| If we fail to successfully respond to competitive pressures in this industry, or to effectively implement our strategies to respond to these pressures, our operating results may be negatively affected |
| Many of our competitors have greater financial, distribution, marketing and other resources than us |
| Heightened competition among our suppliers, increased shopping alternatives and trends toward vertical integration could create additional competitive pressures |
| These factors could result in price reductions, reduced sales and margins, loss of market share or greater operating costs, any of which could materially and negatively impact our results of operations |
| Susceptibility to changes in business and economic conditions We operate in an industry characterized by high sales volume and low profit margin which is sensitive to national and regional business and economic conditions |
| We cannot fully foresee the changes in business and economic conditions which may result from domestic reasons or foreign unrest |
| Our profitability is dependent on sales growth and control over merchandise, distribution and occupancy costs and operating and administrative expenses |
| Our operating results are also subject to seasonal fluctuations and the impact of weather conditions |
| Adverse weather conditions of unusually cold temperatures or above-average rainfall tends to adversely impact sales in affected markets |
| Changes in legislation or regulation Changes in legislation and regulations related to the sale and distribution of food products, sale of alcoholic beverages, labor laws, environmental laws, health and safety laws, land use, accounting standards and taxation laws may have a material impact on our financial condition or results of operations |
| Operational inefficiencies Our efforts to maintain and improve our operational efficiencies are largely dependent on the expertise and experience of our senior management, various key employees and our underlying management information systems |
| The failure to attract and retain qualified employees in the future could have a material adverse effect on our business |
| We believe our information systems are a key element of enhancing our competitive position and achieving operational efficiency |
| We continually evaluate and upgrade our management information systems |
| Although we do not anticipate any disruption in our operations as a result of system upgrades, integrations or other activity, there can be no assurance that such disruption will not occur or that the desired benefits from system upgrades will be realized |
| We depend on our distribution system, including third-party distribution, to distribute goods, products and supplies to our store locations |
| A disruption in our distribution system could have a material adverse effect on our results of operations |
| 11 ______________________________________________________________________ Inability to execute our stores expansion plan An element of our growth strategy is to continue expansion through new store openings and relocations and remodels of existing stores |
| Our success in executing this expansion plan is dependent on our ability to locate and obtain favorable store sites, enter into acceptable lease or purchase agreements for these store sites, open new or relocated stores in a timely manner and adapt distribution, management information and other operating systems sufficiently to support store expansion in an efficient and profitable manner |
| Executing this expansion plan will further require that we hire, train and retain the skilled management and other associate resources necessary to meet staffing needs of new store operations in a timely and cost-effective manner |
| Unforeseen claims and litigation matters We currently face and in the future may face various claims and litigation which could adversely impact our operating results and if proven, the impact may be serious |
| These claims could arise from 1) our employees, including wage disputes, discrimination, working condition and work-related injuries; 2) our customers, including problems with the quality, safety or integrity of the food products we sell; 3) governments for non-compliance with legislation and regulations; and 4) our suppliers for non-compliance with any purchase agreement |
| Any of these events could result in significant costs, loss of customers and/or could harm our ability to market and sell our food and related products |
| Debt and capital resources Our bank credit facility and lease facility contain financial covenants and other restrictions that may limit our operating flexibility |
| Our bank credit facility expires on November 18, 2009 and our lease facility expires on November 30, 2006 |
| If we are unable to comply with these covenants and restrictions, we may be required to seek alternative means of financing such obligations |
| Additionally, our lease facility expires on November 30, 2006 which will require us to finance the settlement of this obligation |
| If we are unable to generate sufficient cash flows to service our debt and lease obligations, or if future borrowings or equity financing are not available to us for the payment or refinancing of our debt, our operating results may be adversely impacted |
| and particularly in the Risk Factors section of “Item 1A Risk Factors |
| ” Each of our fiscal years consists of twelve-week periods in the first, second and fourth quarters of the fiscal year and a sixteen-week period in the third quarter |
| Our fiscal year 2004 consisted of 53 weeks, with thirteen weeks in the fourth quarter |
| Overview During fiscal years 2005, 2004 and 2003, the major factors that impacted our results of operations and financial position are as follows: • 2005 comparable sales increased 2dtta6 percent over 2004 sales that were favorably impacted by the labor dispute between the United Food and Commercial Workers Union and three major grocery chains in southern California |
| This labor dispute, which commenced early in the 2003 fourth quarter and was settled in February 2004, had a significant positive effect on our sales volume, results of operations and financial position for 2004 and 2003 |
| • Gross margin for 2005 as compared to 2004 was adversely impacted by increased distribution costs due to increased volume, labor costs and fuel costs, as well as expenditures and inefficiencies in distribution associated with the implementation of our new supply chain management system to improve our distribution network |
| • We opened 13 new stores and relocated two stores during 2005 and at January 1, 2006, operated 236 stores in the United States, as compared to 223 stores at January 2, 2005 and 219 stores at December 28, 2003 |
| While the sales increase attributable to the new and relocated stores helped improve our total sales performance in 2005, the operating loss from these new stores reduced our operating income generated from existing stores |
| 17 ______________________________________________________________________ • During 2005, we recorded a dlra14dtta7 million pre-tax charge related to the settlement of a class action lawsuit involving wage and hour claims by non-exempt employees in our California stores |
| • The litigation and other charges of dlra13dtta8 million in 2003 related to legal actions regarding compensation matters of our stores associates and financing fees associated with our revolving bank credit facility and real estate synthetic lease facility |
| • The sale and divestiture of our Florida broadline foodservice operations and our Florida stores businesses (collectively, the “Florida Operations”) and our broadline foodservice operations in northern California (the “Northern California Foodservice Operations”), completed during the third quarter of 2003, allowed us to divest our loss producing operations, concentrate our management focus on our core store operations and concentrate our resources to strengthen our balance sheet and on continued development of our Smart & Final and Cash & Carry store formats |
| See further discussion under “Discontinued operations” below |
| • The adoption of Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) Nodtta 46, “Consolidation of Variable Interest Entities,” as of June 15, 2003 resulted in a one-time, net-of-tax charge related to the cumulative effect of an accounting change and the consolidation of the assets, liabilities and results of operations of our real estate synthetic lease facility not previously consolidated |
| The impact of the aforementioned labor dispute was unprecedented and is not expected to repeat in the foreseeable future |
| We anticipate that some of the retained sales volume and customers may be lost as the three major supermarket chains undergo intensive sales promotion to rebuild their sales after the labor dispute |
| The retail grocery market in southern California has become increasingly competitive as the three major supermarket chains in the region undergo market repositioning to restore their market share; consequently, there is no assurance that our sales growth will maintain at the current level |
| We believe that our future growth depends on our ability to expand by opening new and relocated stores and undergoing remodels in the current stores to better serve our customers and that our profitability depends on sales growth from such expansion, improving gross margins and implementing effective cost controls |
| Summary Income from continuing operations was dlra22dtta0 million, or dlra0dtta69 per diluted share, for fiscal year 2005, compared to dlra31dtta5 million, or dlra0dtta99 per diluted share, for fiscal year 2004 and dlra13dtta6 million, or dlra0dtta46 per diluted share, for fiscal year 2003 |
| Included in income from continuing operations for 2005 was a dlra14dtta7 million pre-tax charge (dlra8dtta8 million net of tax, or dlra0dtta27 per diluted share) related to reserves for litigation, and for 2003, a dlra13dtta8 million pre-tax charge (dlra8dtta3 million net of tax, or dlra0dtta28 per diluted share) related to reserves for litigation and financing fees and costs |
| Included in the net income for 2005 was the aforementioned dlra8dtta8 18 ______________________________________________________________________ million, net of tax, charge related to reserves for litigation |
| Contributing to the net loss for 2003 was the loss from discontinued operations of dlra68dtta5 million, net of tax, the dlra5dtta3 million charge, net of tax, related to the cumulative effect of a change in accounting principle to adopt FIN Nodtta 46, and the aforementioned dlra8dtta3 million, net of tax, charge related to reserves for litigation and financing fees and costs |
| Accounting Changes The consolidated statement of operations for 2003 included a dlra5dtta3 million, net of tax, or dlra0dtta18 per diluted share, cumulative effect of a change in accounting principle, representing the cumulative amount of depreciation and interest expense, in excess of the rental income of the variable interest entity, as a result of adopting FIN Nodtta 46 as of June 15, 2003 |
| Results of Operations The following table shows, for the fiscal years indicated, certain condensed consolidated statements of operations data, expressed as a percentage of sales |
| Totals may not aggregate due to rounding |
| Fiscal Year 2005 2004 2003 Sales 100dtta0 % 100dtta0 % 100dtta0 % Cost of sales, buying and occupancy 83dtta3 82dtta7 82dtta8 Gross margin 16dtta7 17dtta3 17dtta2 Operating and administrative expenses 13dtta8 14dtta1 14dtta2 Litigation and other charges 0dtta7 — 0dtta8 Income from operations 2dtta1 3dtta2 2dtta2 Interest expense, net 0dtta5 0dtta7 0dtta9 Income from continuing operations before income tax provision 1dtta7 2dtta5 1dtta3 Income tax provision (0dtta6 ) (1dtta0 ) (0dtta5 ) Equity earnings of joint venture 0dtta1 0dtta1 — Income from continuing operations 1dtta1 1dtta6 0dtta8 Discontinued operations, net of tax — (0dtta1 ) (4dtta0 ) Income (loss) before cumulative effect of accounting change 1dtta1 1dtta5 (3dtta2 ) Cumulative effect of accounting change (variable interest entity), net of tax — — (0dtta3 ) Net income (loss) 1dtta1 % 1dtta5 % (3dtta5 )% 19 ______________________________________________________________________ Sales Sales from continuing operations were dlra2cmam002dtta9 million in 2005, dlra1cmam955dtta6 million in 2004 and dlra1cmam730dtta1 million in 2003 |
| Historically, sales have followed a seasonal pattern in which first quarter sales tend to be the lowest |
| Third quarter sales are comparatively high because the third quarter includes 16 weeks, whereas the other quarters include 12 weeks |
| Our 2004 fiscal year consisted of 53 weeks with 13 weeks in the fourth quarter of 2004 |
| The following table sets forth the growth in sales and transaction sizes from continuing operations for fiscal years 2005, 2004 and 2003 |
| We define comparable stores as those that have been in operation for 52 full weeks, including stores that have been remodeled or relocated within their same market area |
| Stores that have been closed during the period are excluded from the calculation |
| Comparable store sales growth for 2005 is calculated using 2005 sales for the 52 weeks ended January 1, 2006 compared to the 2004 sales for the 53 weeks ended January 2, 2005, excluding the sales for the week ended October 10, 2004 which is the first week of fourth quarter 2004 |
| Comparable store sales growth for 2004 is calculated using 2004 sales for the 52 weeks ended December 26, 2004 compared to the 2003 sales for the 52 weeks ended December 28, 2003 |
| 2005 2004 2003 Total sales growth 2dtta4 % 13dtta0 % 10dtta0 % Comparable store sales growth 2dtta6 % 11dtta0 % 8dtta8 % Comparable store transaction size $ 43dtta24 $ 41dtta65 $ 39dtta40 Comparable store sales growth for 2005 was attributable to an increase in our comparable average transaction of 4dtta0prca to dlra43dtta24 as compared to 2004 despite a continued strong competitive environment |
| The increase is noteworthy considering that our sales in the first and second quarters of 2004 were favorably impacted by the effect of a labor dispute that ended in February 2004 and its residual effect against three southern California supermarket chains |
| Sales for 2004 benefited from increased levels of customer visits and average transaction size, favorable summer weather, aggressive campaigning for market share, the effect of the labor dispute, and the customers retained after the labor action |
| Our comparable store sales growth for 2004 as compared to 2003 increased significantly during the first three quarters and was negative during the fourth quarter of 2004, reflecting the impact of the labor dispute that commenced early in our 2003 fourth quarter and ended in our 2004 first quarter |
| Comparable sales increases for all the reporting years are also attributable to store relocations and store remodeling |
| Total sales growth was also attributable to new stores opened during the reporting years |
| Stores opened, relocated and closed in our continuing operations during 2005, 2004 and 2003 are as follows: 2005 2004 2003 Beginning US store count 223 219 217 New stores 13 4 4 Stores relocated 2 2 5 Stores closed or relocated (2 ) (2 ) (7 ) Ending US store count 236 223 219 20 ______________________________________________________________________ Gross margin Gross margin represents sales less cost of sales, buying and occupancy |
| The major categories of costs included in cost of sales, buying and occupancy are cost of goods, distribution costs, costs of our buying department and store occupancy costs, net of earned vendor rebates and other allowances |
| Distribution costs consist of all warehouse receiving and inspection costs, warehousing costs, all transportation costs associated with shipping goods from our warehouses to our stores, and other costs of our distribution network |
| We do not exclude any portion of these costs from cost of sales |
| Gross margin from continuing operations decreased dlra5dtta0 million from dlra339dtta1 in 2004 to dlra334dtta1 million in 2005, primarily due to increased distribution costs and occupancy costs and one week less in 2005, offsetting the increase in sales and the improved gross margin rate from sales |
| The 0dtta6 percentage point decrease was primarily attributable to a 0dtta68 percent increase in distribution costs due to increased labor costs and fuel costs and additional outside storage and delivery costs, as well as expenditures associated with the implementation of our new supply chain management system |
| Other decreases included a 0dtta14 percent increase in occupancy costs primarily due to costs associated with new and relocated stores and store remodeling |
| Additionally, a 0dtta11 percent unfavorable sales mix change resulted from strong sales growth in Cash & Carry stores that target only business customers and generate a lower gross margin rate |
| These decreases were partially offset by a 0dtta26 percent favorable variance in improved merchandise margin rates |
| The dlra42dtta1 million increase was primarily due to the significant increase in sales as compared to 2003 |
| The increase in gross margin as a percentage of sales was primarily attributable to the decrease of 0dtta32 percent in occupancy costs as a percentage of sales due to the relatively fixed nature of these costs and the effect of adopting FIN Nodtta 46 as of June 15, 2003 |
| These gross margin rate increases were partially offset by a 0dtta13 percent increase in distribution costs and a 0dtta18 percent increase due to changes in sales mix |
| Distribution costs increased as a result of higher labor and fuel costs |
| The change in sales mix was the result of strong sales growth at the Cash & Carry stores that serve only business customers and generate a lower gross margin rate, as well as, the increased sales in national brands, a result of the labor dispute |
| National brands generate lower gross margins compared to our signature private label brands |
| As a result of the adoption of FIN Nodtta 46 as of June 15, 2003, we recorded approximately dlra7dtta9 million of costs as interest expense in each of 2005 and 2004 and dlra4dtta2 million in 2003 that, prior to adoption, were recorded in cost of sales as rental expense |
| In addition, pursuant to FIN Nodtta 46, we recorded in each of 2005 and 2004 approximately dlra1dtta2 million of depreciation expense in cost of sales and dlra0dtta7 million in 2003 that previously was not recorded |
| When compared to 2003, the net effect of FIN Nodtta 46 increased the gross margin from continuing operations as a percentage of sales by approximately 0dtta13 percent in both 2005 and 2004 |
| 21 ______________________________________________________________________ Operating and administrative expenses The major categories of operating and administrative expenses include store direct expenses associated with displaying and selling at the store level (primarily labor and related fringe benefit costs) advertising and marketing costs, overhead costs and corporate office costs |
| Operating and administrative expenses from continuing operations for 2005 were dlra276dtta8 million, a slight increase of dlra0dtta1 million, over 2004 |
| Increases attributable to higher sales volume and increased costs in fringe benefit, other store operation costs and information technology offset decreases in incentive compensation costs and asset impairment and increases in gain from sale of properties |
| Operating and administrative expenses as a percentage of sales decreased from 14dtta1 percent in 2004 to 13dtta8 percent in 2005 |
| The major factors of this percentage of sales decrease included 0dtta29 percent attributable to reductions in incentive compensation costs, 0dtta11 percent in positive effect of sales mix change as a result of increased sales volume at Cash & Carry stores that require less direct store operation expenses, 0dtta10 percent in gain from sale of properties and 0dtta08 percent in decreased asset impairment charges |
| These decreases were partially offset by 0dtta18 percent increase in store operating expense, primarily in fringe benefits and services provided at the store level and 0dtta07 percent increase in other corporate expenses |
| Operating and administrative expenses from continuing operations for 2004 were dlra276dtta7 million, up dlra31dtta1 million, or 12dtta7 percent, over 2003 |
| Over half of the dlra31dtta1 million increase was attributable to increased costs driven by the higher sales volume, such as labor, fringe benefits and other store costs |
| Other increases in 2004 included a dlra2dtta5 million non-cash impairment charge associated with certain capitalized software development costs and increases in marketing expenses, reserves for sales and use tax audits and incentive compensation costs |
| Operating and administrative expenses as a percentage of sales decreased from 14dtta2 percent in 2003 to 14dtta1 percent in 2004 |
| The major factors of this percentage of sales decrease included 0dtta20 percent attributable to reductions in overhead, general and administrative costs primarily associated with store operations and decreased utility costs and 0dtta07 percent in positive effect of sales mix change as a result of increased sales volume at Cash & Carry stores that require less direct store operation expenses |
| These decreases were partially offset by increases of 0dtta12 percent in reserves for sales and use tax audits and 0dtta09 percent in asset impairment charges |
| Litigation and other charges In the third quarter 2005, we recorded dlra19dtta0 million of pre-tax charges related to the settlement of a class action lawsuit involving wage and hour claims by our non-exempt employees in our California stores |
| Based on the fairness hearing and final court approval of the settlement on February 16, 2006, we reversed dlra4dtta3 million, pre-tax, of the reserves in our fourth quarter 2005 which resulted in a full year 2005 pre-tax charge of dlra14dtta7 |