ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by or on behalf of the Company. Certain statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations, other parts of this report and other Company filings are forward-looking statements. These statements discuss, among other things, future sales, operating results, cash flows and financial condition. Such statements may be identified by such words as "anticipate," "expect," "may," "believe," "could," "estimate," "project," "maybe," "appears," "intend," "plan" and similar words or phrases. Forward-looking statements reflect the Company's current plans and expectations regarding important risk factors and are based on information currently available to us. The Company cautions readers that any forward-looking statements contained in this report or made by the management of the Company involve risks and uncertainties, and are subject to change based on various important factors. In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, "Item 1A. Risk Factors," in the Company's Annual Report on Form 10-K for the year ended December 29, 2012. The risks described in the Company's Annual Report on Form 10-K are not the only risks it faces. Additional risks and uncertainties not currently known to the Company or that it currently deems to be not material could also have an adverse effect on the Company's future sales, operating results, cash flows or financial position. The Company does not undertake any obligation to update forward-looking statements.
Critical Accounting Policies
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that may affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities. Management has established accounting policies that they believe are appropriate in order to reflect the accurate reporting of the Company's operating results, financial position and cash flows. The Company applies these accounting policies in a consistent manner. Management bases their estimates on historical experience, current and expected economic conditions and various other factors that management believes to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about various aspects of the Company's business, including the carrying values of assets and liabilities that are not readily apparent from other sources. The Company reevaluates these significant factors and makes adjustments where facts and circumstances dictate. Future events and their effects cannot be determined with absolute certainty, and therefore actual results may differ from estimates. As discussed in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2012, management considers its policies on accounting for inventories and cost of sales, impairment of long-lived assets, insurance reserves, vendor allowances and share-based compensation to be the most critical in the preparation of the Company's financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain.
Overview
Arden is a holding company which conducts operations through its first and second tier wholly-owned subsidiaries, Arden-Mayfair, Inc. and Gelson's, respectively, as well as owning and managing its own real estate through Mayfair Realty, Inc. which is wholly-owned by the Company and Arden-Mayfair, Inc. As of December 31, 2011, Gelson's operated 18 full-service supermarkets in Southern California. As described below, on February 25, 2012 and June 15, 2013, the Gelson's stores in Northridge and Pasadena, respectively, were closed, reducing the number of supermarkets operated by Gelson's to 16. The Company opened a new store in Long Beach, California on November 7, 2013, increasing the number to
17. In addition, the Company plans to open a new store in La Ca?ada Flintridge in February 2014.
Gelson's caters to those customers who expect superior quality, service and merchandise selection. In addition to the customary supermarket offerings, Gelson's offers specialty items such as imported foods, unusual delicatessen items, prepared foods and organic and natural food products. Gelson's stores include the typical service departments such as meat, seafood, service deli, floral, sushi, cheese and bakery. In addition, some stores offer further services including fresh pizza, coffee bars, self-service hot and cold food cases, gelato bars and carving carts offering cooked meats.
The Company's management focuses on a number of performance indicators in evaluating financial condition and results of operations. Same store sales, transaction count, gross profit and labor costs are some of the key factors that management considers. Both sales and gross profit are significantly influenced by competition in our trade area. Gelson's faces competition from regional and national supermarket chains (most of which have greater resources and a larger market share than Gelson's), stores specializing in natural and organic foods, specialty and gourmet markets and grocery departments in mass merchandise and club stores. Weak economic conditions have led to an even more competitive market in the grocery industry in recent years. As discretionary income declined, some consumers have reduced their spending and are making more price conscious decisions which has caused us to compete for fewer customer dollars and offer more promotional discounts as our competitors have also done.
Labor and other related payroll costs are the second largest expense (after product cost) incurred by Gelson's and thus is a financial measure which is closely monitored by management. As of fiscal 2012 year-end, Gelson's had approximately 1,135 full-time and 953 part-time store, warehouse and office employees. The majority of Gelson's employees are members of the United Food & Commercial Workers International Union (UFCW). Gelson's current contract with the UFCW, which expires on March 2, 2014, provided for bonuses in lieu of wage increases within 30 days following ratification in October 2011 and again in March 2013 for employees at certain experience levels. The contract also provided for wage increases for certain classes of employees in March 2012. The agreement that the three major grocery retailers in our trade area – Vons, Ralphs and Albertsons grocery chains (Majors) – reached with the UFCW provides for hourly wage rates based on job classification and experience that, in some cases, are less than those agreed to by Gelson's.
The Company contributes to multi-employer health care and pension plan trusts on behalf of its employees who are members of the UFCW. All employers who participate in the UFCW multi-employer plans are required to contribute at the same hourly rate based on straight-time hours worked in order to fund the plans. The Company's health and welfare contribution rate increased effective the beginning of March 2012 and March 2013 in accordance with the UFCW collective bargaining agreement. As a result, average weekly health and welfare expense increased on each of these dates by approximately $15,000. A one-time surcharge of approximately $136,000 was paid in both March 2012 and March 2013 and an additional surcharge of $272,000 is due in February 2014. With respect to the pension plan, a rate increase became effective October 2012 resulting in an increase in expense of approximately $5,000 per week. A similar increase in the pension contribution rate occurred effective October 2013. The increase in health and welfare and pension costs, as well as the labor cost issue discussed above, has negatively impacted the Company's profitability and will continue to unless the Company is able to continue offsetting the increased expense through a combination of sales growth, increased gross margin, reduced labor hours and cost savings in other areas. In addition, the most recently available certified zone status provided by the pension plan trust indicates that the pension plan was in critical status (less than 65 percent funded) as defined by the Pension Protection Act of 2006 for the year ended March 31, 2012. A rehabilitation plan has been implemented by the plan trustee which includes a schedule of benefit cuts and contribution rate increases that allows for projected emergence from critical status at the end of the rehabilitation period on March 31, 2024. However, if the funded status of the plan deteriorates or if the rehabilitation plan is unsuccessful or if any of the participating employers in the plan withdraws from the plan due to insolvency and is not able to contribute an amount sufficient to cover the underfunded liabilities associated with its participants, the Company may be required to negotiate with the union for additional contributions in the future.
The Company's current and prior quarterly results have frequently reflected fluctuations in operating income as a result of adjustments recorded to reflect the change in the fair value of SARs that have been granted to non-employee directors and certain employees. Each SAR entitles the holder to receive cash upon exercise equal to the excess of the fair market value of a share of the Company's Class A, as determined in accordance with the SARs agreement, on the date of exercise over the grant price. Fluctuations in the market price of the Company's Class A impact the recognition or reversal of SARs compensation expense in the period being reported upon. Since the Company cannot predict future fluctuations in the market price of its stock, it also cannot forecast future SARs compensation expense adjustments and the extent to which operating income will be impacted. Volatility in the stock market makes this difficult to predict. Under the CIC Plan, discussed below, and under the amendments to the Directors' Phantom Stock Unit Agreements, vesting of SARs units may accelerate in the event of a Change in Control.
Gelson's closed its store located in Northridge, California after the close of business on February 25, 2012. Effective March 6, 2012, Gelson's reached an agreement with the landlord and a third party to assign the lease of the Northridge store to the third party. Gelson's rent and all other obligations under the lease agreement ended May 1, 2012. In accordance with the assignment of the lease, various items of equipment were transferred by Gelson's to the assignee and Gelson's paid the assignee a lease assignment fee of $1,850,000 during the second quarter of 2012. In addition, Gelson's incurred other closing costs to transfer excess product and supplies to other Gelson's locations, to write off product which could not be transferred, to shut down and relocate or write off equipment and to maintain the store until Gelson's was released from its lease obligation. Other closing costs totaled approximately $393,000 during fiscal 2012. Anticipated exit activity costs were recorded during 2012 on the Condensed Consolidated Statement of Comprehensive Income in the line titled Loss (Gain) from Exit Activity. These costs were net of the reversal in 2012 of a deferred rent liability of $331,000 previously recorded for the Northridge location.
In September 2012, Gelson's entered into a lease for a supermarket location in the marina area of Long Beach, California. Gelson's took possession of the property on March 1, 2013. After extensively remodeling the site, Gelson's opened a new supermarket at that location on November 7, 2013.
On March 18, 2013, the Company announced its decision to terminate the lease for its Gelson's location in Pasadena, California in accordance with the lease terms. The store was closed on June 15, 2013 and Gelson's rent and all other obligations under the lease agreement ended July 21, 2013. Gelson's transferred some of the fixtures and equipment from the Pasadena location to the new Long Beach store discussed above. Gelson's has recorded closing costs of approximately $121,000 to transfer excess product and supplies to other Gelson's locations, to write off product which could not be transferred, to shut down and relocate or dispose of equipment and to maintain the store until Gelson's was released from its lease obligation. These closing costs are included in the Loss (Gain) from Exit Activity line on the Condensed Consolidated Statement of Comprehensive Income.
In September 2013, Gelson's entered into a lease for a supermarket location in La Ca?ada Flintridge, California. Gelson's took possession of the property on November 1, 2013 and anticipates opening a new supermarket at that location in February 2014. The remodel and actual opening of the location is subject to, among other things, necessary governmental approvals.
On July 15, 2013, the Company announced that its Board of Directors had initiated a process to explore and evaluate strategic alternatives, which may include a possible sale of the Company. The Company has retained Moelis & Company as its exclusive financial adviser to assist the Company in connection with the strategic review process. The Company has not made a decision to pursue any specific strategic transaction or any other strategic alternative, and there is no defined timeline for this strategic review. There can be no assurance that the review of strategic alternatives will result in the consummation of any transaction. The Company does not intend to comment further regarding the evaluation of strategic alternatives until such time as the Company's Board of Directors has determined that further disclosure is appropriate or required.
In connection with the decision to explore strategic alternatives, the Board of Directors adopted the Arden Group, Inc. CIC Plan to ensure a smooth transition in the event a Change in Control is consummated. Under the CIC Plan, certain employees of Arden and Gelson's are eligible to receive various retention and/or severance benefits upon or after a Change in Control. Under certain circumstances, the vesting of those employees' SARs units would accelerate upon a Change in Control. Employees eligible to participate in the CIC Plan must enter into a letter agreement with the Company that sets forth the terms, conditions and amount of the participant's CIC Plan benefits. Subject to the terms and conditions of the CIC Plan, upon a Change in Control, a participant under the CIC Plan who remains employed through the date of the Change in Control or who is terminated without cause or resigns for good reason prior thereto would be eligible to receive retention payments. Beginning 30 days prior to a Change in Control and for one year thereafter, if a participant is terminated without cause or resigns for good reason, the participant would receive specified severance benefits. The Company's obligation to provide each of the retention and/or severance benefits under the CIC Plan is conditioned upon the participant providing a general release of claims and complying with certain nondisclosure covenants.
Results of Operations
Third Quarter Analysis
Same store sales from the Company's 16 supermarkets were $111,068,000 during the third quarter of 2013 compared to $104,709,000 in the third quarter of 2012. The 6.1% increase in same store sales is due to an increase in the number of transactions in the third quarter of 2013 compared to the same period of the prior year, as well as inflation.
The Company's gross profit as a percent of sales was 38.0% in the third quarter of 2013 compared to 38.6% in the same period of 2012. In calculating gross profit, the Company deducts product costs (net of discounts and allowances) and inbound freight charges, as well as warehouse, transportation, purchasing, advertising and occupancy costs. Gross profit as a percent of sales for the Company may not be comparable to those of other companies in the grocery industry since there may be differences in recording certain costs as cost of sales or as SG&A expense.
SG&A expense, excluding the Loss (Gain) from Exit Activities discussed above, as a percent of sales was 32.4% in the third quarter of 2013 compared to 30.7% in the same period of 2012. The increase in SG&A expense as a percent of sales is primarily due to an increase in SARs compensation expense in the third quarter of 2013 compared to the same period of the prior year principally resulting from the increase in the price of the Company's Class A. The Company recorded SARs compensation expense of approximately $1,939,000 in the third quarter of 2013 as the result of an increase in SARs fair value since the beginning of the quarter and additional vesting. In comparison, the Company recognized approximately $200,000 of SARs compensation expense in the third quarter of 2012. SG&A expense in the third quarter of 2013 was also negatively impacted by an increase in worker's compensation premiums effective July 1, 2013 and an increase in UFCW health and welfare and pension contribution rates as discussed above partially offset by a reduction in labor dollars as a percent of sales. In addition, the increase in SG&A expense as a percent of sales was partially offset by an increase in sales without a comparable increase in expense as some costs do not increase at the same rate as sales.
Year-To-Date Analysis
Same store sales from the Company's 16 supermarkets (excluding the Northridge and Pasadena locations which were closed February 25, 2012 and June 15, 2013, respectively), were $329,118,000 during the first nine months of 2013. This represents an increase of 5.8% from the same period of the prior year, when same store sales were $311,003,000. The increase in sales is due to an increase in the number of transactions in the first nine months of 2013 compared to the same period of the prior year, as well as inflation.
The Company's gross profit as a percent of sales was 38.2% in the first nine months of 2013 compared to 38.2% in the same period of 2012. In calculating gross profit, the Company deducts product costs (net of discounts and allowances) and inbound freight charges, as well as warehouse, transportation, purchasing, advertising and occupancy costs. Gross profit as a percent of sales for the Company may not be comparable to those of other companies in the grocery industry since there may be differences in recording certain costs as cost of sales or as SG&A expense.
SG&A expense, excluding the Loss (Gain) from Exit Activity discussed above, as a percent of sales was 31.6% in the first nine months of 2013 compared to 30.9% in the same period of 2012. The increase in SG&A expense as a percent of sales is primarily due to an increase in SARs compensation expense in the first nine months of 2013 compared to the same period of the prior year principally resulting from the increase in the price of the Company's Class A. The Company recorded SARs compensation expense of approximately $3,049,000 in the first nine months of 2013 as the result of an increase in SARs fair value since the beginning of the year and additional vesting. In comparison, during the first nine months of 2012, the Company reversed approximately $234,000 of SARs compensation expense recognized in prior periods. SG&A expense in the first nine months of 2013 was also negatively impacted by an increase in UFCW health and welfare and pension contribution rates as discussed above partially offset by a reduction in labor dollars as a percent of sales. In addition, the increase in SG&A expense as a percent of sales was partially offset by an increase in sales without a comparable increase in expense as some costs do not increase at the same rate as sales.
CAPITAL EXPENDITURES/LIQUIDITY
The Company's current cash position, including short-term investments and net cash provided by operating activities, is the primary source of funds available to meet the Company's capital expenditure and liquidity requirements. The Company's cash position, including short-term investments, at the end of the third quarter of 2013 was $25,716,000. During the thirty-nine weeks ended September 28, 2013, the Company generated $22,243,000 of cash from operating activities compared to $20,982,000 in the same period of 2012.
Cash not required for the immediate needs of the Company is temporarily invested in U.S. Treasuries, certificates of deposit, money market funds, commercial paper, mutual funds and corporate and government securities. The Company is continually investigating opportunities for the use of these funds including new locations and the expansion and remodel of existing stores. In September 2012, Gelson's entered into a lease for a Gelson's supermarket location in Long Beach, California. Gelson's took possession of the property on March 1, 2013. After extensively remodeling the site, Gelson's opened a new supermarket at that location on November 7, 2013. In September 2013, Gelson's entered into a lease for a supermarket location in La Ca?ada Flintridge, California. Gelson's took possession of the property on November 1, 2013 and, after some remodeling, anticipates opening the store in February 2014. In addition, Gelson's has committed to remodeling the exterior of its Sherman Oaks location.
The Company has an unsecured revolving line of credit facility available for standby letters of credit, funding operations and expansion. The credit agreement provides for borrowings and/or letters of credit up to an aggregate principal amount at any one time of $25,000,000 and expires on June 1, 2014. There were no outstanding borrowings against the revolving line of credit as of September 28, 2013. The Company currently maintains four standby letters of credit aggregating $7,394,000 as of September 28, 2013 in connection with lease and self-insurance requirements.
The following table sets forth the Company's contractual cash obligations and commercial commitments as of September 28, 2013:
Contractual Cash Obligations (In Thousands)
Less Than After
Total 1 Year 1-3 Years 4-5 Years 5 Years
7% Subordinated Income
Debentures
Due September 2014 Including
Interest $ 1,314 $ 1,314 $ 0 $ 0 $ 0
Operating Leases 148,651 11,659 22,852 21,032 93,108
Total Contractual Cash
Obligations (1) $ 149,965 $ 12,973 $ 22,852 $ 21,032 $ 93,108
Other Commercial Commitments (In Thousands)
Less Than After
Total 1 Year 1-3 Years 4-5 Years 5 Years
Standby Letters of Credit (2) $ 7,394 $ 7,394 $ 0 $ 0 $ 0
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(1) Other Contractual Obligations
The Company had the following other contractual cash obligations at September 28, 2013. The Company is unable to include these liabilities in the tabular disclosure of contractual cash obligations as the exact timing and amount of payments are unknown.
Self-Insurance Reserves
The Company is primarily self-insured for losses related to general and auto liability claims and for all open years prior to July 1, 2006 for worker's compensation. The Company maintains stop-loss coverage to limit its loss exposure on a per claim basis. Effective July 1, 2006, the Company purchased a fully insured guaranteed cost worker's compensation insurance policy for losses occurring after June 30, 2006. This policy replaced the high deductible program for worker's compensation. Liabilities associated with the risks that are retained by the Company under the high deductible programs are estimated, in part, by considering historical claims experience and regression analysis. Accruals are based on undeveloped reported claims and an estimate of claims incurred but not reported. While the ultimate amount of claims incurred is dependent on future developments, in management's opinion recorded reserves are adequate to cover the future payment of claims. The Company's reserve for unpaid and incurred but not reported claims at September 28, 2013 was approximately $1,670,000.
Property, Plant and Equipment Purchases
The Company has an ongoing program to remodel existing supermarkets and to add new stores. During the first nine months of 2013, capital expenditures were $12,034,000. As of September 28, 2013, management had authorized future expenditures on incomplete projects for the purchase and remodel of property, plant and equipment which totaled approximately $9,360,000 which includes a portion of the remodeling expenditures for the new store in Long Beach and anticipated remodeling expenditures for the new store in La Ca?ada Flintridge, California, as discussed above.
(2) Standby Letters of Credit
The Company's letters of credit renew automatically each year unless the issuer notifies the Company otherwise. The amount of each outstanding letter of credit held pursuant to the Company's worker's compensation and general and auto liability insurance programs is adjusted annually based upon the outstanding claim reserves as of the renewal date. Each letter of credit obligation related to insurance will cease when all claims for the particular policy year are closed or the Company negotiates a release. The amount of another letter of credit related to one of the Company's leases is adjusted periodically in accordance with the lease.
The Company has a stock repurchase program, authorized by the Board of Directors, to purchase shares of its Class A in the open market or in private transactions from time to time. The timing, volume and price of purchases are at the discretion of the management of the Company. There are currently 132,806 shares of Class A authorized for repurchase. No stock was repurchased under this program during the third quarter of 2013.
On October 18, 2013, the Company paid a regular quarterly cash dividend of $0.25 per share of Class A totaling approximately $768,000 to stockholders of record as of September 27, 2013.
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