all costs associated with transporting goods from the Company’s distribution facilities to its stores, net of earned vendor rebates and allowances. The Company recognizes, as a reduction to cost of goods sold, certain rebates and allowances (“allowances”) from its vendors as the allowances are earned. Allowances are earned by promoting certain products or by purchasing specified amounts of product. The Company records a liability for allowance funds that have been received but not yet earned. Included as a reduction in cost of goods sold for fiscal 2003 and fiscal 2004 is $4.6 million and $4.4 million, respectively, of advertising costs in excess of the fair value of the co-operative advertising.
Selling, General and Administrative Expenses
Included in selling, general and administrative expenses are all store operation costs which includes all store labor costs associated with receiving, displaying and selling the Company’s products at the store level; all advertising costs, net in fiscal 2004 and fiscal 2003 of the portion of co-operative advertising allowances directly related to the fair value of the advertising and net of all co-operative advertising allowances in fiscal 2002; certain salary, wages and administrative costs associated with the purchasing of the Company’s products and all security, management information services, accounting and corporate management costs.
As noted under “Cost of Goods Sold”, the Company includes all purchasing and distribution costs to deliver the product for sale to its stores in cost of goods sold, except for certain salary, wages and administrative costs associated with the purchasing of its products. The amount of salary, wages and administrative costs associated with the purchase of its products included in selling, general and administrative costs was $861,000, $891,000 and $1,057,000 in fiscal 2002, fiscal 2003 and fiscal 2004, respectively.
Vendor Rebates and Allowances
The Company receives certain allowances from its vendors that relate to the purchase and promotion of certain products. All allowances, except for advertising allowances described under “Advertising Allowances”, are recognized as a reduction in cost of goods sold as the performance is completed and inventory sold. Allowances, such as slotting fees, which are tied to the promotion of certain products are recognized as reductions in cost of goods sold as the Company meets the required performance criteria. Allowances that are based upon purchase or sales volumes are recognized as reductions in cost of goods sold as the products are sold. The Company receives lump-sum payments from vendors for the promotion or purchase of products over multi-year periods. The Company records a liability for unearned allowances and recognizes, as a reduction in cost of goods sold, these allowances over time as the criteria of these contracts are met.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 1 - The Company and Summary of Significant Accounting Policies (contd.)
Advertising Allowances
The Company receives co-operative advertising allowances from vendors for advertising specific vendor products over specific periods of time. For fiscal 2003 and fiscal 2004, the Company recognized the portion of co-operative advertising allowances directly related to the fair value of advertising as a reduction in advertising costs. In fiscal 2003 and fiscal 2004, $4.6 million and $4.4 million, respectively, of excess allowances received over the fair value of advertising were recorded as a reduction to cost of goods sold. In fiscal 2002, all co-operative advertising allowances were recognized as reductions in advertising expense. A significant portion of the Company’s advertising expenditures is in the form of twice weekly print advertisements. The Company distributes its print ads through inserts in local newspapers, in direct mailers and as handouts distributed in its stores. The Company analyzes, on a monthly basis, the direct out-of-pocket costs for printing and distributing its print ads. Using the number of ads in a typical twice weekly advertisement, the actual direct costs of an individual advertisement is determined. The cost determined is deemed to be the fair value of advertising. The amount of co-operative advertising allowance recognized as a reduction in advertising expense was $11.9 million, $5.9 million and $7.1 million in fiscal 2002, fiscal 2003 and fiscal 2004, respectively.
Advertising
The Company’s advertising costs, net of vendor allowances for co-operative advertising, are recognized in the period the advertising is incurred and are included in selling, general and administrative expenses. Advertising costs, net of vendor allowances, were $23.7 million, $27.4 million and $29.7 million in fiscal 2002, 2003 and 2004, respectively.
Leases
Certain of the Company’s operating leases provide for minimum annual payments that change over the life of the lease. The aggregate minimum annual payments are expensed on the straight-line basis over the minimum lease term. The Company recognizes a liability for minimum step rents when the amount of straight-line rent expense exceeds the actual lease payment and it reduces the step rent liability when the actual lease payment exceeds the amount of straight-line rent expense.
Recent Accounting Pronouncements
In November 2004, the FASB issued Statement 151, “Inventory Costs”, an amendment of APB 43, Statement 151 clarifies what amount of expenses should be recognized as current period charges. The Company does not expect the adoption to of this pronouncement to have a material impact on the results of its operations.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 2 - Impact of Recent EITF
Effective September 30, 2002, the Company adopted EITF Issue No. 02-16 “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” The Company’s adoption of the EITF has had no effect on the Company’s current year or prior years’ net income. For fiscal 2003 and fiscal 2004 vendor payments of $4.6 million and $4.4 million, respectively, related to advertising reimbursements in excess of advertising cost were recorded as reductions to cost of goods sold. Financial statements for fiscal 2002 were not reclassified. The following table shows the pro forma consolidated operating profit for fiscal 2002 if the impact of EITF Issue No. 02-16 had been applied to fiscal 2002.
Note 3 - Santee
In 1997, in connection with the construction of a new dairy facility in City of Industry, California, Markets and Hughes Markets (“Hughes”), the owners Santee contributed the outstanding shares of Santee to a new entity Santee Dairies, LLC (“SDL”) with each company owning 50% of SDL. Markets and Hughes each entered into separate product purchase agreements (“PPA”) with Santee for the purchase of fluid milk and other products. Financing for the new dairy was provided through the issuance of $80.0 million Senior Secured 9.36% Notes due 2008 (“Santee Notes”). One of the covenants of the Santee Notes was a covenant that required the payment of the outstanding Santee Notes in the event of a change in control of Santee.
Certain disagreements arose regarding the PPA’s and other matters between Markets and Ralphs, the parent company of Hughes, and Ralphs and Santee. In order to settle the resulting litigation, Markets, Hughes, Santee and SDL entered into three separate but interconnected agreements “Settlement Agreement and Release of all Claims”, “Dissolution and Transfer Agreement” and “Assignment and Assumption Agreement” all three agreements collectively known as the “Settlement Agreement”. Under the Settlement Agreement, the Ralphs Guaranty was terminated, a new purchase of products schedule for Ralphs was established, Hughes agreed to pay $1,550,000 to Markets, SDL was dissolved and the shares of Santee, previously held by SDL, were transferred equally to Markets and Hughes. Concurrently with this transfer, Hughes immediately transferred Hughes’ Santee shares to Santee for cancellation and retirement.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 3 - Santee (contd.)
Through the Settlement Agreement, Hughes relinquished its interest in Santee to Markets. The consideration received by Markets under the Settlement Agreement was $1,550,000 in cash and the value of the additional 50% ownership interest in Santee. The value assigned to the additional 50% interest in Santee was $21.8 million which was determined by management based upon the net present value of the most probable future cash flows. The Settlement Agreement’s effective date was the close of business on February 6, 2004. In fiscal 2004, the Company incurred legal fees of $500,000 related to the Settlement Agreement. In addition, the Company, through Santee, made payments, aggregating $500,000, to four Directors of Santee who had been named by Hughes as defendants in litigation settled by the Settlement Agreement. Three of the four Directors are related parties to the Company. The net consideration received by the Company under the Settlement Agreements was $22.4 million which was recorded as a gain in fiscal 2004 in the Consolidated Statements of Income under the line item “Selling, general and administrative expenses.”
The following table is a condensed balance sheet that discloses the value assigned to the Santee assets acquired and the liabilities assumed as a result of the Settlement Agreement:
Previously, Markets accounted for Santee under the equity method of accounting as Markets owned 50% of the stock and did not exercise control over Santee. The dissolution of SDL and the retirement of the Hughes’ shares gave Markets 100% direct ownership of Santee and caused a change in control of Santee. The change in control triggered the early payment requirement of the Santee Notes, which included a make whole provision. In order to finance the payment of the Santee Notes and the make whole payment, Markets loaned Santee $55.0 million. On February 6, 2004, Santee redeemed $53.5 million of Santee Notes, all the notes outstanding, and paid a make whole fee of $8.5 million. In addition, $1.2 million of previously unamortized debt issuance costs related to the Santee Notes was expensed. The make-whole fee and amortization of the remaining debt issuance costs were recorded as a component of interest expense related to debt purchase in the Company’s Consolidated Statements of Income.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 3 - Santee (contd.)
Santee has been included in the consolidated financial statements of the Company as a wholly-owned subsidiary as of the effective date of the Settlement Agreement. The following table provides supplemental pro forma results of operations presented as though Santee had been consolidated as of the beginning of the reporting periods.
Condensed Pro Forma Results of Operations
(in thousands, except per share amounts)
Prior to the Company obtaining 100% ownership of Santee, the Company recognized income of $929,000 in fiscal 2004 and the Company recognized income of $2.9 million and $1.3 million for fiscal years 2002 and 2003, respectively. The Company is a significant customer of Santee which supplies the Company with a substantial portion of its fluid milk and dairy products.
Note 4 - Issuance of New Debt and Early Extinguishment of Debt
On June 17, 2004, the Company issued $525.0 million of unregistered 8.125% Senior Notes due June 15, 2012 and $175.0 million of unregistered Floating Rate Senior Notes due June 15, 2010. On October 4, 2004, subsequent to year-end, the Company exchanged the unregistered 8.125% Senior Notes due June 15, 2012 and unregistered Floating Rate Senior Notes due June 15, 2010 for substantially identical registered 8.125% Senior Notes due June 15, 2012 and registered Floating Rate Senior Notes due June 15, 2010 collectively, (the “Notes”). The Company incurred $22.7 million of debt issuance cost related to the issuance of the Notes which will be amortized over the term of the respective Notes.
The Notes are guaranteed by Markets, Development, and the Company’s indirect subsidiary Santee (each, a “subsidiary guarantor,” and collectively, the “subsidiary guarantors”). Condensed consolidating financial information with respect to the subsidiary guarantors is not provided because the Company has no independent assets or operations, the subsidiary guarantees are full and unconditional and joint and several, and there are no other subsidiaries of the Company other than the subsidiary guarantors.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 4 - Issuance of New Debt and Early Extinguishment of Debt (contd.)
On June 17, 2004 the Company used part of the proceeds from the issuance of these notes for the purchase of $397.8 million of the 10.75% Senior Notes due August 2006, the payment of $16.9 million for tender premium and fees on the purchased 10.75% Senior Notes, the early retirement of the $20.0 million 5.0% Subordinated Note due March 2007 and to pay accrued interest on the purchased 10.75% Senior Notes and the retired 5.0% Subordinated Note. On August 16, 2004, the Company redeemed the remaining outstanding $41.0 million 10.75% Senior Notes and paid a make whole fee on the redemption of $1.1 million. In addition, the Company recognized an expense in fiscal 2004 of $5.2 million related unamortized debt issuance costs on the 10.75% Senior Notes that were tendered and redeemed and $2.7 million related to the unamortized debt issuance costs on the 5.0% Subordinated Note which was retired. The tender premium and fees, the make whole fee and the amortization of remaining unamortized debt issuance costs for both the 10.75% Senior Notes and the 5.0% Subordinated Note were recorded as components of interest expense related to debt purchase in the Company’s Consolidated Statements of Income.
Note 5 - Debt
Long-term debt consisted of the following:
Interest on the 8.125% Senior Notes due June 2012, is payable semi-annually in arrears on June 15 and December 15. Principal on the 8.125% Senior Notes is due in the fiscal year 2012.
Interest on the Floating Rate Notes due June 2010, is payable quarterly in arrears on March 15, June 15, September 15 and December 15. The interest rate on the Floating Rate Senior Notes is reset quarterly equal to LIBOR plus 3.50%. The interest rate in effect on the Floating Rate Senior Notes at September 26, 2004 was 5.38%. Principal on the Floating Rate Senior Notes is due in fiscal year 2010.
Interest capitalized during fiscal years 2002, 2003 and 2004 amounted to $144,000, $126,000 and $323,000 respectively. Interest expense incurred, before the effect of capitalized interest, during 2002, 2003 and 2004 amounted to $53.0 million, $53.4 million and $54.3 million, respectively.
During fiscal 2002, the Company redeemed $250,000 of its 10.75% Senior Notes due 2006. The Notes were restricted and unregistered. The Notes were redeemed for $250,000 plus accrued interest.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 6 - Bank Facilities
On June 17, 2004, the Company entered into an amended and restated credit facility (the “New Credit Facility”) with Bank of America N.A. (“Bank of America”) as sole and exclusive administrative agent, and sole initial lender, consisting of a three-year revolving credit facility in a principal amount of up to $75.0 million, with the right to increase, under certain circumstances, the size of the New Credit Facility to an aggregate principal amount of $100.0 million. The New Credit Facility amended and restated the existing credit facility in its entirety. Subject to certain restrictions, the entire amount of the New Credit Facility may be used for loans, letters of credit, or a combination thereof. Borrowings under the New Credit Facility are unsecured and will be used for certain working capital, capital expenditures and other corporate purposes. Letters of credit under the letter of credit facility are expected to be used to support obligations incurred in connection with the construction of stores, construction of the new corporate office and distribution facilities and workers’ compensation insurance obligations. The availability of the loans and letters of credit are subject to certain borrowing restrictions.
The New Credit Facility is guaranteed by the Company and all of its existing and future material subsidiaries, including Development and Santee (subject, in the case of Santee, to termination upon certain specified events).
Loans under the New Credit Facility bear interest at a rate based upon either (i) the “Base Rate” (defined as the higher of (a) the Federal Funds Rate plus 0.50% and (b) the rate of interest publicly announced by Bank of America as its “reference rate”), plus 1.00%, or (ii) the “Offshore Rate” (defined as the average British Bankers Association Interest Settlement Rate for deposits in dollars, adjusted for the maximum reserve requirement for Eurocurrency funding), plus 1.75%. For Offshore Rate Loans, the Offshore Rate will be applied in consecutive periods of the earlier of (a) the maturity date of the loan or (b) periods, as selected by Markets of one, two, three or six months.
The New Credit Facility will cease to be available and will be payable in full on May 31, 2007. Notwithstanding such maturity date, at any time prior thereto Markets shall be entitled to request the issuance of standby letters of credit having a term which is up to one year following such maturity date, and commercial letters of credit having a term which is up to six months following such maturity date. Loans under the New Credit Facility must be repaid for a period of ten consecutive days semi-annually.
Loans under the New Credit Facility may be repaid and re-borrowed. The loans under the New Credit Facility may be prepaid at any time without penalty, subject to certain minimums and payment of any breakage and re-deployment costs in the case of loans based on the offshore rate. The commitments under the New Credit Facility may be reduced by Markets. Markets will be required to pay a commitment fee equal to 0.25% per annum on the actual daily unused portion of the revolving loan facility and the letter of credit facility, payable quarterly in arrears. Outstanding letters of credit under the credit facility are subject to a fee of 1.25% per annum on the face amount of such letters of credit, payable quarterly in arrears. Markets will be required to pay standard fees charged by Bank of America with respect to the issuance, negotiation, and amendment of commercial letters of credit issued under the letter of credit facility.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 6 - Bank Facilities (contd.)
The New Credit Facility requires Markets to meet certain financial tests, including minimum net worth and other tests. The New Credit Facility contains covenants which, among other things, limit the ability of Markets and its subsidiaries to (i) incur indebtedness, grant liens and guarantee obligations, (ii) enter into mergers, consolidations, liquidations and dissolutions, asset sales, investments, leases and transactions with affiliates, and (iii) make restricted payments. The New Credit Facility also contains covenants that apply to the Company and its subsidiaries, and the Company is a party to the New Credit Facility for purposes of these covenants. These covenants, among other things, limit the ability of the Company and its subsidiaries to incur indebtedness, make restricted payments, enter into transactions with affiliates, and make amendments to the Indenture governing the 8.125% Senior Notes due June 15, 2012 and the Floating Rate Senior Notes due June 15, 2010.
The New Credit Facility contains customary events of default, including payment defaults; material inaccuracies in representations and warranties; covenant defaults; cross-defaults to certain other indebtedness; certain bankruptcy events; certain ERISA events; judgment defaults; invalidity of any guaranty; and change of control.
In November 2004, Santee entered into a revolving line of credit with Bank of America (“the Revolver”). Under the Revolver, Santee may borrow up to $5.0 million of which $2.0 million may be used to secure letters of credit issued to support workers’ compensation liabilities. Borrowings under the Revolver are secured by the receivables of Santee. The Revolver is scheduled to expire on May 31, 2007.
Advances under the Revolver bear interest at Bank of America’s prime rate plus 0.5% with interest due monthly or, if elected by Santee, at the Interbank Offered Rate plus 1.75%. The outstanding undrawn portion of the workers’ compensation letter of credit is subject to an annual commitment fee of 1.25%.
Under the Revolver, Santee is required to comply with certain financial covenants, which include certain financial ratios.
As of September 26, 2004, for purposes of the credit facilities with Bank of America, Santee, Markets and the Company were in compliance with all restrictive covenants. The Company is also subject to certain covenants associated with its 8.125% Senior Notes due 2012 and its Floating Rate Senior Notes due 2010. As of September 26, 2004, the Company was in compliance with all such covenants. However, there can be no assurance that Santee, Markets or the Company will be able to achieve the expected operating results or implement the capital expenditure strategy upon which future compliance with such covenants is based.
The Company had no short-term borrowings outstanding at the end of fiscal years 2002, 2003 and 2004, and the Company did not incur any short-term borrowings during fiscal years 2002, 2003 and 2004.
Note 7 - Leases
The Company leases the majority of its retail stores, offices and distribution facilities. Certain of the operating leases provide for minimum annual payments that change over the life of the lease. The aggregate minimum annual payments are expensed on the straight-line basis over the minimum lease term. In addition, certain leases provide for additional rents based on sales and some of these leases allow the Company to reduce current year contingent rent payments by amounts paid for property taxes, insurance and in some cases capital expenditures. Primary lease terms range from 3 to 55 years and substantially all leases provide for renewal options.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 7 - Leases (contd.)
Following is a summary of future minimum lease payments as of September 26, 2004:
Rental expense and sublease income were as follows:
Aggregate sublease income to be received subsequent to September 26, 2004 is approximately $4.0 million.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 8 - Income Taxes
The provision for income taxes consisted of the following:
A reconciliation of the provision for income taxes to amounts computed at the federal statutory rate is as follows:
Components of deferred income taxes are as follows:
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 8 - Income Taxes (contd.)
As of September 26, 2004, the Company had approximately $17.5 million of federal net operating loss carryforwards which expire beginning in 2012 through 2020 if not utilized, approximately $4.7 million of state net operating loss carryforwards which expire beginning in 2005 through 2012 if not utilized, and $2.1 million of state manufacturers tax credits which expire between 2006 and 2011. The Company records a valuation allowance to reflect the estimated amount of deferred tax assets that more likely than not will not be realized. Due to anticipated federal and state usage limitation of the net operating loss and tax credit carryforwards under Internal Revenue Code Section 382 and applicable state statutes, the Company has established valuation allowances for the entire amount of state manufactures tax credit of $2.1 million. Although there can be no assurances as to future taxable income of the Company, the Company believes that its expectations of future taxable income, when combined with the income taxes paid in prior years and established valuation reserves, will be adequate to realize the deferred income tax assets.
The Company establishes deferred tax liabilities for anticipated tax timing differences where payment of tax is anticipated. Such amounts represent a reasonable provision for taxes ultimately expected to be paid, and the amounts may be adjusted over time as additional information becomes known. The effects of changes to accrued liabilities related to tax matters resulted in a reduction in tax expense of approximately $6.1 million and $0.5 million in fiscal 2004 and fiscal 2003, respectively.
Note 9 - Retirement Plans
Pension Plan
The Company has a noncontributory defined benefit pension plan covering substantially all non-union employees. The plan provides for benefits based on an employee’s compensation during the eligibility period while employed with the Company. The Company’s funding policy for this plan is to contribute annually at a rate that is intended to provide sufficient assets to meet future benefit payment requirements.
Net periodic pension cost included the following components:
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 9 - Retirement Plans (contd.)
Pension Plan (contd.)
The following table sets forth the plan’s funded status and amounts recognized in the Company’s balance sheet at:
Expenses recognized for this retirement plan were $2.4 million, $3.1 million and $3.8 million in 2002, 2003 and 2004, respectively.
Profit Sharing Plan
The Company has a noncontributory defined contribution profit sharing plan covering substantially all non-union employees. Union employees may participate if their collective bargaining agreement specifically provides for their inclusion. The Company may contribute up to 7.5% of total compensation paid or accrued during the year to each plan participant subject to limitations imposed by the Internal Revenue Code. The Company recognized expenses for this plan in the amount of $550,000, $668,000 and $1.0 million in 2002, 2003 and 2004, respectively.
Multi-Employer Plans
The Company also contributes to multi-employer defined benefit retirement plans in accordance with the provisions of the various labor agreements that govern the plans. Contributions to these plans are generally based on the number of hours worked. Information for these plans as to vested and non-vested accumulated benefits and net assets available for benefits is not available.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 9 - Retirement Plans (contd.)
Multi-Employer Plans (contd.)
The Company’s expense for these retirement plans and health and welfare plans consisted of the following:
The Company’s employer contributions fluctuate as a result of periodic resumptions and suspensions of employer contributions to collective bargaining trusts.
Note 10 - Labor Relations
The Company’s collective bargaining contract with the UFCW was ratified in fiscal 2004 and extends through March 2007. The Company’s collective bargaining agreement with the International Brotherhood of Teamsters was renewed in September 2002 and expires in September 2005. Santee’s collective bargaining agreement with the International Brotherhood of Teamsters was renewed in March 2004 and expires in March 2007. Management believes it has good relations with its employees.
Note 11 - Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short-term maturity of these instruments.
Receivables
The carrying amount approximates fair value because of the short-term maturity of these instruments.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 11 - Fair Value of Financial Instruments (contd.)
Long-Term Debt and Capital Lease Obligations
The fair value of the 8.125% Senior Notes and the Floating Rate Senior Notes, are based on quoted market prices. Although market quotes for the fair value of the Company’s capitalized lease obligations are not readily available, the Company believes the stated value approximates fair value.
The estimated fair values of the Company’s financial instruments are as follows:
Note 12 - Litigation Matters
In the ordinary course of its business, the Company is party to various legal actions which the Company believes are incidental to the operation of the business of the Company and its subsidiaries. The Company records an appropriate provision when the occurrence of loss is probable and can be reasonably estimated. The Company believes that the outcome of such legal proceedings to which the Company is currently a party will not have a material adverse effect upon its results of operations or its consolidated financial condition.
On July 9, 2003, the Company’s principal operating subsidiary Markets agreed to a settlement of two lawsuits which had been filed on behalf of certain of Markets’ existing and former store managers and assistant managers which alleged that such workers are non-exempt under California labor laws and are therefore entitled to overtime wages. Markets admitted no wrong doing under the settlement and it believes it has appropriately followed California law in the classification and payment of its employees. Markets believes that the store managers and assistant managers are highly compensated employees with duties and responsibilities which place them in the exempt category under California law and that such employees are not entitled to overtime wages. Markets continues to feel the case was without merit; however, because of escalating litigation expenses, Markets determined a settlement was the best solution. The amount of the settlement was $3.2 million. Of the $3.2 million, $1.2 million of the settlement was recognized as expense in fiscal 2003 and the remaining was expensed in prior years.
On February 6, 2004, a final settlement agreement became effective between Markets and Hughes to resolve litigation matters and control of Santee. For a description of the Settlement Agreement see “Note 3 - Santee”.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 13 - Stock Redemption
During fiscal 2002, the Company obtained consent of the holders of its 10.75% Senior Notes due 2006 to make a distribution and payment to stockholders consisting of $25.0 million in cash and a subordinated note in the principal amount of $20.0 million. On January 22, 2002, the Company redeemed 11,699 shares of the Company’s stock previously held by La Cadena Investments (“La Cadena”), the sole shareholder of the Company, and made a cash payment of $20.0 million and executed a $20.0 million subordinated note due March 31, 2007 to a former partner of La Cadena. The subordinated note bore interest at a rate of 5.0% per annum, payable semi-annually. In February 2004, the Company retired the 5.0% Subordinated Note. On February 1, 2002, the Company paid a $4.5 million dividend to La Cadena. Fees for consent of the holders of its 10.75% Senior Notes and fees and expenses of the transaction, including a $500,000 financial advisory service fee to La Cadena, were approximately $5.0 million.
Note 14 - Phantom Stock Plan
The Company maintains a phantom stock plan for certain executives of Markets. Existing stockholders and partners of La Cadena are not eligible to receive awards. Awards under the plan are for units that have an assigned value. Awards under the plan vest after five years, except that upon a participant’s early retirement, permanent total disability or death, awards are considered partially vested at the rate of 20% for each year of employment following the grant. If a participant voluntarily terminates his or her employment, or is terminated for cause, any unvested awards under the plan will terminate and no payment will be made thereunder. As of September 29, 2002, September 28, 2003 and September 26, 2004, there were 668,000, 693,000 and 702,000 units outstanding, respectively. The Company recognized an expense for the plan of $6.0 million, $6.0 million and $24.0 million in 2002, 2003 and 2004, respectively.
Note 15 - Dividend Payment
On June 17, 2004, the Company paid a $45.0 million dividend to La Cadena Investments, the sole stockholder of the Company.
Note 16 - Corporate Office and Distribution Facilities
Markets plans to build new corporate office and distribution facilities on approximately 160 acres of real property located on the former Norton Air Force Base (“NAFB”) in the City of San Bernardino, California. Markets has entered into an Owner Participation Agreement with the Inland Valley Development Agency, a joint powers agency (“IVDA”), which is the entity responsible for the redevelopment of NAFB, to acquire approximately 93 acres of the project property owned by IVDA. As a component of this Agreement IVDA is completing an agreement with a sister governmental agency for an additional 51 acres that would be transferred or leased to Markets with a purchase option. Of the 160 acre project site, 16 acres are privately owned. Markets has acquired one of these parcels and is negotiating the acquisition of the three remaining privately held parcels consisting of approximately 13.5 acres. The Agreement with IVDA requires Markets to acquire those parcels not owned by IVDA, to relocate all tenants and other business owners occupying buildings on the project property, to construct and complete the corporate office and distribution facilities and to obtain all City of San Bernardino building permits and entitlements required for construction of the project. Markets also has entered into an agreement with Hillwood/San Bernardino LLC (“Hillwood”), the master developer of NAFB, for infrastructure improvements. Under the Hillwood Agreement, Markets will share costs associated with the infrastructure improvements including water, sewer, streets and utilities, which will be required by the City of San Bernardino for the project. Markets, after completion of the acquisition of the project property, will secure its commitment with Hillwood for infrastructure improvements by the posting of either cash or letters of credits in the amount of $10.8 million. The agreements with IVDA and Hillwood are contingent upon Markets successfully completing acquisition of all the privately owned property.
STATER BROS. HOLDINGS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (contd.)
Note 16 - Corporate Office and Distribution Facilities (contd.)
The NAFB site will be used to relocate and consolidate Markets’ corporate office and all distribution facilities to a single integrated facility from the 13 distribution buildings at 7 different locations currently in use. The site is located within eight miles of the main distribution facility in Colton, so there will be no change in the average distance between the new facility and Markets retail supermarkets. The facility will consist of approximately 2.1 million square feet and will include Markets’ corporate office, truck maintenance and other support facilities required for consolidation of all of its Southern California office, distribution and maintenance operations. Taking into account the increased cost of raw materials including steel, concrete and asphalt the projected net cost of the facility is approximately $220 million and completion of the construction is planned for the winter of 2006.
Note 17 - Quarterly Results (unaudited)
Quarterly results for fiscal 2002, 2003 and 2004 are as follows:
(In thousands)