ITEM 1. BUSINESS
Forward-Looking Statements
We have made statements in this report that constitute forward-looking statements as that term is defined in the federal securities laws. These forward-looking statements concern our operations, economic performance and financial condition and include statements regarding: opportunities for growth; the number of early childhood education and care centers expected to be added in future years; the profitability of newly opened centers; capital expenditure levels; the ability to refinance or incur additional indebtedness; strategic acquisitions, investments, alliances and other transactions; changes in operating systems and policies and their intended results; our expectations and goals for increasing center revenue and improving our operational efficiencies; changes in the regulatory environment; the potential benefit of tax incentives for child care programs; our projected cash flow; and our marketing efforts to sell and lease back centers. The forward-looking statements are subject to various known and unknown risks, uncertainties and other factors. When we use words such as "believes," "expects," "anticipates," "plans," "estimates" or similar expressions, we are making forward-looking statements.
Although we believe that our forward-looking statements are based on reasonable assumptions, our expected results may not be achieved. Actual results may differ materially from our expectations. Important factors that could cause actual results to differ from expectations include, among others:
o the effects of general economic conditions;
o competitive conditions in the child care and early education industries;
o various factors affecting occupancy levels, including, but not limited to, the reduction in or changes to the general labor force that would reduce the need for child care services;
o the availability of a qualified labor pool, the impact of labor organization efforts and the impact of government regulations concerning labor and employment issues;
o federal and state regulations regarding changes in child care assistance programs, welfare reform, transportation safety, minimum wages and licensing standards;
o the loss of government funding for child care assistance programs;
o our inability to successfully execute our growth strategy;
o the availability of financing or additional capital;
o difficulty in meeting or the inability to meet our obligations to repay our indebtedness;
o the availability of sites and/or licensing or zoning requirements that may make us unable to open new centers;
o our inability to integrate acquisitions;
o our inability to successfully defend against or counter negative publicity associated with claims involving alleged incidents at our centers;
o our inability to obtain insurance at the same levels, or at costs comparable to those incurred historically;
o the effects of potential environmental contamination existing on any real property owned or leased by us; and
o other risk factors that are discussed in this report and, from time to time, in our other Securities and Exchange Commission reports and filings.
We caution you that these risks may not be exhaustive. We operate in a continually changing business environment and new risks emerge from time to time.
You should not rely upon forward-looking statements except as statements of our present intentions and of our present expectations that may or may not occur. You should read these cautionary statements as being applicable to all forward-looking statements wherever they appear. We assume no obligation to update or revise the forward-looking statements or to update the reasons why actual results could differ from those projected in the forward-looking statements.
Overview
KinderCare is the largest for-profit provider of early childhood education and care in the United States in terms of the number of centers and licensed capacity. At August 22, 2003, we served approximately 116,000 children and their families at 1,259 child care centers. At our child care centers, we provide educational services to infants and children up to twelve years of age. However, the majority of the children are from six weeks to five years old. The total licensed capacity at our centers was approximately 167,000 at August 22, 2003.
We operate child care centers under two brands as follows:
o KinderCare - At August 22, 2003, we operated 1,189 KinderCare centers. The brand was established in 1969 and operates centers in 39 states, as well as two centers located in the United Kingdom.
o Mulberry - We operated 70 Mulberry centers at August 22, 2003, which are located primarily in the northeast region of the United States and southern California. In addition, we had seven service contracts to operate before- and after-school programs.
Within each brand, we operate two types of centers: community centers and employer-sponsored centers. The vast majority are community centers. Our employer-sponsored centers partner with companies to provide on-site or near-site education and child care for the families of their employees.
We offer a reading and literacy program, for a fee, in selected centers. This program enhances the educational services offered to children four years and older attending our centers. During fiscal year 2003, 960 of our centers offered this reading and literacy program. In fiscal year 2004, we expect to begin offering the Spanish version of a language enrichment program, also on a supplemental fee basis.
Our centers are open year round. The hours vary by location, although Monday through Friday from 6:30 a.m. to 6:00 p.m. is typical. Children are usually enrolled on a weekly basis for either full- or half-day sessions. Hourly enrollment is permitted where capacity allows. Tuition rates vary for children of different ages and by location. See "Tuition."
Center-based child care continues to be our primary business. However, we also own and operate a distance learning company serving teenagers and young adults. Our subsidiary, KC Distance Learning, Inc., is based in Bloomsburg, Pennsylvania and operates two business units as follows:
o Keystone National High School, an accredited high school distance learning program, which provides courses delivered in either online or correspondence formats, and
o Learning and Evaluation Center, which provides subject extension or make-up and extra credit courses to high school students.
KC Distance Learning sells and/or delivers its high school curriculum over the kcdistancelearning.com, keystonehighschool.com and creditmakeup.com websites. The information on our websites is not incorporated by reference in this report.
We hold minority investments in Voyager Expanded Learning, Inc., a developer of educational curricula for elementary and middle schools and a provider of a public school teacher retraining program, and Chancellor Beacon Academies, Inc., a charter school management company.
We are a Delaware corporation organized on November 14, 1986. Our principal executive offices are located at 650 N.E. Holladay Street, Suite 1400, Portland, Oregon 97232. Our telephone number is (503) 872-1300. Our website addresses include kindercare.com, kindercareatwork.com, mulberrychildcare.com, kcdistancelearning.com, keystonehighschool.com and creditmakeup.com. This report will be available on our website, kindercare.com, as soon as practicable after filing with the Securities and Exchange Commission. The information on our websites is not incorporated by reference in this report.
Business Strategy
We are pursuing a business strategy containing the following key elements:
Provide High Quality Educational Programs. We have developed high quality proprietary curricula of age-specific learning programs based on the latest educational research. All of our educational programs are designed to respond to the needs of the children and parents we serve and to prepare children for success in school and in life. We provide curriculum-specific training for our staff to enable effective delivery of our programs. Periodically, we revise our educational programs to take advantage of the latest developments in early childhood education.
Operate Accredited Centers. Although not mandated by any regulatory authority, we pursue accreditation of our centers by the National Association for the Education of Young Children, referred to as NAEYC. NAEYC is a national organization that has established comprehensive criteria for providing quality early childhood education and care. The accreditation process strengthens the quality of the centers by motivating the teaching staff and enhancing their understanding of developmentally appropriate early childhood practices. At August 22, 2003, we had 485 accredited centers and approximately 300 centers actively pursuing accreditation.
Increase Existing Center Revenue. We have ongoing initiatives to increase center revenue by:
o Sharing best practices
o Providing incentives for center directors
o Using targeted marketing
o Recruiting, retaining and training qualified staff
o Maintaining competitive tuition pricing
We have supported these initiatives by: (i) requiring management to visit centers and providing an automated way to collect best practices and assess quality; (ii) focusing our bonus program to reward center directors for enrollment growth, in addition to overall operating profit performance; (iii) driving local marketing efforts including direct mail solicitation, telephone directory and internet yellow pages and customer referrals; (iv) focusing on recruiting and retaining high quality center personnel; and (v) implementing market specific rate increases in centers where the quality of our services, demand and other market conditions support such increases. See "Tuition."
Improve Operational Efficiencies. Strong overhead controls are expected to help us to contain costs. We focus on center-level economics, which makes each center director accountable for center expenditures. For example, we developed a labor tool to assist center directors in managing labor hours relative to attendance levels at their centers. We believe this focus has a positive effect on cost control at the centers.
Pursue Strategic Partnerships. Our market position makes us an attractive strategic partner for companies with compatible products and services, and our large, nationwide customer base gives us a valuable distribution network for such products and services. Our market position also gives us the ability to spread the costs of programs and services over a large number of centers. We believe that strategic partnerships strengthen our reputation as a child care provider and enrich the experiences of children enrolled at our centers.
In some markets, we face competition from the public school sector with respect to preschool and before- and after-school programs. We would like to partner with the public schools to provide these services or enhancement programs through management and/or licensing agreements.
Continue to Open and Acquire Centers. We plan to expand by opening 25 to 30 new centers per year. We target locations where we believe the market for center-based child care will support tuition rates higher than the current average rates. There continues to be opportunities to locate centers in many attractive markets across the United States. Also, we believe that many of our competitors have recently reduced or eliminated spending on new development.
The following is a summary of our center opening activity over the past five years:
We have opened five new centers from the end of fiscal year 2003 to August 22, 2003.
Due to the changing demographics of today's workforce and the prevalence of dual career families, a growing number of companies are providing child care benefits in the form of subsidies or availability. We attempt to meet this need by partnering with companies to provide on-site or near-site child care to attract and retain employees. We intend to pursue growth in this area through expanded relationships with our existing customers, as well as expansion of our customer base through internal growth, selective acquisitions and strategic alliances.
We also plan to continue making selective acquisitions of existing high-quality centers. Our strong market position enhances the opportunities to capitalize on consolidation of the highly fragmented child care segment of the education industry.
Manage Asset Portfolio. At August 22, 2003, we owned 769, or 61.1%, of our 1,259 centers. Those centers have an approximate net book value of $608.9 million, which includes land, building and equipment costs. In July 2003 we completed a refinancing of a portion of our debt that included a $300.0 million mortgage loan secured by first mortgages or deeds of trust on 475 of our owned centers. We also mortgaged another 119 of our owned centers as collateral for our new revolving credit facility. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources." These 594 centers are included in our 769 owned centers and have an approximate net book value of $397.5 million.
During the fourth quarter of fiscal year 2002, we began selling centers to individual real estate investors and then leasing them back. The resulting leases have been classified as operating leases. We continue to manage the operations of any centers sold in such transactions. During fiscal year 2003, we had completed sales totaling $88.8 million and another $12.6 million from the end of fiscal year 2003 to August 22, 2003. We are currently in the process of negotiating another $42.9 million of sales. We believe this has been an effective way to monetize our real estate assets and reduce leverage. We expect this effort to continue, assuming the market for such transactions remains favorable.
We also routinely analyze the profitability of our existing centers. If a center continues to under perform, exit strategies are employed in an attempt to minimize the resulting financial liability. An effort is made to time center closures to minimize the negative impact on affected families.
Pursue Strategic Acquisitions. We plan to continue to evaluate acquisition opportunities of companies in the education industry that offer educational content and services to children, teenagers and adults. These opportunities would complement our center based educational and distance learning services.
Educational Programs
We have developed a series of educational programs, including five separate proprietary age-specific curricula. Our educational programs recognize the importance of using high quality, research-based curriculum materials designed to create a rich and nurturing learning environment for children. The programs are revised on a rotating basis to take advantage of the latest research in child development.
Our educational programs and materials are designed to respond to the needs of our children, parents and families and to prepare children for success in school and in life. Specifically, we focus on the development of the whole child: physically, socially, emotionally, cognitively and linguistically.
Training. We provide curriculum-specific training for teachers and caregivers to assist them in effectively delivering our programs. Each curriculum is designed to provide teachers with the necessary materials and enhancements to enable effective delivery based on the resources and needs of the local
community. We emphasize selection of staff who are caring adults responsive to the needs of children. We strive to give each teacher the opportunity, training and resources to effectively implement the best in developmentally and age appropriate practice. Opportunities for professional growth are available through company-wide training such as the Certificate of Excellence Program. We also make available more advanced training opportunities, including tuition reimbursement for employment-related college courses or course work in obtaining a Child Development Associate credential.
Infant and Toddler Curricula. Our infant and toddler program, Welcome to Learning(R), is designed for children ages six weeks to two years. The infant component, for children from six weeks to 15 months, is based on building relationships with the child and the family and focuses on providing a safe and nurturing environment. The toddler component lets children from 12 to 24 months feel free to explore and discover the world around them.
Two-Year-Old Curriculum. Our Early Learning Curriculum focuses on using the latest research in brain development to provide learning experiences for children during one of their most critical developmental stages. This curriculum provides children with opportunities to explore and discover the world around them with both daily and long-term extended activities and projects. The Early Learning Curriculum is offered for children from 24 to 36 months.
Preschool Curricula. We have two preschool programs designed for children three to five years of age. Both programs use research-based goals and objectives as their framework to provide a high quality learning experience for children. We also offer a reading and literacy program as a program enhancement. This program is available, for a fee, in selected centers. In fiscal 2004, we expect to begin offering the Spanish version of a language enrichment program, on the same supplemental fee basis.
The Preschool Readiness Curriculum focuses on three-year-olds. Monthly themes are divided into two-week units to allow children extended time for in-depth exploration and discovery. Curriculum activities emphasize emerging readiness skills in reading and language development. Specially designed LetterBooks are used to introduce children to phonics and letter and word recognition. Discovery areas support children's learning of basic math and science concepts, computer awareness, creative arts, blocks, cooking and homeliving.
The Preschool at KinderCare curriculum focuses on four-year-olds. It teaches children to enjoy learning through hands-on involvement and stimulating activities. Monthly themes are divided into one-week units providing a comprehensive array of activities relevant to the lives of older preschoolers. Curriculum materials build pre-reading, writing and language skills. Discovery areas provide opportunities for exploration and choice based on children's interests.
Kindergarten Curriculum. For five-year-olds, we offer the Kindergarten at KinderCare ... Journey to Discovery(R) program. Children learn through play, hands-on exploration, activities and experiences that are real world and sensory in nature. This curriculum emphasizes reading development, beginning math concepts and those skills necessary to give children the confidence to succeed in school. Our kindergarten is offered in approximately two-thirds of our child care centers and meets state requirements for instructional curriculum prior to first grade.
School-Age Curriculum. Our KC Imagination Highway(R) program is a project-based curriculum designed for children ages six to twelve. The program includes a number of challenging activities and projects designed to stimulate the imagination of elementary school-age children through researching, designing, building, decorating and presenting. This program meets the needs of parents looking for content rich after-school experiences that keep school-age children interested and involved.
Summer Curriculum. We offer a summer program called Summer ExplorationsSM to elementary school-agers. This program is a fun-filled, academic-based curriculum of 10 weekly themes selected from the following 15 topics:
o Abracadabra o Cartooning o Rap, Rhythm & Rock o Act It Out o Crazy Creations o Science Mania o American Pride o Foodle For Your Noodle o Tournament of Games o At Head of the Class o Mega Machines o Up, Up, & Away o Can You Dig It o Outer Space o Wild, Wild Wilderness
Accreditation. We continue to stress the importance of offering high quality programs and services to children and families. At August 22, 2003, we had 485 centers accredited by NAEYC. See "Business Strategy, Operate Accredited Centers."
Tuition
We determine tuition charges based upon a number of factors, including the age of the child, full- or part-time attendance, location and competition. Tuition is generally collected on a weekly basis, in advance. Tuition rates are typically adjusted company-wide each year to coincide with the back-to-school period. However, we may adjust individual center rates at any time based on competitive position, occupancy levels and consumer demand. Our focus on center-level economics has enabled us to better implement market specific increases in rates without losing occupancy in centers where the quality of our services, demand and other market conditions support such increases. Our weighted average weekly tuition rate was as follows:
o Twelve weeks ended August 22, 2003 $151.63
o Fiscal year 2003 $144.45
o Fiscal year 2002 $137.72
o Fiscal year 2001 $129.34
See "Item 6. Selected Historical Consolidated Financial and Other Data, Note (g)" for a description of average weekly tuition rate.
Seasonality
New enrollments are generally highest during the traditional fall "back to school" period and after the calendar year-end holidays. Enrollment generally decreases 5% to 10% during the summer months and calendar year-end holidays.
Marketing, Advertising and Promotions
We conduct our marketing efforts through various promotional activities and customer referral programs. Additionally, we utilize targeted direct mail, telephone and internet yellow pages advertising, access to informative and user-friendly websites and newspaper and magazine advertisements. We continually evaluate the effectiveness of our marketing efforts and attempt to use the most cost-effective means of advertising. Currently, interested customers can call toll-free or access our internet websites,
kindercare.com and mulberrychildcare.com, to locate their nearest center or obtain information. The information on our websites is not incorporated by reference in this report.
We have focused on center-specific marketing opportunities such as (1) choosing sites that are convenient for customers in order to encourage drive-by identification, (2) renovating our existing centers to enhance their curb appeal and (3) upgrading the signage at our centers to a uniform standard to enhance customer recognition of our centers.
Our local marketing programs include periodic extended evening hours and a five o'clock snack that is provided to the children as they are picked up by their parents. We also sponsor a referral program under which parents receive tuition credits for every new customer referral that leads to a new enrollment. We hold parent orientation meetings in the fall at which center directors and staff explain our educational programs, as well as policies and procedures. We also periodically hold open house events and have established parent forums to involve parents in center activities and events. We offer these programs and events in an effort to retain current customers.
Our new center pre-opening marketing effort includes direct mail and newspaper support, as well as local public relations support. Every new center hosts a grand opening, an open house and provides individualized center tours where parents and children can talk with staff, visit classrooms and play with educational toys and computers.
Employer-Sponsored Child Care Services
Through KinderCare At Work(R), we offer a more flexible format for our services by individually evaluating the needs of each sponsoring company to find the appropriate format to fit its needs for on-site or near-site employee child care. Our current relationships with employers include centers owned or leased by us and various forms of management contracts. The management contracts generally provide for a three- to five-year initial period with renewal options ranging from two to five years. Our compensation under existing agreements is generally based on a fixed fee with annual escalations. KinderCare At Work(R) can also assist organizations in one or more aspects of implementing a child care related benefit, including needs assessments, financial analysis, architectural design and development plans. KinderCare At Work's(R) website address is kindercareatwork.com. The information on our websites is not incorporated by reference into this report.
At August 22, 2003, we operated 44 on-site/near-site employer-sponsored early childhood education and care centers for 40 different employers, including Universal Orlando Resort, Saturn Corporation, LEGO Systems, Inc., Oregon State University and several other businesses, universities and hospitals. Of the 44 employer-sponsored centers, 39 were owned or leased by us and five were operated under management contracts.
We also offer back-up child care, a program that utilizes our existing centers to provide back-up child care services to the employees of subscribed employers. Current clients include Universal Orlando Resort, Prudential Financial, US Cellular and KPMG.
Site Selection for New Centers
We seek to identify attractive new sites for our centers in large, metropolitan markets and smaller, growth markets that meet our operating and financial goals. We look for sites where we believe the market for our services will support tuition rates higher than our current average rates. Our real estate department performs comprehensive studies of geographic markets to determine potential areas for new center development. These studies include analysis of land prices, development costs, competitors, tuition pricing and demographic data such as population, age, household income and employment levels. In
addition, we review state and local laws, including zoning requirements, development regulations and child care licensing regulations to determine the timing and probability of receiving the necessary approvals to construct and operate a new center.
We target sites that offer convenience for our customers, are located in appealing markets and provide opportunities for drive-by interest. We make specific site location decisions for new centers based upon a detailed site analysis that includes feasibility and demographic studies, as well as comprehensive financial modeling. Within a prospective area, we often analyze several alternative sites. Each potential site is evaluated against our standards for location, convenience, visibility, traffic patterns, size, layout, affordability and functionality, as well as potential competition.
We opened 28 new centers during fiscal year 2003 and five more through August 22, 2003. These new centers have an average licensed capacity of 176. When mature, these larger centers are designed to generate higher revenues, operating income and margins than the older centers. These new centers also have higher average costs of construction and typically take three to four years to reach maturity. On average, our new centers should begin to produce positive EBITDA during the first year of operation and begin to produce positive net income by the end of the second year of operation. Accordingly, as more new centers are developed and opened, profitability will be negatively impacted in the short-term but is expected to be enhanced in the long-term once these new, more profitable centers achieve anticipated levels.
Our real estate and development staff work closely with our operations, purchasing, human resources and marketing personnel to streamline the new center opening process. We believe this results in a more efficient transition of new centers from the construction phase to field operation.
Real Estate Asset Management Program
At August 22, 2003, we owned 769, or 61.1%, of our 1,259 centers. Those centers have an approximate net book value of $608.9 million, which includes land, building and equipment costs. In July 2003, we completed a refinancing of a portion of our debt that included a $300.0 million mortgage loan secured by first mortgages or deeds of trust on 475 of our owned centers. We also mortgaged another 119 of our owned centers as collateral for our new revolving credit facility. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources." These 594 centers are included in our 769 owned centers and have an approximate net book value of $397.5 million.
During the fourth quarter of fiscal year 2002, we began selling centers to individual real estate investors and then leasing them back. The resulting leases have been classified as operating leases. We continue to manage the operations of any centers that are sold in such transactions. During fiscal year 2003, we completed sales totaling $88.8 million, which represented 41 centers. From the end of fiscal year 2003 through August 22, 2003, we completed another $12.6 million of sales. We are currently in the process of negotiating another $42.9 million of sales. It is possible that we will be unable to complete these transactions. We expect this effort to continue, assuming the market for such transactions remains favorable.
During fiscal years 2001 and 2000, we used a synthetic lease facility to construct 44 centers. The related leases are classified as operating leases for financial reporting purposes. The synthetic lease facility was terminated in July 2003 as part of our debt refinancing. The 44 centers are now owned by us and will be reflected in the fiscal year 2004 financial statements. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources."
We routinely analyze the profitability of our existing centers through a detailed evaluation that considers leased versus owned status, lease options, operating history, premises expense, capital
requirements, area demographics, competition and site assessment. Through this evaluation process, our asset management staff formulates a plan for the property reflecting our strategic direction and marketing objectives. If a center continues to underperform, exit strategies are employed in an attempt to minimize our financial liability. We make an effort to time center closures to minimize the negative impact on affected families. During fiscal year 2003, we closed 28 centers. From the end of fiscal year 2003 to August 22, 2003, 10 additional centers were closed.
Our asset management department also manages the disposition of all surplus real estate owned or leased by us. These real estate assets include undeveloped sites, unoccupied buildings and closed centers. We disposed of ten surplus properties in fiscal year 2003. From the end of fiscal year 2003 to August 22, 2003, three surplus properties were sold. We were in the process of marketing an additional seven surplus properties at August 22, 2003.
Employees
At August 22, 2003, we employed approximately 25,000 people. Of these employees, over 24,000 were employed in our centers. Center employees include the following:
o center directors,
o assistant directors,
o regular full- and part-time teachers,
o temporary and substitute teachers
o teachers' aides, and
o non-teaching staff, including cooks and van drivers.
There are approximately 360 employees in the corporate headquarters and 150 field management and support personnel. Approximately 7.1% of our 25,000 employees, including all management and supervisory personnel, are salaried. All other employees are paid on an hourly basis. We do not have an agreement with any labor union and we believe that we have good relations with our employees.
Human Resources
Regional and Center Personnel. Our centers are organized into six geographic regions, each headed by a region vice president. The region vice presidents are supported by 81 area manager positions for KinderCare and nine region director positions for Mulberry.
Individual centers are managed by a center director and, in most cases, an assistant director. All center directors participate in periodic training programs or meetings and must be familiar with applicable state and local licensing regulations. During fiscal year 2002, we conducted a center director retention survey. We believe the results of the survey reflect overall center director satisfaction. As a result of the survey, we revised the center director bonus plan in fiscal year 2003 to increase the focus on customer retention and new enrollments.
Due to high employee turnover rates in the child care segment of the education industry in general, we emphasize recruiting and retaining qualified personnel. The turnover of personnel experienced by us and other providers in our industry results in part from the fact that a significant portion of our employees earn entry-level wages and are part-time employees.
Training Programs. All center teachers and other non-management staff are required to attend an initial half-day training session prior to being assigned full duties and to complete a six week on-the-job
basic training program. Our basic orientation and staff training program is delivered via a video series. Additionally, we have developed and implemented training programs to certify personnel as teachers of various age groups in accordance with our internal standards and in connection with our age-specific educational programs. We offer ongoing sales and service training to center directors and area managers that focuses on enrollment and retention of families, training on delivery of our educational programs, health and safety related training. Center staff also participate in ongoing in-service training as required by state licensing authorities, most of which is focused on education and child health and safety related issues.
Employee Benefits. The corporate human resources department monitors salaries and benefits for competitiveness.
Communication and Information Systems
We have a fully automated information, communication and financial reporting system for our centers. This system uses personal computers and links every center and regional office to the corporate headquarters. The system is designed to provide timely information on items such as net revenues, enrollments, attendance, expenses, payroll and staff hours.
Our nationwide network includes the internet and company-wide intranet and email applications. Through the use of Netscape Navigator(R) software, our intranet allows center directors to have immediate access to corporate information and provides center directors with the ability to distribute reports, update databases and revise center listings on a daily basis. We regularly seek new uses for our intranet as a tool to communicate with our centers. For example, in fiscal year 2002, we implemented a center visitation program. The program provides an automated way to communicate information to the corporate headquarters and for management to assess quality and identify best practices.
Competition in the Child Care Segment of the Education Industry
The child care sector is competitive and highly fragmented, with the most important competitive factors generally based upon reputation, location and price. Competition consists principally of the following:
o other for-profit, center-based child care providers;
o preschool, kindergarten and before- and after-school programs provided by public and private schools;
o child care franchising organizations;
o local nursery schools and child care centers, including church-affiliated and other non-profit centers;
o providers of child care services that operate out of homes; and
o substitutes for organized child care, such as relatives, nannies and one parent caring full-time for a child
Competition includes other large, national, for-profit companies providing child education and care services, many of which offer these services at a lower price than we do. These other for-profit providers continue to expand in many of the same markets where we currently operate or plan to operate. We compete by offering (i) high quality education and recreational programs, (ii) contemporary, well-equipped facilities, (iii) trained teachers and supervisory personnel and (iv) a range of services, including infant and toddler care, drop-in service and the transportation of older children enrolled in our before- and after-school program between the centers and schools.
In some markets, we also face competition with respect to preschool services and before- and after-school programs from public schools that offer such services at little or no cost to parents. In many instances, public schools hire third party operators to manage these programs, and we are currently evaluating opportunities in this area. The number of school districts offering these services is growing and it is expected that this form of competition will increase in the future.
Local nursery schools, child care centers and in-home providers generally charge less for their services than we do. Many church-affiliated and other non-profit child care centers have lower operating expenses than we do and may receive donations and/or other funding to subsidize operating expenses. Consequently, operators of such centers often charge tuition rates that are less than our rates. In addition, fees for home-based care are normally substantially lower than fees for center-based care because providers of home care are not always required to satisfy the same health, safety, insurance or operational regulations as our centers.
Our employer-sponsored centers compete with center-based child care chains, some of which have divisions that compete for employer-sponsorship opportunities, and with other organizations that focus exclusively on the work-site segment of the child care market.
Insurance
Our insurance program currently includes the following types of policies: workers' compensation, comprehensive general liability, automobile liability, property, excess "umbrella" liability, directors' and officers' liability and employment practices liability. These policies provide for a variety of coverages, which are subject to various limits, and include substantial deductibles or self-insured retentions. Special insurance is sometimes obtained with respect to specific hazards, if deemed appropriate and available at reasonable cost. Claims in excess of, or not included within, our coverage may be asserted. The effects of these claims could have an adverse effect on us. At August 22, 2003, approximately $34.0 million of letters of credit were outstanding to secure obligations under retrospective and self-insurance programs.
Governmental Laws and Regulations Affecting Us
Center Licensing Requirements. Our centers are subject to numerous state and local regulations and licensing requirements. We have policies and procedures in place to assist in complying with such regulations and requirements. Although these regulations vary from jurisdiction to jurisdiction, government agencies generally review the fitness and adequacy of buildings and equipment, the ratio of staff personnel to enrolled children, staff training, record keeping, childrens' dietary program, the daily curriculum and compliance with health and safety standards. In most jurisdictions, these agencies conduct scheduled and unscheduled inspections of the centers and licenses must be renewed periodically. Most jurisdictions establish requirements for background checks or other clearance procedures for new employees of child care centers. Repeated failures of a center to comply with applicable regulations can subject it to sanctions, which might include probation or, in more serious cases, suspension or revocation of the center's license to operate and could also lead to sanctions against our other centers located in the same jurisdiction. In addition, this type of action could lead to negative publicity extending beyond that jurisdiction.
We believe that our operations are in substantial compliance with all material regulations applicable to our business. However, there is no assurance that a licensing authority will not determine a particular center to be in violation of applicable regulations and take action against that center and possibly other centers in the same jurisdiction. In addition, there may be unforeseen changes in regulations and licensing requirements, such as changes in the required ratio of child center staff personnel to enrolled children, that could have a material adverse effect on our operations. States in which
we operate routinely review the adequacy of regulatory and licensing requirements and implement changes which may significantly increase our costs to operate in those states.
Child Care Tax Incentives. Tax incentives for child care programs can potentially benefit us. Section 21 of the Internal Revenue Code of 1986, referred to as the Code, provides a federal income tax credit ranging from 20% to 35% of specified child care expenses with maximum eligible expenses of $3,000 for one child and $6,000 for two or more children. The fees paid to us by eligible taxpayers for child care services qualify for these tax credits, subject to the limitations of Section 21 of the Code. However, these tax incentives are subject to change.
Code Section 45F provides incentives to employers to offset costs related to employer-provided child care facilities. Costs related to (a) acquiring or constructing property used as a qualified child care center, (b) operating an existing child care center, or (c) contracting with an independent child care operator to care for the children of the taxpayer's employees will qualify for the credit. The credit amount is 25% of the qualified costs. An additional credit of 10% of qualified expenses for child care resource and referral services has also been enacted. The maximum credit available for any taxpayer is $150,000 per tax year.
Many states offer tax credits in addition to the federal credits discussed above. Credit programs vary by state and may apply to both the individual taxpayer and the employer.
Child Care Assistance Programs. During the twelve weeks ended August 22, 2003 and for fiscal year 2003, approximately 21.8% and 22.0%, respectively, of our net revenues were generated from federal and state child care assistance programs, primarily the Child Care and Development Block Grant and At-Risk Programs. These programs are designed to assist low-income families with child care expenses and are administered through various state agencies. Although additional funding for child care may be available for low income families as part of welfare reform and the reauthorization of the Block Grant, there is no assurance that we will benefit from any such additional funding.
There can be no assurance that federal or state child care assistance programs will continue to be funded at current levels. Many states have recently experienced fiscal problems and have reduced or may in the future reduce spending on social services. A termination or reduction of child care assistance programs could have a material adverse effect on our business.
Americans with Disabilities Act. The federal Americans with Disabilities Act, referred to as the ADA, and similar state laws prohibit discrimination on the basis of disability in public accommodations and employment. Compliance with the ADA requires that public accommodations reasonably accommodate individuals with disabilities and that new construction or alterations made to commercial facilities conform to accessibility guidelines unless structurally impracticable for new construction or technically infeasible for alterations. Non-compliance with the ADA could result in the imposition of injunctive relief, fines, an award of damages to private litigants and additional capital expenditures to remedy such noncompliance. We have not experienced any material adverse impact as a result of these laws.
Federal Transportation Regulations. In August and September of 1998, the National Highway Transportation Safety Administration, referred to as NHTSA, issued interpretive letters that appear to modify its interpretation of regulations governing the sale by automobile dealers of vehicles intended to be used for the transportation of children to and from school by child care providers. These letters indicate that dealers may no longer sell 15-passenger vans for this use, and that any vehicle designed to transport eleven persons or more must meet federal school bus standards if it is likely to be used significantly to transport children to and from school or school-related events. These interpretations have affected the type of vehicle that may be purchased by us for use in transporting children between schools
and our centers and, in effect, required us to commence a scheduled replacement of our remaining fleet of vans with school buses. NHTSA's interpretation and potential related changes in state and federal transportation regulations have increased our costs to transport children because school buses are more expensive to purchase and maintain and, in some jurisdictions, require drivers with commercial licenses. At August 22, 2003, we had 1,173 school buses out of a total of 2,389 vehicles used to transport children.
Trademarks and Service Marks
We own and use various registered and unregistered trademarks and service marks covering the name KinderCare, our schoolhouse logo and a number of other names, slogans and designs, including:
o Feed Me Fun(R) o Lakemont Academy(TM) o I Think. I Can.(TM) o Let's Move, Let's Play(R) o KC Imagination Highway(R) o Mulberry Child Care Centers, o Keystone National High School(TM) Inc.(R) o Kid's Choice(TM) o Mulberry Child Care and o Kindergarten at KinderCare... Preschool(R) Journey to Discovery(R) o My Window On The World(R) o KinderCare At Work(R) o Razzmatazz(R) o KinderCare Connections(TM) o Summer ExplorationsSM o Kindustry(TM) o Welcome To Learning(R) o Your Child's First Classroom(R)
A federal registration in the United States is effective for ten years and may be renewed for ten-year periods perpetually, subject only to required filings based on continued use of the mark by the registrant. A federal registration provides the presumption of ownership of the mark by the registrant and notice of its exclusive right to use such mark throughout the United States in connection with the goods or services specified in the registration. In addition, we have registered various trademarks and service marks in other countries, including Canada, Germany, Japan, the People's Republic of China and the United Kingdom. However, many of these foreign countries require us to use the marks locally to preserve our registration rights and, because we have not conducted business in foreign countries other than the United Kingdom, we may not be able to maintain our registration rights in all other foreign countries. We believe that our name and logo are important to our operations. We intend to maintain and renew our trademark and service mark registrations in the United States and the United Kingdom.
ITEM 2.
ITEM 2. PROPERTIES
Early Childhood Education and Care Centers
Of our child care centers in operation at August 22, 2003, we owned 769, leased 485 and operated five under management contracts. We own or lease other centers that have not yet been opened or are being held for disposition. In addition, we own real property held for the future development of centers.
The community and employer-sponsored centers we operated at August 22, 2003 were located as follows:
Our typical community center is a one-story, air-conditioned building constructed based on our design and located on approximately one acre of land. Larger capacity centers are situated on parcels
ranging from one to four acres of land. The community centers contain classrooms, play areas and complete kitchen and bathroom facilities. The centers can accommodate from 70 to 270 children, with most centers able to accommodate 95 to 190 children. Over the past few years, we have opened community centers that are larger in size with a capacity ranging from 135 to 220 children. New prototype community centers range in capacity from 145 to 180 children, depending on site and location. Each center is equipped with a variety of audio and visual aids, educational supplies, games, puzzles, toys and outdoor play equipment. Centers also lease vehicles used for field trips and transporting children enrolled in our before- and after-school program. All community centers are equipped with computers for children's educational programs.
KinderCare At Work(R) provides employer-sponsored child care programs individualized for each such sponsor. Facilities are on or near the employer's site and range in capacity from 75 to 230 children.
Center Maintenance Program
We use a centralized maintenance program to ensure consistent high-quality maintenance of our facilities located across the country. Each of our maintenance technicians has a van stocked with spare parts and handles emergency, routine and preventative maintenance functions through an automated work order system. Technicians are notified and track all work orders via palm top computers. At August 22, 2003, specific geographic areas were supervised by two regional directors and 13 facility managers, each of whom manages between six and ten technicians.
Center Renovation Program
We have continued a renovation program, which includes interior and playground renovations and signage replacements, to ensure that all of our centers meet specified standards that we establish. We believe that our properties are in good condition and are adequate to meet our current and reasonably anticipated future needs.
Environmental Compliance
We are not aware of any existing environmental conditions that currently or in the future could reasonably be expected to have a material adverse effect on our financial position, operating results or cash flows. We have not incurred material expenditures to address environmental conditions at any owned or leased property. Approximately ten years ago, we established a process of obtaining environmental assessment reports to reduce the likelihood of incurring liabilities under applicable federal, state and local environmental laws upon acquisition or lease of prospective new centers or sites. These assessment reports have not revealed any environmental liability that we believe would have a material adverse effect on us. Nevertheless, it is possible that these assessment reports do not or will not reveal all environmental liabilities and it is also possible that sites acquired prior to the establishment of our current process have environmental liabilities. In connection with the origination of a $300.0 million mortgage loan obtained in July 2003, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources," a third party performed Phase I environmental assessments for approximately half of the centers secured by the mortgage loan. Although there were no material adverse findings, operations and maintenance plans relating to lead paint and asbestos were recommended and have been implemented. Additionally, from time to time, we have conducted additional limited environmental investigations and remedial activities at some of our former and current centers. However, we have not undertaken an in-depth environmental review of all of our owned and leased centers. Consequently, there may be material environmental liabilities of which we are unaware.
In addition, no assurances can be given that: future laws, ordinances or regulations will not impose any material environmental liability; the current environmental condition of our owned or leased centers will not be adversely affected by conditions at locations in the vicinity of our centers (such as the presence of leaking underground storage tanks) or by third parties unrelated to us; or, on sites we lease to others, the tenants will not violate their leases by introducing hazardous or toxic substances into our owned or leased centers that could expose us to liability under federal, state, or local environmental laws.
Corporate Headquarters
Our corporate office is located in Portland, Oregon. We lease approximately 80,000 square feet of office space for annual rental payments of $26.50 per square foot. The initial term of the lease expires in November 2007 with one five-year extension option at market rent.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We do not believe that there are any pending or threatened legal proceedings that, if adversely determined, would have a material adverse effect on our business or operations. However, we are subject to claims and litigation arising in the ordinary course of business, including claims and litigation involving allegations of physical or sexual abuse of children. We have notice of such allegations that have not yet resulted in claims or litigation. Although we cannot be assured of the ultimate outcome of the allegations, claims or lawsuits of which we are aware, we believe that none of these allegations, claims or lawsuits, either individually or in the aggregate, will have a material adverse effect on our financial position, operating results or cash flows. In addition, we cannot predict the negative impact of publicity that may be associated with any such allegation, claim or lawsuit.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4(a). Executive Officers of the Registrant
Set forth below is information regarding our executive officers:
David J. Johnson. Mr. Johnson has been Chief Executive Officer and Chairman of our Board since February 1997. Between September 1991 and November 1996, Mr. Johnson served as President, Chief Executive Officer and Chairman of the Board of Red Lion Hotels, Inc., which was formerly a KKR affiliate, or its predecessor. From 1989 to September 1991, Mr. Johnson was a general partner of Hellman & Friedman, a private equity investment firm based in San Francisco. From 1986 to 1988, he served as President, Chief Operating Officer and director of Dillingham Holdings, a diversified company headquartered in San Francisco. From 1984 to 1987, Mr. Johnson was President and Chief Executive Officer of Cal Gas Corporation, a principal subsidiary of Dillingham Holdings.
Dan R. Jackson. Mr. Jackson was promoted to Executive Vice President, Chief Financial Officer in November 2002. He had served as Senior Vice President, Finance since October 1999. He joined us in February 1997 as Vice President of Financial Control and Planning. Prior to that time, Mr. Jackson held various financial positions with Red Lion Hotels, Inc., or its predecessor, from September 1985 to January 1997, the last of which was Vice President, Controller. From 1978 to 1985, Mr. Jackson held several financial management positions with Harsch Investment Corporation, a real estate holding company based in Portland, Oregon.
Edward L. Brewington. Mr. Brewington was promoted in July 2001 to Senior Vice President, Human Resources and Education. He had served as Vice President, Human Resources since April 1997. From June 1993 to April 1997, Mr. Brewington was with Times Mirror where his last position held was Vice President, Human Resources for the Times Mirror Training Group. Prior to that time, Mr. Brewington spent 25 years with IBM in various human resource, sales and marketing positions.
S. Wray Hutchinson. Mr. Hutchinson was promoted to Senior Vice President, Operations in October 2000. He had served as Vice President, Operations since April 1996. He joined us in 1992 as District Manager in New Jersey and was later promoted to Region Manager for the Chicago, Illinois market.
Eva M. Kripalani. Ms. Kripalani was promoted in July 2001 to Senior Vice President, General Counsel and Secretary. She had served as Vice President, General Counsel and Secretary since July 1997. Prior to joining us, Ms. Kripalani was a partner in the law firm of Stoel Rives LLP in Portland, Oregon, where she had worked since 1987.
Bruce A. Walters. Mr. Walters has served as Senior Vice President, Chief Development Officer since July 1997. From June 1995 to February 1997, Mr. Walters served as the Executive Vice President of Store Development for Hollywood Entertainment Corporation in Portland, Oregon. Prior to that time, Mr. Walters spent 14 years with McDonald's Corporation in various domestic and international development positions.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCK HOLDER MATTERS
Stock Split
On July 15, 2002, the Board of Directors authorized a 2-for-1 stock split of our common stock and an increase of the authorized common shares to 10.0 million shares. The 2-for-1 stock split was effective August 19, 2002 for stockholders of record on August 9, 2002. All of the information in this report, including all references to the number or price of shares of common stock, gives effect to the stock split. The information in this report also gives effect to adjustments in the number of shares available, the number of shares subject to options granted and the exercise price of those options under our stock option plan, in each case, to reflect the stock split.
Market Information
In February 1997, affiliates of KKR became owners of 15.7 million shares of our common stock in a recapitalization transaction. Since then, our common stock has been traded in the over-the-counter ("OTC") market in the "pink sheets" published by the National Quotation Bureau. It is listed on the OTC Bulletin Board under the symbol "KDCR."
The market for our common stock must be characterized as very limited due to the very low trading volume, the small number of brokerage firms acting as market makers and the sporadic nature of the trading activity. The following table sets forth, for the periods indicated, information with respect to the high and low bid quotations for our common stock as reported by a market maker for our common stock, as reported on the OTC Bulletin Board. The quotations represent inter-dealer quotations without retail markups, markdowns or commissions and may not represent actual transactions.
See "Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters."
(a) The average weekly trading volume during fiscal year 2003 and 2002 was less than 100 shares and 1,000 shares, respectively.
Approximate Number of Security Holders, Outstanding Options and Warrants
At August 22, 2003, there were 135 holders of record of our common stock and outstanding options or warrants to purchase 2,357,589 shares of our common stock.
Dividend Policy
During the past two fiscal years, we have not declared or paid any cash dividends or distributions on our capital stock. We do not intend to pay any cash dividends for the foreseeable future. We intend to retain earnings, if any, for the future operation and expansion of our business. Any determination to pay dividends in the future will be at the discretion of our Board of Directors and will be dependent upon our results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law and other factors deemed relevant by our Board of Directors. Further, the indenture governing our senior subordinated notes and our credit facility currently contain limitations on our ability to declare or pay cash dividends on our common stock, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources. Our credit facility allows us to pay dividends provided that the aggregate amount paid does not exceed $30.0 million plus 50.0% of the cumulative consolidated net income available to stockholders at such time, and that, at the time of payment, the consolidated debt to consolidated EBITDA ratio, as defined in the credit agreement, is less than 3.0 to 1.0. As our consolidated debt to consolidated EBITDA ratio is greater than 3.0 to 1.0, we are currently prohibited from paying dividends. Future indebtedness or loan arrangements incurred by us may also prohibit or restrict our ability to pay dividends and make distributions to our stockholders.
The following table provides information about compensation plans (including individual compensation arrangements) under which our equity securities are authorized for issuance to employees or non-employees (such as directors and consultants), at May 30, 2003:
ITEM 6.
ITEM 6. SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA
The following table sets forth selected historical consolidated financial and other data, with dollars in thousands, except per share amounts and child care center data. See "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
The following discussion should be read in conjunction with "Item 6. Selected Historical Consolidated Financial and Other Data" and the consolidated financial statements and the related notes presented in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this report. We utilize a financial reporting schedule comprised of 13 four-week periods. Our fiscal year ends on the Friday closest to May 31. The information presented refers to the 52 weeks ended May 30, 2003 as "fiscal 2003," the 52 weeks ended May 31, 2002 as "fiscal 2002," and the 52 weeks ended June 1, 2001 as "fiscal 2001." Our first fiscal quarter includes 16 weeks and the remaining quarters each include 12 weeks.
A center is included in comparable center net revenues when it has been open and operated by us at least one year and it has not been rebuilt or permanently relocated within that year. Therefore, a center is considered comparable during the first four week period it has prior year net revenues. Non-comparable centers include those that have been closed during the past year.
Fiscal 2003 compared to Fiscal 2002
The following table shows the comparative operating results of KinderCare, with dollars in thousands, except the average weekly tuition rate:
Revenues, net. Net revenues increased $31.1 million, or 3.8%, from the same period last year to $850.0 million in fiscal 2003. The increase was due to higher average weekly tuition rates as well as additional net revenues generated by newly opened centers. The average weekly tuition rate increased $6.73, or 4.9%, to $144.45 in fiscal 2003, due primarily to tuition increases. Occupancy declined to 63.3% from 65.6% for the same period last year primarily due to reduced full-time equivalent attendance within the population of older centers. See "Item 6. Selected Historical Consolidated Financial and Other Data, Notes (g) and (h)" for descriptions of average weekly tuition rate and occupancy. Comparable center net revenues increased $10.2 million, or 1.3%.
During the periods indicated, we opened and closed centers as follows:
Salaries, wages and benefits. Expenses for salaries, wages and benefits increased $15.6 million, or 3.4%, from the same period last year to $469.6 million. Total salary, wage and benefit expense as a percentage of net revenues was 55.2% and 55.4% for fiscal 2003 and 2002, respectively.
Salary, wage and benefit expense directly associated with the centers was $434.9 million, an increase of $12.8 million from the same period last year. The increase was primarily due to overall higher wage rates and higher medical insurance costs. See "Inflation and Wage Increases." At the center level, salary, wage and benefit expense as a percentage of net revenues improved to 51.2% for fiscal 2003 from 51.5% for fiscal 2002. This improvement was due primarily to strong controls over the management of labor hours.
Depreciation and amortization. Depreciation and amortization expense increased $1.2 million from the same period last year to $59.4 million. Depreciation increased primarily due to newly opened centers, offset by the cessation of goodwill amortization. Amortization of goodwill decreased $2.4 million as a result of the adoption of Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets, in the first quarter of fiscal 2003. See "Item 8. Financial Statements and Supplementary Data, Note 2. Summary of Significant Accounting Policies, Goodwill and Other Intangible Assets." Depreciation declined for those centers that were sold and leased back as part of our sale-leaseback program, because those centers are now classified as operating leases. See "Liquidity and Capital Resources."
Depreciation expense included $2.7 million and $3.0 million of impairment charges related to certain under-performing centers and undeveloped properties during fiscal 2003 and 2002, respectively. Under-performing centers are those with estimated future cash flows, undiscounted and without interest charges, less than the carrying value of the asset. We performed an undiscounted cash flow analysis and determined that 43 centers were impaired in fiscal 2003 primarily as a result of occupancy declines at individual centers and the result of electing to exit leases at certain centers. As a result of such analyses, write-downs were taken to reduce the carrying value of those 43 centers to their estimated fair value. In addition, discontinued operations included impairment charges of $0.7 million and $0.6 million for fiscal 2002, respectively, related to certain centers closed in fiscal 2003.
Rent. Rent expense increased $4.8 million from the same period last year to $52.6 million primarily due to our sale-leaseback program. See "Liquidity and Capital Resources." In addition, the
rental rates experienced on new and renewed center leases were higher than those experienced in previous fiscal periods.
Other operating expenses. Other operating expenses include costs directly associated with the centers, such as insurance, janitorial, maintenance, utilities, transportation, provision for doubtful accounts, food and marketing costs, and expenses relating to region management and corporate administration. Other operating expenses increased $13.3 million, or 7.2%, from the same period last year, to $197.8 million. Other operating expenses as a percentage of net revenues were 23.3% and 22.6% for fiscal 2003 and 2002, respectively. The increase was due primarily to insurance costs that were $12.7 million higher than the same period last year. The provision for doubtful accounts declined $2.3 million from the same period last year. The reduction in our provision for doubtful accounts was due to the implementation of automated programming that allows us to have stronger controls over our receivables.
Operating income. Operating income was $70.6 million, a decrease of $3.9 million, or 5.2%, from the same period last year. Operating income decreased primarily due to higher insurance costs and rent expense, offset in part by the impact of higher tuition rates. Operating income as a percentage of net revenues was 8.3% compared to 9.1% for the same period last year.
Interest expense. Interest expense was $41.0 million compared to $44.1 million for the same period last year. The decrease was substantially attributable to lower interest rates and a decrease in the principal balance, both on our revolving credit facility. The weighted average interest rate on our long-term debt, including amortization of deferred financing costs, was 8.0% and 7.8% for fiscal 2003 and 2002, respectively. A larger portion of our debt was comprised of 9.5% senior subordinated notes during fiscal 2003, which resulted in an increase in the weighted average interest rate in fiscal 2003 compared to fiscal 2002. See "Item 8. Financial Statements and Supplementary Date, Note. 8, Long-Term Debt."
Loss on minority investment. During the fourth quarter of fiscal 2003, we wrote down the net book value of a minority investment, by $6.7 million due to a reduced valuation of the subject company. During fiscal 2002, we recorded a write down of $2.3 million to the net book value of the same investment for a similar reason, in addition to dilution of our minority interest in that investment. The minority investment was accounted for under the cost method. See "Item 8. Financial Statements and Supplementary Data, Note 2. Summary of Significant Policies."
Income tax expense. Income tax expense was $9.2 million, or 39.6% of pretax income, in fiscal 2003 and $11.3 million, or 39.5% of pretax income, in fiscal 2002. The slight increase in the effective tax rate was due to the relative impact of tax credits at different levels of taxable income, the impact of the cessation of goodwill amortization and an increase in expenses that are disallowed for income tax purposes. Income tax expense was computed by applying estimated effective income tax rates to income before income taxes. Income tax expense varies from the statutory federal income tax rate due primarily to state and foreign income taxes, offset by tax credits.
Discontinued operations. Discontinued operations resulted in losses of $0.7 million and $0.8 million in fiscal 2003 and 2002, respectively. Discontinued operations represents the operating results for all periods presented of the 28 centers closed during fiscal 2003.
Discontinued operations included the following, with dollars in thousands:
Depreciation expense related to discontinued operations included impairment charges of $0.7 million and $0.6 million for fiscal 2003 and 2002, respectively. Other operating expenses related to discontinued operations included gains on closed center sales of $1.2 million in fiscal 2003.
Net income. Net income was $13.4 million in fiscal 2003, a decrease of $3.1 million, or 18.9%, from the same period last year. The decrease was due to higher insurance costs, the write-down of a minority investment and increased rent expense, offset in part by higher tuition rates and reduced interest costs. Basic and diluted net income per share were $0.68 and $0.67 for fiscal 2003. For fiscal 2002, basic and diluted net income per share were $0.83 and $0.82, respectively.
Fiscal 2002 compared to Fiscal 2001
The following table shows the comparative operating results of KinderCare, with dollars in thousands, except the average weekly tuition rate:
Revenues, net. Net revenues increased $85.3 million, or 11.6%, from the same period last year to $818.9 million in fiscal 2002. The increase was primarily due to the acquisition of the Mulberry centers in the fourth quarter of fiscal 2001 and the additional net revenues generated by the newly opened centers. Comparable center net revenues increased $6.1 million, or 0.8%.
The average weekly tuition rate increased $8.38, or 6.5%, to $137.72 in fiscal 2002 due primarily to tuition increases. Occupancy declined to 65.6% in fiscal 2002 from 68.3% in fiscal 2001 primarily due to reduced full-time equivalent attendance within the older center population.
During fiscal 2002 and 2001, we opened, acquired and closed centers as follows:
Salaries, wages and benefits. Expenses for salaries, wages and benefits increased $51.8 million, or 12.9%, from the same period last year to $454.0 million. Total salary, wage and benefit expense as a percentage of net revenues was 55.4% for fiscal 2002 compared to 54.8% for fiscal 2001.
Salary, wage and benefit expense directly associated with the centers was $422.1 million, an increase of $48.5 million from fiscal 2001. The increase was primarily due to costs from the acquired and newly opened centers and overall higher wage rates. At the center level, salary, wage and benefit expense as a percentage of net revenues increased to 51.5% in fiscal 2002 from 50.9% in fiscal 2001 due primarily to higher medical insurance costs.
The expense related to region management and corporate administration was $31.9 million, an increase of $3.3 million from the same period last year. The increase was primarily due to the acquisition of Mulberry during the fourth quarter of fiscal 2001. In addition, we expanded the field operations team that oversees the KinderCare centers. During fiscal 2003, the field management structure was reorganized, see "Item 1. Business, Human Resources."
Depreciation and amortization. Depreciation and amortization expense increased $12.2 million from the same period last year to $58.2 million. Depreciation increased due to the acquisition of the Mulberry centers, increased capital spending, particularly for new center development, and a $3.0 million asset impairment charge.
During the fourth quarter of fiscal 2002, 38 underperforming centers and certain undeveloped properties were determined to be impaired, which resulted in an impairment charge of $3.6 million, of which $0.6 million is included in the discontinued operations for charges related to centers closed in fiscal 2003, for the fiscal year compared to $1.0 million in fiscal 2001. Underperforming centers are those with estimated future cash flows less than the net book value of the center. We performed an undiscounted cash flow analysis and determined that 38 centers were impaired primarily as a result of occupancy declines at individual centers.
Amortization of goodwill and other intangible assets increased $2.2 million as a result of the acquisition of Mulberry in the fourth quarter of fiscal 2001.
Rent. Rent expense increased $9.6 million from the same period last year to $47.7 million. The increase was primarily due to the acquisition of the Mulberry leased centers in the fourth quarter of fiscal 2001 and rent from the synthetic lease facility used to finance new center construction during fiscal 2001 and 2000. In addition, the rental rates experienced on new and renewed center leases were higher than those experienced in previous fiscal periods.
Other operating expenses. Other operating expenses increased $12.4 million, or 7.2%, from the same period last year, to $184.5 million. The increase was due primarily to additional center level costs from the acquired and newly opened centers. Other operating expenses as a percentage of net revenues declined to 22.6% from 23.5% for the same period last year as a result of cost controls over variable center level and corporate expenditures.
Operating income. Operating income was $74.5 million, a decrease of $0.7 million, or 1.0%, from the same period last year. The decreased operating income was primarily due to the $3.6 million impairment charge included in depreciation expense, higher insurance costs and rent expense. Operating income was positively impacted by the control of variable center level and corporate expenditures. Operating income as a percentage of net revenues was 9.1% compared to 10.2% for the same period last year.
Interest expense. Interest expense was $44.1 million compared to $48.8 million for the same period last year. The decrease was substantially attributable to lower interest rates, offset partially by additional borrowings. Our weighted average interest rate on our long-term debt, including amortization of deferred financing costs, was 7.8% and 9.7% for fiscal 2002 and 2001, respectively.
Loss on minority investment. During the fourth quarter of fiscal 2002, we wrote down the net book value of a minority investment. The $2.3 million write-down was due to a reduced valuation of the subject company and dilution of our minority investment.
Income tax expense. Income tax expense was $11.3 million, or 39.5% of pretax income, in fiscal 2002 and $10.4 million, or 38.4% of pretax income, in fiscal 2001. The increase in the effective tax rate was due to additional goodwill amortization, which is not deductible for tax purposes. Income tax expense was computed by applying estimated effective income tax rates to the income before income taxes. Income tax expense varies from the statutory federal income tax rate due primarily to state and foreign income taxes, offset by tax credits.
Discontinued operations. Discontinued operations resulted in losses of $0.8 and $0.1 million in fiscal 2002 and 2001, respectively. Discontinued operations represents the operating results for all periods presented of the 28 centers closed during fiscal 2003.
Discontinued operations included the following, with dollars in thousands:
Depreciation expense related to discontinued operations included impairment charges of $0.6 million for fiscal 2002. There were no impairment charges related to discontinued operations in fiscal 2001.
Net income. Net income was $16.5 million, an increase of $0.9 million, or 5.6%, from the same period last year. The increase was due to lower interest costs, offset partially by the write-down in a minority investment and a decline in operating income due primarily to the $3.6 million asset impairment charge. Basic and diluted net income per share were $0.83 and $0.82, respectively, for fiscal 2002. For fiscal 2001, basic and diluted net income per share before the cumulative effect of a change in accounting principle were $0.86 and $0.85, respectively, and were $0.82 and $0.81, respectively, after such effect.
We implemented Securities and Exchange Commission SAB No. 101 with respect to non-refundable fee revenues in the first quarter of fiscal 2001. This resulted in a one-time charge of $0.8 million, net of taxes, which was recorded as a cumulative effect of a change in accounting principle.
Liquidity and Capital Resources
In July 2003 we refinanced a portion of our debt. We obtained a new $125.0 million revolving credit facility, and, as described below in greater detail, one of our subsidiaries obtained a $300 million mortgage loan. Proceeds from the mortgage loan were used to pay off the $98.0 million balance on the then existing revolving credit facility, $47.0 million of term loan facility and $97.9 million under the synthetic lease facility. We also used a portion of the remaining proceeds to repurchase $37.0 million aggregate principal amount of our 9.5% senior subordinated notes.
The $300.0 million mortgage loan is secured by first mortgages or deeds of trust on 475 of our owned centers located in 33 states. We refer to the mortgage loan as the CMBS Loan and the 475 mortgaged centers as the CMBS Centers. In connection with the CMBS Loan, the CMBS Centers were transferred to a newly formed wholly owned subsidiary of ours, which is the borrower under the CMBS Loan and which is referred to as the CMBS Borrower. Because the CMBS Centers are owned by the CMBS Borrower and subject to the CMBS Loan, recourse to the CMBS Centers by our creditors will be effectively subordinated to recourse by holders of the CMBS Loan.
The CMBS Loan is nonrecourse to the CMBS Borrower and us, subject to customary recourse provisions, and has a maturity date of July 9, 2008, which may be extended to July 9, 2009, subject to
certain conditions. The CMBS Loan bears interest at a per annum rate equal to LIBOR plus 2.25% and requires monthly payments of principal and interest. Principal payments are based on a 30-year amortization (based on an assumed rate of 6.5%). We have purchased an interest rate cap agreement to protect us from significant changes in LIBOR during the initial three years of the CMBS Loan. Under the cap agreement, which terminates July 9, 2006, LIBOR is capped at 6.50%. We are required to purchase additional interest rate cap agreements capping LIBOR at a rate no higher than 7.0% for the period from July 9, 2006 to the maturity date of the CMBS Loan.
Each of the centers included in the CMBS Centers is being ground leased by the CMBS Borrower to another wholly owned subsidiary formed in connection with the CMBS Loan, which is referred to as the CMBS Operator, and is being managed by us pursuant to a management agreement with the CMBS Operator.
Prepayment of the CMBS Loan is prohibited through July 8, 2005, after which prepayment is permitted in whole, subject to a prepayment premium of 3.0% from July 8, 2005 through July 8, 2006, 2.0% from July 9, 2006 through July 8, 2007 and 1.0% from July 9, 2007 through January 8, 2008, with no prepayment penalty thereafter. In addition, after July 9, 2005, the loan may be partially prepaid (a) up to $15.0 million each loan year in connection with releases of mortgaged centers with no prepayment premium and (b) up to $5.0 million each loan year subject to payment of the applicable prepayment premium.
The CMBS Loan contains a provision that requires the loan servicer to escrow 50% of excess cash flow generated from the CMBS Centers (determined after payment of debt service on the CMBS Loan, certain fees and required reserve amounts) if the net operating income, as defined in the CMBS Loan Agreement, of the CMBS Centers declines to $60.0 million, as adjusted to account for released properties. The amount of excess cash flow to be escrowed increases to 100% if the net operating income of the CMBS Centers declines to $50.0 million, as adjusted. The net operating income of the CMBS Centers for the trailing 13 periods ended July 1, 2003 was approximately $83.0 million. The maximum amount of excess cash flow that can be escrowed is limited to one year of debt service on the CMBS Loan and one year of rent due under the ground lease with the CMBS Operator during the term of the CMBS Loan. The escrowed amounts are released if the CMBS Centers generate the necessary minimum net operating income for two consecutive quarters. The annual debt service on the CMBS Loan is approximately $22.8 million (assuming a 6.50% interest rate). The annual rent due under the ground lease is $34.0 million during the term of the CMBS Loan. These excess cash flow provisions could limit the amount of cash made available to us.
During the fourth quarter of fiscal 2003, we committed to acquire $11.0 million aggregate principal amount of our 9.5% senior subordinated notes at an aggregate price of $11.1 million, which included a loss of $0.1 million. In addition, this transaction resulted in the write-off of deferred financing costs of $0.2 million. These $0.3 million of costs were included in interest expense in fiscal 2003. In June 2003, we acquired $4.0 million aggregate principal amount of our 9.5% senior subordinated notes at an aggregate price of $4.1 million, which included a loss of $0.1 million and deferred financing costs of $0.1 million were written off related to this transaction.
Our principal sources of liquidity are cash flow generated from operations, proceeds received from our sale-leaseback program and borrowings under our revolving credit facility. At August 22, 2003, we had drawn $20.0 million under our new revolving credit facility and had outstanding letters of credit totaling $73.6 million. Our availability under our new credit facility was $31.4 million. Our principal uses of liquidity are new center development and debt service.
Our consolidated net cash provided by operating activities for fiscal 2003 was $78.7 million compared to $87.5 million in the same period last year. The decrease in net cash flow was due to the change in working capital. Cash and cash equivalents totaled $18.1 million at May 30, 2003, compared to $8.6 million at May 31, 2002.
EBITDA, which is a non-GAAP financial measure, is defined as earnings before interest, taxes, depreciation, amortization and the related components of discontinued operations. EBITDA reflects a non-GAAP financial measure of our liquidity. A non-GAAP financial measure is a numerical measure of historical or future financial performance, financial position or cash flow that excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, from the most directly comparable measure calculated and presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). We believe EBITDA is a useful tool for certain investors and creditors for measuring our ability to meet debt service requirements. Additionally, management uses EBITDA for purposes of reviewing our results of operations on a more comparable basis. We have provided EBITDA in previous filings and continue to provide this measure for comparability between periods. EBITDA was restated from amounts reported in previous filings in order to comply with SEC Regulation G, Conditions for Use of Non-GAAP Financial Measures. EBITDA does not represent cash flow from operations as defined by GAAP, is not necessarily indicative of cash available to fund all cash flow needs and should not be considered an alternative to net income under GAAP for purposes of evaluating our results of operations. EBITDA was calculated as follows, with dollars in thousands:
A reconciliation of EBITDA to cash provided by operating activities was as follows, with dollars in thousands:
EBITDA was $123.4 million for fiscal 2003, a decrease of $6.8 million from the same period last year. The decrease was primarily due to higher insurance costs, the write-down of a minority investment and increased rent expense, offset in part by higher tuition rates and control over center labor
productivity. In fiscal 2002, EBITDA increased $9.3 million from fiscal 2001 due to the addition of the Mulberry centers and the additional contributions of the newer centers.
We utilized approximately $10.3 million of net operating loss carryforwards to offset taxable income in our 2001 through 2003 fiscal years. Approximately $2.5 million of net operating loss carryforwards are available at May 30, 2003 to be utilized in future fiscal years. If such net operating loss carryforwards were reduced due to a change of control or otherwise, we would be required to pay additional taxes and interest, which would reduce available cash.
During the fourth quarter of fiscal year 2002, we began selling centers to individual real estate investors and then leasing them back. The resulting leases have been classified as operating leases. We will continue to manage the operations of any centers that are sold in such transactions. The sales were summarized as follows, with dollars in thousands:
The deferred gains are amortized on a straight-line basis, typically over a period of 15 years. Subsequent to May 30, 2003, we closed $12.6 million in sales, which included eight centers, and are currently in the process of negotiating another $42.9 million of sales related to 20 centers. It is possible that we will be unable to complete these transactions. We expect our sale-leaseback efforts to continue into fiscal year 2004, assuming the market for such transactions remains favorable.
We expect to fund future new center development through the new $125.0 million revolving credit facility and sale-leaseback proceeds, although alternative forms of funding continue to be evaluated and new arrangements may be entered into in the future.
In fiscal year 2000, we entered into a $100.0 million synthetic lease facility under which a syndicate of lenders financed the construction of new centers for lease to us for a three to five year period. A total of 44 centers were constructed for $97.9 million. As noted above, the synthetic lease facility was terminated in July 2003 as part of our refinancing. The 44 centers are now owned by us and the assets will be reflected in our fiscal 2004 consolidated financial statements.
In fiscal 2001, our acquisition spending, including transaction fees, for Mulberry, NLKK, a distance learning company, and two independently operated centers totaled $32.4 million in cash. In addition to the cash payments, we issued 860,000 shares of our common stock to the sellers of Mulberry and assumed $3.3 million of debt. In August 2002, 119,838 of the 860,000 shares were returned to us, which included 99,152 shares that were released from an indemnity escrow and 20,686 shares that were redeemed from certain former shareholders of Mulberry. All 119,838 shares were cancelled.
We made a minority investment in an education-based company of $10.1 million in fiscal 2001. During fiscal 2001, notes receivable of $4.8 million were issued to us by another company in which we hold a minority investment. During fiscal 2002, $2.2 million of such notes were converted into additional stock of the subject company. During the fourth quarters of fiscal 2003 and fiscal 2002, we wrote down the net book value of a cost method minority investment by $6.7 million and $2.3 million, respectively.
We believe that cash flow generated from operations, proceeds from our sale-leaseback program and borrowings under the new revolving credit facility will adequately provide for our working capital and debt service needs and will be sufficient to fund our expected capital expenditures for the foreseeable future. Any future acquisitions, joint ventures or similar transactions may require additional capital, and such capital may not be available to us on acceptable terms or at all. Although no assurance can be given that such sources of capital will be sufficient, the capital expenditure program has substantial flexibility and is subject to revision based on various factors, including but not limited to, business conditions, cash flow requirements, debt covenants, competitive factors and seasonality of openings. If we experience a lack of working capital, it may reduce our future capital expenditures. If these expenditures were substantially reduced, in management's opinion, our operations and cash flow would be adversely impacted.
We may experience decreased liquidity during the summer months and the calendar year-end holidays due to decreased attendance during these periods. See "Item 1. Seasonality."
We have certain contractual obligations and commercial commitments. Contractual obligations are those that will require cash payments in accordance with the terms of a contract, such as a loan agreement or lease agreement. Commercial commitments represent potential obligations for performance in the event of demands by third parties or other contingent events, such as lines of credit. Our contractual obligations and commercial commitments at May 30, 2003 were as follows, with dollars in thousands:
In accordance with SFAS No. 6, "Classification of Short-Term Obligations Expected to Be Refinanced, an Amendment of ARB No. 43, Chapter 3A," the $104.0 million balance on our previous revolving credit facility and the current portion of our $47.0 million term loan facility were classified as long-term debt at May 30, 2003 since those current obligations were financed on a long-term basis subsequent to May 30, 2003. Both are reflected above in accordance with the payment schedule required as a result of the refinancing. Other commitments include center development commitments, obligations to purchase vehicles and other purchase order commitments, primarily related to operations at our centers.
Capital Expenditures
During fiscal 2003 and 2002, we opened 28 and 35 new centers, respectively. We expect to open approximately 25 to 30 new centers in fiscal year 2004 and to continue our practice of closing centers that are identified as not meeting performance expectations. In addition, we may acquire existing centers from local or regional early childhood education and care providers. We may not be able to successfully negotiate and acquire sites and/or previously constructed centers, meet our targets for new center additions or meet targeted deadlines for development of new centers.
New centers are located based upon detailed site analyses that include feasibility and demographic studies and financial modeling. The length of time from site selection to construction and, finally, the opening of a community center ranges from 16 to 24 months. Frequently, new site negotiations are delayed or canceled or construction is delayed for a variety of reasons, many of which are outside our control. The average total cost per community center typically ranges from $1.9 million to $2.8 million, including the cost of land, depending on the size and location of the center. However, the actual costs of a particular center may vary from such range.
Our new centers typically have a licensed capacity ranging from 145 to 180, while the centers constructed during fiscal 1997 and earlier have an average licensed capacity of 125. When mature, these larger centers are designed to generate higher revenues, operating income and margins than our older centers. These new centers also have higher average costs of construction and typically take three to four years to reach maturity. On average, our new centers should begin to produce positive EBITDA during the first year of operation and begin to produce positive net income by the end of the second year of operation. Accordingly, as more new centers are developed and opened, profitability will be negatively impacted in the short-term but is expected to be enhanced in the long-term once these new centers achieve anticipated levels of occupancy.
Capital expenditures included the following, with dollars in thousands:
In fiscal 2001, capital expenditures do not include the $64.4 million drawn on the off-balance sheet synthetic lease facility during that fiscal year or the acquisition of Mulberry. As discussed above, the synthetic lease facility was terminated in July 2003 in connection with the refinancing of a portion of our debt.
Capital expenditure limits under our new revolving credit facility for fiscal year 2004 are $110.0 million. Also, we have some ability to incur additional indebtedness, including through mortgages or sale-leaseback transactions, subject to the limitations imposed by the indenture under which our senior subordinated notes were issued and the new credit facility.
Application of Critical Accounting Policies
Critical Accounting Estimates. The preparation of financial statements in conformity with GAAP requires that management make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Predicting future events is inherently an imprecise activity and as such requires the use of judgment. Actual results may vary from estimates in amounts that may be material to the financial statements.
For a description of our significant accounting policies, see "Item 8. Financial Statements and Supplementary Data, Note 2. Summary of Significant Accounting Policies." The following accounting estimates and related policies are considered critical to the preparation of our financial statements due to the business judgment and estimation processes involved in their application. Management has reviewed the development and selection of these estimates and their related disclosure with the Audit Committee of the Board of Directors.
Revenue recognition. Tuition revenues, net of discounts, and other revenues are recognized as services are performed. Payments may be received in advance of services being rendered, in which case the revenue is deferred and recognized during the appropriate time period, typically a week. Our non-refundable registration and education fees are amortized over the average enrollment period, not to exceed one year. The recognition of our net revenues meets the criteria of the Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, including the existence of an arrangement, the rendering of services, a determinable fee and probable collection.
Accounts receivable. Our accounts receivable are comprised primarily of tuition due from governmental agencies, parents and employers. Accounts receivable are presented at estimated net realizable value. We use estimates in determining the collectibility of our accounts receivable and must rely on our evaluation of historical experience, specific customer issues, governmental funding levels and current economic trends to arrive at appropriate reserves. Material differences may result in the amount and timing of bad debt expense if actual experience differs significantly from management estimates.
Long-lived and intangible assets. We assess the potential impairment of property and equipment and finite-lived intangibles whenever events or changes in circumstances indicate that the carrying value may not be recoverable. An asset's value is impaired if our estimate of the aggregate future cash flows, undiscounted and without interest charges, to be generated by the asset is less than the carrying value of the asset. Such cash flows consider factors such as expected future operating income and historical trends, as well as the effects of demand and competition. To the extent impairment has occurred, the loss will be measured as the excess of the carrying amount of the asset over its estimated fair value. Such estimates require the use of judgment and numerous subjective assumptions, which, if actual experience varies, could result in material differences in the requirements for impairment charges.
Impairment charges were as follows, with dollars in thousands:
Goodwill and other indefinite-lived intangible assets must be tested at least annually for impairment and written down to their fair market values, if necessary. At June 1, 2002, we had $42.6 million of goodwill recorded on our consolidated balance sheet. We performed a transitional impairment test in the second quarter of fiscal 2003, as required by SFAS No. 142. Although quoted market prices are typically the best evidence in determining fair value, we used the value of our stock as determined by the Board of Directors, as it was a more practical measure to perform the transitional impairment test. The quoted market price for our stock is not the best value indicator due to limited trading volume. The fair value of the reporting unit related to the recorded goodwill, as of June 1, 2002, exceeded the carrying value at the same date; hence, there was no evidence of impairment. During the fourth quarter of fiscal 2003, we performed the annual impairment test and again determined there was no evidence that the $42.6 million of goodwill was impaired. We will perform our annual impairment test in the fourth quarter of each subsequent fiscal year. Please refer to "Initial Adoption of Accounting Policies" below.
Investments. Investments, wherein we do not exert significant influence or own over 20% of the investee's stock, are accounted for under the cost method. We measure the fair value of these investments using multiples of comparable companies and discounted cash flow analysis. During the
fourth quarters of fiscal 2003 and 2002, we wrote down a minority investment by $6.7 million and $2.3 million, respectively, due to a reduced valuation on the subject company and dilution of our minority investment.
Self-insurance obligations. We self-insure a portion of our general liability, workers' compensation, auto, property and employee medical insurance programs. We purchase stop loss coverage at varying levels in order to mitigate our potential future losses. The nature of these liabilities, which may not fully manifest themselves for several years, requires significant judgment. We estimate the obligations for liabilities incurred, but not yet reported or paid, based on available claims data and historical trends and experience, as well as future projections of ultimate losses, expenses, premiums and administrative costs. The insurance expense and accrued obligations for these self-insurance programs were as follows, with dollars in thousands:
Rising costs for medical care and stop loss coverage have resulted in significant increases in workers' compensation and medical insurance expenses. Our internal estimates are reviewed annually and updated quarterly by a third party actuary. While we believe that the amounts accrued for these obligations are sufficient, any significant increase in the number of claims and costs associated with claims made under these programs could have a material adverse effect on our financial position, cash flows or results of operations.
Income taxes. Accounting for income taxes requires us to estimate our future tax liabilities. Due to timing differences in the recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded tax assets, we assess the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability or enacted tax rates, we provide a valuation allowance for the asset. Should any significant changes in the tax law or our estimate of the necessary valuation allowance occur, we would be required to record the impact of the change. This could have a material effect on our financial position or results of operations.
Initial Adoption of Accounting Policies
During the fiscal year ended May 30, 2003, we adopted the following new accounting pronouncements. Please also refer to "Item 8. Financial Statements and Supplementary Data."
Goodwill and Other Intangible Assets. Effective June 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires discontinuing the amortization of goodwill and other intangible assets with indefinite useful lives. Therefore, we ceased amortization of goodwill at June 1, 2002. Goodwill amortization was $2.4 million and $1.1 million, pretax, during fiscal 2002 and 2001, respectively.
Impairment of Long-Lived Assets and Discontinued Operations. Effective June 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of business.
SFAS No. 144 modifies the accounting and reporting for long-lived assets to be disposed of by sale and it broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 does not apply to goodwill and other indefinite-lived intangible assets, as these assets are governed by SFAS No.142, as discussed above.
We have determined that the 28 centers closed during fiscal 2003, which included five owned and 23 leased centers, met the criteria of discontinued operations. Therefore, the operating results for these 28 centers were classified as discontinued operations, net of tax, in the consolidated statements of operations for all periods presented. Discontinued operations were as follows, with dollars in thousands:
We believe that most of our future center closures will now be categorized as discontinued operations. The owned centers that meet the criteria of held for sale have been classified as current in the consolidated balance sheets for all periods presented. As a result, property and equipment of $0.7 million and $1.8 million was classified as current assets held for sale at May 30, 2003 and May 31, 2002, respectively.
SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, was adopted in the second quarter of fiscal 2003. SFAS No. 146 requires costs associated with exit or disposal activities be recorded at their fair values when a liability has been incurred, rather than at the date of commitment to an exit or disposal plan. SFAS No. 146 was effective for disposal activities initiated after December 31, 2002. This adoption did not have a material impact on our financial position or results of operations.
SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, amends the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, to require prominent disclosures in annual and interim financial statements about the method of accounting for stock-based compensation and the effect in measuring compensation expense. We have provided the required disclosures commencing with this report. See "Item 8. Financial Statements and Supplementary Data, Note 2. Summary of Significant Accounting Policies, Stock-Based Compensation."
FIN 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, requires expanded disclosures by guarantors in interim and annual financial statements about obligations under certain guarantees. In addition, FIN 45 requires guarantors to recognize, at the inception of a guarantee, a liability for the obligation it has undertaken in issuing the guarantee. The recognition and initial measurement provision was applicable to guarantees issued or modified after December 31, 2002. FIN 45 does not have an impact on our financial position as a result of paying off the synthetic lease facility in July 2003 as part of our refinancing.
Recently Issued Accounting Pronouncements
FIN 46, Consolidation of Variable Interest Entities, requires consolidation where there is a controlling financial interest in a variable interest entity,
previously referred to as a special-purpose entity. FIN 46 will be effective during the second quarter of our fiscal year 2004. We do not anticipate an impact to our financial position or results of operations.
SFAS No. 149, Amendments of Statement 133 on Derivative Instruments and Hedging Activities, amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003. SFAS No. 149 is effective in our first quarter of our fiscal year 2004. We do not anticipate a material impact to our financial position or results of operations.
SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement requires that an issuer classify a financial instrument that is within its scope as a liability, or an asset in some circumstances. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective in our second quarter of our fiscal year 2004. This statement is not expected to have a material impact to our financial position or results of operations.
Seasonality
See "Item 1. Business, Seasonality."
Governmental Laws and Regulations Affecting Us
See "Item 1. Business, Governmental Laws and Regulations Affecting Us."
Inflation and Wage Increases
We do not believe that the effect of inflation on the results of our operations has been significant in recent periods, including the last three fiscal years.
Expenses for salaries, wages and benefits represented approximately 55.2% of net revenues for fiscal 2003. We believe that, through increases in our tuition rates, we can recover any future increase in expenses caused by adjustments to the federal or state minimum wage rates or other market adjustments. However, we may not be able to increase our rates sufficiently to offset such increased costs. We continually evaluate our wage structure and may implement changes at targeted local levels.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our consolidated financial position, results of operations or cash flows. We are exposed to market risk in the areas of interest rates and foreign currency exchange rates.
Interest Rates
Our exposure to market risk for changes in interest rates relates primarily to debt obligations. We had no cash flow exposure due to rate changes on our 9.5% senior subordinated notes aggregating $290.0 million at May 30, 2003. We also had no cash flow exposure on certain industrial revenue bonds, mortgages and notes payable, which aggregated $5.6 million at May 30, 2003. However, we had cash flow exposure on certain industrial revenue bonds subject to variable LIBOR, which aggregated $8.5 million at May 30, 2003. Accordingly, a 1% (100 basis points) change in the LIBOR rate would have resulted in interest expense changing by approximately $0.1 million in each of fiscal 2003, 2002 and 2001. In addition, we also had cash flow exposure on our vehicle leases with variable interest rates. A
1% (100 basis points) change in the interest rate defined in the vehicle lease agreement would have resulted in rent expense changing by approximately $0.5 million for each of fiscal 2003, 2002 and 2001.
We have cash flow exposure on the CMBS Loan entered into in July 2003, which bears interest at a rate equal to LIBOR plus 2.25%. We have purchased an interest rate cap agreement to protect us from significant movements in LIBOR during the initial three years of the CMBS Loan. The LIBOR strike price is 6.50% under the interest rate cap agreement, which terminates July 9, 2006, at which time we are required to purchase an additional interest rate cap agreement. In addition, we have cash flow exposure on our new revolving credit facility which is subject to LIBOR pricing. The new credit facility currently bears interest at a rate equal to LIBOR plus 3.25%, which is subject to change based on the achievement of certain performance measures.
Foreign Exchange Risk
We are exposed to foreign exchange risk to the extent of fluctuations in the United Kingdom pound sterling. Based upon the relative size of our operations in the United Kingdom, we do not believe that the reasonably possible near-term change in the related exchange rate would have a material effect on our financial position, results of operations or cash flows.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
KinderCare Learning Centers, Inc. and Subsidiaries Notes to Consolidated Financial Statements
1. Nature of Business
KinderCare Learning Centers, Inc., referred to as KinderCare, is the leading for-profit provider of early childhood education and care services in the United States. At May 30, 2003, we served approximately 127,000 children and their families at 1,264 child care centers. At our child care centers, education and care services are provided to infants and children up to twelve years of age. However, the majority of the children we serve are from six weeks to five years old. The total licensed capacity at our centers was approximately 167,000 at May 30, 2003.
We operate child care centers under two brands as follows:
o KinderCare - At May 30, 2003, we operated 1,194 KinderCare centers. The brand was established in 1969 and includes centers in 39 states, as well as two centers located in the United Kingdom.
o Mulberry - We operated 70 Mulberry centers at May 30, 2003, which are located primarily in the northeast region of the United States and southern California. In addition, we had 12 service contracts to operate before- and after-school programs.
We also partner with companies to provide on- or near-site care to help employers attract and retain employees. Included in the 1,264 centers, at May 30, 2003, are 47 employer-sponsored centers. In addition to our center-based child care operations, we own and operate a distance learning company serving teenagers and young adults. Our subsidiary, KC Distance Learning, Inc., offers an accredited high school program delivered in either online or correspondence format. We have made minority investments in Voyager Expanded Learning, Inc., a developer of educational curricula for elementary and middle schools and a provider of a public school teacher retraining program and Chancellor Beacon Academies, Inc., a charter school management company.
2. Summary of Significant Accounting Policies
Basis of Presentation. The consolidated financial statements include the financial statements of KinderCare and our subsidiaries, all of which are wholly owned. All significant intercompany balances and transactions have been eliminated in consolidation.
Fiscal Year. References to fiscal 2003, fiscal 2002 and fiscal 2001 are to the 52 weeks ended May 30, 2003, the 52 weeks ended May 31, 2002 and the 52 weeks ended June 1, 2001, respectively. We utilize a financial reporting schedule comprised of 13 four-week periods. Our fiscal year ends on the Friday closest to May 31. The first quarter includes 16 weeks and the second, third and fourth quarters each include 12 weeks.
Revenue Recognition. We recognize revenue for child care services as earned in accordance with Securities and Exchange Commission ("SEC") Staff Accounting Bulletin ("SAB") No. 101, Revenue Recognition in Financial Statements. Net revenues include tuition, fees and non-tuition income, reduced by discounts. We receive fees for reservation, registration, education and other services. Non-tuition income is primarily comprised of field trip revenue. Registration and education fees are amortized over the estimated average enrollment period, not to exceed 12 months. Tuition, other fees and non-tuition income are recognized as the related services are provided.
On June 3, 2000, we implemented SAB No. 101. As a result of that implementation, a non-recurring charge of $0.8 million, net of income tax benefit of $0.5 million, was recorded in the first quarter of fiscal 2001 related to non-refundable registration and education fee revenues that were originally recognized in the fourth quarter of fiscal 2000. This one-time charge was recorded as a cumulative effect of a change in accounting principle.
Advertising. Costs incurred to produce media advertising for seasonal campaigns are expensed during the quarter in which the advertising first takes place. Costs related to website development are capitalized or expensed in accordance with Statement of Position ("SOP") No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 identifies the characteristics of internal use software and related costs, and provides guidance on whether the costs should be expensed as incurred or capitalized. Other advertising costs are expensed as incurred. Advertising costs were $10.8 million, $12.1 million and $12.5 million during fiscal 2003, 2002 and 2001, respectively.
Cash and Cash Equivalents. Cash and cash equivalents consist of cash held in banks and liquid investments with maturities, at the date of acquisition, not exceeding 90 days.
Accounts receivable. Our accounts receivable are comprised primarily of tuition due from governmental agencies, parents and employers. Accounts receivable are presented at estimated net realizable value. We use estimates in determining the collectibility of our accounts receivable and must rely on our evaluation of historical experience, specific customer issues, governmental funding levels and current economic trends to arrive at appropriate reserves. Material differences may result in the amount and timing of bad debt expense if actual experience differs significantly from our estimates.
Property and Equipment. Property and equipment are stated at cost. Interest and overhead costs incurred in the construction of buildings and leasehold improvements are capitalized. Depreciation on buildings and equipment is provided on the straight-line basis over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the estimated useful life of the improvements or the lease term, including expected lease renewal options where we have the unqualified right to exercise the option and expect to exercise such option.
Our property and equipment is depreciated using the following estimated useful lives:
Life -------------- Buildings........................................ 10 to 40 years Building renovations............................. 2 to 15 years Leasehold improvements........................... 2 to 15 years Computer equipment............................... 3 to 5 years All other equipment.............................. 3 to 10 years
Asset Impairments. Long-lived assets and certain identifiable intangibles to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. We regularly evaluate long-lived assets for impairment by comparing projected undiscounted cash flows for each asset to the carrying value of such asset. If the projected undiscounted cash flows are less than the asset's carrying value, we record an impairment charge, if necessary, to reduce the carrying value to estimated fair value. During fiscal 2003, 2002 and 2001, impairment charges of $3.3 million, $3.6 million and $1.0 million, respectively, were recorded with respect to certain underperforming and undeveloped centers. The impairment charges are included as a component of depreciation expense from continuing and discontinued operations in the statement of operations.
Goodwill and Other Intangible Assets. Effective June 1, 2002, we adopted Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets. As a result, we ceased amortization of goodwill at June 1, 2002. Amortization of goodwill for fiscal 2002 and 2001 was $2.4 million and $1.1 million, pre-tax, respectively. These assets must now be tested at least annually for impairment and written down to their fair market values, if necessary. At June 1, 2002, we had $42.6 million of goodwill recorded on our consolidated balance sheet. We performed a transitional impairment test in the second quarter of fiscal 2003, as required by SFAS No. 142. In addition, we performed our annual impairment test in the fourth quarter of fiscal 2003. Although quoted market prices are the best evidence in determining fair value, we used the value of our stock as determined by the Board of Directors, as it was a more practical measure to perform the transitional impairment test. The fair value of the reporting unit related to the recorded goodwill, as of June 1, 2002 and May 30, 2003, exceeded the carrying value at the same date, hence there was no evidence of impairment.
If SFAS No. 142 had been adopted in the prior fiscal year, our pro forma net income and net income per share for fiscal 2002 and 2001 would have been as follows, with dollars in thousands, except per share amounts:
Certain amounts of goodwill amortization were not tax deductible in fiscal 2002 and 2001, and therefore are not shown net of tax above. Non-deductible goodwill amortization was $1.4 million and $0.3 million in fiscal 2002 and 2001, respectively.
Our finite-lived intangibles, which are non-competition agreements, included in other assets in the consolidated balance sheets were as follows, with dollars in thousands:
These intangible assets are amortized on a straight-line basis over their contractual lives that range from 3 to 5 years. Amortization of these intangibles will be substantially complete in the second quarter of fiscal year 2004.
Deferred Financing Costs. Deferred financing costs are amortized on a straight-line basis over the lives of the related debt facilities. Such method approximates the effective yield method.
Investments. Investments, wherein we do not exert significant influence or own over 20% of the investee's stock, are accounted for under the cost method. We measure the fair value of these investments using multiples of comparable companies and discounted cash flow analysis. During the
fourth quarters of fiscal 2003 and 2002, we wrote down a minority investment by $6.7 million and $2.3 million, respectively, due to a reduced valuation on the subject company and dilution of our minority investment.
Self-Insurance Programs. We are self-insured for certain levels of general liability, workers' compensation, auto, property and employee medical insurance coverage. Estimated costs of these self-insurance programs are accrued at the undiscounted value of projected settlements for known and anticipated claims incurred. A summary of self-insurance liabilities was as follows, with dollars in thousands:
Income Taxes. Income tax expense is based on pre-tax financial accounting income. Deferred income taxes result primarily from the expected tax consequences of temporary differences between financial and tax reporting. If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is established.
Stock-Based Compensation. We measure compensation expense for our stock-based employee compensation plans using the method prescribed by Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued to Employees, and provide pro forma disclosures of net income and earnings per share as if the method prescribed by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, had been applied in measuring compensation expense.
Had compensation expense for our stock option plans been determined based on the estimated weighted average fair value of the options at the date of grant in accordance with SFAS No. 148, our net income and basic and diluted net income per share would have been as follows, with dollars in thousands, except per share data:
A summary of the weighted average fair values was as follows:
Comprehensive Income. Comprehensive income does not include the reversal of certain contingency accruals as a result of fresh-start reporting related to our emergence from bankruptcy in March 1993. Such contingency accruals represent reserves equal to the tax benefit of pre-bankruptcy income tax net operating loss carryforwards. The tax benefits were reserved due to uncertainty associated with their future realization. As realization of these benefits becomes more likely than not, the reserve is reversed from other liabilities and credited to additional paid-in capital. Up to an additional $9.5 million may be reversed in future periods.
Discontinued Operations. Effective June 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, for the disposal of a segment of business. SFAS No. 144 modifies the accounting and reporting for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions.
We closed 28 centers in fiscal 2003, which included five owned and 23 leased centers. These center closures meet the criteria of discontinued operations in SFAS No. 144. The operating results for these 28 centers were classified as discontinued operations, net of tax, in the consolidated statements of operations for all periods presented. A summary of discontinued operations follows, with dollars in thousands:
Operating expenses included impairment charges of $0.7 million and $0.6 million for fiscal 2003 and 2002, respectively, and gains on closed center sales in the amount of $1.2 million for fiscal 2003. The owned centers that meet the criteria of held for sale have been classified as current in the consolidated balance sheets for all periods presented. As a result, property and equipment of $0.7 million and $1.8 million was classified as current assets held for sale at May 30, 2003 and May 31, 2002, respectively.
Net Income per Share. The difference between basic and diluted net income per share was a result of the dilutive effect of options, which are considered potential common shares. A summary of the weighted average common shares was as follows:
Stock split. On July 15, 2002, the Board of Directors authorized a 2-for-1 stock split of our $0.01 par value common stock effective August 19, 2002 for stockholders of record on August 9, 2002. All references to the number of common shares and per share amounts within these consolidated financial statements and notes thereto for the fiscal years ended May 30, 2003, May 31, 2002 and June 1, 2001 have been restated to reflect the stock split. Concurrent with the stock split, the number of authorized common shares was increased from 20.0 million to 100.0 million shares.
Reporting for Segments. We operate in one reportable segment.
Exit or Disposal Activities. In the second quarter of fiscal 2003, we adopted SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that costs
associated with exit or disposal activities be recorded at their fair values when a liability has been incurred, rather than at the date of commitment to an exit or disposal plan. SFAS No. 146 was effective for disposal activities initiated after December 31, 2002. This adoption did not have a material impact on our financial position or results of operations.
Guarantees. Financial Accounting Standards Board ("FASB") Interpretation 45 ("FIN 45"), Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, requires expanded disclosures by guarantors in interim and annual financial statements about obligations under certain guarantees. In addition, FIN 45 requires guarantors to recognize, at the inception of a guarantee, a liability for the obligation it has undertaken in issuing the guarantee. The recognition and initial measurement provision was applicable to guarantees issued or modified after December 31, 2002. FIN 45 does not currently have an impact on our financial position as a result of paying off the synthetic lease facility in July 2003 as part of our refinancing.
Recently Issued Accounting Pronouncements. FASB FIN 46, Consolidation of Variable Interest Entities, requires consolidation where there is a controlling financial interest in a variable interest entity, previously referred to as a special-purpose entity. FIN 46 will become effective during the second quarter of our fiscal year 2004. We do not anticipate an impact to our financial position or results of operations.
SFAS No. 149, Amendments of Statement 133 on Derivative Instruments and Hedging Activities, amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003. SFAS No. 149 is effective in our first quarter of our fiscal year 2004. We do not anticipate a material impact to our financial position or results of operations.
SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement requires that an issuer classify a financial instrument that is within its scope as a liability, or an asset in some circumstances. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective in our second quarter of our fiscal year 2004. This statement is not expected to have a material impact to our financial position or results of operations.
Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different conditions or if our assumptions change. The most significant estimates underlying the accompanying consolidated financial statements include the timing of revenue recognition, the allowance for doubtful accounts, long-lived and intangible asset valuations and any resulting impairment, the valuation of our investments, the adequacy of our self-insurance obligations and future tax liabilities.
Reclassifications. As a result of the 28 centers closed in fiscal 2003, we have restated amounts previously reported in our consolidated statements of operations for fiscal years 2002 and 2001 to reflect the results of discontinued operations separate from continuing operations. We have also restated the first three quarters of fiscal 2003 and each of the four quarters of fiscal 2002 for similar reasons. See "Note 16. Quarterly Results (Unaudited)." In addition, certain other prior period amounts have been reclassified to conform to the current year's presentation.
3. Receivables
Receivables consisted of the following, with dollars in thousands:
4. Prepaid Expenses and Supplies
Prepaid expenses and supplies consisted of the following, with dollars in thousands:
5. Property and Equipment
Property and equipment consisted of the following, with dollars in thousands:
6. Other Assets
Other assets consisted of the following, with dollars in thousands:
7. Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities consisted of the following, with dollars in thousands:
8. Long-Term Debt
Long-term debt consisted of the following, with dollars in thousands:
Refinancing. In July 2003 we refinanced a portion of our debt. We obtained a new $125.0 million revolving credit facility, and, as described below in greater detail, one of our subsidiaries obtained a $300.0 million mortgage loan. Proceeds from the mortgage loan were used to pay off the balance on the then existing revolving credit facility, the term loan facility and the synthetic lease facility. We also used a portion of the remaining proceeds to repurchase $37.0 million aggregate principal amount of our 9.5% senior subordinated notes. In accordance with SFAS No. 6, "Classification of Short-Term Obligations Expected to Be Refinanced, an Amendment of ARB No. 43, Chapter 3A," the $104.0 million balance on our previous revolving credit facility and our annual $0.5 million installment on our term loan were classified as long-term debt at May 30, 2003.
Mortgage Loan. The $300.0 million mortgage loan is secured by first mortgages or deeds of trust on 475 of our owned centers located in 33 states. We refer to the mortgage loan as the CMBS Loan and the 475 mortgaged centers as the CMBS Centers. In connection with the CMBS Loan, the CMBS Centers were transferred to a newly formed wholly owned subsidiary of ours, which is the borrower under the CMBS Loan and which is referred to as the CMBS Borrower. Because the CMBS Centers are is owned by the CMBS Borrower and subject to the CMBS Loan, recourse to the CMBS Centers by our creditors will be effectively subordinated to recourse by holders of the CMBS Loan.
The CMBS Loan is nonrecourse to the CMBS Borrower and us, subject to customary recourse provisions, and has a maturity date of July 9, 2008, which may be extended to July 9, 2009, subject to certain conditions. The CMBS Loan bears interest at a per annum rate equal to LIBOR plus 2.25% and requires monthly payments of principal and interest. Principal payments are based on a 30-year amortization (based on an assumed rate of 6.5%). We have purchased an interest rate cap agreement to protect us from significant changes in LIBOR during the initial three years of the CMBS Loan. Under the cap agreement, which terminates July 9, 2006, LIBOR is capped at 6.50%. We are required to purchase additional interest rate cap agreements capping LIBOR at a rate no higher than 7.0% for the period from July 9, 2006 to the maturity date of the CMBS Loan.
Each of the centers included in the CMBS Centers is being ground leased by the CMBS Borrower to another wholly owned subsidiary formed in connection with the CMBS Loan, which is referred to as the CMBS Operator and is being managed by us pursuant to a management agreement with the CMBS Operator.
Prepayment of the CMBS Loan is prohibited through July 8, 2005, after which prepayment is permitted in whole, subject to a prepayment premium of 3.0% from July 8, 2005 through July 8, 2006, 2.0% from July 9, 2006 through July 8, 2007 and 1.0% from July 9, 2007 through January 8, 2008, with no prepayment penalty thereafter. In addition, after July 9, 2005, the loan may be partially prepaid (a) up to $15.0 million each loan year in connection with releases of mortgaged centers with no prepayment premium and (b) up to $5.0 million each loan year subject to payment of the applicable prepayment premium.
The CMBS Loan contains a provision that requires the loan servicer to escrow 50% of excess cash flow generated from the CMBS Centers (determined after payment of debt service on the CMBS Loan, certain fees and required reserve amounts) if the net operating income, as defined in the CMBS Loan agreement, of the CMBS Centers declines to $60.0 million, as adjusted to account for released properties. The amount of excess cash flow to be escrowed increases to 100% if the net operating income of the CMBS Centers to $50.0 million, as adjusted. The net operating income of the CMBS Centers for the trailing 13 periods ended July 1, 2003 was approximately $83.0 million. The maximum amount of excess cash flow that can be escrowed is limited to one year of debt service on the CMBS Loan and one year of the rent due under the ground lease with the CMBS Operator. The escrowed amounts are released if the CMBS Centers generate the necessary minimum net operating income for two consecutive quarters. The maximum annual debt service on the CMBS Loan is approximately $22.8 million (assuming a 6.50% interest rate). The maximum annual rent under the ground lease is $34.0 million for the term of the CMBS Loan. These excess cash flow provisions could limit the amount of cash made available to us.
Credit Facility. Our new $125.0 million credit facility is secured by first mortgages or deeds of trusts on 119 of our owned centers and certain other collateral and has a maturity date of July 9, 2008. The revolving credit facility includes borrowing capacity of up to $75.0 million for letters of credit and up to $10.0 million for selected short-term borrowings.
The credit facility bears interest, at our option, at either of the following rates, which are adjusted in quarterly increments based on the achievement of performance goals:
o an adjusted LIBOR rate plus, a rate ranging from 2.00% to 3.25%, dependent upon the ratio of total consolidated debt to total consolidated EBITDA, initially 3.25% at August 22, 2003.
o an alternative base rate plus, a rate ranging from 0.75% to 2.00%, dependent upon the ratio of total consolidated debt to total consolidated EBITDA.
---------------
EBITDA is defined in the credit facility as net income before interest expense, income taxes, depreciation, amortization , non-recurring charges, non-cash charges, gains and losses on asset sales, restructuring charges or reserves and non-cash gains.
The credit facility contains customary covenants and provisions that restrict our ability to:
o make certain fundamental changes to our business,
o consummate asset sales,
o declare dividends,
o grant liens,
o incur additional indebtedness, amend the terms of or repay certain indebtedness, and
o make capital expenditures.
In addition, the credit facility requires us to meet or exceed certain leverage and interest and lease expense coverage ratios.
Under the new revolving credit facility we are required to pay a commitment fee at a rate ranging from 0.40% to 0.50% on the available commitment. The fee is payable quarterly in arrears. In addition, we are required to pay a letter of credit fee at a rate of LIBOR minus 0.125% plus a fronting fee of 0.125%. These fees are also payable quarterly in arrears.
Series A Through E Industrial Revenue Bonds. We are obligated to various issuers of industrial revenue bonds, which are referred to as refunded IRBs. Such bonds mature in calendar 2009. The refunded IRBs were issued to provide funds for refunding an equal principal amount of industrial revenue bonds that were used to finance the cost of acquiring, constructing and equipping specific centers. At May 30, 2003, the refunded IRBs bore interest at a variable rate of 1.70%, and each was secured by a letter of credit under the revolving credit facility.
Other Industrial Revenue Bonds. We are also obligated to various issuers of other industrial revenue bonds that mature to calendar 2005. The principal amount of such IRBs was used to finance the cost of acquiring, constructing and equipping specific child care centers. The IRBs are secured by these centers. At May 30, 2003, the IRBs bore interest at rates of 2.98% to 4.55%.
Senior Subordinated Notes. In fiscal 1997, we issued $300.0 million aggregate principal amount of 9.5% unsecured senior subordinated notes under an indenture between Marine Midland Bank, as
trustee, and us. During fiscal 2000 we acquired $10.0 million aggregate principal amount of our 9.5% senior subordinated debt at an aggregate price of $9.6 million. This transaction resulted in a write-off of deferred financing costs of $0.3 million and a gain of approximately $0.1 million.
During the fourth quarter of fiscal 2003, we committed to acquire $11.0 million aggregate principal amount of our 9.5% senior subordinated notes at an aggregate price of $11.1 million, which included loss of $0.1 million. In addition, this transaction resulted in the write-off of deferred financing costs of $0.2 million. The $0.3 million of costs related to the loss and the write-off of the deferred financing costs associated with the repurchase were included in interest expense in fiscal 2003. The $11.4 million aggregate purchase, which included $0.3 million of accrued interest, was completed in June 2003.
During fiscal year 2004, we have acquired an additional $41.0 million aggregate principal amount of our 9.5% senior subordinated notes at an aggregate price of $41.8 million, resulting in the write-off of deferred financing costs of $0.9 million and a loss of approximately $0.8 million that will be recognized during fiscal 2004. We used $37.0 million of proceeds from our debt refinancing and $4.0 million of cash flow from operations to repurchase the 9.5% senior subordinated notes. We will continue to repurchase aggregate principal amounts of our 9.5% subordinated notes using cash flow from operations and proceeds under our sale-leaseback program as long as the market supports such transactions.
The 9.5% notes are due February 15, 2009 and are general unsecured obligations, ranked behind all existing and future indebtedness that is not expressly ranked behind, or made equal with, the notes. The 9.5% notes bear interest at a rate of 9.5% per year, payable semi-annually on February 15 and August 15 of each year. The 9.5% notes may be redeemed at any time, in whole or in part, on or after February 15, 2002 at a redemption price equal to 104.75% of the principal amount of the notes in the first year and declining yearly to par at February 15, 2005, plus accrued and unpaid interest, if any, to the date of redemption.
Upon the occurrence of a change of control, we will be required to make an offer to repurchase all notes properly tendered at a price equal to 101% of the principal amount plus accrued and unpaid interest to the date of repurchase.
The indenture governing the notes contains covenants that limit our ability to:
o incur additional indebtedness or liens,
o incur or repay other indebtedness,
o pay dividends or make other distributions,
o repurchase equity interests,
o consummate asset sales,
o enter into transaction with affiliates,
o merge or consolidate with any other person or sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of our assets, and
o enter into guarantees of indebtedness.
Principal Payments. At May 30, 2003, the aggregate minimum annual maturities of long-term debt for the five fiscal years subsequent to May 30, 2003 were as follows, with dollars in thousands:
Fiscal Year: 2004........................................ $ 13,744 2005........................................ 6,297 2006........................................ 2,810 2007........................................ 2,815 2008........................................ 178,838 Thereafter.................................. 250,576 ------------ $ 455,080 ============
In accordance with SFAS No. 6, "Classification of Short-Term Obligations Expected to Be Refinanced, an Amendment of ARB No. 43, Chapter 3A," the $104.0 million balance on our previous revolving credit facility and the current portion of our $47.0 million term loan facility were classified as long-term debt at May 30, 2003 since those current obligations were financed on a long-term basis subsequent to May 30, 2003. Both are reflected above in accordance with the payment schedule required as a result of the refinancing.
9. Restructuring Charges (Reversals)
During the fourth quarter of fiscal 1999, the Board of Directors authorized a provision of $4.0 million for the planned early termination of certain center operating leases. The provision included an estimate of discounted future lease payments and anticipated incremental costs related to closure of the centers. A total of 61 underperforming leased centers were closed: 36 in fiscal 2001 and 25 in fiscal 2000.
By June 1, 2001 we had paid and/or entered into contractual commitments to pay $3.9 million of lease termination and closure costs for such closed centers. During the fourth quarter of fiscal 2001, the remaining reserve of $0.1 million was reversed.
A summary of the lease termination reserve was as follows, with dollars in thousands:
Balance at June 2, 2000...................................... $ 2,946 Payments with respect to the closed centers.................. (2,176) Contractual commitments with respect to the closed centers... (670) Reversal of remaining reserve................................ (100) --------- Balance at June 1, 2001.................................... $ -- =========
A summary of the aggregate financial operating performance of the 61 closed centers was as follows, with dollars in thousands:
10. Income Taxes
The provision for income taxes attributable to income before income taxes and cumulative effect of a change in accounting principle consisted of the following, with dollars in thousands:
A reconciliation between the statutory federal income tax rate and the effective income tax rates on income before income taxes and cumulative effect of a change in accounting principle was as follows, with dollars in thousands:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities were summarized as follows, with dollars in thousands:
The valuation allowance increased by $0.1 million during fiscal 2003 due to the creation of foreign net operating loss carryforwards, of which the eventual utilization are in doubt. Deferred tax assets, net of valuation allowances, have been recognized to the extent that their realization is more likely than not. However, the amount of the deferred tax assets considered realizable could be adjusted in the future as estimates of taxable income or the timing thereof are revised. If we are unable to generate sufficient taxable income in the future through operating results, increases in the valuation allowance may be required through an increase to tax expense in future periods. Conversely, if we recognize taxable income of a suitable nature and in the appropriate periods, the valuation allowance will be reduced through a decrease in tax expense in future periods.
At May 30, 2003, we had $2.5 million of net operating losses available for carryforward that expire over various dates through fiscal year 2010. Utilization of the net operating losses is subject to an annual limitation. We have tax credits available for carryforward for federal income tax purposes of $3.2 million, which are available to offset future federal income taxes through fiscal year 2023.
11. Benefit Plans
Stock Purchase and Option Plans. During fiscal 1997, the Board of Directors adopted and, during fiscal 1998, the stockholders approved the 1997 Stock Purchase and Option Plan for Key Employees of KinderCare Learning Centers, Inc. and Subsidiaries, referred to as the 1997 Plan. The 1997 Plan authorizes grants of stock or stock options covering 5,000,000 shares of our common stock. Grants or awards under the 1997 Plan may take the form of purchased stock, restricted stock, incentive or nonqualified stock options or other types of rights specified in the 1997 Plan.
During fiscal 2003, the Board of Directors adopted the 2002 Stock Purchase and Option Plan for Key California Employees of KinderCare Learning Centers, Inc. and Subsidiaries, referred to as the California Stock Plan. The California Stock Plan authorizes 100,000 shares of our common stock as
available for grants. The California Stock Plan is substantially similar to the 1997 plan, except for modifications required by California law.
During fiscal 2001, certain officers purchased 22,024 shares of restricted common stock in aggregate, respectively, under the terms of the 1997 Plan. No shares were purchased in fiscal 2003 or 2002. All of the officers, with the exception of the CEO, have executed term notes in order to purchase restricted stock. The term notes mature from calendar 2005 to 2011 and bear interest at rates ranging from 2.69% to 4.44% per annum, payable semi-annually on June 30 and December 31. At May 30, 2003, the term notes totaled $1.1 million and are reflected as a component of stockholders' equity.
Grants or awards under the 1997 Plan and the California Plan are made at fair market value as determined by the Board of Directors. Options granted during fiscal 2003, 2002 and 2001 have exercise prices ranging from $12.21 to $14.67 per share. At May 30, 2003, options outstanding had exercise prices ranging from $9.50 to $14.67. A summary of outstanding options for the 1997 Plan and the California Plan was as follows:
The stock options granted were non-qualified options that vest 20% per year over a five-year period. Options outstanding at May 30, 2003 had the following characteristics:
1997 Plan California Plan --------- --------------- Exercisable options.................. 1,460,860 1,000 Weighted average exercise price...... $ 9.89 $ 13.61 Remaining average contractual life, in years........................... 5.8 8.4
There were 2,213,362 shares and 93,000 shares available for issuance under the 1997 Plan and the California Plan at May 30, 2003, respectively.
We have adopted the disclosure only provisions of SFAS No. 148. Accordingly, no compensation cost has been recognized for stock options granted with an exercise price equal to or less than the fair value of the underlying stock on the date of grant. Please see "Note 2. Summary of Significant Accounting Policies, Stock-Based Compensation" for our pro forma disclosures of net income and earnings per share had compensation cost been recognized for our stock options.
Savings and Investment Plan. The Board of Directors adopted the KinderCare Learning Centers, Inc. Savings and Investment Plan, referred to as the Savings Plan, effective January 1, 1990 and approved the restatement of the Savings Plan effective July 1, 1998. Effective June 10, 2003, the Board
approved the adoption of a new prototype plan. All employees, other than highly compensated employees, over the age of 21 are eligible to participate in the Savings Plan on entry dates of April 1 and October 1, whichever most closely follows the employee's date of hire. Participants may contribute, in increments of 1%, up to $12,000 per calendar year to the Savings Plan. We have matched participants' contributions up to 1% of compensation on a discretionary basis. During fiscal years 2003, 2002 and 2001, we contributed $0.4 million, $0.3 million and $0.4 million, respectively, to the Savings Plan.
Nonqualified Deferred Compensation Plan. The Board of Directors adopted the KinderCare Learning Centers, Inc. Nonqualified Deferred Compensation Plan, effective August 1, 1996 and approved a restatement of the plan effective January 1, 1999. Under the Nonqualified Deferred Compensation Plan, certain highly compensated or key management employees are provided the opportunity to defer receipt and income taxation of such employees' compensation. We have matched participants' contributions up to 1% of compensation on a discretionary basis. During each of fiscal years 2003, 2002 and 2001 we contributed $0.1 million to the Nonqualified Deferred Compensation Plan.
Directors' Deferred Compensation Plan. On May 27, 1998, the Board of Directors adopted the KinderCare Learning Centers, Inc. Directors' Deferred Compensation Plan. Under this plan, non-employee members of the Board of Directors may elect to defer receipt and income taxation of all or a portion of their annual retainer. Any amounts deferred under the Directors' Deferred Compensation Plan are credited to a phantom stock account. The number of shares of phantom stock credited to the director's account will be determined based on the amount of deferred compensation divided by the then fair value per share, as defined in the Directors' Deferred Compensation Plan, of our common stock.
Distributions from the Directors' Deferred Compensation Plan are made in cash and reflect the value per share of the common stock at the time of distribution multiplied by the number of phantom shares credited to the director's account. Distributions from the Directors' Deferred Compensation Plan occur upon the earlier of (1) the first day of the year following the director's retirement or separation from the Board or (2) termination of the Directors' Deferred Compensation Plan.
12. Disclosures About Fair Value of Financial Instruments
Fair value estimates, methods and assumptions are set forth below for our financial instruments at May 30, 2003 and May 31, 2002.
Cash and cash equivalents, receivables, investments and current liabilities. Fair value approximates the carrying value of cash and cash equivalents, receivables and current liabilities as reflected in the consolidated balance sheets at May 30, 2003 and May 31, 2002 because of the short-term maturity of these instruments. Our minority investments, accounted for under the cost method, are recorded at cost or net realizable value, which approximate fair value.
Long-term debt. Based on recent market activity, the estimated fair value of our $290.0 million of 9.5% senior subordinated notes was $293.1 million at May 30, 2003. At May 31, 2002, the estimated fair value approximated the $290.0 million book value of the 9.5% senior subordinated notes. The carrying values for our remaining long-term debt of $165.1 and $242.3 million at May 30, 2003 and May 31, 2002, respectively, approximated market value based on current rates. At August 22, 2003, we had $238.0 million outstanding on our 9.5% senior subordinated notes with an estimated fair value of $244.0 million.
13. Acquisitions
In April 2001, we acquired Mulberry Child Care Centers, Inc., referred to as Mulberry, a child care and early education company based in Dedham, Massachusetts. We acquired 100% of Mulberry's
stock in exchange for 860,000 shares of our common stock valued at $11.8 million. In connection with the transaction, we paid $13.1 million to the sellers and assumed $3.3 million of Mulberry's debt. In August 2002, 119,838 of the 860,000 shares were returned to us, which included 99,152 shares that were released from an indemnity escrow and 20,686 shares that were repurchased from certain former shareholders of Mulberry. All 119,838 shares have been cancelled. Our subsidiary, KC Distance Learning, Inc., acquired NLKK, Inc., referred to as NLKK, a distance learning company based in Bloomsburg, Pennsylvania in June 2000. NLKK was purchased for $15.1 million in cash. See "Consolidated Statements of Cash Flows."
Both acquisitions were accounted for under the purchase method. The results of operations for Mulberry and NLKK for the periods subsequent to the acquisitions were included in our results of operations for all periods presented. The purchase price for both transactions was allocated to the assets and liabilities of the respective companies based on their estimated fair values. Goodwill from the purchase of Mulberry totaled $26.4 million and from NLKK totaled $15.2 million. The net book value of goodwill related to these acquisitions was $40.0 million at May 30, 2003 and May 31, 2002 and $38.6 million at June 1, 2001.
14. Commitments and Contingencies
We conduct a portion of our operations from leased or subleased day care centers. At May 30, 2003, we leased 529 operating centers under various lease agreements that average twenty year terms. Most leases contain standard renewal clauses. A majority of the leases contain standard covenants and restrictions, all of which we were in compliance with at May 30, 2003. A majority of the leases are classified as operating leases for financial reporting purposes. We have 15 center leases that were classified as capital leases, as well as certain equipment capital leases.
During the fourth quarter of fiscal year 2002, we began selling centers to individual real estate investors and then leasing them back. The resulting leases have been classified as operating leases. We will continue to manage the operations of any centers that are sold in such transactions. The sales are summarized as follows, with dollars in thousands:
The deferred gains are amortized on a straight-line basis typically over a period of 15 years.
Each vehicle in our fleet is leased pursuant to the terms of a 12-month non-cancelable master lease which may be renewed on a month-to-month basis after the initial 12-month lease period. Payments under the vehicle leases vary with the number, type, model and age of the vehicles leased. The vehicle leases require that we guarantee specified residual values upon cancellation. At May 30, 2003, our residual guarantee was $5.7 million. In most cases, we expect that substantially all of the leases will be renewed or replaced by other leases as part of the normal course of business. All such leases are classified as operating leases. Expenses incurred in connection with the fleet vehicle leases were $9.2 million, $9.8 million and $11.7 million for fiscal 2003, 2002 and 2001, respectively.
Following is a schedule of future minimum lease payments under capital and operating leases, that have initial or remaining non-cancelable lease terms in excess of one year at May 30, 2003, with dollars in thousands:
In July 2003 we completed a refinancing of a portion of our debt, which included terminating the $97.9 million synthetic lease facility. See "Note 8. Long-Term Debt."
The present value of the future minimum lease payments for leases classified as capital leases were as follows, with dollars in thousands:
The net book value of property and equipment recorded under capital leases was as follows, with dollars in thousands:
In fiscal year 2000, we entered into a $100.0 million synthetic lease facility under which a syndicate of lenders financed the construction of new centers for lease to us for a three to five year period. A total of 44 centers were constructed for $97.9 million. As noted above, the synthetic lease facility was terminated in July 2003 as part of our refinancing. The 44 centers are now owned by us and the assets will be reflected in our fiscal year 2004 consolidated financial statements.
We are presently, and are from time to time, subject to claims and litigation arising in the ordinary course of business. We believe that none of the claims or litigation of which we are aware will
materially affect our financial position, operating results or cash flows, although assurance cannot be given with respect to the ultimate outcome of any such actions.
15. Subsequent Event
In July 2003 we refinanced a portion of our debt. We obtained a $300.0 million mortgage loan, as well as a new $125.0 million revolving credit facility. See "Note 8. Long-Term Debt" for a more detailed discussion of the mortgage loan and revolving credit facility.
16. Quarterly Results (Unaudited)
A summary of results of operations for fiscal 2003 and fiscal 2002 was as follows, with dollars in thousands, except per share data. The first quarter of each fiscal year included 16 weeks and the second, third and fourth quarters each included 12 weeks. The quarterly results for the first three quarters of fiscal 2003 and each of the four quarters of fiscal 2002 were restated to exclude the operating results of 28 centers closed in fiscal 2003. The operating results for these centers were classified as discontinued operations.
(a) Net income during the fourth quarter of fiscal 2003 and fiscal 2002 included a loss on minority investment of $4.0 million and $1.4 million, net of taxes, respectively.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders KinderCare Learning Centers, Inc.
We have audited the accompanying consolidated balance sheets of KinderCare Learning Centers, Inc., and subsidiaries as of May 30, 2003 and May 31, 2002, and the related consolidated statements of operations, stockholders' equity and comprehensive income, and cash flows for each of the years ended May 30, 2003, May 31, 2002 and June 1, 2001. 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 auditing standards generally accepted in the United States of America. 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, such consolidated financial statements present fairly, in all material respects, the financial position of KinderCare Learning Centers, Inc. and subsidiaries as of May 30, 2003 and May 31, 2002, and the results of their operations and their cash flows for each of the years ended May 30, 2003, May 31, 2002 and June 1, 2001, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, effective June 1, 2002.
DELOITTE & TOUCHE LLP
Portland, Oregon August 11, 2003
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. DISCLOSURE CONTROLS AND PROCEDURES
Disclosure Controls and Procedures. Our management has evaluated, under the supervision and with the participation of our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the "Exchange Act"). Based on that evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting. There has been no change in our internal control over financial reporting that occurred during our fiscal year ended May 30, 2003 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding directors appearing under the caption "Election of Directors" and "Board of Directors Meetings, Committees and Compensation" in our Proxy Statement for the 2003 Annual Meeting of Shareholders is hereby incorporated by reference.
Information regarding executive officers is included in Part I of this report, see "Item 4(a), Executive Officers of the Registrant."
Information required by Item 405 of Regulation S-K appearing under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in our 2003 Proxy Statement is hereby incorporated by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information appearing under the captions "Board of Directors Meetings, Committees and Compensation" and under "Executive Compensation" in our 2003 Proxy Statement is hereby incorporated by reference. See "Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters," for information concerning our equity compensation plans.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information appearing under the captions "Security Ownership of Certain Beneficial Owners and Management" and "Equity Compensation Plans" in our 2003 Proxy Statement is hereby incorporated by reference. See "Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters," for information concerning our equity compensation plans.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information appearing under the caption "Certain Relationships and Related Transactions," in our 2003 Proxy Statement is hereby incorporated by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information appearing under the caption "Independent Public Accountants" in our 2003 Proxy Statement is hereby incorporated by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The following is an index of the financial statements, schedules and exhibits included in this report or incorporated herein by reference:
(a)(1) Financial Statements:
Page Consolidated balance sheets at May 30, 2003 and May 31, 2002...... 42 Consolidated statements of operations for the fiscal years ended May 30, 2003, May 31, 2002 and June 1, 2001........... 43 Consolidated statements of stockholders' equity and comprehensive income for the fiscal years ended May 30, 2003, May 31, 2002 and June 1, 2001................. 44 Consolidated statements of cash flows for the fiscal year ended May 30, 2003, May 31, 2002 and June 1, 2001................. 45 Notes to consolidated financial statements........................ 46-65 Independent auditors' report...................................... 66
(a)(2) Schedules to Financial Statements: None.
(a)(3) Exhibits: The following exhibits are filed with this report or incorporated herein by reference:
Exhibit Description Number of Exhibits - ------- ---------------
2(a) Stockholders' Agreement between KinderCare and the stockholders parties thereto (incorporated by reference from Exhibit 2.3 of our Registration Statement on Form S-4, filed March 11, 1997, File No. 333-23127).
3(a) Amended and Restated Certificate of Incorporation of KinderCare (incorporated by reference from Exhibit 3(a) to our Annual Report on Form 10-K for the fiscal year ended May 31, 2002).
3(b) Restated Bylaws of KinderCare effective September 1, 2001 (incorporated by reference from Exhibit 3(a) to our Quarterly Report on Form 10-Q for the quarterly period ended September 21, 2001).
4(a) Indenture dated February 13, 1997 between KinderCare and Marine Midland Bank, as Trustee (incorporated by reference from Exhibit 4.1 of our Registration Statement on Form S-4, filed March 11, 1997, File No. 333-23127).
4(b) First Supplemental Indenture dated September 1, 1999 to the Indenture dated as of February 13, 1997 between KinderCare and HSBC Bank USA (formerly known as Marine Midland Bank), as Trustee (incorporated by reference from Exhibit 4(a) to our Quarterly Report on Form 10-Q for the quarterly period ended September 17, 1999).
4(c) Form of 9.5% Series B Senior Subordinated Note due 2009 (incorporated by reference from Exhibit 4.3 of our Registration Statement on Form S-4, filed March 11, 1997, File No. 333-23127).
10(a) Revolving Credit Agreement dated July 1, 2003 among KinderCare, the several lenders from time to time parties thereto (referred to as Lenders), and Citicorp North America, Inc. as Administrative Agent for the lenders.
10(b) Guarantee dated July 1, 2003 among certain subsidiaries of KinderCare and Citicorp North America, Inc.
Exhibit Description Number of Exhibits - ------- ---------------
10(c) Pledge Agreement dated July 1, 2003 among KinderCare, certain subsidiaries of KinderCare and Citicorp North America, Inc..
10(d) Security Agreement dated July 1, 2003 among KinderCare, certain subsidiaries of KinderCare and Citicorp North America, Inc.
10(e) Form of Mortgage, Assignment of Leases and Rents, Security Agreement and Financing Statement dated July 1, 2003 from KinderCare and certain subsidiaries of KinderCare to Citicorp North America, Inc.
10(f) Registration Rights Agreement dated February 13, 1997 among KCLC Acquisition, KLC Associates L.P. and KKR Partners II, L.P. (incorporated by reference from Exhibit 10.2 of our Registration Statement on Form S-4, filed March 11, 1997, File No. 333-23127).
10(g) Lease between 600 Holladay Limited Partnership and KinderCare dated June 2, 1997 (incorporated by reference from Exhibit 10(f) of our Annual Report on Form 10-K for the fiscal year ended May 30, 1997).
10(h) Addendum dated June 28, 2000 to Lease dated June 2, 1997 between 600 Holladay Limited Partnership and KinderCare (incorporated by reference from Exhibit 10(a) to our Quarterly Report on Form 10-Q for the quarterly period ended September 22, 2000).
10(i)* 1997 Stock Purchase and Option Plan for Key Employees of KinderCare Learning Centers, Inc. and Subsidiaries (incorporated by reference from Exhibit 10(c) to our Quarterly Report on Form 10-Q for the quarterly period ended September 19, 1997).
10(j)* 2002 Stock Purchase and Option Plan for Key California Employees.
10(k)* Form of Restated Management Stockholder's Agreement (incorporated by reference from Exhibit 10(f) to our Annual Report on Form 10-K for the fiscal year ended June 1, 2001).
10(l)* Form of Non-Qualified Stock Option Agreement (incorporated by reference from Exhibit 10(g) to our Annual Report on Form 10-K for the fiscal year ended June 1, 2001).
10(m)* Form of Restated Sale Participation Agreement (incorporated by reference from Exhibit 10(h) to our Annual Report on Form 10-K for the fiscal year ended June 1, 2001).
10(n)* Form of Term Note.
10(o)* Form of Pledge Agreement (incorporated by reference from Exhibit 10(h) to our Quarterly Report on Form 10-Q for the quarterly period ended September 19, 1997).
10(p)* Stockholders' Agreement dated as of February 14, 1997 between KinderCare and David J. Johnson (incorporated by reference from Exhibit 10(l) to our Quarterly Report on Form 10-Q for the quarterly period ended September 19, 1997).
10(q)* Nonqualified Stock Option Agreement dated February 14, 1997 between KinderCare and David J. Johnson (incorporated by reference from Exhibit 10(j) to our Quarterly Report on Form 10-Q for the quarterly period ended September 19, 1997).
10(r)* Sale Participation Agreement dated February 14, 1997 among KKR Partners II, L.P., KLC Associates, L.P. and David J. Johnson (incorporated by reference from Exhibit 10(k) to our Quarterly Report on Form 10-Q for the quarterly period ended September 19, 1997).
10(s)* Directors' Deferred Compensation Plan (incorporated by reference from Exhibit 10(q) to our Annual Report on Form 10-K for the fiscal year ended May 29, 1998).
10(t) Form of Indemnification Agreement for Directors and Officers of KinderCare (incorporated by reference from Exhibit 10(r) to our Annual Report on Form 10-K for the fiscal year ended May 29, 1998).
10(u)* Restated Nonqualified Deferred Compensation Plan effective January 1, 1999 (incorporated by reference from Exhibit 10(a) to our Quarterly Report on Form 10-Q for the quarterly period ended March 5, 1999).
10(v)* Form of Executive Split Dollar Life Insurance Agreement (incorporated by reference from Exhibit 10(b) to our Quarterly Report on Form 10-Q for the quarterly period ended March 5, 1999).
Exhibit Description Number of Exhibits - ------- ---------------
10(w) Loan Agreement dated July 1, 2003 between KC Propco, LLC and Morgan Stanley Mortgage Capital, Inc.
10(x) First Amendment to Loan Agreement dated August 1, 2003 between KC Propco, LLC and Morgan Stanley Capital, Inc.
10(y) Management Agreement dated July 1, 2003 between KC Opco, LLC and KinderCare.
10(aa) Lease Agreement dated July 1, 2003 between KC Propco, LLC and KC Opco, LLC.
10(bb)* Form of letter regarding the Fiscal Year 2004 Management Bonus Plan.
10(cc)* Employment Separation Agreement, Waiver and Release dated October 9, 2002, between KinderCare and Robert Abeles (incorporated by reference from Exhibit 10(aa) of our Registration Statement on Form 10, filed December 9, 2002, File No. 0-17098).
21 Subsidiaries of KinderCare.
23 Independent Auditors' Consent - Deloitte & Touche LLP.
31(a) Rule 13(a)-14(a) Certification of Chief Executive Officer.
31(b) Rule 13(a)-14(a) Certification of Chief Financial Officer.
32(a) Section 1350 Certification of Chief Executive Officer.
32(b) Section 1350 Certification of Chief Financial Officer.
* Management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K: Filed April 22, 2003 for third quarter earnings released April 21, 2003.
(c) Exhibits Required by Item 601 of Regulation S-K: The exhibits to this report are listed under Item 15(a)(3) above.
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, on August 28, 2003.
KINDERCARE LEARNING CENTERS, INC.
By: /s/ DAVID J. JOHNSON ------------------------------------ David J. Johnson Chief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer)
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 indicated on August 28, 2003:
By: /s/ DAVID J. JOHNSON ------------------------------------ David J. Johnson Chief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer)
By: /s/ DAN R. JACKSON ------------------------------------ Dan R. Jackson Executive Vice President, Chief Financial Officer (Principal Financial and Accounting Officer)
By: /s/ HENRY R. KRAVIS ------------------------------------ Henry R. Kravis Director
By: /s/ GEORGE R. ROBERTS ------------------------------------ George R. Roberts Director
By: /s/ MICHAEL W. MICHELSON ------------------------------------ Michael W. Michelson Director
By: /s/ SCOTT C. NUTTALL ------------------------------------ Scott C. Nuttall Director
By: /s/ RICHARD J. GOLDSTEIN ------------------------------------ Richard J. Goldstein Director