Item 1. Business
As used herein, and except where the context otherwise requires, the terms “MDS” and the “Company” refer to Midas, Inc. and its consolidated subsidiaries. The term “Midas” refers to the Midas retail system only. The term “SpeeDee” refers to the SpeeDee retail system. References to fiscal years are to years ended January 1, 2011 (“fiscal 2010”), January 2, 2010 (“fiscal 2009”), and January 3, 2009 (“fiscal 2008”).
Background
MDS has been in the business of selling automotive repair franchises since 1956. Through March of 2008, the Company’s sole franchise concept was Midas auto repair centers. In April of 2008, MDS acquired the SpeeDee Oil Change and Tune-up franchise system and now sells Midas, SpeeDee and Midas-SpeeDee co-branded franchises.
The Midas network of franchised and company-operated shops is one of the largest and most recognized providers of automotive repair and maintenance services in North America with 1,538 shops, located in all 50 U.S. states and nine Canadian provinces as of January 1, 2011. The SpeeDee network of franchised and company-operated shops consists of 106 shops in the U.S., located in 10 states. In addition, both Midas and SpeeDee license their brands outside of North America. There are 781 Midas shops licensed in 13 other countries, and 65 licensed SpeeDee shops in Mexico. On a worldwide basis, there were 2,490 Midas and SpeeDee shops as of January 1, 2011.
From 1972 to 1998, the MDS business was owned by Whitman Corporation (“Whitman”). MDS became an independent public company on January 30, 1998 in a spin-off transaction whereby Whitman distributed all issued and outstanding shares of MDS to shareholders of record of Whitman stock.
MDS’s principal executive offices are located at 1300 Arlington Heights Road, Itasca, Illinois 60143, and its telephone number is (630) 438-3000. The Company’s Internet address is www.Midas.com. MDS makes available, free of charge on or through its website, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission.
Franchise Industry Overview
There are two main types of franchises: product distribution franchises and business format franchises. In product distribution franchising, the franchisor licenses its trademark and logo to its franchisee, and allows the franchisee to sell its products; however, the product distribution franchisor typically does not provide the franchisee with a system for running the business. Examples of such franchises are automotive dealerships, soft drink bottlers, and gas stations. A business format franchise not only allows the franchisee to use the franchisor’s trademark, but also provides the franchisee with a system to conduct operations. Midas and SpeeDee are business format franchises. Business format franchises are the most common type of franchise, encompassing businesses such as fast food, retail, lodging, personal services, and automotive repair. Besides Midas, some of the larger automotive service franchisors include Jiffy Lube, AAMCO, Meineke, and MAACO. According to a recent national study, business format franchised businesses in the U.S. produced goods and services worth approximately $706 billion across more than 765,000 franchised establishments in 2010.
Business format franchising is a synergistic way of doing business. The franchisor provides the franchisee with an established and proven business system. For the new franchisee, the franchisor provides initial training, an operations manual, and an established brand name. Thus, the franchisee is more likely to be initially
successful than if he tried to start a new business on his own. The franchisee owns his own business, but also has access to support from the franchisor and his fellow franchisees. On an ongoing basis, the franchisor develops various programs to support the franchisee and the brand. Such programs include advertising, marketing, training, and development of supply chain relationships.
For the franchisor, the benefits of the relationship go well beyond the royalties and fees. Franchisees have invested their own capital in their businesses, and thus have greater motivation to succeed than the average company employee. Strong motivation is especially important in a service business such as auto repair. The Company believes that franchisees can also deliver superior results due to their knowledge of local markets, their involvement in local communities, and their potential for innovation.
The Company believes Midas and SpeeDee franchises are an attractive proposition for a wide variety of people. Some franchisees have prior experience in the automotive aftermarket. They want to be their own boss, but find comfort in being associated with a larger organization and a leading brand. Some franchisees were successful businesspersons in other fields, but are looking for a new career for themselves and/or their families. The training and support available from MDS is attractive to them, as are the relative prospects for the automotive service business.
Economists forecast that the unemployment rate will continue to remain elevated in the United States for the next several years. Many people are searching for new ways to earn money. For those who are employed, the fear of future layoffs may also motivate them to search for alternatives in which they can be their own boss, and have greater control over their own financial well being. While this economic environment is stimulating increased interest in becoming a franchisee, most candidates rely at least in part on financing in order to buy a franchise. Certain measures have been taken by the U.S. Government to improve access to capital for small business formation, but the credit markets remain tight. MDS anticipates the availability of financing will constrain the growth in the number of people who can become franchisees in the near term.
Automotive Aftermarket Industry Overview
Midas and SpeeDee compete in the approximately $165 billion U.S. automotive aftermarket industry, which includes replacement parts (excluding collision parts and parts for heavy duty trucks), accessories, maintenance items, batteries and automotive fluids for cars and light trucks. Approximately 87% of this amount is from the sale of installed parts and labor (the Do-It-For-Me or “DIFM” segment of the market) and 13% is from the Do-It-Yourself or “DIY” market. Midas and SpeeDee participate in the DIFM segment of the market, but do not participate in the DIY market.
Historically, the DIFM market has been growing because of the increasing size and age of the country’s automotive fleet, the increased technological complexity of vehicles leading to higher cost repairs and maintenance, and the generally increasing number of miles driven annually. In addition, recent industry statistics indicate that there is more than $54 billion in neglected vehicle maintenance every year.
According to published industry information, the number of vehicles in use in the U.S. grew every year from 1992 through 2008, primarily as a result of steady annual increases in new light truck sales. In addition, the average age of vehicles in use continues to increase. From 1995 to 2009, the average age of cars in use grew from 8.4 years to 10.6 years. While the number of vehicles in use declined slightly in 2009, the slowdown in new car sales has caused a further aging of the vehicle population. This trend should continue to benefit the DIFM industry because older vehicles tend to require more maintenance and repair services.
The increased technological sophistication of modern automobiles has also had a positive effect on the DIFM industry. Although vehicle parts have become more durable, many parts are now more technologically advanced. As a result, the cost to diagnose and repair today’s high-technology vehicles has increased. Most automotive service providers have attempted to offset the decline in revenue resulting from the improved durability of automotive parts by expanding their service menus.
Vehicle usage influences the demand for automotive repair and maintenance. Vehicle usage causes wear and tear, leading to the need for vehicle repair. Vehicle usage also influences vehicle maintenance, as maintenance schedules are generally based upon odometer readings. Miles driven is a key indicator of vehicle usage. Historically, since the end of World War II, total miles driven in the United States have increased nearly every year. However, in the 12 months ended December 2008, total miles driven declined 3.4%, by far the largest annual decline since World War II. The dramatic increase in gasoline prices in 2007 and 2008 and the very weak economic climate appear to have influenced driving habits in an unprecedented fashion. In both 2009 and 2010, miles driven were up slightly, but they remain at approximately the level recorded in 2005.
One additional industry trend of note has been the steady decline in the number of service outlets in the U.S. over the past 10 years. The decrease is largely attributable to a reduction in the number of local service stations offering automotive repair. More recently, however, automobile dealerships have been closing in record numbers, causing consumers to seek out alternatives. Offsetting this decline has been an increase in the number of independent maintenance and repair shops and large automotive repair chains. It is expected that the current economic environment will lead to an accelerated level of closures across all automotive service providers, allowing the remaining outlets to gain market share.
Company Overview
MDS operates in a single business segment with retail, real estate, supply chain and point-of-sale technology operations in support of the franchising of Midas and SpeeDee automotive service shops in North America. Retail operations consist of company-operated Midas and SpeeDee shops. Real estate activities include the development, ownership and leasing of Midas and SpeeDee shops in the U.S. and Canada. Supply chain activities include providing value-added merchandising services to franchisees in which the Company establishes relationships with vendors who distribute products and equipment directly to Midas and SpeeDee shops. Point-of-sale technology operations consist of the ownership, development, sale and leasing of automotive shop management software to Midas franchisees and other third-party automotive service providers. Outside of North America the Company operates on a master-franchise basis whereby the Midas and SpeeDee trademarks are licensed to master franchisees that sub-franchise Midas and SpeeDee shops in their respective territories.
The following table sets forth the number of North American franchised shops, company-operated shops, and shops outside of North America for each of the Midas and SpeeDee brands, as of the end of each of the fiscal periods indicated (note that the SpeeDee brand was acquired by MDS in fiscal 2008):
As of January 1, 2011, there were 46 shops within the Midas and SpeeDee systems operating as Co-Brand locations. These are included in the year end 2010 totals.
A further discussion of the Company’s business activities follows.
Franchises and the North American Midas and SpeeDee Systems
MDS is the franchisor of the Midas franchise system throughout North America and the SpeeDee franchise system in the U.S. Both Midas and SpeeDee have developed methodologies and systems for the establishment and operation of franchised auto service shops. These systems include site selection, shop construction and layout, equipment selection and installation, purchasing and inventory control methods, accounting methods, merchandising, advertising, sales and promotional techniques, installation techniques, personnel training and other matters relating to the efficient and successful operation of auto service shops and the maintenance of high standards of quality.
Midas and SpeeDee identify and qualify franchisees through a well-organized recruitment program. Franchisees are qualified based primarily upon a candidate’s financial suitability and operational experience, among other criteria. MDS also considers a franchisee’s ability to work within the franchise system. Each franchisee enters into a standard franchise and trademark agreement with the Company. The franchise and trademark agreements vary by country, but these variances do not substantially alter the franchise arrangement. The franchise agreements cover all aspects of the contractual relationship between the franchisor and franchisee, including: terms and fees of the franchise agreement, royalty payments, advertising, real estate control, site selection, training, equipment and inventory requirements for the proper operation of a shop, warranty programs and shop management software requirements. All franchise agreements prevent ownership of a competing auto service business.
Summarized below are key aspects of the current forms of franchise agreements offered by MDS as franchisor for both the Midas and SpeeDee franchise systems:
Midas Franchise Agreement: The initial term of the franchise agreement is 20 years. The initial franchise fee is $30,000 for the first shop, and is due at the time the franchise and trademark agreement is signed. This agreement is generally not signed until the franchisee has a shop that is ready to open. Prior to opening a Midas shop, franchisees are required to complete a training program. In opening a Midas shop, a franchisee typically makes additional expenditures relating to fixtures, machinery and equipment and initial product inventory. The Midas franchise agreement may be terminated by the franchisee upon thirty days’ written notice.
Midas franchisees pay the Company monthly royalties based on a percentage of sales. Monthly royalty payments must be made via automated clearing house (“ACH”) debit. The royalty on most service categories is 10% of sales. The Company is obligated to spend an amount equal to one-half of the royalty payments it receives from Midas franchisees for advertising placed during the calendar year the royalties are received or during the following calendar year. The Company, as franchisor, administers the use of franchise advertising funds. MDS incurs additional advertising costs that are included in its selling, general and administrative expenses.
An important feature of the Midas system is the requirement that the retail customer be provided a written warranty from the Company on certain Midas products that will be honored at all Midas shops in North America. Each Midas shop is required to honor such warranties in accordance with their terms and with policies issued from time to time by the Company. See “Supply Chain Activities” below for a more detailed description of the Midas warranty program.
In most instances, MDS retains, through real estate agreements between franchisees and Midas Realty (described below), the ability to occupy a site in the event of a termination of the applicable franchise agreement. This ensures that the site may continue to be operated as a Midas shop.
SpeeDee Franchise Agreement: The initial term of the SpeeDee franchise agreement is 15 years. The initial franchise fee is $30,000 for the first shop, and is due at the time the franchise and trademark agreement is signed. Unlike the Midas system, the SpeeDee franchise and trademark agreement is signed when the franchisee is
approved and before a site is located. Prior to opening a SpeeDee shop, franchisees are required to complete a training program. In opening a SpeeDee shop, a franchisee typically makes additional expenditures relating to fixtures, machinery and equipment and initial product inventory. The SpeeDee franchise and trademark agreement cannot be terminated by the franchisee.
SpeeDee franchisees pay the Company weekly royalties based on a percentage of sales. Weekly payments must be made via ACH debit. The royalty on most service categories is 6% of sales (5% for brakes). In addition, franchisees pay 6% of sales each week to support advertising and promotions, primarily within a shop’s Designated Marketing Area (DMA). The Company, as franchisor, administers the use of franchise advertising funds.
The SpeeDee franchise agreement provides for real estate control of the location by the franchisor. However, SpeeDee had not historically mandated compliance with this aspect of the franchise agreement, but is doing so on a go-forward basis.
The Midas-SpeeDee Co-Brand Franchise Agreement: As of January 1, 2011, there were 46 Co-Brand locations in operation. Of these, 26 were company-operated units and 20 were franchised units. Two locations had been opened de novo as Co-Brand shops with the remaining converted from the existing Midas or SpeeDee shop formats. The Company has developed a Co-Brand franchise agreement that is being used with the franchised Co-Brand locations. The initial term is 15 years. The initial fee is $40,000 for single shop owners. Existing Midas and SpeeDee franchisees who convert to the Co-Brand concept will be charged an initial fee of $10,000. The Midas-SpeeDee franchise and trademark agreement cannot be terminated by the franchisee.
Co-Brand franchisees must pay the Company weekly royalties based on a percentage of sales. Weekly payments must be made via ACH debit. The royalty is generally either 5% or 6% of sales depending on the service category and whether the shop was originally a Midas or SpeeDee location. An equal amount is collected for advertising and promotions. The Company, as franchisor, administers the use of franchise advertising funds.
Real estate control is required of all Co-Brand shops. The Midas lifetime warranty program is honored at all Co-Brand locations and, as with the Midas franchise agreement, the franchisee is required to maintain inventory of Midas approved parts sufficient to satisfy the needs of warranty customers. Use of the R.O. Writer shop management software system, as discussed below under “Progressive Automotive Systems and the R.O. Writer Software System,” is required for all Co-Brand locations.
The North American Midas System
The North American Midas system consists of 1,538 shops operated by the Company and its franchisees under the Midas brand. Midas shops provide a comprehensive array of automotive repair and maintenance services and are located in all 50 states and nine Canadian provinces. The Company’s geographic breadth results in substantial market coverage throughout North America and strong credibility for Midas’ North American lifetime warranty program.
Midas benefits from leading market positions in core retail service offerings and strong brand equity. Midas believes it is among the leaders in terms of market share in the North American automotive service industry (excluding tires, collision parts and parts for heavy duty trucks). In 2010, approximately 53% of North American retail system sales were in categories where the Company believes Midas has either the number one or number two market position as shown by its internal estimates of market share.
The Midas retail system enjoys very strong brand recognition, demonstrated by a consumer awareness rate of over 90%, and high levels of customer loyalty through its lifetime warranty program. According to MDS tracking studies, Midas is among the leading brands mentioned by consumers when considering an automotive repair provider.
Midas shops historically operated as under-car specialists. From its inception in 1956 through 1959, the Midas retail system focused exclusively on replacement of exhaust systems. On a national basis, Midas added shock replacement in 1960, brake repair in 1979 and alignment in 1988. MDS estimates that the potential market for these core offerings is only 13% of the approximately $165 billion U.S. automotive aftermarket parts and services industry.
Despite the addition of other under-car services, exhaust replacement remained a vital part of the Midas service mix. As recently as 1997, exhaust replacement services constituted 35% of Midas’ retail shop revenues in the North American market. But as automobile manufacturers began to employ non-corrosive stainless steel exhaust systems in the mid 1980’s, the average life of an original equipment exhaust system began to increase from three years to over 10 years. As a result, beginning in the mid 1990’s, the core exhaust replacement business of Midas shops began to experience sustained revenue declines. This trend, combined with the increased technological complexity and durability of newer vehicles, put significant pressure on the historical Midas shop business model.
In response to these trends, the Midas retail system began to broaden its service menu in 1999, with the purpose of transforming itself from an under-car specialist to a full-service automotive repair and maintenance provider, leveraging the strong brand name and nationwide presence of the Midas system. Beginning in 2000, Midas implemented a New Midas strategy, which included the rollout of new service categories and a renewed focus on customer service. Under the New Midas strategy, the Midas system expanded its retail offerings to include general repair, heat exchange products and climate control services. These New Midas categories more than doubled the size of Midas’ addressable market. Today, most Midas shops offer exhaust, brake, suspension, air conditioning, tires, batteries and a wide variety of other routine maintenance services. Since 1997, U.S. exhaust sales at Midas retail shops have declined at an annual rate of 8.6% on a same-store basis, but this deterioration has been offset by the expansion of Midas’ service offerings into the New Midas categories. Currently, New Midas services account for approximately 47% of system-wide retail sales. The Company continues to expand Midas shop service offerings as it repositions the Midas brand as a source for total car care.
The following table compares the current U.S. Midas retail service mix with last year, five years ago and 20 years ago.
Trend in U.S. Midas Retail Service Mix
The broadening of Midas system retail service offerings has generally offset the continuing deterioration in the exhaust replacement market. As a result, the average sales of a Midas shop have risen slightly over the past five years. The average U.S shop sales were approximately $652,000 in 2010 and $641,000 in 2005. The Company believes that the Midas system has the potential for substantial growth in retail sales.
Midas shops are generally located in free-standing buildings in high traffic areas with good visibility and easy access to major roadways. The Company believes that its portfolio of Midas real estate locations built over the past 50 years could not be easily replicated. Given the limited number of desirable repair shop locations and impediments to opening repair shops resulting from zoning and building code restrictions, as well as landlord and developer requirements, entry into the automobile repair market on a large-scale basis is difficult.
The Company supports the Midas retail network with an annual advertising program that is one of the largest in the automotive aftermarket repair business. North American franchisees pay the Company monthly royalties of approximately 10% of retail sales. MDS is obligated to spend an amount equal to one-half of the
royalty payments received from Midas franchisees for advertising placed during the calendar year in which the royalties are received or during the following calendar year. In addition, the Company incurs supplemental advertising costs, primarily related to its company-operated shops, which are included in selling, general and administrative expenses. In fiscal 2010, total Midas advertising spending in North America was approximately $50.0 million.
An important feature of the Midas system is the requirement that the retail customer be provided a written lifetime warranty from Midas on certain products (namely brake friction, mufflers, shocks and struts) that will be honored at any Midas shop throughout North America. Each Midas shop is required to honor such warranties in accordance with their terms and with policies as issued from time to time by the Company, which ensures consistency throughout the Midas system.
The Company believes that its Midas lifetime warranty program provides a competitive advantage over other automotive repair companies and independent service shops, and the breadth of its geographic coverage makes it difficult to duplicate the Midas program. This program generates recurring business from existing customers and promotes customer loyalty. The Company believes that many of its first-time customers choose Midas based upon the lifetime warranty program. In addition, significant portions of exhaust, brake, shock and strut jobs performed at retail involve customers returning for warranty service. Importantly, most warranty replacement work is profitable at the shop level as, in accordance with the terms of the warranty, customers are charged for labor plus other non-warranted parts necessary for the warranty replacement. Additionally, many Midas customers returning for warranty service choose to spend substantial incremental dollars on additional services. The Company believes that its presence in all 50 states and nine Canadian provinces, coupled with the repeat business generated by its North American lifetime warranty program, can be leveraged to capture a larger percentage of automotive repair and maintenance services in segments other than exhaust, brakes and suspension/steering.
Franchised Midas Shops
As of January 1, 2011, there were 1,437 North American franchised shops, which were located in all 50 U.S. states and nine Canadian provinces. Approximately 630 franchisees operate these shops, with only one franchisee having more than 38 shops. Over 67% of the franchised shops are owned and operated by franchisees with five or fewer shop locations. Approximately 30% of Midas franchised locations are owned by single shop operators, and this percentage is growing.
Midas franchisees are all subject to the Midas Franchise and Trademark Agreement and are obligated to operate their shops in accordance with Midas’ standards and policies. In North America, franchisees are required to maintain a sufficient quantity of approved Midas warranted products-principally mufflers, shock absorbers, struts and brake pads and shoes-adequate to meet the public demand for these products and to promptly fill customers’ requests for replacement under the terms of various Midas warranties. The Company makes Midas warranted products and other automotive parts available to its Midas franchisees through distribution agreements with certain automotive parts suppliers in the U.S. and Canada.
Midas supports the U.S. franchise network with four regional managers, 14 franchise business managers and 19 shop operations managers. Franchise business managers each manage approximately 40 franchisees and focus on business consulting, compliance and franchise matters. Shop operations managers assist franchisees and shop managers with operations execution and support Midas’ on-site training efforts for both new and existing franchisees.
In Canada, Midas supports the Canadian franchisee network with a general manager, four district managers and one shop operations manager.
A typical franchised Midas shop is approximately 4,000 square feet and has six service bays. In 2010, the average U.S. franchised shop had sales of $650,000, while the average Canadian franchised shop had sales of C$806,000.
The International Midas Dealers Association (the “IMDA”) is an independent association of Midas franchisees. Approximately 46% of the Midas franchised locations in North America have membership in the IMDA. Midas’ management communicates on a regular basis with IMDA representatives and various IMDA committees to solicit franchisee input on various matters affecting the Midas system.
Company-Operated Midas Shops
The Company believes that owning and operating some Midas shops is an important element of a successful franchise system. Although the company-operated shops business is unprofitable, such ownership allows for the orderly transition of franchises, provides a valuable test-marketing platform for the rollout of new products and services, enables the Company to upgrade underperforming locations and helps to accelerate the successful transition of the entire Midas system to the new business model. Upon acquisition of a shop, the Company typically upgrades shop equipment, expands the services offered, installs new point-of-sale software, updates the shop to the new Midas image, upgrades the quality of technicians, and enhances local marketing efforts.
During fiscal 2010, the Company acquired or opened 23 Midas company-operated shops, re-franchised 20 shops and closed 2 shops. As of January 1, 2011, the Company owned and operated 101 Midas shops in 10 U.S. states and Canada, with the largest concentrations in California (26 shops), Florida (20 shops), Illinois (10 shops), Indiana (9 shops) and Colorado (9 shops), most of which are currently targeted for refranchising.
Going forward, the Company intends to reduce the number of company-operated Midas shop locations through re-franchising. However, from time-to-time, to protect its market position, Midas may acquire additional North American Midas shops.
The typical company-operated Midas shop is staffed with a manager, an assistant manager or shop foreman, and three to four automotive service technicians. The Midas company-operated shop business is managed by a vice president/general manager, four regional operations managers and 15 market managers.
The typical U.S. company-operated shop is approximately 4,000 square feet, has six service bays and generated annual revenues of approximately $679,000 in 2010.
Midas International Operations
As of January 1, 2011, there were approximately 781 Midas shops located in Europe, Australia, the Middle East, Latin America and the Caribbean. In each of these areas of the world, a master-franchisee licenses the Midas trademark from the Company (each a “licensee”), and sub-franchises the Midas brand to local franchisees. These licensees may also operate Midas shops on a company-operated basis.
In exchange for the use of the Midas trademarks, licensees are required to pay a license fee to the Company. This license fee varies by region, but is generally calculated as a percentage of Midas system-wide sales in the region. During fiscal 2010, the Company recorded revenues of approximately $4.3 million from international Midas licensees.
The Company meets periodically with its international licensees to ensure compliance with licensing agreements, communicate operating and marketing best practices and share the Company’s vision for future growth and development.
The Company continues to seek ways to leverage the value of the global Midas brand through development of additional licensee relationships throughout the world.
For a discussion of the resolution of Midas’ arbitration with its European licensee, see Item 3 “Legal Proceedings.”
For financial information about the principal geographic areas in which the Company operates, see Note 14 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
The SpeeDee System
On March 30, 2008 Midas acquired the assets of G.C. & K.B. Investments, Inc. and its affiliated entities that franchised and sub-franchised SpeeDee quick-lube and automotive maintenance shops. The purchase price was $21.0 million. As of January 1, 2011, SpeeDee had 106 shop locations in the U.S. in 10 states, and 65 shops in Mexico. Of the U.S. shop locations, six were company-operated and 16 shops were sub-franchised to a licensee who controls the franchise rights to SpeeDee locations in the New England region. The majority of SpeeDee shops are owned by single location franchisees that both own and operate their shops.
This strategic acquisition expanded the Company’s retail network in North America, leveraged the Company’s supply chain relationships and enhanced the Company’s operational capabilities within the quick-lube and maintenance categories.
The typical SpeeDee shop derives more than 50% of its sales from quick lube and fluid exchange services compared to less than 10% at Midas shops in the U.S. This service mix results in a much higher car count at the typical SpeeDee shop when compared to the typical Midas shop. An average SpeeDee shop services nearly 30 cars per day as opposed to Midas shops, which serve an average of 13 cars per day. In addition, SpeeDee services cars much earlier in their lifecycle as approximately 34% of the vehicles serviced by SpeeDee are less than four years old compared to only 7% of the vehicles serviced at the typical Midas shop.
A typical SpeeDee shop is approximately 3,000 square feet, has eight service bays and generated annual revenues of approximately $730,000 in 2010.
The SpeeDee business is currently operated on a stand-alone basis with respect to store operations and marketing. The SpeeDee system is managed by a Vice President of Operations, a Vice President of Finance, a Manager of Marketing, two regional managers and four district managers. In addition, SpeeDee maintains regional offices with a small administrative staff in Louisiana and California. Most accounting, administrative and legal functions were consolidated into the MDS corporate office upon acquisition. The SpeeDee company-operated shops are managed by the district managers who also manage the franchise businesses in the region.
The Midas-SpeeDee Co-Brand Opportunity
The Company believes the acquisition of SpeeDee provides both the Midas and SpeeDee franchise systems with a unique opportunity for growth in the future. By combining into one location Midas’ expertise in general repairs and strong brand awareness with SpeeDee’s strength in executing quick-lube and fluid exchanges, the Company believes it can create a powerful new format focused on satisfying the needs of time-pressed consumers seeking value, excellence and a long-term auto service relationship. The Company expects that a Midas-SpeeDee Co-Brand format shop will see customers much earlier in the lifecycle of their vehicle (relative to the typical Midas shop) and will be more able to convert these vehicles into general repair customers (relative to the typical SpeeDee shop) as the vehicles age. The resulting higher unit sales volume may produce a higher return on investment for the franchisee by better leveraging shop overhead expenses.
The Company began testing this concept by co-branding 4 franchised SpeeDee shops in 2008 and 4 Midas company-operated shops in early 2009. At the end of 2010, there were 46 co-branded shops, including 16 SpeeDee shops that have added Midas repairs and services and 29 Midas shops that have added SpeeDee oil change services. A brand-new franchised Midas-SpeeDee shop opened as a co-brand in Texas in late 2009.
There are 14 company-operated Midas shops in the Chicago and San Diego areas that added SpeeDee services in 2009. These shops reported comparable shop sales increases of 8% for the year. An additional 12 Midas company shops added SpeeDee in 2010. Sales at these shops were up by 14% during the portion of the
year they were co-branded. Two Midas franchisees added SpeeDee services to their Midas shops in late 2009 and a third Midas franchisee added SpeeDee in the third quarter of 2010. Comparable shop retail sales at these franchised locations increased by 18% during the portion of the year they were co-branded.
The comparable shop sales gains at these co-branded shops were well above the U.S. average for 2010 of approximately 3%. As a result, the company intends to make this program available to all qualifying Midas and SpeeDee franchisees and expects to co-brand between 25 and 50 additional shops in 2011.
Real Estate
Midas Realty Corporation (“Midas Realty”), a wholly-owned subsidiary of MDS, leases real estate that is subleased to Midas franchisees and owns real estate in the U.S. and Canada that is leased to Midas franchisees. In circumstances where the Company does not own or lease real estate for Midas shops, Midas Realty enters into contingent operating lease agreements or other forms of real estate control in order to ensure its ability to take possession of the real estate used by Midas shops in the event of a franchisee termination. This approach allows the Company to maintain control of a Midas shop location in the event of a franchisee termination and prevents re-branding of a location to a competitive branded repair facility or an independent repair facility.
The agreements with Midas Realty remain in effect throughout the term of the related Franchise Agreement. In the instance when Midas Realty owns the real estate or has the primary lease on a Midas shop, the franchisee is required to lease or sublease the Midas shop from Midas Realty. If the franchisee owns the real estate, the franchisee is required to provide Midas Realty with real estate control through one of two alternative means. The first alternative provides for the lease of the premises from the franchisee to Midas Realty, and Midas Realty in turn leases the premises back to the franchisee. So long as the franchisee continues to be both the landowner and the franchisee of that shop, no rent is exchanged between the franchisee and Midas Realty. If the real estate is sold to a third party or if the franchised Midas shop is sold to a new franchisee to whom the sublease is assigned, Midas Realty will then collect rent from the franchisee and pay rent to the landowner. Under the second alternative, the franchisee enters into a conditional option to lease with Midas Realty that grants Midas Realty the option to lease the premises in the event that the related Franchise Agreement is terminated. If the franchisee leases the real estate upon which the Midas shop is located from a third party, MDS requires that the franchisee grant to Midas Realty a conditional assignment of the lease to take effect upon the termination of the related Franchise Agreement.
As of January 1, 2011, Midas Realty owned 204 retail Midas locations, leased 486 Midas locations and used other forms of real estate control over an additional 673 Midas locations. This approach provides effective control over 1,363 of the 1,538 Midas shops in North America, or approximately 89%. See Note 8 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
SpeeDee Worldwide Realty Corporation (“SpeeDee Realty”), also a wholly-owned subsidiary of MDS, leases real estate that is subleased to SpeeDee franchisees. SpeeDee Realty does not own any real estate. SpeeDee Realty uses the same forms of real estate control documents that are used by Midas Realty to ensure its ability to take possession of the real estate used by SpeeDee shops in the event a franchisee is terminated by the Company. As of January 1, 2011, SpeeDee Realty leased 10 SpeeDee locations and used other forms of real estate control over an additional 29 SpeeDee locations.
The Company believes that its portfolio of real estate locations built over the past 50 years could not be easily replicated. Given the limited number of desirable repair shop locations and impediments to opening repair shops resulting from zoning and building code restrictions, as well as landlord and developer requirements, entry into the automobile repair market on a large-scale basis is difficult.
Supply Chain Activities
The Midas and SpeeDee systems in North America are supported by the Company’s supply chain activities. MDS provides value-added merchandising services to franchisees by establishing relationships with vendors who distribute products and equipment directly to Midas and SpeeDee shops. The Company establishes and actively manages these relationships with parts vendors on behalf of Midas and SpeeDee franchisees in order to provide them with ready access to high quality parts at favorable pricing.
Historically, the Company was more directly involved in the supplying of automotive parts and equipment to Midas franchisees. For most of its history through late 2003, the Company supplied a broad range of automotive parts to Midas franchisees in North America through its network of regional parts distribution centers and Parts Warehouse Inc. (“PWI”) quick delivery sites. In addition, the Company manufactured exhaust products and equipment, which were distributed to Midas franchisees and other non-Midas customers. During 2003, the Company outsourced the wholesale distribution of Midas brand products and other replacement parts, closed all but one of the Company’s regional distribution centers and disposed of its PWI quick-delivery distribution locations. Subsequently, in fiscal 2005, the Company entered into new exhaust supply arrangements with its vendors, which allowed the Company to exit its unprofitable exhaust manufacturing and distribution business. As a result of these agreements, MDS ceased production at its Hartford, Wisconsin exhaust manufacturing plant during the third quarter of fiscal 2005. The Company continued to operate its exhaust distribution warehouse in Chicago, Illinois during the first quarter of 2006 in order to provide Midas brand exhaust products to certain Midas franchisees prior to their final conversion to the new exhaust supply program. During the first quarter of fiscal 2006, all remaining exhaust inventory and equipment was sold and liquidated and the Chicago exhaust distribution warehouse was closed. As a result of the above transformation of the Company’s supply chain activities, the Company is no longer engaged in the manufacturing or distribution of parts to Midas franchisees.
Under the current supply chain business model, the Company establishes relationships with large vendors of automotive replacement parts and arranges for the distribution of these products directly to Midas and SpeeDee shops. Most franchisees’ parts sourcing needs are addressed through the Company’s relationships with major full-line automotive replacement parts suppliers such as the National Automotive Parts Association (“NAPA”), Uni-Select Inc., and CarQuest Corporation. These vendors provide franchisees with weekly delivery of replacement parts to retail shops, as well as access to just-in-time parts delivery through a broad network of quick-delivery parts distribution sites across North America. The Company believes its supply agreements with these suppliers enable Midas and SpeeDee franchisees to purchase high quality replacement auto parts at favorable pricing.
For most supply chain relationships, the vendor bills the Midas or SpeeDee franchisee directly for his purchases. The Company’s involvement is limited to negotiating preferred pricing and terms on behalf of franchisees by leveraging the buying power of the Company’s nationwide retail network.
From 2003 through 2007, MDS received product royalties from these vendors based on Midas shop purchases. These product royalties were recorded as revenue and were used to offset the future cost of redemptions under the Midas lifetime warranty program. Effective as of the beginning of 2008, the Company significantly expanded the number of approved U.S. suppliers and modified its contracts with existing U.S. suppliers. Under the new arrangement, MDS no longer receives product royalties from U.S. vendors. These royalties are instead paid to franchisee shops in the form of rebates, which lower the shop’s cost of goods. At the same time, the Company instituted a new fee to its Midas shops that will cover the future cost of warranty redemptions. This fee is adjusted annually with the intention that the Company has no net cost or profit from the U.S. Midas lifetime warranty program. In Canada, in July 2009, the Company adopted the U.S. program for both managing supply chain relationships and administering the Midas lifetime warranty program. See Note 1 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
In addition to the above described full-line parts supply arrangements, MDS has established relationships with certain suppliers to support the more specialized sourcing needs of franchisees. Currently, these include the Company’s agreements with Bridgestone-Firestone and Interstate Battery for the distribution of tires and
batteries, respectively. The Company also maintains relationships with key equipment vendors to provide franchisees with cost-competitive access to shop equipment. Under most of these arrangements, the Company bills the franchisee for the product purchased from the vendor, and then the Company, in turn, pays the vendor for the product. The Company records the sale of the product and holds the related accounts receivable. The Company’s gross margins on these purchasing arrangements are very low, and the gross profit is primarily intended to cover administrative costs and potential bad debts that might arise from the sale of these products. MDS also receives royalties on the ultimate sale of these products to consumers at retail in the Midas and SpeeDee systems.
Progressive Automotive Systems and the R.O. Writer Software System
In January 2001, the Company acquired the assets of Progressive Automotive Systems, a provider of automotive industry shop management software sold under the name R.O. Writer. The software is specifically designed to meet the needs of the auto repair industry, and MDS continues to develop and enhance the system. The Company believes this software helps to promote operational consistency and excellence throughout the Midas system. As of January 1, 2011, the R.O. Writer system was installed in approximately 960 Midas shops, comprising approximately 62% of Midas system locations throughout North America. Additionally, the system has been installed in several thousand non-Midas auto service shops in the United States.
Proprietary Information
MDS holds various patents, trademarks, trade names and copyrights, none of which, other than the Midas and SpeeDee names, is considered by MDS to be material to its financial condition and results of operations. MDS vigorously defends the Midas name throughout the world, and the name is registered as a trademark in approximately 100 countries in addition to the U.S. The SpeeDee name is registered in the U.S. and Mexico. The Company also owns certain trade secrets including price lists, training manuals and inventory systems.
Competition
The franchising industry is highly competitive and fragmented, and the number, size and strength of competitors varies from format to format. Both Midas’ and SpeeDee’s competitors include franchisors of restaurants, services and lodging as well as direct competitors within the franchised auto service industry (such as Jiffy Lube, MAACO, Meineke and AAMCO). Certain of these competitors are well-capitalized. MDS believes that competition in the franchising industry is primarily based on the brand name, historical success of franchisees, strength of franchisor support for franchisees, size of initial investment, franchise fee and royalty rate. MDS believes that Midas and SpeeDee generally have a favorable competitive position with respect to each of these variables.
The automotive repair industry is highly competitive and fragmented, and the number, size and strength of competitors vary from region to region. Both Midas’ and SpeeDee’s primary competitors include national, regional and local specialty chains, both franchised and company-operated, car dealerships, independent repair shops and service bays operated by mass merchandisers. Certain of these competitors are well-capitalized, and a number of them have instituted expansion plans. MDS believes that competition in the automotive repair industry is primarily based on customer service and reputation, shop location, name awareness and price. MDS believes that Midas and SpeeDee generally have a favorable competitive position with respect to each of these variables.
Customers
No customer accounted for more than 10% of the Company’s total sales and revenues in fiscal 2010, 2009 or 2008.
Seasonality
As a result of changes in the Company’s business model over the past five years, the seasonality of the Company’s sales has been reduced. In fiscal 2010, 2009 and 2008 revenues by quarter were not significantly different.
Regulatory Compliance
Franchising Matters. The Company is subject to a variety of federal and state laws governing franchise sales and marketing and franchise trade practices. Applicable laws and regulations generally require disclosure of business information in connection with the sale of franchises. Certain state regulations also affect the ability of the franchisor to revoke or refuse to renew a franchise. The Company deals with franchisees in good faith and strives to comply with regulatory requirements. From time to time the Company and one or more franchisees may become involved in a dispute regarding certain aspects of the franchise relationship, including, among other things, payment of royalties, location of shops, advertising, purchase of certain products by franchisees, compliance with franchise system standards and franchise renewal criteria. There can be no assurance that compliance problems will not be encountered from time to time, or that material disputes with one or more franchisees will not arise.
Consumer Protection Matters. National automotive repair chains have been the subject of investigations and reports by consumer protection agencies and the Attorneys General of various states. Publicity in connection with such investigations can have an adverse effect on the financial condition and results of operations of a company. In addition to such investigations, state and local governments have enacted numerous consumer protection laws. MDS has instituted procedures, including uniform standards of service to be followed by all Midas and SpeeDee shops, to improve customer satisfaction, which also aids in regulatory compliance.
In January 2010, MDS acquired 22 shops from a Midas franchisee in connection with a settlement between the franchisee and the California Attorney General and the California Bureau of Automotive Repair. The franchisee had been charged with violating state and professional codes in a suit seeking civil penalties and costs. The Company was not named in the suit and worked closely with the California Attorney General’s Office on acquiring these shops. This matter is now closed.
Environmental and Occupational Safety Matters. The Company’s shops handle used automotive oils and certain solvents that are disposed of by licensed third-party contractors. As a result, the Company is subject to a number of federal, state and local laws designed to protect the environment. MDS, through its company-operated shops, is also subject to regulation regarding the installation of catalytic converters and certain other emissions-related parts. In addition to environmental laws, the Company is subject to the Federal Occupational Safety and Health Act and other laws regulating safety and health. The Company maintains programs to facilitate compliance with these laws, the costs of which are not material to its financial condition and results of operations.
Employees
As of January 1, 2011, MDS had approximately 940 employees including approximately 725 in company-operated shops. None of the employees are covered by collective bargaining agreements. MDS generally considers its relationships with employees to be good. Midas and SpeeDee franchisees hire and are responsible for their own employees.
Cautionary Statements under the Private Securities Litigation Reform Act of 1995
Forward-Looking Statements
This report contains (and oral communications made by MDS may contain) forward-looking statements that may be identified by their use of words like “plans,” “expects,” “anticipates,” “intends,” “estimates,” “forecasts,” “will,” “outlook” “should” or other words of similar meaning. All statements that address the Company’s expectations or projections about the future, including statements about MDS’s strategy for growth, cost
reduction goals, expenditures and financial results, are forward-looking statements. Forward-looking statements are based on the Company’s estimates, assumptions and expectations of future events and are subject to a number of risks and uncertainties. MDS cannot guarantee that these estimates, assumptions and expectations are accurate or will be realized. MDS disclaims any intention or obligation (other than as required by law) to update or revise any forward-looking statements.
Item 1A.
Item 1A. Risk Factors
In addition to the factors discussed elsewhere in this annual report, the following are some of the important factors that could cause the Company’s actual results to differ materially from those projected in any forward-looking statements:
We are engaged in litigation that if determined adversely to us could have a material adverse effect on our business.
As described under “Item 3. Legal Proceedings,” we are currently party to two class action lawsuits. The purported class action suit brought by certain California brake customers has sought unspecified damages. A class action suit brought by Canadian franchisees has sought approximately $168 million in damages. While we believe that these claims are without merit and have vigorously defended against these claims, an adverse determination in any of these proceedings could have a material adverse effect on our business.
Virtually all of our revenues outside of North America are derived from the license fees of one licensee. The loss or reduction of these fees due to an adverse change in our relationship with this licensee, with whom we recently completed arbitration proceedings, or in this licensee’s business would have a material adverse effect on our net income.
Virtually all of our revenues outside of North America are derived from MESA, an Italian company that operates the Midas system in Europe and South America under a License Agreement and an Agreement of Strategic Alliance, as amended (the “ASA”). Mobivia Groupe S.A. (“Mobivia”, previously known as Norauto), a French company, acquired MESA (previously known as Magneti Marelli Services S.p.A.) from the Fiat Group in October 2004.
We recently completed binding arbitration proceedings in Geneva, Switzerland with MESA and Mobivia. The arbitral tribunal issued its ruling on March 3, 2011. Midas prevailed in its defense of the vast majority of claims that MESA and Mobivia had asserted as to Midas’ obligation to invest under the ASA in Midas Europe. However, the arbitral tribunal has awarded MESA  17.45 million (approximately US $23.4 million) plus interest of five percent from June 12, 2009 (approximately US $2.1 million through the ruling date), in connection with MESA’s claim that Midas failed to cooperate in the improvement of the IT systems in the European operations. Because MESA failed to prevail in the majority of its claims, the arbitral tribunal ordered MESA to pay 85 percent of Midas’ legal and other arbitration expenses and Midas to pay 15 percent of MESA’s expenses, resulting in MESA being required to pay Midas approximately $2.5 million. The damages payable to MESA will be offset by  1.5 million (US $2.1 million) in Midas Europe license fee payments due to Midas that were held in escrow as of the ruling date.
License fees are payable under the terms of the License Agreement which continues through 2028 and provides for additional 30 year extensions. The arbitral tribunal declined to make any rulings in respect of the License Agreement, due to its finding that it did not have the jurisdiction to do so. The License Agreement between Midas and MESA therefore continues in full force and the license fee royalty stream is to continue. The ruling does not deal with the Company’s obligations under the License Agreement or change the Company’s obligations under the ASA. However, it is not yet known how the ruling will impact our day-to-day business relationship with MESA and/or Mobivia. While MESA added 26 new Midas shops in fiscal 2010 and sales
increased by approximately 3.5%, the loss of the European licensing fees due to an adverse change to MESA’s and/or Mobivia’s business would have a material adverse effect on our net income. In fiscal 2010, MDS recorded $4.1 million in international license fee revenue under the License Agreement. This amount represented 2.1% of consolidated revenue and 29.3% of operating income. This license fee is paid in Euros and varies based upon a percentage of retail sales.
See Item 3 “Legal Proceedings” for a further discussion of the arbitration.
We rely on franchising for a substantial portion of our operating revenues. The failure of our franchisees to successfully operate stores consistent with our standards would have a material adverse effect on our profitability.
We rely on franchising for a substantial portion of our operating revenues. Therefore, our business is dependent on the ability of our franchisees to deliver high quality services. Our franchisees are independent contractors and are not our employees. We provide training and support to franchisees, but the quality of franchised store operations may be diminished by any number of factors beyond our control. We have been modifying the business models of our franchise systems. These changes generally require franchisees to perform more technologically complex repairs and maintenance services, and require greater investment in personnel and equipment. Consequently, not all franchisees may successfully operate stores in a manner consistent with our standards and requirements or hire and train qualified managers, technicians and other store personnel. If they do not, our image and reputation may suffer, and system-wide sales and profitability could decline. In addition, a reduction in system-wide sales and profitability could negatively impact the collectibility of receivables owed by franchisees to the Company.
The failure to successfully implement our new business models could have a material adverse effect on our financial condition and results of operations.
We are in the process of repositioning the Midas retail system in North America from a business model focused on the servicing and replacement of mufflers, brakes, shock absorbers and struts to a model that encompasses a complete line of services. As a result of the change in business model, our Midas company-operated and franchised shops have had to make, and will have to continue to make, investments in training, new personnel and equipment. As a result of the inability of certain Midas franchisees to adapt to the changing environment and successfully adopt the new business model, we have in some cases reacquired franchises to prevent the closing of these shops. While we believe that the selective acquisition of certain franchises is consistent with the implementation of our business model, our long term success depends upon the ability of our franchisees to profitably implement the new business model. While comparable shop sales have been maintained or improved at Midas shops that have made the transition to the new business model, we cannot assure shareholders that the change in the long run will be successfully marketed, that consumers will accept the new model or that the remaining shops will be willing to or can successfully make the transition to the new format.
In addition, we are in the process of implementing a new Midas-SpeeDee Co-Brand business model. This program combines the Midas and SpeeDee franchise operations into one location. We believe that this business model could provide us with a platform for growth of sales at existing Midas and SpeeDee locations as well as future unit growth in North America. The sales results at the 46 shops that have co-branded so far have been encouraging and the Company is in the process of making this program available to all qualified Midas and SpeeDee locations. However, we cannot assure shareholders that the co-brand business model will succeed at driving sales or profitability for the Company or its franchisees. Furthermore, we cannot assure shareholders that franchisees would be willing or able to make a transition to the new concept on a broad scale. Finally, due to issues related to location overlap, certain SpeeDee and Midas shop locations would not be allowed to make the transition even if the franchisees wanted and were able to do so.
A reduction in the availability of consumer credit may reduce consumer purchases of our products and services, which would adversely affect our revenues.
Credit card purchases account for a significant portion of the revenue of the Midas and SpeeDee systems in North America. A reduction in credit available to customers in general, and Midas credit card holders in particular, would have an adverse impact on MDS revenues.
A reduction in the availability of business credit could adversely affect our ability to sell franchises, lower our revenues or lead to slower payment of franchisee obligations due to MDS as franchisor.
Most new franchisees finance a significant portion of their shop investment with debt. A further reduction in the availability of business credit may hinder our ability to sell new franchises, as well the ability of our selling franchisees to find capable buyers. In addition, our franchise systems are comprised of franchisees who are small business operators that rely upon credit to fund their operations. When the availability of credit is reduced, it can harm the ability of our franchisees to fund their operations. As a consequence, franchisees can fail and go out of business or become delinquent in making payments, including payments due to the franchisor.
We are a leveraged company that utilizes debt to fund our business.
We currently have substantial debt on our balance sheet. The financing provided to us is subject to covenants that require us to maintain a certain net worth and maintain compliance with certain leverage ratios. If we do not perform in accordance with these covenants, the financial institutions providing the funds have the option to withdraw their funding support. The accrual of the $25.5 million European arbitration award in 2010 caused us to be in violation of certain financial covenants as of January 1, 2011. While our lenders have waived this violation and have modified our future covenant requirements, we cannot assure shareholders that we will remain in compliance with our debt covenants in the future. The payment of the arbitration award will increase our debt, thereby causing an increase in interest expense. In addition, our current financing agreement expires on October 27, 2013. While we believe we have excellent relations with our banks, we cannot assure shareholders that we will be able to refinance our existing credit facility when it expires in fiscal 2013, nor can we give any assurances to shareholders that the terms of any new financing arrangement will be favorable to the Company.
A downturn in the economy may delay or reduce consumer purchases of our products and services, which would adversely affect our revenues.
Many factors affect the level of consumer spending on automotive services, including, among others, general business conditions, interest rates, gasoline prices, the availability of consumer credit and consumer confidence in future economic conditions. Consumer purchases of regular service interval maintenance generally are reduced during recessionary periods, when gasoline prices are high, or when disposable income is lower.
A decline in the usage of automobiles would adversely affect demand for our products and services.
While the number of automobiles registered in the U.S. has historically increased over time, a sustained reduction in the number of miles driven by automobile owners would adversely affect the demand for our products and services. For example, when the retail cost of gasoline increases or the economy enters a severe recession, the number of miles driven by automobile owners typically decreases, which historically has resulted in less frequent service intervals and fewer repairs. In the U.S., in 2008 we experienced the largest one-year drop in miles driven since World War II and we believe that this trend negatively impacted the Company’s overall financial performance in the past three years.
We operate in a highly competitive market and the failure of our franchisees to effectively compete would have a material adverse effect on our financial condition and results of operations.
The automotive services industry is highly fragmented and highly competitive. There are numerous direct competitors for our retail auto service shops. Our shops compete with national, regional and local specialty chains, both franchised and company-owned, car dealerships, independent repair shops and service bays of mass merchandisers. We believe the principal competitive factors in the markets served by our shops are, in no particular order, customer service and reputation, shop location, name awareness and price. We also compete with businesses of the types noted above and with other parties in the sale of franchises. Competitive factors include startup costs, royalty rates, franchisee support and the financial performance of existing franchises. Many of our competitors are large and have a substantially longer operating history. Many competitors have greater financial resources than we possess. Our failure to compete effectively or the failure of individual shops to compete effectively would have a material adverse effect on our financial condition and results of operations.
Our inability to respond to consumer demands would adversely affect our results of operations.
If we were unable to respond to changes in consumer demands in a timely manner, it would adversely affect our revenues. Furthermore, if we fail to make continuous and successful new product and service introductions, this could adversely affect our financial performance. Our success in general, and at franchised system shops in particular, depends on our ability to identify, originate and define automotive product and service trends as well as to anticipate, gauge and react to changing consumer demands in a timely manner. Our automotive products and services must appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to rapid change. We may not be able to continue to develop appealing automotive products and services or meet changing consumer demands in the future. If we or our franchisees misjudge the market for automotive products and services, we or our franchisees may be faced with excess inventories and sunk training and equipment costs for certain automotive products and services and missed opportunities for other products and services.
Advances in automotive technology could adversely affect demand for our maintenance and repair services.
The demand for the services offered by our shops could be adversely affected by continuing developments in automotive technology. Automotive manufacturers are producing cars that last longer and require service and maintenance at less frequent intervals. For example, some manufacturers now recommend that consumers change oil at 10,000 mile intervals and replace spark plugs and other engine components at 100,000 miles, a significant increase from the mileage intervals recommended for earlier models and those currently recommended by most manufacturers. In addition, the improvement in original equipment manufacturers’ parts quality has in the past reduced, and may in the future reduce, demand for the products and services offered by our shops, thereby adversely affecting our franchise system revenues. Improvement in the quality of parts manufactured may extend the useful lives and warranties of those parts and may reduce demand for our products and services by decreasing the frequency of replacement or refurbishment of those parts. In turn, longer and more comprehensive warranty programs offered by automobile manufacturers and other third parties also could adversely affect the demand for services offered by our shops. We believe that a majority of new automobile owners have their cars serviced by their new car dealer during the period the car is under warranty. Major automobile manufacturers are experimenting with various advanced engine technologies, some of which could negatively impact demand for services currently performed within our franchise systems. Finally, advances in automotive technology could require that we and our franchisees incur additional costs to update our technical training programs and upgrade the diagnostic capabilities of Midas and SpeeDee shops.
The failure to attract and maintain an adequate supply of skilled labor could have a material adverse effect on our financial performance.
The provision of high quality services by our shops requires an adequate supply of skilled labor. In addition, the operating costs and operating revenues of auto service shops may be adversely affected by high turnover in skilled technicians. Trained and experienced automotive technicians are in high demand. The expansion of our business model from muffler and brake service to more complicated automotive repairs has required many franchised and company-operated shops to hire highly skilled full-service automobile technicians. Accordingly, our ability to increase productivity and revenues could be affected by our inability to attract and maintain the employment of skilled technicians necessary to provide key shop services. If we or our franchisees are unable to attract and maintain the adequate skilled labor force necessary to operate these shops efficiently, or if labor expenses increase as a result of a shortage in the supply of skilled technicians, our financial performance would be adversely affected.
The failure to comply with applicable franchise laws could have a material adverse effect on our financial condition and results of operations.
We are subject to federal and state laws and regulations, including the regulations of the Federal Trade Commission as well as similar authorities in individual states, in connection with the offer, sale and termination of franchises and the regulation of the franchisor-franchisee relationship. Our failure to comply with these laws could subject us to liability to franchisees and to fines or other penalties imposed by governmental authorities. In addition, we may become subject to litigation with, or other claims filed with state or federal authorities by, franchisees based on alleged unfair trade practices, implied covenants of good faith and fair dealing, payment of royalties, location of shops, advertising expenditures, franchise renewal criteria or express violations of agreements. There can be no assurance that compliance problems will not be encountered from time to time, or that material disputes will not arise with one or more franchisees. Accordingly, our failure to comply with applicable franchise laws and regulations could have a material adverse effect on our financial condition and results of operations.
We must commit resources to maintain and develop our key brands. The failure to maintain the Midas and SpeeDee brands would have a material adverse effect on our financial condition and results of operations.
If we fail to continue maintaining and developing the Midas and SpeeDee brand names, future revenues would be adversely affected. We believe that maintaining and developing our brand names is critical to our success and that the importance of brand recognition may increase as competitors offer products and services similar to our products and services. We incur substantial marketing expenditures to create and maintain brand loyalty as well as increase awareness of our brands. If our brand-building strategies are unsuccessful, these expenses may never be recovered, as we may be unable to increase future revenues or successfully implement certain business strategies.
Failure to protect our intellectual property would reduce our competitiveness.
We rely on trademark, trade secret, patent and copyright law to protect our intellectual property, including the Midas and SpeeDee brand names. We cannot be sure that these intellectual property rights can be successfully asserted or will not be invalidated, circumvented or challenged in the future. In addition, the laws of some of the foreign countries in which our products and services are or may be sold do not protect our intellectual property rights to the same extent as the laws of the United States. Our failure to protect our proprietary information, and any successful intellectual property challenges or infringement proceedings against us, could make us less competitive and could have a material adverse effect on our business, financial condition and results of operations.
The failure to comply with consumer protection regulations would have a material adverse effect on our financial condition and results of operations.
National automotive repair chains have been the subject of investigations and reports by consumer protection agencies and the Attorneys General of various states. Negative publicity in connection with such investigations could have an adverse effect on the financial condition and results of operations of our company. In addition, state and local governments have enacted numerous consumer protection laws and the failure to comply with these laws would have a material adverse effect on our financial condition and results of operations.
The failure to comply with extensive environmental regulation applicable to our business could have a material adverse effect on our financial condition and results of operations.
Environmental compliance costs and liabilities could have a material adverse effect on our financial condition. Our operations and properties are subject to increasingly stringent laws and regulations relating to environmental protection, including laws and regulations governing air emissions, water discharges and waste management. Such laws and regulations can impose fines and criminal sanctions for violations and require the installation of costly pollution control equipment or operational changes to limit pollution emissions and decrease the likelihood of accidental hazardous substance releases. Some of our current and former properties have been used as gas stations and dry cleaners. Accordingly, we could become subject to potentially material liabilities relating to the investigation and cleanup of contaminated properties, and to claims alleging personal injury or property damage as the result of exposures to, or releases of, hazardous substances. In addition, stricter interpretation of existing laws and regulations, new laws and regulations, the discovery of previously unknown contamination or the imposition of new or increased requirements could require us to incur costs or become the basis of new or increased liabilities that could reduce earnings and cash available for our operations.
Significant changes in the market value of our defined benefit plan assets could have a material adverse effect on our financial condition and results of operations.
We have a defined benefit plan that we offer to individuals employed by MDS. The assets in the plan are invested in a combination of equities, bonds and cash in order to fund ongoing plan obligations and ensure the future funded status of the plan. Historically, our defined benefit plan had been well-funded and we did not have to make any material contributions to fund the plan. As a result of the significant downturn in the U.S. stock market in 2008, and despite the recovery in the U.S. Stock market in the past two years, the plan is currently underfunded. Consequently, our pension expense has substantially increased in the past two years and it is projected to remain elevated for the next several years. We are obligated to make substantial cash contributions to fund the plan in order to remain in compliance with certain U.S. Government rules and guidelines. Cash contributions of $1.4 million and $0.6 million were made to the plan in fiscal 2010 and 2009, respectively, and the Company expects to make additional cash contributions of $3.1 million in fiscal 2011.
Further significant changes in the value of plan assets could affect the amount and timing of incremental income statement expense for the Company and could result in changes to our projected incremental cash contributions to the plan in current and future years. The U.S. Government establishes rules that govern the funding requirements of such plans and we comply with these rules. We cannot project the future funded status of our plan nor can we project the future funding requirements of the plan that would result from changes in the funded status or changes in government rules regarding required funding.
The failure to maintain adequate levels of taxable income within our U.S. and Canadian subsidiaries would have a material adverse effect on our corporate income tax expense and the valuation of our net deferred tax assets.
Our balance sheet contains significant deferred tax assets for net operating loss carry forwards and other reserves and liabilities that are deductible for tax purposes in future years. We must maintain adequate levels of taxable income in key subsidiaries in all future years to preserve the utilization of these deferred tax assets prior
to their expiration. If we determine that it is more likely than not that these assets will not be fully utilized in future years, we will have to record an incremental charge to income tax expense and record an incremental valuation allowance against the corresponding deferred tax assets.
If our stock price remains at its current level, it will have a material adverse effect on our future corporate income tax expense.
As prior MDS stock awards vest, the estimated fair value of the award is amortized as an expense charged to our book income statement. For tax purposes, stock awards are not deductible until they vest (for restricted stock) or until they are exercised (for options). As the expense is amortized on our book income statement, we recognize a deferred tax asset on our balance sheet. The deferred tax asset is then reversed when the corresponding restricted stock vests or when the corresponding options are exercised. If our tax deduction is less than our book income statement deduction, the full deferred tax asset will not be realized. The tax effected difference between our book deduction and our tax deduction is charged to income tax expense. This happens if and when restricted stock vests at a stock price below its grant price, or if stock options are exercised at a stock price which results in a tax deduction that is less than the Black-Scholes valuation of the option at grant date.
The lowering of U.S. corporate income tax rates would have a material adverse effect on our corporate income tax expense.
Our balance sheet contains a significant U.S. deferred tax asset, which is valued at a combined (federal plus state) income tax rate of 39.2%. If the U.S. corporate income tax rates were reduced in the next several years, the deferred tax assets would have to be written-down to their net realizable value. This would result in incremental U.S. income tax expense for the Company.
Our results of operations may be adversely affected by acts of war or terrorism
War or terrorist activities or the threat of them may increase our cost of doing business or otherwise impact our financial performance.
Item 1B.
Item 1B. Unresolved Staff Comments
The Company has no unresolved Staff Comments.
Item 2.
Item 2. Properties
MDS owns and leases real estate in various communities throughout North America that it uses for company-operated shops or leases and sub-leases to Midas and SpeeDee franchisees. As of January 1, 2011, MDS owned 204 retail Midas locations, leased 486 Midas locations and used other forms of real estate control over an additional 673 Midas locations. This approach provides effective control over 1,363 of the 1,538 Midas shops in North America, or approximately 89%.
As of January 1, 2011, SpeeDee Realty leased 10 SpeeDee locations in the United States.
MDS leases approximately 62,000 square feet of office space in Itasca, Illinois, where its corporate headquarters is located. This lease runs through January 2019. In addition, the Company leases two small office facilities, one in Louisiana and one in California, in connection with the management of the SpeeDee franchise system.
Item 3.
Item 3. Legal Proceedings
California Class Action
The Company is currently involved in a class action lawsuit filed in the Superior Court of California for the County of Los Angeles in June 2006 that alleges that certain franchised California Midas shops intentionally issued invoices to certain brake customers that incorrectly indicated that the customers had received Midas-branded brake products when, in fact, they had received inferior non-Midas brake products. MDS denies the plaintiffs’ allegations and is vigorously defending this lawsuit. MDS has thus far been successful in challenging the legal sufficiency of the plaintiffs’ claims. The plaintiffs’ third amended complaint was dismissed in February 2009. The plaintiffs filed a fourth amended complaint in March of 2009. The Company continues to believe that the allegations are without merit. However, there can be no assurance the Company will prevail in such proceedings. An adverse ruling could have a material adverse effect on the Company’s financial condition and results of operations.
Canadian Franchise Class Action
A class action lawsuit was filed against the Company in the Ontario Superior Court of Justice by two Canadian Midas franchisees. The plaintiffs alleged various violations of the Midas Franchise and Trademark Agreement and applicable law and sought class certification and monetary damages of approximately $168 million. The class certification hearing took place in February 2009 and the court released its certification ruling on March 26, 2009. Of the many claims asserted by the plaintiff, the only claim for which class certification was granted was the issue of whether Midas Canada breached its common law and statutory duties of good faith and fair dealing when it implemented its new supply chain program in 2003. All other causes of action were rejected by the court. The Company is currently in the process of compiling historical documents as a result of the plaintiffs’ discovery request. The Company continues to believe this lawsuit is without merit. However, there can be no assurance the Company will prevail in such proceedings. An adverse ruling could have a material adverse effect on the Company’s financial condition and results of operations.
MESA/Mobivia Arbitration
On June 12, 2009, the Company received a Notice of Arbitration from MESA S.p.A. (“MESA”) and Mobivia Groupe S.A. (“Mobivia”, formerly known as Norauto Groupe SA). MESA is an Italian company that operates the Midas system in Europe and South America under a License Agreement and an Agreement of Strategic Alliance, as amended (the “ASA”) with the Company. Mobivia is a French company that acquired MESA (previously known as Magneti Marelli Services S.p.A) from the Fiat Group in October 2004.
Background
Until 1998, the Company directly owned and managed its network of franchised and company-operated Midas shops throughout the world. In 1998, the Company reached an agreement with Magneti Marelli S.p.A. (“Marelli”), a member of the Fiat Group (the ASA). The Company concluded that Marelli had the financial and human resources to accelerate the development of the Midas business in Europe and South America at a much faster pace than the Company. Accordingly, under the ASA the Company sold its interests in Europe and South America (“Midas Europe”) to Marelli for $100 million in October 1998 (of which $84 million was paid under the ASA, and an upfront payment of $16 million was paid under a separate License Agreement). The License Agreement was entered into for the use of the Midas trademarks as part of the transaction.
In October 2004, Mobivia acquired Magneti Marelli Services S.p.A. (“Marelli Services”) from the Fiat Group. Marelli Services was a newly-formed subsidiary of the Fiat Group that was created to own the Midas Europe business that was purchased from the Company in 1998. Upon acquisition by Mobivia in October 2004, Marelli Services was renamed MESA S.p.A. by Mobivia.
The License Agreement with Marelli (and now with MESA) provided for fixed U.S. dollar denominated royalty payments of approximately $9 million per year until 2007. Effective January 1, 2008, the royalty converted to 1% of Midas Europe’s system-wide retail sales. As a result, the royalty paid to the Company by MESA decreased from approximately $8.9 million in 2007 to approximately $4.4 million in 2008.
Arbitration
Under the terms of the ASA, all disputes are to be settled by binding arbitration in Geneva, Switzerland under the UNCITRAL Arbitration Rules by a panel of three arbitrators. In demanding arbitration, MESA and Mobivia claimed that the Company had breached, and continued to breach, its obligations to cooperate and execute the agreement in good faith by failing to develop the Midas System in Europe and South America. As a result, MESA asked the arbitrators to require the Company to pay for damages and losses incurred by MESA and Mobivia, including a portion of royalties previously paid to the Company, and for the alleged decrease in the value of the MESA business and lost profits because of MESA’s inability to successfully open Midas shops in new countries, in an estimated amount of  102 million.
MESA and Mobivia also asked the arbitral tribunal to require the Company to renegotiate the terms of the ASA and the License Agreement currently in effect or to cancel these agreements due to the alleged breach by the Company and require the Company to indemnify MESA and Mobivia for any losses resulting from the termination of these agreements. These alleged losses were claimed to be between  57 and  154 million.
In January 2010, the arbitral tribunal issued an interim order permitting MESA to pay into escrow half the amounts MESA owes Midas in royalties under the License Agreement (beginning with the payment paid by MESA for royalties due in February 2010). As of January 1, 2011, approximately  1.4 million were being held in escrow. The arbitral tribunal took the position that MESA would suffer harm that could not be easily remedied if damages were awarded and Midas was unable to pay them.
On February 10, 2010, Midas made its first substantive written submission to the arbitral tribunal, and, in June 2010, Midas filed its second substantive written submission to the arbitral tribunal. Formal hearings were held in Geneva, Switzerland on July 13-16, 2010. On August 2, 2010 Midas and MESA and Norauto filed their closing submissions.
The arbitral tribunal issued its ruling on March 3, 2011. Midas prevailed in its defense of the vast majority of claims that MESA and Mobivia had asserted as to Midas’ obligation to invest under the ASA in Midas Europe. However, the arbitral tribunal has awarded MESA  17.45 million (approximately US $23.4 million) plus interest of five percent from June 12, 2009 (approximately $2.1 million through the ruling date), in connection with MESA’s claim that Midas failed to cooperate in the improvement of the IT systems in the European operations.
Because MESA failed to prevail in the majority of its claims, the arbitral tribunal ordered MESA to pay 85 percent of Midas’ legal and other arbitration expenses and Midas to pay 15 percent of MESA’s expenses, resulting in MESA being required to pay Midas a net amount of approximately $2.5 million.
The damages payable to MESA will be offset by  1.5 million (US $2.1 million) in MESA’s license fee payments due to Midas that were held in escrow as of the ruling date.
The License Agreement between Midas and MESA continues in full force and the license fee royalty stream is to continue uninterrupted.
Item 4.
Item 4. Reserved
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s Common Stock is listed on the New York Stock Exchange under the symbol “MDS”. As of December 31, 2010, there were 4,063 holders of record of the Common Stock. Information about the high and low prices of MDS Common Stock is shown below.
MDS has not paid a dividend during the last three fiscal years and has no current plans to pay a dividend in the future. The Company’s revolving credit facility limits the Company’s ability to pay dividends, subject to compliance with certain financial ratios.
The following table includes all issuer repurchases, including those made pursuant to publicly announced plans or programs and those not made pursuant to publicly announced plans or programs.
(1) Includes shares surrendered to cover the withholding taxes upon the vesting of restricted stock. In the fourth fiscal quarter of 2010, no shares were surrendered in lieu of taxes and, for the full year 2010, a total of 32,739 shares were surrendered in lieu of taxes.
(2) On November 9, 2004, the Company announced that the Board of Directors had authorized a share repurchase of up to $25 million in MDS stock. On May 9, 2006, the MDS Board of Directors authorized a $25 million increase in the share repurchase program, and on May 8, 2007, the Board authorized an additional $50 million increase. As of January 1, 2011, a total of approximately 3,248,100 shares had been repurchased under this plan since its inception. The average price of shares repurchased under the plan was approximately $20.21. This program has been suspended.
Performance Graph
The following performance graph compares the Company’s cumulative total shareholder return on Common Stock from December 31, 2005 to January 1, 2011 with the cumulative total return during the same periods of S&P 500 Index and Standard & Poor’s 600 Specialty Stores (the “peer group”), neither of which includes MDS. These comparisons assume an initial investment of $100 and the reinvestment of dividends.
Item 6.
Item 6. Selected Financial Data
The following table presents selected historical financial information of MDS. The information set forth below should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements of MDS and the notes thereto. The operating results data set forth below for fiscal years 2010, 2009 and 2008 and the balance sheet data as of the end of fiscal 2010 and 2009 are derived from, and are qualified by reference to, the audited financial statements of MDS included herein, and should be read in conjunction with those financial statements and the notes thereto. The operating results data for fiscal years 2007 and 2006 and the balance sheet data as of the end of fiscal 2008, 2007 and 2006 are derived from audited financial statements of MDS not included herein.
(a) On March 30, 2008 Midas acquired the assets of G.C. & K.B. Investments, Inc. and its affiliated entities that franchise or sub-franchise SpeeDee quick-lube and automotive maintenance shops. During fiscal 2010, 2009 and 2008, SpeeDee generated revenue of approximately $6.6 million, $5.1 million and $3.5 million, respectively.
(b) On March 3, 2011, an arbitral tribunal issued a judgment against the Company awarding damages of $25.5 million to MESA, an Italian company that operates the Midas system in Europe under a License Agreement and an Agreement of Strategic Alliance. See Note 2 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
(c) In 2005, MDS began a process to exit exhaust manufacturing and distribution and to rationalize the company-operated shops operation. These and other actions led to business transformation charges for 2006 through 2009. Business transformation costs for fiscal years 2008 and 2009 are described in Note 17 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
(d) In 2010, 2009 and 2008, the Company recorded favorable pre-tax adjustments to its estimated warranty liability of $0.3 million, $0.6 million and $3.4 million, respectively.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following table presents, for the fiscal periods indicated, selected financial information as a percentage of total sales and revenues.
Company Overview
MDS management is focused on building shareholder value through the profitable growth of the Company. The three main drivers of profit growth for MDS are the refranchising of company-operated shops, increasing the shop count through the opening of additional franchised units and increasing comparable shop sales. These drivers are closely integrated, as the opening of franchises is much easier in an environment where franchised shop sales and profits are growing.
Refranchising Company-Operated Shops
While many of the company-operated shops are profitable, the company-operated shop business is unprofitable as a whole. This is because the Company has acquired unprofitable shops from certain multi-shop franchisees in order to protect its markets. Most recently, the Company acquired 22 shops in Northern California from a financially and operationally troubled franchisee in January 2010. The Company acquired the shops in conjunction with a settlement between the franchisee and the California Attorney General and the California Bureau of Automotive Repair. These shops generated an operating loss of $1.3 million in 2010. The refranchising of company-operated shops, particularly those that are unprofitable, benefits the Company in a number of ways. First, the operating losses and capital investment requirements of the shops are replaced by
royalty revenue that has minimal associated costs and capital investment. Second, the operational risks associated with running a shop on a day-to-day business are no longer borne by the Company. Third, the Company is able to reduce corporate overhead in its company-operated shop business and in back-office support functions.
As of January 1, 2011, MDS operated 107 company-operated Midas, SpeeDee and Midas-SpeeDee Co-Branded shops. Most of these shops are currently targeted for re-franchising. The Company refranchised 22 company-operated shops in fiscal 2010 and expects to refranchise additional shops during 2011. The Company would like to reduce to size of the company-operated shop portfolio to fewer than 50 shops. Achieving this goal will be a multi-year process for the Company.
Growing Shop Count
Sales performance among U.S. Midas shops varies dramatically between the top-third performing shops and the bottom-third performing shops. In fiscal 2010, the top-third performing shops reported comparable shop sales increases of over 17%, including a 9% increase in brake sales, while the bottom-third performing shops experienced a 9% decline in sales, including a 12% decline in brake sales. The Company believes that the disparity in performance is substantially due to the fact that Midas is an older franchise system and that certain long-term franchisees are struggling with the ongoing changes required to adapt to the current automotive aftermarket. As a result, the Company has been working diligently to identify those franchisees that cannot or will not adapt to the new environment and has been assisting them in transitioning out of the Midas system in favor of new franchise ownership.
The benefits of transitioning Midas shops to new franchisees can be seen in the performance of these shops. Sales at shops within the first year after transition have historically far outperformed the sales performance of the broader Midas system. In some cases, the improvement is dramatic with sales rising by more than 100%. In the next several years the Company hopes to accelerate the number of transitions each year and thereby increase the capacity of the Midas system as a whole to adapt and succeed in this new business environment. Additionally, the Company hopes to significantly increase the number of single-shop, owner-operator franchisees. Currently, about 30% of shops in the Midas system are owned by single-shop franchisees compared to 22% in 2005. MDS management strongly believes the automotive service business is often best managed by single-shop owners who work the business on a daily basis.
In addition to transitions, the Company believes that the re-opening of previously-operated Midas shops (i.e., “available shop inventory”) and the acquisition/conversion of competing automotive repair centers both provide a significant opportunity to grow the North American franchise system.
As of January 1, 2011, the Company’s available shop inventory consisted of 71 shops, 16 of which were owned by the Company and 55 of which were leased from third parties. During 2010, the Company collected an average annual rent amount of approximately $60,000 from the locations it leased to franchisees and collected an average of $29,000 in royalties from each Midas shop in North America. Therefore, the reopening of these previously operated shops has the potential of adding significant revenues and operating profits in the future. The annual base rent obligation on the 55 shops that are leased from third parties is approximately $2.8 million.
The Company also believes that the acquisition of existing automotive repair shops, as well as the conversion of independent repair facilities to the Midas, SpeeDee or Co-Brand formats, is the most efficient way to grow the MDS system. Furthermore, the Company believes that the current economic environment will result in an increase in acquisition and conversion opportunities, as competitors struggle to remain viable.
Growing Comparable Shop Sales
The Company believes that the key to growing sales in the Midas system in North America is to grow average daily car count by focusing on those services that are most critical to the regular maintenance of
vehicles; namely, oil and other fluid exchanges, brake replacement and tire replacement. These services are required of all vehicles at periodic intervals and management believes future success in automotive service requires that a service provider possess expertise, credibility and top-of-mind awareness in all three categories.
As a result, in 2009, the Company changed its promotional advertising strategy in the U.S. from national television advertising to a more locally-focused advertising approach featuring value-priced oil changes. This change has had a significant impact on average daily car count per shop, as car count grew by 12% in fiscal 2009 and by an additional 10% in fiscal 2010. The Company believes that this value-priced, locally-focused oil change advertising strategy will provide an opportunity to form broader, longer-term relationships with these new customers for brake repairs, factory scheduled maintenance and major repairs.
Comparable shop sales of oil changes in North America have increased in each of the past three years and rose 16% in fiscal 2010. However, revenues from this category still represent less than 10% of U.S. Midas system sales, and the typical Midas shop performs approximately eight oil changes per day. While oil change revenue and car count have been growing over the past several years, management believes the Midas system has the capacity to significantly increase that number.
With respect to growing brake sales, the Company has been and continues to deliver training that is focused on establishing greater operating uniformity throughout the Midas system, including phone handling, customer interaction, product stocking and the brake inspection process, as well as the customer follow-up process.
The Company also continues to believe that the sales of tires and related tire services represent a significant opportunity for sales growth at Midas. Comparable shop sales of tires and related tire services in the U.S. increased significantly in each of the prior four years and were up nearly 8% in fiscal 2010.
Finally, the Company believes that by Co-Branding Midas and SpeeDee shops by combining into one location Midas’ expertise in general repairs and strong brand awareness with SpeeDee’s strength in executing quick-lube and fluid exchanges, that it has created a powerful new format focused on satisfying the needs of time-pressed consumers seeking value, excellence in service and a long-term auto service relationship.
The Company began testing this concept by co-branding 4 franchised SpeeDee shops in 2008 and 4 Midas company-operated shops in early 2009. At the end of 2010, there were 46 co-branded shops, including 16 SpeeDee shops that have added Midas repairs and services and 29 Midas shops that have added SpeeDee oil change services. A brand-new franchised Midas-SpeeDee shop opened as a co-brand in Texas in late 2009.
There are 14 company-operated Midas shops in the Chicago and San Diego areas that added SpeeDee services in 2009. These shops reported comparable shop sales increases of 8% for the year. An additional 12 Midas company shops added SpeeDee in 2010. Sales at these shops were up by 14% during the portion of the year they were co-branded. Two Midas franchisees added SpeeDee services to their Midas shops in late 2009 and a third Midas franchisee added SpeeDee in the third quarter of 2010. Comparable shop retail sales at these franchised locations increased by 18% during the portion of the year they were co-branded.
The comparable shop sales gains at these co-branded shops were well above the U.S. average for 2010 of approximately 3%. As a result, the company intends to make this program available to all qualifying Midas and SpeeDee franchisees and expects to co-brand between 25 and 50 additional shops in 2011.
MDS management believes that while the current economic environment, and the need to develop stronger customer relationships and improve operations execution, pose significant challenges for automotive aftermarket service providers, the potential to succeed is significant for those automotive service providers that are willing and able to adapt.
Fiscal Reporting Periods
Fiscal 2010 and fiscal 2009 were each comprised of 52 weeks, while fiscal 2008 was comprised of 53 weeks. The extra week in fiscal year 2008 did not have a material impact on results of operations because the approximately $2 million in additional revenues were completely offset by a similar amount of additional costs and expenses.
Results of Operations-Fiscal 2010 Compared to Fiscal 2009
Total sales and revenues for fiscal 2010 increased $9.6 million, or 5.3%, from fiscal 2009. Within the retail auto service business, royalty revenues and license fees decreased $0.6 million, or 1.1%, from fiscal 2009. This decrease primarily reflects fewer shops in operation in North America, growth in the company-operated shop portfolio and weakness in Canadian retail sales, partially offset by a comparable shop sales increase of 3.3% in the U.S., and a weaker U.S. dollar that increased the value of Canadian royalties.
Revenues from real estate leases declined $0.8 million to $31.8 million driven by a net reduction in the number of shops paying rent to Midas due to shop closures and the acquisition of company-operated shops from franchisees, partially offset by a more favorable Canadian currency exchange rate.
Sales from company-operated shops were $77.6 million in fiscal 2010 compared to $65.4 million in fiscal 2009. The increased revenues reflect an increase in the average company-operated shop count in the past year, as well as an increase in comparable shop sales of 2.9% for Midas company-operated shops.
Replacement part sales and product royalties decreased 9.5% from $25.3 million to $22.9 million in fiscal 2010 primarily due to lower sales of tires to Midas franchisees. While comparable shop sales of tires grew by nearly 8% in 2010, franchisees are shifting their purchases to regional wholesalers who bill shops directly for their tires purchases. Warranty fee revenue increased $0.7 million to $1.2 million as 2010 was the third year under the new U.S. warranty program and redemptions grew. Warranty fee revenue is recognized as redemptions occur and is offset by an equivalent amount of warranty expense. Software sales and maintenance revenue increased $0.5 million to $5.9 million reflecting continued growth in the Company’s R.O. Writer point-of-sale software business, especially with customers outside of the Midas system.
Total operating costs and expenses increased $32.8 million, or 19.5%, in fiscal 2010 to $201.4 million. Occupancy expenses for franchised shops declined $0.2 million to $22.5 million in fiscal 2010 due to fewer franchised shops under lease during the period. Company-operated shop costs and expenses rose to $81.0 million in fiscal 2010 from $68.3 million in fiscal 2009. The increase in operating expenses was driven by the higher average shop count and higher comparable shop sales, as well as the incremental overhead required to support the higher shop count. Payroll and employee benefit costs improved to 42.8% of company-operated shop sales in fiscal 2010 compared to 43.0% in the same period of the prior year. Company-operated shop occupancy and other expenses as a percentage of company-operated shop sales improved to 32.9% for fiscal 2010 compared to 33.6% for the same period in the prior year. Company-operated shop parts cost of sales increased from 27.8% of company-operated shop sales in fiscal 2009 to 28.7% in fiscal 2010, primarily as a result of an increase in the proportion of sales of lower margin oil and tires and higher discounts.
Replacement part cost of sales increased slightly in fiscal 2010 to 91.7% of replacement part sales and product royalties from 90.5% in fiscal 2009. Warranty expense in fiscal 2009 was $0.9 million compared to an expense of $0.1 million in fiscal 2009. This increase is directly related to the increase in warranty fee billings.
Selling, general and administrative expenses in fiscal 2010 decreased $0.7 million, or 1.4%, from fiscal 2009 to $50.5 million. The decrease was primarily the result of cost containment measures initiated in late 2009.
The Company recorded a $25.5 million European arbitration award as an expense in fiscal 2010 as a result of a ruling by an arbitral tribunal on March 3, 2011. See Note 2 of Notes to Consolidated Financial Statements for a more detailed discussion.
During fiscal 2010, the Company sold and refranchised 22 company-operated shops and gains were essentially offset by losses. During fiscal 2009, the Company recorded a net loss on sale of $0.2 million in connection with the sale of certain company-operated shop assets.
In fiscal 2010, the Company recorded no business transformation charges. During fiscal 2009, MDS recorded business transformation charges of $3.2 million. The charges include $0.4 million for severance in connection with a reduction in force, $0.8 million of lease and other costs related to the closure of four unprofitable company-operated shops, and $1.5 million in third party consulting costs related to development of the Co-Brand building image, the re-design of the customer sales and follow-up process (and subsequent restructuring of the field organization) and a study of the Midas France business and marketplace. In addition, approximately $0.1 million is related to the changeover of the Canadian warranty program and $0.4 million is part of the Company’s final funding of the rollout of a new shop image for Canadian Midas franchisees.
As a result of the above changes, operating income decreased $23.2 million to a loss of $9.0 million in fiscal 2010 from $14.2 million in fiscal 2009 and operating income margin decreased to (4.7)% of sales from 7.8% of sales.
Interest expense was $9.3 million in fiscal 2010 compared to $8.3 million in fiscal 2009. Interest expense increased in fiscal 2010 primarily due to an increase in the Company’s average borrowing rate as a result of the resetting of interest rate spreads to current market rates when the Company extended its credit agreement in December 2009.
Other income was $0.3 million in fiscal 2010 compared to $0.4 million in fiscal 2009. Other income consists primarily of interest income on overdue customer accounts and foreign currency exchange gains or losses.
The Company’s effective tax rate was (25.5)% in fiscal 2010 compared to 58.7% in fiscal 2009 and the 2010 statutory tax rate of 39.2%. The variance in the fiscal 2010 tax rate from the statutory rate was primarily due to the $25.5 million European arbitration award, which resulted in a net operating loss for the year. In addition, the effective tax rate was impacted by the revaluation of the U.S. deferred tax asset associated with restricted stock that vested in May and July 2010 at a stock price that was lower than the stock price on the day these awards were initially granted. The rate was also affected by an increase in the valuation allowance against the foreign tax credit carryover based on expected utilization. Finally, the rate was negatively impacted by the forfeiture of certain restricted shares by former executives. The fiscal 2009 variance from the statutory rate was due to the revaluation of the U.S. deferred tax asset associated with restricted stock that vested in May 2009 at a stock price that was lower than the stock price on the day these awards were initially granted, as well as a revaluation of the Canadian deferred tax asset due to a reduction in certain provincial corporate income tax rates enacted during fiscal 2009.
As a result of the above items, primarily because of the $25.5 million European arbitration award, net income decreased $16.0 million from net income of $2.6 million in fiscal 2009 to a net loss of $13.4 million in fiscal 2010.
Results of Operations-Fiscal 2009 Compared to Fiscal 2008
Total sales and revenues for fiscal 2009 declined $4.6 million, or 2.5%, from fiscal 2008. Within the retail auto service business, royalty revenues and license fees decreased $3.6 million, or 6.3%, from fiscal 2008. This decrease reflects fewer selling days, weakness in Midas retail sales as total North American comparable shop sales declined 1.6%, a reduction in the number of Midas shops in operation due to shop closures, a stronger U.S. dollar reducing the value of Canadian and European royalties and lower franchise fees. While royalty revenue in the Midas system was down in fiscal 2009, U.S. car count rose by 14% and U.S. oil change revenues increased by 27% on a comparable shop basis as the Company used value-priced oil changes to acquire new customers in 2009.
Revenues from real estate leases declined $2.0 million to $32.6 million driven by a net reduction in the number of shops paying rent to Midas due to shop closures, lower revenue from sales-based rental agreements and a weaker Canadian dollar.
Sales from company-operated shops were $65.4 million in fiscal 2009 compared to $61.4 million in fiscal 2008. The increased revenues reflect an increase in comparable shop sales of 2.4% during fiscal 2009, as well as an increase in the company-operated shop count due to net shop acquisitions in the past 12 months.
Replacement part sales and product royalties decreased 13.4% from $29.2 million to $25.3 million in fiscal 2009 as equipment revenue and sales of tires to U.S. franchisees declined. The Company recorded lower sales of tires to U.S. Midas franchisees despite the fact that tire revenues grew 7.9% at retail. U.S. Franchisees are purchasing more tires from local distributors approved by Bridgestone-Firestone in order to diversify their tire offering. These local purchases are direct between the Midas franchisee and the local tire distributor and are therefore not included in sales and revenues. Software sales and maintenance revenue increased $0.4 million to $5.4 million reflecting continued growth in the Company’s R.O. Writer point-of-sale software business, especially with customers outside of the Midas system.
Total operating costs and expenses increased $2.5 million, or 1.5%, in fiscal 2009 to $168.6 million. Occupancy expenses for franchised shops declined $0.1 million to $22.7 million in fiscal 2009 due to fewer shops under lease. Company-operated shop costs and expenses rose to $68.3 million in fiscal 2009 from $63.0 million in fiscal 2008. The increase in operating expenses was driven by higher sales, additional shops and incremental overhead required to support the higher shop count, and one-time costs associated with launching the Co-Brand test concept in Chicago and San Diego. Payroll and employee benefit costs increased to 43.0% of company-operated shop sales in fiscal 2009 compared to 42.5% in the same period of the prior year, primarily due to increased headcount to launch the Chicago and San Diego Co-Brand units. Company-operated shop occupancy and other expenses as a percentage of company-operated shop sales were 33.6% for fiscal 2009 compared to 33.9% for the prior year. Company-operated shop cost of sales increased from 26.2% of company-operated shop sales in fiscal 2008 to 27.8% in fiscal 2009, primarily as a result of an increase in the proportion of sales of oil and tires and higher discounts that helped to drive customer traffic.
Replacement part cost of sales increased to 90.5% of replacement part sales and product royalties, from 90.4% in fiscal 2008. Warranty expense in fiscal 2009 was $0.1 million compared to a benefit of $2.7 million in fiscal 2008. U.S. warranty expense increased each quarter during fiscal 2009 and no warranty expense was recorded in Canada in the second half of 2009. Both trends reflect changes in the warranty programs in both countries whereby Midas franchisees are now responsible for funding the warranty program and the Company’s future warranty expense will be exactly offset by warranty revenue. In fiscal 2009, the Company recorded favorable adjustments totaling $0.6 million to its U.S. and Canadian warranty reserves due to a change in estimate for the expected redemption rates for warranted product sold by Midas franchisees. In fiscal 2008, the Company recorded favorable adjustments totaling $3.4 million to its U.S. and Canadian warranty reserves due to a change in estimate for the expected redemption rates for warranted product sold by Midas franchisees.
Selling, general and administrative expenses in fiscal 2009 declined $2.9 million, or 5.4%, from fiscal 2008 to $51.2 million. The decrease was achieved despite incremental operating expenses related to the vesting of certain restricted stock, as well as ongoing legal costs for two purported class action lawsuits and the MESA arbitration.
During fiscal 2009, MDS recorded business transformation charges of $3.2 million. The charges include $0.4 million for severance in connection with a reduction in force, $0.8 million of lease and other costs related to the closure of four unprofitable company-operated shops, and $1.5 million in third party consulting costs related to development of the Co-Brand building image, the re-design of the customer sales and follow-up process (and subsequent restructuring of the field organization) and a study of the Midas France business and marketplace. In addition, approximately $0.1 million is related to the changeover of the Canadian warranty program and $0.4
million is part of the Company’s final funding of the rollout of a new shop image for Canadian Midas franchisees. During fiscal 2008, the Company recorded business transformation charges of $1.6 million. The 2008 charges reflected $1.3 million for the Company’s partial funding of the rollout of a new shop image for Midas franchisees and $0.3 million for the closure of an unprofitable company operated shop.
During fiscal 2009, the Company recorded a loss on sale of $0.2 million in connection with the sale of certain company-operated shop assets. During fiscal 2008, the Company recorded a loss on sale of $0.9 million in connection with the sale of certain shop assets.
As a result of the above changes, operating income decreased $7.1 million to $14.2 million in fiscal 2009 from $21.3 million in fiscal 2008 and operating income margin decreased to 7.8% of sales from 11.4% of sales.
Interest expense was $8.3 million in fiscal 2009 compared to $9.1 million in fiscal 2008. Interest expense declined in fiscal 2009 due to lower average bank debt compared to the prior year and a reduction in the Company’s average borrowing rate.
Other income was $0.4 million in fiscal 2009 compared to $0.8 million in fiscal 2008. Other income consists primarily of interest income on overdue customer accounts and foreign currency exchange gains or losses.
The Company’s effective tax rate was 58.7% in fiscal 2009 compared to 40.3% in fiscal 2008 and the 2009 statutory tax rate of 39.2%. The fiscal 2009 variance from the statutory rate was primarily due to the revaluation of the remaining U.S. deferred tax asset associated with restricted stock that vested in May 2009 at a stock price that was lower than the stock price on the day these awards were initially granted, as well as a revaluation of the Canadian deferred tax asset due to a reduction in corporate income tax rates for both Ontario and British Columbia enacted during fiscal 2009.
As a result of the above items, net income decreased $5.2 million from net income of $7.8 million in fiscal 2008 to net income of $2.6 million in fiscal 2009.
Liquidity, Financial Condition and Capital Resources
Following is a summary of the Company’s cash flows from operating, investing and financing activities for fiscal 2010 and 2009, respectively (in millions):
The Company’s cash management system permits the Company to make daily borrowings and repayments on its revolving line of credit, allowing MDS to minimize interest expense and to maintain a low cash balance. The Company’s cash and cash equivalents decreased $0.3 million in fiscal 2010.
The Company’s operating activities provided net cash of $16.0 million during fiscal 2010 compared to $19.4 million of cash provided by operations in fiscal 2009. Excluding changes in assets and liabilities and cash outlays for business transformation charges, cash provided by operating activities decreased $4.0 million from $22.1 million in fiscal 2009 to $18.1 million in fiscal 2010, primarily due to a $25.5 million increase in European arbitration award costs, which caused a $16.0 million decline in net income, and a $9.6 million lower utilization of deferred tax assets. In addition, there was an $0.8 million decrease in stock based compensation expense as limited stock awards were granted to management in 2010 and a $3.2 million decrease in business transformation charges.
Changes in assets and liabilities increased from a $0.7 million use of cash in fiscal 2009 to a $1.9 use of cash in fiscal 2010. In fiscal 2010, the reduction in inventory was substantially off-set by a decline in accounts payable and accrued expenses due to the timing of payments and the recording of a receivable for the $2.5 million fee recovery awarded by the arbitral tribunal. The $0.7 million use of cash in fiscal 2009 was driven by an increase in company-operated shop tire inventories.
Investing activities used $4.9 million of cash in fiscal 2010 compared to $4.1 million of cash in fiscal 2009. Investing activities in fiscal 2010 consisted of $4.3 million in capital expenditures, $3.5 million paid in conjunction with the acquisition of 22 shops and other assets from a Midas franchisee in Northern California, and $2.9 million in cash generated as a result of the sale of 22 company-operated Midas shops and two company-operated SpeeDee shops. The $4.3 million in capital expenditures included $2.0 million in real estate and leasehold improvements, $1.4 million for company-operated shop equipment additions and $0.9 million for systems development projects. Fiscal 2009 investing activities consisted of $3.1 million in capital expenditures, $1.3 million paid in conjunction with the acquisition of 10 shops and other assets from Midas franchisees and $0.3 million in cash generated as a result of the sale of four company-operated shops. The $3.1 million in capital expenditures included $1.6 million in Co-Brand related investments in Midas company-operated shops, $0.6 million for systems development projects, $0.5 million for company-operated shop equipment additions, $0.3 million of real estate and $0.1 million of other capital expenditures.
Net cash used in financing activities was $11.4 million in fiscal 2010, compared to net cash used of $15.5 million in fiscal 2009. During fiscal 2010, MDS decreased total debt by $10.7 million, decreased outstanding checks by $0.3 million and paid $0.4 million to repurchase shares of the Company’s common stock from employees to satisfy tax obligations upon vesting of restricted stock awards. The decrease in total debt is net of $0.1 million of capital leases assumed as a result of acquisition of 22 shops and other assets from a Midas franchisee in Northern California. During fiscal 2009, MDS decreased total debt by $13.1 million, decreased outstanding checks by $0.2 million, paid $1.5 million for financing fees in association with the amendment and extension of the Company’s revolving credit facility and paid $0.7 million to repurchase shares of the Company’s common stock from employees to satisfy tax obligations upon vesting of restricted stock awards.
On December 4, 2009, MDS entered into a three-year extension of its existing unsecured revolving credit facility. The credit agreement was extended through October 27, 2013 with no material changes in existing covenants. The extended facility is for $125 million and is further expandable to $175 million by the Company with lender approval. The interest rate floats based on the underlying rate of LIBOR and the Company’s leverage and was priced at LIBOR plus 3.00% at January 1, 2011. This facility requires maintenance of certain financial covenants including maximum allowable leverage, minimum fixed charge coverage and minimum net worth.
As a result of the accrual of the $25.5 million European arbitration award in 2010, the Company was in violation of certain financial covenants as of January 1, 2011. On March 16, 2011, the Company’s lenders waived the covenant violations and entered into an amendment to the credit agreement. The amendment provides, among other things, that the $25.5 million arbitration award is excluded from the definition of consolidated adjusted EBITDA as defined in the credit agreement for purposes of the covenant calculations.
The financial covenants require that the Company maintain a maximum leverage ratio (“Leverage Ratio”) of Total Debt (defined as outstanding borrowings and letters-of-credit under the revolving credit facility plus the balance of capital leases but excluding finance leases) to consolidated adjusted EBITDA (“Consolidated
Adjusted EBITDA”) of no more than 3.00 to 1.00. The March 2011 amendment increased this maximum to 3.50 to 1.00 for fiscal year end 2010 and the first two fiscal quarters of fiscal 2011, being reduced to 3.25 to 1.00 at the end of the third and fourth quarters of fiscal 2011. The allowable leverage ratio then returns to 3.00 to 1.00 for all remaining periods. The Company is required to test this ratio quarterly on a trailing twelve month basis.
Consolidated Adjusted EBITDA means for the relevant period: consolidated net income, plus, to the extent deducted from revenues in determining consolidated net income, (i) consolidated interest expense, (ii) expense for income taxes paid or accrued, (iii) depreciation, (iv) amortization of stock based compensation expenses, (v) corporate restructuring costs not to exceed $2.5 million in the aggregate in fiscal 2010 and 2009, (vi) special charges not to exceed $0.5 million in fiscal 2009 related to the new image and warranty program, (vii) company-operated shop restructuring costs and losses (net of realized gains upon disposition) of up to $1.0 million in each fiscal year, and, (viii) the $25.5 million European arbitration award expense, and, minus, to the extent included in consolidated net income, extraordinary gains realized other than in the ordinary course of business.
Consolidated Adjusted EBITDA as of the three most recent measurement periods was as follows (dollars in millions):
As calculated in accordance with the amended credit agreement, the following table presents the Company’s actual Leverage Ratio as of the three most recent measurement periods (dollars in millions):
The financial covenants require that the Company maintain a minimum fixed charge coverage ratio (“Fixed Charge Ratio”) of not less than 1.3 to 1.0. This ratio is calculated as (a) Consolidated Adjusted EBITDA plus Net Rent for the previous fiscal year to (b) consolidated interest expense paid in cash, plus (i) Net Rent for the previous fiscal year, (ii) consolidated capital expenditures, (iii) scheduled principal payments made, and, (iv) expense for taxes paid in cash. Net Rent is defined as consolidated rent expense less consolidated rent revenue from leased shops subleased to franchisees for the most recently completed full fiscal year.
As calculated in accordance with the amended credit agreement, the following table presents the Company’s actual Fixed Charge Ratio as of the three most recent measurement periods (dollars in millions):
The financial covenants also require that the Company maintain a minimum net worth of not less than $17.5 million plus 50% of positive consolidated net income for quarterly periods beginning with the fourth quarter of fiscal 2010. Prior to the March 2011 amendment, the covenants required the Company to maintain a minimum net worth of not less than $20.0 million plus 50% of positive consolidated net income beginning in fiscal 2010 through the third quarter of 2010. As calculated in accordance with the amended credit agreement, the following table presents the Company’s actual minimum net worth as of the three most recent measurement periods (dollars in millions):
As of January 1, 2011, a total of $62.7 million was outstanding under the revolving credit facility. As of January 2, 2010, a total of $71.9 million was outstanding under the revolving credit facility. As of January 1, 2011, there was $35.7 million of available borrowing capacity under the Company’s revolving credit facility, as amended.
In November 2005, $20 million in revolving bank debt was converted from floating rate to fixed rate by locking-in LIBOR at 4.89% for a five-year period. In addition, in March 2007, MDS entered into an interest rate swap arrangement to convert an additional $25 million in revolving bank debt from floating rate to a fixed rate by locking-in LIBOR at 4.91% through October 2010. Both of these swap arrangements expired prior to January 1, 2011.
In January 2010, the Company entered into a $40 million forward starting swap to coincide with the end dates of its existing swaps. As a result of this forward swap transaction, in the period from November 2010 through October 2013 (end of the recently extended bank agreement) the Company has locked-in LIBOR at 2.71% for $40 million of its $62.7 million in revolving bank debt.
The November 2005, March 2007 and January 2010 swap arrangements have been designated as cash flow hedges and have been evaluated to be highly effective. As a result, the after-tax change in the fair value of these swaps is recorded in accumulated other comprehensive loss as a gain or loss on derivative financial instruments.
On November 9, 2004, the MDS Board of Directors authorized a share repurchase program to begin in fiscal 2005 for up to $25 million of the Company’s outstanding common stock. On May 9, 2006, the MDS Board of Directors authorized a $25 million increase in the share repurchase program and on May 8, 2007 the MDS Board of Directors authorized an additional $50 million increase in such program. The Company has paid approximately $65.7 million for shares acquired under this current program since the buyback program was first authorized in 2004. At this time, the Company has suspended its share repurchases and is focused on reducing outstanding bank debt.
The Company expects to pay the European arbitration award during the first half of 2011 and has sufficient borrowing capacity available to do so while remaining within compliance of the debt covenants. The Company believes that cash generated from operations and remaining availability under the current debt agreement after the payment of the European arbitration award provides sufficient liquidity to finance operations and execute strategic initiatives for at least the next 12 months.
Off-Balance Sheet Arrangements
The Company had no off-balance sheet arrangements as of January 1, 2011.
Contractual Obligations
The following table reflects the Company’s contractual obligations under long-term debt and lease agreements as of January 1, 2011:
The debt, capital lease obligations and finance lease obligation payments shown above represent principal payments required under those agreements. Additionally, MDS is required to make certain interest payments in connection with those obligations.
In addition to the amounts shown above, the Company currently has $0.8 million outstanding on standby letters of credit that expire in 2011.
Additionally, MDS is due rental revenue in the amounts shown below under sublease agreements on leased properties and rental agreements on owned properties:
Critical Accounting Policies and Estimates
In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management must make a variety of decisions which impact the reported amounts and related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied, the assumptions on which to base accounting estimates, and the consistent application of those accounting principles. Due to the type of industry in which the Company operates and the nature of its business, the following accounting policies are those that management believes are most important to the portrayal of the Company’s financial condition and results and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
Valuation of Warranty Liabilities
Customers are provided a written warranty from MDS on certain Midas products purchased from Midas shops in North America, namely brake friction, mufflers, shocks and struts. The warranty will be honored at any Midas shop in North America and is valid for the lifetime of the vehicle, but is voided if the vehicle is sold.
Prior to July 1, 2009 in Canada and January 1, 2008 in the U.S., product royalties received from the Company’s preferred supply chain vendors were recorded in revenue and substantially offset the cost of warranty claims. Beginning on January 1, 2008 in the U.S. and July 1, 2009 in Canada, the Midas warranty program became funded directly by franchisees. The Company maintains a warranty accrual to cover the estimated future liability associated with outstanding warranties issued prior to July 1, 2009 in Canada and January 1, 2008 in the U.S. The Company determines the estimated amount of outstanding warranty claims based on: 1) an estimate of the percentage of all warranted products sold and registered in prior periods at retail that are likely to be redeemed; and 2) an estimate of the cost of redemption of each future warranty claim on a current cost basis. These estimates are computed using actual historical registration and redemption data as well as actual cost information on current redemptions.
The determination of the number of products sold that are likely to be redeemed requires MDS to make significant estimates and assumptions regarding the relationship of historical warranty claim behavior; warranty claim behavior across product lines and geographical areas; and the impact of changes in consumer behavior on future warranty claims. A decrease of one percentage point in the estimated percentage of warranted products likely to be redeemed in the U.S. would have the effect of decreasing the Company’s January 1, 2011 outstanding U.S. warranty liability by approximately $1.8 million. A change in the estimated current cost of warranty redemptions of one dollar would have the effect of changing the outstanding U.S. warranty liability by approximately $0.5 million.
As of January 1, 2011, the estimated aggregate deferred warranty obligations under the new U.S. and Canadian programs were $6.8 million and the estimated aggregate warranty liability under the former program was $10.8 million.
Valuation of Receivables
The Company records receivables due from its franchisees and other customers at the time the sale is recorded in accordance with its revenue recognition policies. These receivables consist of amounts due from the sale of products, royalties due from franchisees and suppliers, rents and other amounts. The future collectability of these amounts can be impacted by the Company’s collection efforts, the financial stability of its customers, and the general economic climate in which it operates. Recent market conditions have increased the uncertainty in making these estimates. Any adverse change in these factors could have a significant impact on the collectability of these assets and could have a material impact on the Company’s consolidated financial statements.
The Company applies a consistent practice of establishing an allowance for accounts that it feels may become uncollectible through reviewing the historical aging of its receivables and by monitoring the financial strength of its franchisees and other customers. Where MDS becomes aware of the inability of a customer or franchisee to meet its financial obligations (e.g., where it is in financial distress or has filed for bankruptcy), the Company specifically reserves for the potential bad debt to reduce the net recognized receivable to the amount it reasonably believes will be collected. The valuation of receivables is performed on a quarterly basis.
In addition, the Company records receivables from third parties at the time a transaction is completed. These third party receivables are recorded at their estimated net realizable value. On a quarterly basis, the Company assesses the collectibility of these receivables.
Pensions
The Company has non-contributory defined benefit pension plans covering certain of its employees. The Company’s funding policy for the U.S. plan is to contribute amounts sufficient to meet the minimum funding requirement of the Employee Retirement Income Act of 1974, plus any additional amounts the Company may deem to be appropriate. The Company accounts for its defined benefit pension plans in accordance with ASC Topic 715, Compensation-Retirement Benefits (“ASC 715”), which requires that amounts recognized in the financial statements be determined on an actuarial basis. The amount recorded as pension assets or liabilities is determined by comparing the projected benefit obligation (PBO) to the fair value of the plan assets. Amounts recognized in accumulated other comprehensive income consist of unrecognized actuarial gains, losses, and prior service costs, net of tax.
As of January 1, 2011 and January 2, 2010, the Company has recorded accrued pension costs as follows (in millions):
To account for its defined benefit pension plans in accordance with ASC 715, the Company must make three main determinations at the end of each fiscal year: First, it must determine the actuarial assumption for the discount rate used to reflect the time value of money in the calculation of the projected benefit obligation for the end of the current fiscal year and to determine the net periodic pension cost for the subsequent year. To determine this rate, the Company’s third-party actuary prepares a detailed analysis of projected future cash flows using the Mercer Discount Yield Curve. See Note 9 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report for a listing of the discount rates used by year.
Second, the Company must determine the actuarial assumption for rates of increase in compensation levels used in the calculation of the accumulated and projected benefit obligations for the end of the current fiscal year and to determine the net periodic pension cost for the subsequent year. In determining these rates the Company looks at its historical and expected rates of annual salary increases. See Note 9 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report for a listing of the rates of increase in compensation levels used by year.
Third, the Company must determine the expected long-term rate of return on assets assumption that is used to determine the expected return on plan assets component of the net periodic pension cost for the subsequent year. The difference between the actual return on plan assets and the expected return is deferred and is recognized in net periodic pension cost over a five-year period. See Note 9 of Notes to Consolidated Financial
Statements included elsewhere in this Annual Report for a listing of the expected long-term rates used by year. The Company assumed a long-term rate of return on U.S. pension assets of 8.25% in fiscal 2010 and 2009, and experienced gains on plan assets of $5.2 million in fiscal 2010 and $6.2 million in fiscal 2009.
The Company’s pension plan investments are comprised primarily of bond and equity mutual funds and cash reserves. The pension plans have no investments in alternative investment vehicles such as private equity funds or hedge funds, nor have the plans ever held such investments.
Volatile market conditions over the past several years have increased the risks associated with certain investments held by MDS pension plans which have negatively impacted the value of investments, net periodic pension costs and created funding requirements. See Note 9 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report for a further description of pension shortfalls we experienced in fiscal 2008 and related contributions we made in fiscal 2009 and 2010. We expect to have additional pension funding obligations in fiscal 2011.
Carrying Values of Goodwill and Long-Lived Assets
Goodwill: The Company tests the recorded amount of goodwill for recovery on an annual basis in the fourth quarter of each fiscal year. Goodwill is tested more frequently if indicators of impairment exist. The Company continually assesses whether any indicators of impairment exist, which requires a significant amount of judgment. Such indicators may include: a sustained significant decline in our share price and market capitalization; a decline in our expected future cash flows; a significant adverse change in legal factors or in the business climate; unanticipated competition; the testing for recoverability of a significant asset group within a reporting unit; or slower growth rates, among others. Any adverse change in these factors could have a significant impact on the recoverability of these assets and could have a material impact on our consolidated financial statements.
The goodwill impairment test is a two step analysis. In Step One, the fair value of each reporting unit is compared to its book value. Management must apply judgment in determining the estimated fair value of these reporting units. Fair value is determined using a combination of present value techniques and quoted market prices of comparable businesses. If the fair value of the reporting unit exceeds its carrying value, goodwill is not deemed to be impaired for that reporting unit, and no further testing would be necessary. If the fair value of the reporting unit is less than the carrying value, the Company performs Step Two. Step Two uses the calculated fair value of the reporting unit to perform a hypothetical purchase price allocation to the fair value of the assets and liabilities of the reporting unit. The difference between the fair value of the reporting unit calculated in Step One and the fair value of the underlying assets and liabilities of the reporting unit is the implied fair value of the reporting unit’s goodwill. A charge is recorded in the financial statements if the carrying value of the reporting unit’s goodwill is greater than its implied fair value.
The determination of fair value of the reporting units and assets and liabilities within the reporting units requires management to make significant estimates and assumptions. These estimates and assumptions primarily include, but are not limited to, the discount rate, terminal growth rates, earnings before depreciation and amortization, and capital expenditures forecasts. Due to the inherent uncertainty involved in making these estimates, actual results could differ from those estimates. In both the U.S. and Canada, the reporting unit is defined as retail operations, which consists of both franchised and Company-operated locations. Both the U.S. and Canadian retail operations reporting units generate significant operating income and therefore the risk of goodwill impairment is remote.
Long-lived Assets: Long-lived assets include property and equipment, intangible assets, long-term prepaid assets and other non-current assets. The Company reviews long-lived assets held for use for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Events that may indicate long-lived assets may not be recoverable include, but are not limited to, a significant decrease
in the market price of long-lived assets, a significant adverse change in the manner in which the Company utilizes a long-lived asset, a significant adverse change in the business climate, a recent history of operating or cash flow losses, or a current expectation that it is more likely than not likely that a long-lived asset will be sold or disposed of in the future. For impairment testing purposes, the Company groups its long-lived assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities (the asset group). There were no events or changes in circumstances identified during the fiscal year that caused the Company to test long-lived assets for impairment.
If the Company determines that a long-lived asset or asset group may not be recoverable, it compares the sum of the expected undiscounted future cash flows that the asset or asset group is expected to generate to the asset or asset group’s carrying value. If the sum of the undiscounted future cash flows exceed the carrying amount of the asset or asset group, the asset or asset group is not considered impaired. However, if the sum of the undiscounted future cash flows is less than the carrying amount of the assets or asset group, a loss is recognized for the difference between the fair value of the asset or asset group and the carrying value of the asset or asset group. The fair value of the asset or asset group is generally determined by discounting the expected future cash flows using a discount rate that is commensurate with the risk associated with the amount and timing of the expected future cash flows. Due to the inherent uncertainty involved in making these estimates, actual results could differ from those estimates.
Deferred Income Taxes
In assessing the valuation of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Any adverse change in these factors could have a significant impact on the realizability of the Company’s deferred tax assets and could have a material impact on the Company’s consolidated financial statements.
Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences at January 1, 2011. In the event that management determines the Company would not be able to realize all or part of the net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. As of January 1, 2011, the Company had recorded a valuation allowance of $2.4 million against certain state income tax net operating loss carry forwards and foreign tax credit carry forwards because the Company has determined that it is more likely than not that this portion of these deferred tax assets will not be realized. However, due to the inherent uncertainty involved in determining the realizability of the company’s deferred tax assets, the future realizability could differ from management estimates at January 1, 2011.
Impact of New Accounting Standards
New Accounting Pronouncements-Adopted
On January 3, 2010, MDS adopted changes issued by the Financial Accounting Standards Board (FASB) to accounting for variable interest entities. These changes require significant modifications to the analysis, evaluation and disclosure of variable interest entities. The adoption of these changes had no material impact on the Company’s Financial Statements.
On January 3, 2010, MDS adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the
transfers. The changes also clarify existing disclosure requirements related to how assets and liabilities should be grouped by class and valuation techniques used for recurring and nonrecurring fair value measurements. Other than the required additional disclosures, the adoption of these changes had no impact on the Company’s Financial Statements.
New Accounting Pronouncements-Issued
In October 2009, the FASB issued new accounting guidance related to the recognition of revenue for multiple deliverable arrangements. The Company does not engage in the type of transactions covered by this guidance. As a result, the Company has determined that the adoption of this guidance will not have a material impact on the on the Company’s Financial Statements.
In January 2010, the FASB issued changes to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances, and settlements on a gross basis rather than as one net number. These changes become effective for MDS beginning January 2, 2011. The Company has determined that the adoption of this guidance will have no impact on the on the Company’s Financial Statements.
Forward Looking Statements
This report contains (and oral communications made by MDS may contain) forward-looking statements that may be identified by their use of words like “plans,” “expects,” “anticipates,” “intends,” “estimates,” “forecasts,” “will,” “outlook” “should” or other words of similar meaning. All statements that address the Company’s expectations or projections about the future, including statements about MDS’s strategy for growth, cost reduction goals, expenditures and financial results, pending legal proceedings or the Company’s ability to recover any costs in such legal proceedings are forward-looking statements. Forward-looking statements are based on the Company’s estimates, assumptions and expectations of future events and are subject to a number of risks and uncertainties. MDS cannot guarantee that these estimates, assumptions and expectations are accurate or will be realized. MDS disclaims any intention or obligation (other than as required by law) to update or revise any forward-looking statements.
The Company’s results of operations and the forward-looking statements could be affected by, among others things: general economic conditions in the markets in which the Company operates; economic developments that have a particularly adverse effect on one or more of the markets served by the Company; the ability to execute management’s internal operating plans; the timing and magnitude of capital expenditures; the Company’s ability to access debt and equity markets; economic and market conditions in the U.S. and worldwide; currency exchange rates; changes in consumer spending levels and demand for new products and services; and overall competitive activities. Certain of these risks are more fully described in Item 1A of Part I of the Company’s annual report on Form 10-K. The Company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company is subject to certain market risks, including foreign currency and interest rates. MDS uses a variety of practices to manage these market risks, including, when considered appropriate, derivative financial instruments. The Company uses derivative financial instruments only for risk management and does not use them for trading or speculative purposes. MDS is exposed to potential gains or losses from foreign currency fluctuations affecting net investments and earnings denominated in foreign currencies. The Company’s primary exposure is to changes in exchange rates for the U.S. dollar versus the Canadian dollar and changes in exchange rates between the U.S. dollar and the Euro for international license fees from Europe.
Interest rate risk is managed through variable rate borrowings in combination with swaps to fixed interest rates on a portion of those borrowings. The Company is exposed to credit risk on certain assets, primarily accounts receivable. The Company provides credit to customers and franchisees in the ordinary course of business and performs ongoing credit evaluations. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company’s customer base. The Company believes its allowance for doubtful accounts is sufficient to cover customer credit risk.
The table below provides information about the Company’s financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted-average interest rates by the expected maturity dates. The actual cash flows for each instrument are denominated and presented in U.S. dollar equivalents (in millions), which is the Company’s reporting currency.
The fair value of the Company’s revolving credit facility is determined as the present value of expected future cash flows discounted at the current interest rate for loans of similar terms and comparable credit risk. Interest rate spreads have declined since the debt was refinanced on December 4, 2009. As a result, the fair value of the debt currently exceeds the book value.
In November 2005, $20 million in revolving bank debt was converted from floating rate to fixed rate by locking-in LIBOR at 4.89% for a five-year period. In addition, in March 2007, MDS entered into an interest rate swap arrangement to convert an additional $25 million in revolving bank debt from floating rate to a fixed rate by locking-in LIBOR at 4.91% through October 2010. Both of these swap arrangements expired prior to January 1, 2011.
In January 2010, the Company entered into a $40 million forward starting swap to coincide with the end dates of its existing swaps. As a result of this forward swap transaction, in the period from November 2010 through October 2013 (end of the recently extended bank agreement) the Company has locked-in LIBOR at 2.71% for $40 million of its $62.7 million in revolving bank debt.
The Company has no firmly committed sales transactions denominated in foreign currencies.
As discussed under Item 3 - “Legal Proceedings”, an arbitral tribunal issued a ruling in March 2011 that requires the Company to pay an award of 17.45 million, plus interest through the date of payment, to its licensee in Europe. The Company accrued this amount in its fiscal 2010 financial statements at the fiscal year-end Euro exchange rate of 1.34 to 1.0. The Euro has strengthened versus the U.S. dollar since year-end and the exchange rate is currently approximately 1.40 to 1.0. The award is to be paid as soon as possible. Unless the U.S. dollars strengthens versus the Euro and depending upon the exchange rate on the date of payment, the Company may incur a substantial exchange loss on this payment. A 0.01 change in the exchange rate will result in a change of $175,000 in the award payment.
Item 8.
Item 8. Financial Statements and Supplementary Data
See Index to Financial Statements on page
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A. Controls and Procedures
(a) Evaluation of disclosure controls and procedures.
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.
The Company’s management, including the Chief Executive Officer and Chief Financial Officer, does not expect that its disclosure controls and procedures and its internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.
(b) Changes in internal controls over financial reporting.
There were no changes in internal controls during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, internal controls over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Our internal control over financial reporting includes those policies and procedures that:
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Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of MDS;
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Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and
•
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree or compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of January 1, 2011. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment and those criteria, management believes that MDS maintained effective internal control over financial reporting as of January 1, 2011.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
The Board of Directors and Shareholders
Midas, Inc.:
We have audited Midas, Inc.’s (the Company) internal control over financial reporting as of January 1, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Midas, Inc. maintained, in all material respects, effective internal control over financial reporting as of January 1, 2011, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Midas, Inc. as of fiscal-year end 2010 and 2009, and the related consolidated statements of operations, cash flows, and changes in shareholders’ equity for each of the fiscal years 2010, 2009 and 2008, and our report dated March 17, 2011 expressed an unqualified opinion on those consolidated financial statements.
Chicago, Illinois
March 17, 2011
Item 9B.
Item 9B. Other Information
Information required to be disclosed pursuant to Item 5.02 of Form 8-K; Departure of certain Directors or Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers.
2011 Annual Incentive Compensation Plan
At its meeting held on March 15, 2011, the Board of Directors (the “Board”) of Midas, Inc. (the “Company”), upon the recommendation of its Compensation Committee (the “Committee”), approved the terms of the 2011 Annual Incentive Compensation Plan (the “2011 Plan”) for the Company’s executive officers and key employees, including its Chief Executive Officer. The 2011 Plan is intended to provide incentives to the 2011 Plan participants in the form of cash bonus payments for achieving certain specified performance goals.
The bonus target levels under the 2011 Plan range between 15% and 90% (or such greater percentage as may result from the enhancement features described below) of the applicable participant’s annual base salary, depending upon the participant’s salary grade within the Company. The bonus target levels for the Company’s officers under the 2011 Plan are as follows:
* as a percentage of annual base salary
As previously noted, the foregoing bonus target levels are subject to the enhancement features described below.
The 2011 Plan is comprised of three components: (1) an Operating Income component (the “Operating Income Component”), which represents 50% of the 2011 Plan’s potential bonus payout, (2) a North American Comparable Shop Retail Sales Increase component (the “Retail Sales Component”), which represents 20% of the 2011 Plan’s potential bonus payout, and (3) an Individual Objectives component (the “Individual Objectives Component”), which represents the remaining 30% of the 2011 Plan’s potential bonus payout.
Bonus awards pursuant to the Operating Income Component are based upon the Company’s achievement of an operating income target of approximately $21,450,000 for 2011, which is then adjusted to exclude the impact of bonus accruals, restricted stock amortization expense, costs related to the expensing of stock options, gains and losses on asset sales, and restructuring costs (the “Financial Target”). In addition, the Operating Income Component contains a “2 for 1” enhancement feature whereby, for each 1% (or pro rata portion thereof) over the Financial Target achieved by the Company, an additional 2% (or corresponding pro rata portion thereof) is added to the target bonus award under the Operating Income Component. Similarly, for each 1% (or pro rata portion thereof) that the Company falls short of the Financial Target, the target bonus award under the Operating Income Component is reduced by 2% (or corresponding pro rata portion thereof). The 2011 Plan specifically provides that no bonus awards are to be paid pursuant to the Operating Income Component unless the Company achieves at least 80% of the Financial Target (the “Financial Target Threshold”).
Bonus awards pursuant to the Retail Sales Component are based upon the Company’s achievement of a 2% comparable shop retail sales increase in North America for 2011 (the “Sales Target”). In addition, the Retail Sales Component contains an enhancement feature whereby, for each 1% (or pro rata portion thereof) over the 2% targeted increase in comparable shop retail sales achieved by the Company in North America, an additional 10% (or corresponding pro rata portion thereof) would be added to the target bonus award payable thereunder (up
to a maximum of 130%). Similarly, for each 1% (or pro rata portion thereof) that the Company falls short of the 2% targeted increase, the target bonus award under the Sales Component would be reduced by 10% (or corresponding pro rata portion thereof), with no payout thereunder if the comparable shop retail sales increase in North America is below 1% in 2011 (the “Sales Target Threshold”). The 2011 Plan specifically provides that no bonus awards are to be paid pursuant to the Retail Sales Component if the Company fails to achieve the Financial Target Threshold under the Operating Income Component.
Bonus awards pursuant to the Individual Objectives Component are based upon a 2011 Plan participant’s achievement of specific individual objectives. Individual objectives are established by mutual agreement of the participant and his or her direct supervisor within the Company (or the Board, in the case of the Chief Executive Officer), and align with, and otherwise support and/or advance, the Company’s overall business strategy. The Individual Objectives Component of the 2011 Plan provides for a maximum achievement percentage of 150% in order to acknowledge and reward extraordinary efforts by the 2011 Plan participant in achieving particular individual objectives. Bonus awards pursuant to the Individual Objectives Component are not contingent upon the Company’s achievement of the Financial Target, the Sales Target or any other financial metrics.
The 2011 Plan provides for a maximum cap of 150% of a participant’s target bonus level, notwithstanding the above-described enhancement features under the Operating Income Component, the Retail Sales Component and the Individual Objectives Component.
The Committee oversees the 2011 Plan. All bonus awards made pursuant to the 2011 Plan are subject to the Committee’s approval. In addition, the Committee has sole authority to determine whether the Financial Target Threshold and the Sales Target Threshold have been achieved by the Company and, if so, the applicable bonus award percentages under the Operating Income Component and the Retail Sales Component resulting from the enhancement features described above. The 2011 Plan also provides the Committee with discretion to include or exclude significant one-time items in determining the level of achievement of the Financial Target and the Sales Target.
Information required to be disclosed pursuant to Item 5.02 of Form 8-K: Departure of certain Directors or Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers.
Also at its meeting held on March 15, 2011, the Board appointed Audrey L. Gualandri, the Company’s Vice President and Controller, as the Company’s principal accounting officer, such appointment to be effective immediately.
Information required to be disclosed pursuant to Item 1.01 of Form 8-K: Entry into a Material Definitive Agreement.
On March 16, 2011, the Company and its lenders entered into a First Amendment to Amended and Restated Credit Agreement dated December 4, 2009. The amendment provides, among other things, that the $25.5 million European arbitration award is excluded from the definition of Consolidated Adjusted EBITDA as defined in the credit agreement for purposes of the covenant calculations. The amendment also increased the maximum Leverage Ratio to 3.50 to 1.00 for fiscal year end 2010 and the first two fiscal quarters of fiscal 2011, being reduced to 3.25 to 1.00 at the end of the third and fourth quarters of fiscal 2011. The allowable leverage ratio then returns to 3.00 to 1.00 for all remaining periods. The Consolidate Net Worth requirement was reduced to $17.5 million and the lenders waived the covenant violations that existed as a result of the recording of the $25.5 million European arbitration award in the fiscal 2010 financial statements.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance of the Registrant
Executive Officers of the Registrant
Information with respect to those individuals who serve as executive officers of the Company is set forth below.
Additional information required by this item, which is set forth under the headings “Proposal 1: Election Of Directors,” “Meetings and Committees of the Board” and “Beneficial Ownership of Common Stock-Section 16 (a) Beneficial Ownership Reporting Compliance” in the Company’s proxy statement (the “2011 Proxy Statement”) for the Annual Meeting of Shareholders to be held on May 10, 2011, is incorporated herein by reference.
There are no family relationships among any of our directors, executive officers or persons nominated to become a director or executive officer.
The Company has adopted a code of ethics that applies to all of its employees, officers, and directors, including its principal executive officer, principal financial officer, and principal accounting officer (controller). The text of the Company’s code of ethics is posted on its website at www.midas.com. The Company intends to
disclose future amendments to, or waivers from, certain provisions of the code of ethics for executive officers and directors on the Company’s website within five business days following the date of such amendment or waiver. Stockholders may request a free copy of the code of ethics from:
Alvin K. Marr
Corporate Secretary
Midas, Inc.
1300 Arlington Heights Road
Itasca, IL 60143
Telephone: (630) 438-3000
MDS has also adopted written charters for its Audit and Finance, Compensation, and Nominating and Corporate Governance Committees, and Corporate Governance Guidelines, all of which are posted on the Company’s website at www.midas.com. Stockholders may request a free copy of the charters and guidelines from the address or telephone number set forth above.
On July 2, 2010, MDS submitted its Section 303A Annual Written Affirmation to the New York Stock Exchange (“NYSE”), including the CEO certification regarding the Company’s compliance with the NYSE corporate governance listing standards, in accordance with the NYSE rules.
Information required by this item is set forth in the 2011 Proxy Statement and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
Information required by this item is set forth in the 2011 Proxy Statement and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table gives information about the Company’s common stock that may be issued under the Company’s equity compensation plans as of January 1, 2011.
Includes the MDS Stock Incentive Plan and the MDS Directors’ Deferred Compensation Plan.
The MDS Directors’ Deferred Compensation Plan was adopted in 2002. This plan provides non-officer directors the option of using their Board and Board Committee annual retainer and meeting attendance fees from the Company to purchase shares of the Company’s Common Stock, or of deferring receipt of such fees in the form of cash units and units representing shares of the Company’s Common Stock. The Plan provides for a 100,000 maximum aggregate number of shares. The Company’s intention is to use treasury shares for such purposes. No shares have been issued under this plan. All current fees and other compensation for directors are outlined in the 2011 Proxy Statement.
The MDS Treasury Stock Plan, adopted in 2002, authorizes the issuance of up to 400,000 shares of MDS common stock held in Treasury pursuant to the exercise of incentive stock options, non-qualified stock options and stock appreciation rights and the grant of restricted stock and performance awards. The plan as amended and restated, was approved by shareholders on May 11, 2010. As of January 1, 2011, only 35,894 shares under this plan remain available for issuance.
The Company issues non-qualified stock options to certain individuals in order to induce them to accept employment with the Company. Pursuant to the rules of the New York Stock Exchange, options issued under this program are not considered part of the MDS Stock Incentive Plan and are not deducted from the number of securities remaining available for future issuance. As of January 1, 2011, inducement options for a total of 552,526 shares were outstanding. These options have a ten-year term and vest over a period of five years commencing from the date of grant.
Information required by Item 403 of Regulation S-K, which is set forth under the heading “Beneficial Ownership of Common Stock” in the 2011 Proxy Statement, is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information required by this item is set forth in the 2011 Proxy Statement and is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
Information required by this item, which is set forth under the heading “Principal Accounting Firm Fees” in the 2011 Proxy Statement, is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) 1. Financial Statements
See Index to Financial Statements on Page.
2. Financial Statement Schedules
See Index to Financial Statements on Page.
(b) Exhibits
* Management Compensatory Plan or Contract
# Filed herewith
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, this 17th day of March 2011.
MIDAS, INC.
By:
/s/ WILLIAM M. GUZIK
William M. Guzik
Executive Vice President and
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities indicated on behalf of the Registrant, this 17th day of March 2011.
MIDAS
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Financial statement schedules are omitted because they are not applicable or the required information is presented in the financial statements or related notes.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Midas, Inc.:
We have audited the accompanying consolidated balance sheets of Midas, Inc. (the “Company”) as of fiscal year end 2010 and 2009, and the related consolidated statements of operations, cash flows, and changes in shareholders’ equity for each of the fiscal years 2010, 2009 and 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Midas, Inc. as of fiscal-year end 2010 and 2009, and the results of its operations and cash flows for fiscal years 2010, 2009 and 2008, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Midas, Inc.’s internal control over financial reporting as of January 1, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 17, 2011 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Chicago, Illinois
March 17, 2011
MIDAS
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except for earnings per share)
See accompanying notes to financial statements.
MIDAS
CONSOLIDATED BALANCE SHEETS
(In millions, except per share data)
See accompanying notes to financial statements.
MIDAS
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
See accompanying notes to financial statements.
MIDAS
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(In millions)
See accompanying notes to financial statements.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Summary of Significant Accounting Policies
Nature of Business and Basis of Presentation
Midas, Inc. (“MDS” or the “Company”) provides retail automotive services principally through franchised or licensed shops in the U.S., Canada, Europe and other countries. Through March of 2008, the Company’s sole franchise concept was Midas auto repair centers (“Midas”). In April of 2008, MDS acquired the SpeeDee Oil Change and Tune-up franchise system (“SpeeDee”) and now sells Midas, SpeeDee and Midas-SpeeDee Co-Branded franchises. The consolidated financial statements presented herein include Midas, Inc. and all of its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Fiscal Periods
Fiscal year 2010 ended on January 1, 2011 and consisted of 52 weeks. Fiscal year 2009 ended on January 2, 2010 and consisted of 52 weeks. Fiscal year 2008 ended on January 3, 2009 and consisted of 53 weeks.
Foreign Currency Translation and Transactions
All assets and liabilities of non-U.S. operations are translated into U.S. dollars using exchange rates as of the end of each fiscal period. Income and expense items are translated at average exchange rates prevailing during each fiscal period. The resulting translation adjustments are recorded as a component of shareholders’ equity. Gains and losses from foreign currency transactions are included in net earnings.
Cash and Cash Equivalents
Cash and cash equivalents consist of deposits with banks and financial institutions and are unrestricted as to withdrawal or use, and which have an original maturity of three months or less. Cash and cash equivalents includes customer credit card payments that settle within 2-3 business days of the fiscal period end.
Fair Value of Financial Instruments
MDS’s financial instruments include cash and cash equivalents, receivables, accounts payable, and long-term debt. No public market exists for the Company’s long term debt. Since the Company’s credit agreement was amended on December 4, 2009, interest rate spreads have declined. As a result, MDS estimates that the fair value of the Company’s $62.7 in debt is approximately $63.8 million. The carrying amounts of the other financial assets and liabilities approximate their fair values because of the short maturities of those instruments.
Derivative Financial Instruments
The Company has market risk exposure to changes in interest rates, principally in the United States. MDS attempts to minimize this risk and fix a portion of its overall borrowing costs through the utilization of interest rate swaps. These swaps are entered into with financial institutions and have critical dates and terms that result in the swaps being highly effective.
Valuation of Receivables
The Company records receivables due from its franchisees and other customers at the time the sale is recorded in accordance with its revenue recognition policies. These receivables consist of amounts due from the sale of products, royalties due from franchisees and suppliers, rents and other amounts. The future collectability
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
of these amounts can be impacted by the Company’s collection efforts, the financial stability of its customers and franchisees, and the general economic climate in which it operates. Recent market conditions have increased the uncertainty in making these estimates. Any adverse change in these factors could have a significant impact on the collectability of these assets and could have a material impact on the Company’s consolidated financial statements.
The Company applies a consistent practice of establishing an allowance for accounts that it feels may become uncollectible through reviewing the historical aging of its receivables and by monitoring the financial strength of its franchisees and other customers. Where MDS becomes aware of the inability of a customer or franchisee to meet its financial obligations (e.g., where it is in financial distress or has filed for bankruptcy), the Company specifically reserves for the potential bad debt to reduce the net recognized receivable to the amount it reasonably believes will be collected. The valuation of receivables is performed on a quarterly basis.
In addition, the Company records receivables from third parties at the time a transaction is completed. These third party receivables are recorded at their estimated net realizable value. On a quarterly basis, the Company assesses the collectibility of these receivables.
Notes Receivable
Notes receivable relate to franchisee financing arrangements for certain previously past due balances and other long-term receivables that exceed one year. They bear interest at a market rate based on the franchisee’s credit quality and are recorded at face value. Interest is recognized over the life of the note. The notes are typically collateralized by inventory, equipment or similar assets of the franchisee. The Company has not and does not intend to sell these receivables. Past due notes receivable are considered during the Company’s valuation of receivables.
Inventory Valuation
Inventories are valued at the lower of cost or net realizable value. Inventory cost is determined using the weighted-average cost method, which approximates the first-in, first-out method. Additionally, the Company periodically evaluates the carrying value of its inventory to assess the proper valuation. This evaluation includes having adequate allowances to cover losses in the normal course of operations, providing for excess and obsolete inventory, and ensuring that inventory is valued at the lower of cost or market. In performing this evaluation, the Company considers historical data such as actual loss experience, past and projected usage, rights to return product to vendors and actual margins generated from sales of its products.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is computed using the straight-line method and includes amortization of assets held under capital and finance leases. When property is sold or retired, the cost and accumulated depreciation are eliminated from the accounts and gains or losses are recorded in the statement of operations. Expenditures for maintenance and repairs are expensed as incurred.
Buildings and improvements are depreciated over useful lives ranging from 10 to 40 years. Machinery and equipment is depreciated over useful lives ranging from three to 12 years, and computer hardware is depreciated over useful lives of three to five years. Major enterprise-level computer software is depreciated over 10 years while all other software is depreciated over five years.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
In assessing the valuation of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences at January 1, 2011. In the event that management determines the Company would not be able to realize all or part of the net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period in which such determination was made.
Carrying Value of Goodwill and Long-Lived Assets
Goodwill: The Company tests the recorded amount of goodwill for recovery on an annual basis in the fourth quarter of each fiscal year. Goodwill is tested more frequently if indicators of impairment exist. The Company continually assesses whether any indicators of impairment exist, which requires a significant amount of judgment. Such indicators may include: a sustained significant decline in our share price and market capitalization; a decline in our expected future cash flows; a significant adverse change in legal factors or in the business climate; unanticipated competition; the testing for recoverability of a significant asset group within a reporting unit; or slower growth rates, among others. Any adverse change in these factors could have a significant impact on the recoverability of these assets and could have a material impact on our consolidated financial statements.
The goodwill impairment test is a two step analysis. In Step One, the fair value of each reporting unit is compared to its book value. Management must apply judgment in determining the estimated fair value of these reporting units. Fair value is determined using a combination of present value techniques and quoted market prices of comparable businesses. If the fair value of the reporting unit exceeds its carrying value, goodwill is not deemed to be impaired for that reporting unit, and no further testing would be necessary. If the fair value of the reporting unit is less than the carrying value, the Company performs Step Two. Step Two uses the calculated fair value of the reporting unit to perform a hypothetical purchase price allocation to the fair value of the assets and liabilities of the reporting unit. The difference between the fair value of the reporting unit calculated in Step One and the fair value of the underlying assets and liabilities of the reporting unit is the implied fair value of the reporting unit’s goodwill. A charge is recorded in the financial statements if the carrying value of the reporting unit’s goodwill is greater than its implied fair value.
The determination of fair value of the reporting units and assets and liabilities within the reporting units requires management to make significant estimates and assumptions. These estimates and assumptions primarily include, but are not limited to, the discount rate, terminal growth rates, earnings before depreciation and amortization, and capital expenditures forecasts. Due to the inherent uncertainty involved in making these estimates, actual results could differ from those estimates. In both the U.S. and Canada, the reporting unit is defined as retail operations, which consists of both franchised and Company-operated locations.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Long-lived Assets: Long-lived assets include property and equipment, intangible assets, long-term prepaid assets and other non-current assets. The Company reviews long-lived assets held for use for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Events that may indicate long-lived assets may not be recoverable include, but are not limited to, a significant decrease in the market price of long-lived assets, a significant adverse change in the manner in which the Company utilizes a long-lived asset, a significant adverse change in the business climate, a recent history of operating or cash flow losses, or a current expectation that it is more likely than not likely that a long-lived asset will be sold or disposed of in the future. For impairment testing purposes, the Company groups its long-lived assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities (the asset group).
If the Company determines that a long-lived asset or asset group may not be recoverable, it compares the sum of the expected undiscounted future cash flows that the asset or asset group is expected to generate to the asset or asset group’s carrying value. If the sum of the undiscounted future cash flows exceed the carrying amount of the asset or asset group, the asset or asset group is not considered impaired. However, if the sum of the undiscounted future cash flows is less than the carrying amount of the assets or asset group, a loss is recognized for the difference between the fair value of the asset or asset group and the carrying value of the asset or asset group. The fair value of the asset or asset group is generally determined by discounting the expected future cash flows using a discount rate that is commensurate with the risk associated with the amount and timing of the expected future cash flows. Due to the inherent uncertainty involved in making these estimates, actual results could differ from those estimates.
Fixed assets held for sale are carried at the lower of the carrying amount or fair value, less costs to sell. Assets held for sale are no longer depreciated.
Revenue Recognition
Franchise royalties are recognized in the periods that correspond to the periods in which retail sales and revenues are recognized by franchisees. Franchise renewal fees are recognized when the new franchise agreement is signed by the franchisee, the renewal period commences and all contractual obligations have been met. Product royalties are recognized as earned based on the volume of franchisee purchases of products from certain vendors. Real estate revenues are recognized as earned on a monthly basis in accordance with underlying property lease terms using the straight-line method. The majority of real estate revenues are derived from Midas shop locations. Nearly all of these locations are subject to an annual percentage rent based upon the location’s retail sales volume for the calendar year. Replacement part sales are recognized at the time products are shipped. Sales and revenues of company-operated shops are recognized when customer vehicles are repaired or serviced. Taxes collected on behalf of taxing authorities are not recognized as revenue, but rather are recorded as a liability and remitted to the proper taxing authority. Warranty fee revenue is recorded at the same time warranty expense is recognized, which is at the time a lifetime warranted product claim is submitted to the Company.
Revenues derived from franchise fees, which represented approximately 0.6%, 0.8% and 1.1% of franchising revenues in fiscal 2010, 2009 and 2008, respectively, are recognized when the franchised shop opens and after certain contractual obligations have been met. Costs related to securing initial franchise agreements and performing the required services under such agreements are charged to expense as incurred.
Advertising
Advertising costs are expensed as incurred.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Recognition of Warranty Costs
Customers are provided a written warranty from MDS on certain Midas products purchased from Midas shops in North America, namely brake friction, mufflers, shocks and struts. The warranty will be honored at any Midas shop in North America and is valid for the lifetime of the vehicle, but is voided if the vehicle is sold. The Company maintains a warranty accrual to cover the estimated future liability associated with outstanding warranties. The Company determines the estimated value of outstanding warranty claims based on: 1) an estimate of the percentage of all warranted products sold and registered in prior periods at retail that are likely to be redeemed; and 2) an estimate of the cost of redemption of each future warranty claim on a current cost basis. These estimates are computed using actual historical registration and redemption data as well as actual cost information on current redemptions.
Annual warranty activity is summarized as follows (in millions):
Warranty expense (benefit) is included in operating costs and expenses in the statements of operations. A portion of warranty expense incurred is also paid as claims within the same fiscal year. Warranty expense was reduced by $0.3 million, $0.6 million and $3.4 million in fiscal 2010, 2009 and 2008, respectively, due to changes in estimated warranty redemptions.
As of January 1, 2008, the Company changed how the Midas warranty obligations are funded in the United States. From June 2003 through December 2007, product royalties received from the Company’s preferred supply chain vendors were recorded as revenue and substantially offset the cost of warranty claims. Beginning in fiscal 2008, the Midas warranty program in the United States is funded directly by Midas franchisees. The franchisees are charged a fee for each warranted product sold to customers. The fee is charged when the warranty is registered with the Company. The fee billed to franchisees is deferred and is recognized as revenue when the actual warranty is redeemed and included in warranty expense. This fee is intended to cover the Company’s cost of the new warranty program, thus revenues under this program will match expenses and the new warranty program will have no impact on the results of operations. In connection with this change, beginning in 2008 Midas system franchisees in the United States started receiving rebates on their purchases from the Company’s preferred supply chain vendors and MDS no longer receives product royalties on Midas franchisee purchases in the United States. Because the Company’s U.S. supply chain partners are responsible for the warranty of parts during the first 12 months, MDS did not begin to record revenues or expenses under the new program until fiscal 2009.
As of July 1, 2009, the Company changed how the Midas warranty obligations are funded in Canada to match the U.S. program. As a result, beginning in July 2009 Midas system franchisees in Canada started receiving rebates on their purchases from the Company’s preferred supply chain vendors and MDS no longer receives product royalties on Midas franchisee purchases in Canada. Because the Company’s Canadian supply chain partners are responsible for the warranty of parts during the first 12 months, MDS did not begin to record revenues or expenses under the new Canadian program until fiscal 2010.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Annual activity for the deferred warranty obligation related to this new program is summarized as follows (in millions):
Stock-Based Compensation
The Company records an expense for outstanding unvested stock awards based on the grant-date fair value of those awards. The fair value of stock option awards has been determined using the Black-Scholes option pricing model.
Earnings Per Share
Because MDS reported a loss in fiscal 2010, all stock options were excluded from the computation of earnings per share as they would be anti-dilutive.
Potential common share equivalents that could impact basic and diluted earnings per share but were excluded because they would be anti-dilutive were as follows (in millions):
Financial Statement Preparation
The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include inventory valuation, valuation of receivables, business transformation charges, carrying values of goodwill, intangible assets, long-lived assets, and net deferred tax assets and warranty obligations. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. The Company adjusts such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity, foreign currency and energy markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.
Management has evaluated all activity of MDS and concluded that one material subsequent event occurred. This event is disclosed below in Note 2 of the Notes to Consolidated Financial Statements.
Impact of New Accounting Standards
On January 3, 2010, MDS adopted changes issued by the Financial Accounting Standards Board (FASB) to accounting for variable interest entities. These changes require significant modifications to the analysis, evaluation and disclosure of variable interest entities. The adoption of these changes had no material impact on the Company’s Financial Statements.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
On January 3, 2010, MDS adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. The changes also clarify existing disclosure requirements related to how assets and liabilities should be grouped by class and valuation techniques used for recurring and nonrecurring fair value measurements. Other than the required additional disclosures, the adoption of these changes had no impact on the Company’s Financial Statements.
(2) Subsequent Event
On March 3, 2011 the arbitral tribunal based in Geneva, Switzerland, issued its final ruling in the arbitration between MDS and its European licensee MESA S.p.A. (“MESA”) and Mobivia Group S.A. (“Mobivia”, formerly known as Norauto Groupe SA). MESA had filed a request for arbitration on June 12, 2009, seeking damages of up to  256 million from MDS, claiming breach of a 1998 agreement of strategic alliance (“ASA”) and requesting termination of the license agreement under which royalty payments are paid to MDS. Under the terms of the ASA, disputes are to be settled by binding arbitration in Geneva, Switzerland, under the UNCITRAL Arbitration Rules.
MDS prevailed in its defense of the vast majority of claims that MESA and Mobivia had asserted as to MDS’ obligation to invest under the ASA in Midas Europe. However, the arbitral tribunal has awarded MESA $23.4 million plus interest of five percent from June 12, 2009 of $2.1 million through the ruling date, in connection with MESA’s claim that MDS failed to cooperate in the improvement of IT systems in the European operations.
Because MESA failed to prevail in the majority of its claims, the arbitral tribunal ordered MESA to pay 85 percent of MDS’ legal and other arbitration expenses and MDS to pay 15 percent of MESA’s expenses, resulting in MESA being required to pay MDS a net amount of approximately $2.5 million.
The damages payable to MESA will be offset by $2.1 million in MESA’s license fee payments due to MDS that were held in escrow as of the ruling date.
As a result of this ruling, MDS recorded a $25.5 million European arbitration award expense in its fiscal 2010 consolidated financial statements, and a corresponding $25.5 million accrued European arbitration award liability. The Company also recorded a $2.5 million reduction in selling, general and administrative expense for the fee recovery, and a corresponding receivable.
The license agreement between Midas and MESA continues in full force and the license fee royalty stream is to continue uninterrupted. The initial term of the license agreement expires in 2028 with additional 30 year options available.
(3) Debt Agreements
On December 4, 2009, MDS entered into a three-year extension of its existing unsecured revolving credit facility. The credit agreement was extended through October 27, 2013 with no material changes in existing covenants. The extended facility is for $125 million and is further expandable to $175 million by the Company with lender approval. The interest rate floats based on the underlying rate of LIBOR and the Company’s leverage and was priced at LIBOR plus 3.00% at January 1, 2011. This facility requires maintenance of certain financial covenants including maximum allowable leverage, minimum fixed charge coverage and minimum net worth.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As a result of the accrual of the $25.5 million European arbitration award in 2010, the Company was in violation of certain financial covenants as of January 1, 2011. On March 16, 2011, the Company’s lenders waived the covenant violations and entered into an amendment to the credit agreement. The amendment provides, among other things, that the $25.5 million arbitration award is excluded from the definition of consolidated adjusted EBITDA as defined in the credit agreement (“Consolidated Adjusted EBITDA”) for purposes of the covenant calculations.
As of January 1, 2011, a total of $62.7 million was outstanding under the revolving credit facility. As of January 2, 2010, a total of $71.9 million was outstanding under the revolving credit facility.
In November 2005, $20 million in revolving bank debt was converted from floating rate to fixed rate by locking-in LIBOR at 4.89% for a five-year period. In addition, in March 2007, MDS entered into an interest rate swap arrangement to convert an additional $25 million in revolving bank debt from floating rate to a fixed rate by locking-in LIBOR at 4.91% through October 2010. Both of these swap arrangements expired prior to January 1, 2011.
In January 2010, the Company entered into a $40 million forward starting swap to coincide with the end dates of its existing swaps. As a result of this forward swap transaction, in the period from November 2010 through October 2013 (end of the recently extended bank agreement) the Company has locked-in LIBOR at 2.71% for $40 million of its $62.7 million in revolving bank debt.
The November 2005, March 2007 and January 2010 swap arrangements have been designated as cash flow hedges and have been evaluated to be highly effective. As a result, the after-tax change in the fair value of these swaps is recorded in accumulated other comprehensive loss as a gain or loss on derivative financial instruments.
The fair value of the Company’s revolving credit facility is determined as the present value of expected future cash flows discounted at the current interest rate for loans of similar terms and comparable credit risk. Interest rate spreads have declined since the debt was refinanced on December 4, 2009. As a result, the fair value of the debt currently exceeds the book value.
(4) Supplemental Balance Sheet, Cash Flow and Shareholders’ Equity Information
Receivables and Notes Receivable
Receivables are stated net of an allowance for doubtful accounts. The allowance for doubtful accounts consisted of (in millions):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The current portion of notes receivable is included in net receivables and the long term portion is included in other assets. Notes receivable consisted of (in millions):
The long term portion of notes receivable are shown net of an allowance for doubtful accounts of $1.2 million in fiscal 2010 and $1.5 million in fiscal 2009.
The acquisition of certain company-operated shops resulted in non-cash reductions of accounts receivable of approximately $2.5 million and $0.3 million during fiscal 2010 and 2009, respectively.
Receivables include certain non-trade receivables such as vendor receivables, insurance recoveries and other non-recurring items. Non-trade receivables were $4.1 million as of January 1, 2011 and $4.9 million as of January 1, 2010.
Inventories
Inventories are comprised of finished goods, net of reserves. Inventory reserves consisted of (in millions):
Property and Equipment
Property and equipment consisted of the following (in millions):
The Company recorded depreciation expense of $8.7 million, $8.8 million, and $9.3 million in fiscal 2010, 2009 and 2008, respectively. Depreciation expense is included in operating costs and expenses in the Statement of Operations.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Goodwill and Other Intangible Assets
Goodwill and other intangible assets consisted of the following (in millions):
In January 2010, MDS acquired 22 Midas shops from an existing Midas franchisee. As a result of this acquisition, the Company recorded $5.5 million in incremental goodwill and other intangibles, which included $1.9 million of intangible franchise agreements, $0.2 million of customer lists and $3.4 million of goodwill. The $1.9 million of intangible franchise agreements will be amortized over a weighted average period of 12 years and the $0.2 million of customer lists will be amortized over a period of 2 years. The goodwill is not amortized in accordance with GAAP, but is tested annually for impairment in the fourth quarter. All of the acquired intangible assets are deductible for tax purposes. Simultaneous with and as part of the transaction, the Company re-franchised two of the locations to a new franchisee and bought out of the lease on a third location, bringing the net acquisition to 19 shops.
In addition to the above activity, the Company re-franchised 18 company-operated Midas and two company-operated SpeeDee shops in fiscal 2010. The re-franchising of these 20 company-operated shops resulted in a write-down of $0.7 million of intangible assets.
During fiscal 2009, the Company acquired 10 Midas shops from franchisees for $1.6 million, which generated $1.3 million of incremental goodwill, franchise agreement and customer list intangibles. In addition, MDS completed the acquisition of three franchised SpeeDee shops from the founders of the SpeeDee business. This acquisition was part of the March 2008 SpeeDee acquisition, but the transfer of the shops from G.C. & K.B. Investments, Inc. to MDS was delayed due to leasing issues. As a result, funds held in escrow were released to G.C. & K.B. Investments, Inc. and $0.8 million of incremental goodwill was recorded. Goodwill, trademark and customer list intangibles were reduced by $0.3 million in connection with the re-franchising of four company-operated shops and the closure of four under performing company-operated shops.
Intangible trademarks and goodwill have indefinite lives and, therefore, are not amortized, but are tested annually for impairment in the fourth quarter. MDS computed its annual test in the fourth quarter, which resulted in no impairment. All of the acquired intangible assets are deductible for tax purposes.
Acquired customer lists are amortized over the first two years after acquisition. Acquired franchise agreements are amortized over the remaining life of the agreements acquired. Approximately $3.9 million of acquired franchise agreements were from the SpeeDee acquisition and will be amortized over the next 19 years. The Company recorded amortization expense of $0.6 million in fiscal 2010 and $0.6 million in fiscal 2009.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Accrued Expenses
Accrued expenses consisted of the following (in millions):
Supplemental Cash Flow Information
Net cash flow from operating activities includes cash payments for interest and income taxes as follows (in millions):
Supplemental Shareholders’ Equity Information
Accumulated other comprehensive loss consisted of the following (in millions):
(5) Advertising
Under the terms of its Midas franchise agreements, MDS is obligated to spend an amount equal to one-half of the royalty payments received from Midas franchisees for advertising expenditures. Amounts received from Midas franchisees for advertising are recorded as liabilities until disbursed. MDS also administers cooperative advertising programs under which amounts received from certain Midas franchisees are recorded as liabilities until they are disbursed. Aggregate expenditures under these programs by Midas’ North American operations amounted to $50.0 million, $47.2 million, and $49.6 million in fiscal 2010, 2009, and 2008, respectively.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Under the terms of its SpeeDee franchise agreements, MDS must use all weekly marketing fees collected from franchisees for the development of advertising and marketing materials and programs or the placement of advertising. Amounts received from SpeeDee franchisees are recorded as a liability until disbursed. Aggregate expenditures under this program were $3.5 in fiscal 2010 and $3.4 million in fiscal 2009. In the nine months in fiscal 2008 after the MDS purchase of SpeeDee expenditures were approximately $2.7 million.
MDS also incurs certain advertising costs that are included in selling, general and administrative expenses, which amounted to $4.9 million, $4.2 million, and $4.4 million in fiscal 2010, 2009, and 2008, respectively.
(6) Income Taxes
Income tax expense (benefit) consisted of the following (in millions):
The items which gave rise to differences between the income taxes in the statements of operations and the income taxes computed at the U.S. statutory rate are summarized as follows:
The Company’s effective tax rate for fiscal 2010 was (25.5)%, which was below the 2010 statutory tax rate of 39.2%. The fiscal 2010 variance from the statutory rate was primarily due to the current year book loss, incremental non-deductible expenses, a write down of the deferred tax asset related to the restricted stock that vested during the year at a value significantly lower than the amount that was expensed for financial statement purposes and a write off of the deferred tax asset related to stock options that were forfeited during the year. In addition the Company increased its valuation allowance against certain foreign tax credit carryforwards based on expected utilization.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Pretax income from non-U.S. operations amounted to $0.7 million in fiscal 2010, $0.9 million in fiscal 2009, and $2.7 million in fiscal 2008. As of January 2010, the non-U.S. operations had no accumulated earnings and profits.
Deferred income taxes are created by “temporary differences” between amounts of assets and liabilities for financial reporting purposes and such amounts as reported under income tax regulations. Deferred tax assets and liabilities consisted of (in millions):
As of January 2, 2010, the Company had recorded valuation allowances of $0.4 million against certain state income tax net operating loss carryovers because the Company has determined that it is more likely than not that this portion of these deferred tax assets will not be realized. During fiscal 2010, the Company recorded an additional valuation allowance of $2.0 million against certain foreign tax credit carryovers because the company determined that it was more likely than not that this portion of the deferred tax asset will not be realized. The Company believes that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the remaining U.S. and Canadian deferred tax assets.
As of January 1, 2011, the Company has net operating loss carryforwards of approximately $64.3 million available to offset future taxable income for Federal and Canadian income tax purposes. The Federal net operating loss carryforwards of approximately $59.1 million expire between 2023 and 2024. The Company generated approximately $3.8 million in Federal taxable income in fiscal 2010 and $6.6 million in fiscal 2009. The Company believes that it will generate sufficient additional Federal taxable income in future years to fully utilize the $59.1 million net operating loss carryforward before it begins to expire in 2023.
The $25.5 million European arbitration award recorded in fiscal 2010 will be treated as a deduction in the Company’s fiscal 2011 income tax return thereby creating an additional $25.5 million of net operating loss carryforwards.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Canadian net operating loss carryforward is approximately $5.2 million and expires between 2014 and 2028. The Company’s Canadian operation generated taxable income of $2.1 million in fiscal 2010 and taxable income of $1.0 million in fiscal 2009. The Company believes that it will generate sufficient taxable income in Canada in future tax years to fully utilize the $5.2 million Canadian net operating loss carryforward before it expires.
The Company also has tax credits of approximately $4.0 million available to offset future Federal income taxes. The tax credits expire between 2015 and 2020.
(7) Franchise Agreements
The Company’s franchise agreements generally cover a 15 to 20-year period and provide for renewals. A franchise agreement can be canceled by the Company only in the event a franchisee fails to comply with the provisions of the agreement. Franchise agreements provide for initial and renewal fees and continuing royalty payments based on a percentage of sales. Midas franchisees pay the Company monthly royalties based on a percentage of sales. In North America, MDS is obligated to spend an amount equal to one-half of the royalty payments it receives for advertising. SpeeDee franchisees pay advertising fees that are not included in the royalty payments.
Worldwide MDS shops in operation as of fiscal year end consisted of (unaudited):
As of January 1, 2011, there were 20 franchised shops and 26 company-operated shops within the Midas and SpeeDee systems operating as Co-Brand locations.
(8) Leases
Control of the real estate used by Midas shops is a fundamental strength of the Midas program. SpeeDee franchise agreements also contain provisions for lease control but until recently such control has not been required. Going forward, real estate control will be required of new and renewing SpeeDee franchisees.
MDS employs a number of methods to ensure continued dedication of the real estate to the franchise program. MDS leases real estate that is subleased to franchisees and owns real estate in the U.S. and Canada that is leased to franchisees. MDS has also entered into contingent operating lease agreements that are described below. At fiscal year end 2010, approximately 89% of real estate associated with North American Midas shops was controlled by Midas, using one of these methods.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Leased Real Estate and Equipment
Gross rent expense applicable to operating leases relates to rentals of shops, corporate administration facilities and other miscellaneous facilities. Gross rent expense, the sublease rental income from franchisees and other third parties that reduced gross rent expense, and the resulting net rent expense for fiscal 2010, 2009 and 2008 are presented below (in millions):
Substantially all of the Company’s operating leases provide that MDS pay taxes, maintenance, insurance, and certain other operating expenses. The subleases with franchisees contain provisions for MDS to recover such costs. Real estate expenses are recognized using the straight-line method.
Real Estate Sale and Leaseback Transaction
MDS owns retail properties throughout the United States and Canada that are leased to franchisees and operated as Midas shops. During fiscal 2002, the Company sold 77 of these properties to Realty Income Corporation, a publicly traded real estate investment trust (REIT), and realized approximately $39.6 million in net proceeds. Simultaneous to that sale, MDS leased these properties from Realty Income Corporation and the sites continue to be leased to Midas franchisees under existing leases. Because these properties will continue to generate rents to MDS, the Company recorded a finance lease obligation pursuant to ASC 840-40 (Subtopic 40, “Sale-Leaseback Transactions”, of Topic 840) on the balance sheet of $39.6 million, equal to the net sale price of the properties, and no gain on the sale was recognized. The properties remain on the balance sheet at their historic cost and continue to be depreciated over their remaining useful lives. Annual lease payments (shown below) will be made through the expiration of the lease in 2022.
Minimum Annual Rental Payments
At fiscal year end 2010, annual minimum rental payments due under capital, finance and operating leases that have initial or remaining non-cancelable terms in excess of one year, along with sublease rental income on real estate due under non-cancelable subleases were as follows (in millions):
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
At fiscal year end 2010 and 2009, the net book value of property under capital leases included in the balance sheets amounted to $0.9 million and $1.2 million, respectively. At fiscal year end 2010 and 2009, the net book value of property under finance leases included in the balance sheets amounted to $24.1 million and $24.7 million, respectively.
Real Estate Owned by Midas and Leased to Franchisees
MDS owns real estate located in various communities throughout the United States and Canada that is leased to franchisees under operating lease agreements. Substantially all leases are for initial terms of 20 years and provide for minimum and contingent rentals.
Real estate leased to franchisees and included in the balance sheets consisted of (in millions):
Rental revenue on owned real estate for fiscal 2010 was $8.3 million, compared to $8.8 million in fiscal 2009 and $9.0 million in fiscal 2008. Minimum future lease payments to be received are as follows (in millions):
Certain sub-leases on owned real estate contain a clause whereby future minimum rental income is contingent upon future retail sales at the location. As a result of this contingency, minimum future lease payments to be received, based upon retail sales, have not been included in the table above. The estimated future lease payments to be received by the Company under these lease agreements, based on the last fixed minimum rent, are as follows (in millions):
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Contingent Operating Lease Agreements
MDS has entered into contingent operating lease agreements covering real estate that is leased by U.S. and Canadian franchisees from parties that are directly or indirectly related to the franchisees. At January 1, 2011, 63 Midas and 13 SpeeDee shops were covered by these contingent operating lease agreements, under which MDS could be required, under certain limited circumstances, to begin making rental payments with respect to individual shop locations. For the contingent Midas shop leases, the average annual shop rental is $59 thousand with an average remaining term of approximately four years. For the contingent SpeeDee shop leases, the average shop rental is $61 thousand with an average remaining term of approximately 12 years.
Management believes that, individually and in the aggregate, any potential difference that might arise under these contingent lease agreements between the rental expense and the rental income from future subleases would not materially affect the financial position or results of operations of MDS.
(9) Pension Plans
Defined Benefit Pension Plans and Other Postretirement Plans
Certain MDS employees in the U.S. and Canada are covered under various defined benefit pension plans sponsored and funded by MDS. Plans covering salaried employees provide pension benefits based on years of service, and generally are limited to a maximum of 20% of the employees’ average annual compensation during the five years preceding retirement. Plans covering hourly employees generally provide benefits of stated amounts for each year of service. Plan assets are invested primarily in common stocks, corporate bonds, government securities and cash and cash equivalent securities. The cost of these plans is being funded currently.
Net periodic pension cost for fiscal 2010, 2009 and 2008 are presented in the following table (in millions):
The principal economic assumptions used in the determination of net periodic pension cost of the U.S. Defined Benefits Plan included the following:
The Company used the Mercer Discount Yield Curve as the basis for determining the 2010 discount rate and used the Citigroup pension index as the basis for determining the 2009 and 2008 discount rates. Such indices are long term in nature, which reflects the future timing of the expected cash flows for the pension plan. The rate of increase in compensation levels reflects a 3.00% increase for 2010 and beyond. Because of a one year wage freeze enacted in 2009, the 2009 actuarial valuation used a 0.00% rate of increase in compensation levels for 2009 and a 3.00% increase for all subsequent years.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company believes the assumed long-term rate of return on pension plan assets is appropriate given the Company’s target long-term asset allocation. The Company believes its target asset allocation is appropriate given the expected timing and amount of expenses for the plan. The Company’s target asset allocation and actual asset allocation for fiscal 2010 and fiscal 2009 were as follows for the U.S. Defined Benefit Plan:
The Canadian Hourly Defined Benefit Plan and the Canadian Salary Defined Benefit Plan assets were allocated 100% to cash and cash equivalents as of the end of fiscal 2010. In early 2011, the plan assets were diversified to a mix more appropriate for the on-going pension obligations as the final wind-up payments were made throughout 2010. The fair value of the Canadian plan assets was approximately $4.0 million as of January 1, 2011.
The fair value of the pension plans’ assets at January 1, 2011 by asset category are as follows (in millions):
Large Cap Domestic Equity Securities: Large cap domestic equity securities are primarily investments in publicly-traded mutual funds either indexed to or containing stocks similar to those contained in the Standard & Poor’s (“S&P”) 500 Index, which represents a market capitalization-weighted index of the 500 largest and most widely held stocks. Standards and Poor’s chooses the member companies for the 500 based on market size, liquidity and industry group representation. Included are the stocks of industrial, financial, utility and transportation companies.
Mid Cap Domestic Equity Securities: Mid cap domestic equity securities are primarily investments in publicly-traded mutual funds either indexed to or containing stocks similar to those contained in the S&P Mid Cap 400, which is the most widely used index for mid-sized companies. The S&P Mid Cap 400 covers over 7% of the U.S. equities market.
Small Cap Domestic Equity Securities: Small cap domestic equity securities are primarily investments in publicly-traded mutual funds either indexed to or containing stocks similar to those contained in the Russell 2000 Index, which measures the performance of the small-cap segment of the entire U.S. equity market. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 8% of the total market capitalization of that index. It includes 2,000 of the smallest securities based on a combination of their market cap and current index membership.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
International Equity Securities: International equity securities are primarily investments in publicly-traded mutual funds either indexed to or containing stocks similar to those contained in the Morgan Stanley Capital International (“MSCI”) Europe Australasia Far East (“EAFE”) Index. The MSCI EAFE Index is a benchmark of international equity investments representing approximately 85% of the developed market’s total capitalization, excluding the U.S. and Canada.
Fixed Income and Cash: Fixed income and cash are primarily mutual funds either indexed to or benchmarked to bonds in the Barclay’s Capital Aggregate Bond Index, which is a market capitalization weighted index for U.S. investment grade bonds, as well as investments in a global bond fund. A portion of the cash is invested in common collective trust money market funds.
The following table presents estimated future benefits payments over the next 10 years, including expected future service, as appropriate, as of January 1, 2011 (in millions):
The changes in the projected benefit obligations for fiscal 2010 and fiscal 2009 were as follows (in millions):
The changes in the fair market value of the plan assets for fiscal 2010 and fiscal 2009 were as follows (in millions):
The Company’s policy is to fund the pension plans in accordance with applicable U.S. and Canadian government regulations and to make additional contributions as required. As of January 1, 2011, the Company has met all regulatory minimum funding requirements. As a result of the significant reduction in the fair value of the U.S. plan assets in 2008, MDS was required to make a contribution to the U.S. plan in fiscal year 2009. New
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
legislation, the Worker, Retiree, Employer Recovery Act of 2008 (WRERA), was passed in late December 2008 and provided temporary relief of pension funding requirements. Under WRERA, the Company made contributions of $1.4 million to the U.S. Plan in 2010 and expects to contribute approximately $3.1 million to the U.S. Plan during 2011.
The following table reconciles the pension plans’ funded status to the amounts recognized in MDS’s balance sheets as of fiscal year end 2010 and 2009 (in millions):
Amounts recognized in accumulated other comprehensive loss as of fiscal 2010 and fiscal 2009 were as follows (in millions and before tax):
As of January 1, 2011, the Company has recorded accrued pension costs as follows (in millions):
The $0.3 million and $2.3 million valuation reserves in fiscal 2010 and fiscal 2009, respectively, represent an offset to the Canadian prepaid pension asset. As per provincial laws, any asset balance in excess of the Projected Benefit Obligation is not an asset of the Company.
Defined Contribution Plans
Substantially all U.S. salaried employees, certain U.S. hourly employees, and certain Canadian employees participate in voluntary, contributory defined contribution plans to which MDS makes full or partial matching contributions. The Company’s matching contributions to these plans amounted to approximately $0.4 million, $0.4 million, and $1.0 million in fiscal 2010, 2009 and 2008, respectively. MDS incurred costs to maintain the defined contribution plans of $0.0 million, $0.1 million and $0.2 million in fiscal 2010, 2009 and 2008, respectively.
(10) Stock-Based Compensation and Other Equity Instruments
Stock Options
The Midas Stock Incentive Plan, the Midas Treasury Stock Plan and the Midas Directors’ Deferred Compensation Plan (the “Plans”) authorize the issuance of up to 4,806,886 shares of Midas common stock pursuant to the exercise of incentive stock options, non-qualified stock options and stock appreciation rights and the grant of restricted stock and performance awards. Options granted pursuant to the Plans generally vest over a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
period of four or five years commencing one year after the date of grant. It is the Company’s policy to issue shares out of treasury when options are exercised. The following table summarizes information regarding the outstanding stock options as of January 1, 2011:
At its annual meeting of shareholders on May 11, 2010, the Company received shareholder approval to implement an employee stock option exchange program. Under this program, employees holding stock options granted between 2004 and 2008 with exercise prices ranging from $15.22 to $23.99 were offered the opportunity to exchange their existing stock options for a lesser number of replacement stock options. The exchange program was completed on September 10, 2010. As a result of this exchange, 747,090 options were retired and 297,760 replacement options were issued at a strike price of $7.52. The replacement options will vest in two equal installments of 50% per year on the first and second anniversaries of the grant date and are exercisable for a period of 10 years from the grant date. The number of replacement stock options granted was determined using an exchange ratio such that the fair value of the replacement options received in the exchange equaled the fair value of the options surrendered in the exchange. The stock option exchange program did not result in additional expense.
Additional information pertaining to option activity during fiscal 2010, 2009 and 2008 was as follows (in millions):
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The weighted average estimated fair value of the options granted or issued in exchange in fiscal 2010, 2009 and 2008 was $3.47, $4.52 and $5.82, respectively, based on the Black-Scholes valuation model using the following assumptions:
As of January 2, 2011, there was $1.7 million in stock option compensation expense related to unvested awards not yet recognized, which is expected to be recognized over a weighted average period of 1.1 years. Due to the limited number of stock option recipients, the Company uses the simplified method to estimate the expected life.
Restricted Stock
Annually the Company grants shares of restricted stock to certain of its employees, officers and directors. Certain restricted stock vests at the five or seven year anniversary, with provisions for accelerated vesting upon the occurrence of certain pre-determined events (“cliff-vesting shares”), while other restricted stock vests equally over periods of three to five-years or only upon the occurrence of certain pre-determined events (the latter being referred to as “performance shares”). The fair value of all but the performance share grants is equal to the stock price on the date of the grant. The fair value of the performance share grants is based on their derived service period calculated using either a Monte Carlo simulation model or management’s expectations of achieving the objectives depending on the nature of the performance criteria. Activity for restricted shares for the prior three years, including the non-vested restricted shares outstanding and the weighted average grant-date fair value of those restricted shares is shown in the table below:
The shares granted in 2010 included independent directors and a special grant to one employee.
The performance shares granted in fiscal 2009 and fiscal 2008 vest only if certain internal performance measures, all pertaining to growth of the company’s cash flow, are met or exceeded. These conditionally vested grants were valued based on management’s estimate of meeting the performance requirement.
MIDAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As of January 1, 2011, there was $2.3 million of unamortized restricted stock compensation of which $6.1 million was included as a reduction to paid-in capital and $3.8 million was included in non-vested restricted stock subject to redemption. The $2.3 million of unamortized restricted stock compensation is expected to be recognized over a weighted average period of 1.4 years.
Restricted stock grants include a “change in control” provision, which provides for cash redemption of unvested restricted stock in certain circumstances. ASC Topic 480, Distinguishing Liabilities From Equity requires securities with contingent cash settlement provisions that are not solely in the control of the issuer, without regard to probability of occurrence, to be classified outside of shareholders’ equity. While the Company believes the possibility of occurrence of any such change of control event is remote, the contingent cash settlement of the restricted stock as a result of such event would not be solely in the control of the Company. As such, the Company presents the $3.8 million value of unvested restricted stock as temporary equity on the consolidated balance sheet. Upon the vesting of the restricted stock the Company reclassifies the value of the restricted stock to permanent equity.
Common Stock Warrants
On March 27, 2003, the Company issued 1.0 million warrants valued at $5.0 million in connection with its 2003 debt restructuring. On January 5, 2004, 500,000 of these warrants were automatically cancelled because the Company met certain financial objectives contained in the warrant agreements. As of January 1, 2011, a total of 41,273 warrants remained outstanding. The exercise price of the warrants is $0.01, and the warrants are exercisable at any time up to March 27, 2013. Any warrants that remain unexercised at March 27, 2013 are automatically exercised as of that date.
(11) Shareholder Rights Agreement and Series A Junior Participating Preferred Stock
In fiscal 2007, MDS adopted a Rights Agreement providing for the issuance of one Preferred Stock Purchase Right (a “Right”) with each share of MDS common stock. Each Right entitles the registered holder to purchase from MDS one one-hundredth of a share of Series A Junior Participating Preferred Stock (a “Preferred Share”) at a price of $80 per one one-hundredth of a Preferred Share (the “Purchase Price”), subject to adjustment. The Rights will become exercisable on the Rights Distribution Date, which is the earlier of the tenth day following a public announcement that a person(s) has acquired beneficial ownership of 20% or more of the MDS common stock (an “Acquiring Person”), or ten business days after the commencement of a tender offer or exchange offer that would result in a person(s) acquiring beneficial ownership of 20% or more of the outstanding shares of Midas common stock.
If a person becomes an Acquiring Person, each Right holder (other than the Acquiring Person) will be entitled to receive, upon exercise of the Right, a number of shares of MDS common stock having a market value of two times the exercise price of the Right. If MDS is acquired in a merger or other business combination, each Right holder (other than the Acquiring Person) will be entitled to receive, upon exercise of a Right, a number of the acquiring Company’s common shares having a market value at that time of two times the exercise price of the Right.
In general, MDS can redeem all the Rights for one cent per Right at any time until the date that a person has become an Acquiring Person. On December 14, 2009, the Rights Agreement was amended to exempt certain institutional investors from the definition of Acquiring Person. Specifically, it exempted investors who have Beneficially Owned (as defined in the Rights Agreement) more than 5% of the Company’s outstanding common stock during the preceding three years and do not Beneficially Own 24.5% or more of the Company’s outstanding common stock.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Rights will expire on December 31, 2017. Until a Right is exercised, the holder of a Right (merely by being a Right holder) will have no rights as a shareholder of Midas, including voting or dividend rights.
Each Preferred Share will be entitled to a minimum preferential quarterly dividend payment of $0.01 per share, but will be entitled to an aggregate dividend of 100 times the dividend declared per share of MDS common stock. Each Preferred Share will have 100 votes, voting together with the MDS common stock. In the event of a merger or other transaction in which shares of common stock of the Company are exchanged, each Preferred Share will be entitled to receive 100 times the amount received per share of MDS common stock.
The Company has 20 million authorized shares of Series A Junior Participating Preferred Stock. There are no Series A Junior Participating Preferred Stock issued or outstanding.
(12) Contingencies
MDS has certain contingent liabilities arising from various pending claims and litigation related to a number of matters. While the Company believes the claims are without merit, an adverse outcome could have a material adverse effect on the business.
California Class Action
The Company is currently involved in a class action lawsuit filed in the Superior Court of California for the County of Los Angeles in June 2006 that alleges that certain franchised California Midas shops intentionally issued invoices to certain brake customers that incorrectly indicated that the customers had received Midas-branded brake products when, in fact, they had received inferior non-Midas brake products. MDS denies the plaintiffs’ allegations and is vigorously defending this lawsuit. MDS has thus far been successful in challenging the legal sufficiency of the plaintiffs’ claims. The plaintiffs’ third amended complaint was dismissed in February 2009. The plaintiffs filed a fourth amended complaint in March of 2009. The Company continues to believe that the allegations are without merit. However, there can be no assurance the Company will prevail in such proceedings. An adverse ruling could have a material adverse effect on the Company’s financial condition and results of operations.
Canadian Franchise Purported Class Action
A class action lawsuit was filed against the Company in the Ontario Superior Court of Justice by two Canadian Midas franchisees. The plaintiffs alleged various violations of the Midas Franchise and Trademark Agreement and applicable law and sought class certification and monetary damages of approximately $168 million. The class certification hearing took place in February 2009 and the court released its certification ruling on March 26, 2009. Of the many claims asserted by the plaintiff, the only claim for which class certification was granted was the issue of whether Midas Canada breached its common law and statutory duties of good faith and fair dealing when it implemented its new supply chain program in 2003. All other causes of action were rejected by the court. The Company is currently in the process of compiling historical documents as a result of the plaintiffs’ discovery request. The Company continues to believe this lawsuit is without merit. However, there can be no assurance the Company will prevail in such proceedings. An adverse ruling could have a material adverse effect on the Company’s financial condition and results of operations.
(13) Derivative Instruments
The Company has market risk exposure to changes in interest rates, principally in the United States. MDS attempts to minimize this risk and fix a portion of its overall borrowing costs through the utilization of interest
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
rate swaps. MDS hedges variable cash flows resulting from floating-rate debt. Variable cash flows from outstanding debt are converted to fixed-rate cash flows by entering into receive-variable, pay-fixed interest-rate swaps. Hedge ineffectiveness is eliminated by matching all terms of the hedged item and the hedging derivative at inception and on an ongoing basis. MDS does not exclude any terms from consideration when applying the matched terms method.
The fair values of the Company’s interest rate swaps are estimated using Level 2 inputs, which are based on model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. The Company also considers counterparty credit-risk and bilateral or “own” credit risk adjustments in estimating fair value, in accordance with the requirements of U.S. GAAP.
The fair value of derivative instruments is summarized as follows (in millions):
Because the interest rate contracts have been designated as cash flow hedges and have been evaluated to be highly effective, there is no impact on the Statement of Operations. The after-tax change in the fair value of these swaps is recorded in accumulated other comprehensive income as a gain or loss on derivative financial instruments.
(14) Business Segment Information
MDS operates in a single business segment and provides retail automotive services principally through franchised and company-operated shops located in North America (United States and Canada) and through franchised and licensed shops in international markets. The Company’s U.S. operations receive royalties from franchisees located in Central America. Such revenues amounted to less than one percent of U.S. sales and revenues in each of the fiscal years presented.
No MDS customer accounted for more than 10% of the Company’s total sales and revenues in fiscal 2010, 2009 or fiscal 2008.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following tables present financial information for each of the principal geographic areas in which the Company operates. Sales and revenues are attributed to geographic areas based on the location of customers.
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(15) Selected Quarterly Financial Data (Unaudited)
Each quarter presented in the following table contains 13 weeks.
The sum of earnings per share for the quarters may not equal the full year amount in each year due to the impact of changes in the average shares outstanding.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As a result of changes in the Company’s business model over the past five years, the seasonality of the Company’s sales has been reduced. In fiscal 2010 and fiscal 2009 revenues by quarter were not significantly different.
Certain factors other than seasonality have impacted the Company’s quarterly net income and earnings per share and these are discussed in greater detail below.
Quarterly Variations-Fiscal 2010
MDS incurred significant legal costs associated with the MESA arbitration of $0.8 million, $1.1 million and $0.8 million in the first, second and third quarters, respectively. An approximate $2.5 million recovery of these fees was granted by an arbitral tribunal in March 2011, and the Company recorded a corresponding credit to selling, general and administrative expense in the fourth quarter. In addition, the tribunal awarded a $25.5 million judgment against the Company that was recorded as an expense in the fourth quarter. In the second quarter MDS recorded incremental operating expenses of $0.2 million related to the vesting of certain restricted stock. Fourth quarter revenues and replacement part cost of sales were higher because of a seasonal increase in tire sales. Fourth quarter tire sales accounted for 29% of tire sales recorded for the year. In the fourth quarter the Company reduced its warranty liability by $0.3 million. The reduction was the result of the Company’s change in estimate for the warranty reserves.
Quarterly Variations-Fiscal 2009
In the second quarter MDS recorded incremental operating expenses of $0.4 million related to the vesting of certain restricted stock. Fourth quarter revenues and replacement part cost of sales were higher because of a seasonal increase in tire sales. Fourth quarter tire sales accounted for 31% of tire sales recorded for the year. In the fourth quarter the Company reduced its warranty liability by $0.6 million. The reduction was the result of the Company’s change in estimate for the warranty reserves. In the fourth quarter a pension adjustment resulted in a $0.4 million reduction in expenses.
The $2.9 million of business transformation charges recorded in the fourth quarter of fiscal 2009 consisted of $0.4 million related to a reduction-in-force announced in October of 2009, $1.5 million for third party consulting costs related to the development of the co-brand image, a re-design of the customer sales and follow-up process in Midas shops and a study of the Midas France business and marketplace, $0.8 million in connection with the closure of four under-performing company-operated shops and $0.2 million pertaining to the Company’s final funding of a new shop image for Midas.
In the second quarter of fiscal 2009, MDS recorded business transformation charges of $0.1 million in connection with the Company’s change in the Canadian warranty program. The remaining business transformation charges relate primarily to the Company’s partial funding of the rollout of a new shop image for Midas shops.
(16) Acquisitions and Divestitures
In January 2010, MDS acquired 22 Midas shops from an existing Midas franchisee. MDS acquired these shops to be run as company-operated shops in connection with a settlement between the franchisee and the California Attorney General and the California Bureau of Automotive Repair. The franchisee had been charged with violating state business and professional codes in a suit seeking civil penalties and costs. The Company was not named in the suit and worked closely with the California Attorney General’s Office on acquiring these shops.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Simultaneous with and as part of the transaction, the Company re-franchised two of the locations to a new franchisee and bought out of the lease on a third location, bringing the net acquisition to 19 shops. The Company is actively seeking to re-franchise the remainder of these shops.
MDS gave total consideration of approximately $6.6 million for the shops. The total cash outlay for the purchase was approximately $3.5 million. The acquisition also resulted in an approximately $2.5 million non-cash reduction of accounts receivable. MDS also assumed certain liabilities of $0.5 million and assumed a capital lease liability of $0.1 million. As a result of this acquisition, the Company recorded $5.5 million in incremental goodwill and other intangibles, which included $1.9 million of intangible franchise agreements, $0.2 million of customer lists and $3.4 million of goodwill.
MDS re-franchised 18 company-operated Midas and two company-operated SpeeDee shops in fiscal 2010. The re-franchising of these 20 company-operated shops resulted in a write-down of $0.7 million of intangible assets. The Company opened a previously closed Midas shop and a previously closed SpeeDee shop as company-operated shops. In addition a company-operated Midas shop was closed during fiscal 2010.
As s result of these actions, the total number of company-operated Midas and Speedee shops at the end of fiscal 2010 was 107, unchanged from the end of fiscal 2009. No net gain or loss was recorded on the acquisition or divestiture of company-operated shops in fiscal 2010.
During fiscal 2009, the Company acquired 10 franchised Midas shops from Midas franchisees to be run as company-operated shops for $1.6 million, which generated $1.3 million of incremental goodwill, trademark and customer list intangibles. In addition, MDS completed the acquisition of three franchised SpeeDee shops from the founders of the SpeeDee business. This acquisition was part of the March 2008 SpeeDee acquisition, but the transfer of the shops from G.C. & K.B. Investments, Inc. to MDS was delayed due to lease issues. Funds held in escrow were released to G.C. & K.B. Investments, Inc. and $0.8 million of incremental goodwill was recorded. Goodwill, trademark and customer list intangibles were reduced by $0.3 million in connection with the re-franchising of four company-operated shops and the closure of four under performing company-operated shops.
(17) Business Transformation Charges
The company recorded business transformation charges of $3.2 million in fiscal 2009 and $1.6 million in 2008 as part of a multi-year plan to reposition the business, eliminate highly unprofitable company-operated shops, and reduce costs. No such charges were recorded in 2010.
The fiscal 2009 charges of $3.2 million included $0.4 million of salary continuation and outplacement costs related to the elimination of 19 corporate positions and $0.8 million in estimated non-recoverable lease costs and asset write-downs related to the closing of four underperforming company-operated shops. Also included was $1.5 million in third party consulting costs to develop the co-brand shop image, re-design the customer sales and follow-up process in Midas shops and a study of the Midas France business and marketplace. The Company also incurred $0.5 million in retail image update and other costs. The retail image update was a program that ended in 2009 whereby a franchisee could get a $2,600 subsidy per shop from the Company if they invested in new paint, signage and point-of-purchase material.
The fiscal 2008 charges of $1.6 million included $1.3 million related to the image update program and $0.3 million in connection with the closing of one underperforming shop.