Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

(Mark one)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended October 9, 2016

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                        to                        .

 

Commission File Number:  001-36626

 

Smart & Final Stores, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

80-0862253

(State or other jurisdiction of

 

(I.R.S. Employer

Incorporation or organization)

 

Identification No.)

 

 

 

600 Citadel Drive

 

 

Commerce, California

 

90040

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code:  (323) 869-7500

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes  x   No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  o

 

Accelerated filer  x

 

 

 

Non-accelerated filer

 

Smaller reporting company  o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o   No  x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common units, as of the latest practicable date.

 

Class

 

Outstanding at November 15, 2016

common stock, $0.001 par value

 

72,631,989

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

 

 

PAGE

 

 

 

PART I - FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

Condensed Consolidated Balance Sheets as of October 9, 2016 (unaudited) and January 3, 2016

3

 

 

 

 

Condensed Consolidated Statements of Operations and Comprehensive Income for the sixteen and forty weeks ended October 9, 2016 and October 4, 2015 (unaudited)

4

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the forty weeks ended October 9, 2016 and October 4, 2015 (unaudited)

5

 

 

 

 

Condensed Consolidated Statement of Stockholders’ Equity for the forty weeks ended October 9, 2016 (unaudited)

6

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

7

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

29

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

46

 

 

 

Item 4.

Controls and Procedures

46

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

47

 

 

 

Item 1A.

Risk Factors

47

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

47

 

 

 

Item 3.

Defaults Upon Senior Securities

48

 

 

 

Item 4.

Mine Safety Disclosures

48

 

 

 

Item 5.

Other Information

48

 

 

 

Item 6.

Exhibits

48

 

 

 

Signatures

 

49

 

2



Table of Contents

 

Part I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Smart & Final Stores, Inc. and Subsidiaries

 

Condensed Consolidated Balance Sheets

(In Thousands, Except Share and Per Share Amounts)

 

 

 

October 9, 2016

 

January 3, 2016

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

54,043

 

$

59,327

 

Accounts receivable, less allowances of $435 and $454 at October 9, 2016 and January 3, 2016, respectively

 

30,304

 

27,304

 

Inventories

 

255,475

 

234,289

 

Prepaid expenses and other current assets

 

34,388

 

29,072

 

Deferred income taxes

 

22,502

 

22,471

 

Assets held for sale

 

3,254

 

 

Total current assets

 

399,966

 

372,463

 

 

 

 

 

 

 

Property, plant, and equipment:

 

 

 

 

 

Land

 

9,259

 

10,940

 

Buildings and improvements

 

17,691

 

20,441

 

Leasehold improvements

 

283,214

 

237,820

 

Fixtures and equipment

 

338,481

 

266,080

 

Construction in progress

 

14,240

 

19,501

 

 

 

662,885

 

554,782

 

Less accumulated depreciation and amortization

 

230,023

 

174,906

 

 

 

432,862

 

379,876

 

 

 

 

 

 

 

Capitalized software, net of accumulated amortization of $14,912 and $12,356 at October 9, 2016 and January 3, 2016, respectively

 

11,292

 

11,365

 

Other intangible assets, net

 

371,130

 

376,122

 

Goodwill

 

611,242

 

611,242

 

Equity investment in joint venture

 

14,090

 

12,763

 

Other assets

 

57,626

 

53,250

 

Total assets

 

$

1,898,208

 

$

1,817,081

 

 

 

 

 

 

 

Liabilities and stockholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

205,264

 

$

194,149

 

Accrued salaries and wages

 

35,540

 

33,859

 

Accrued expenses

 

87,352

 

77,374

 

Current portion of debt, less debt issuance costs

 

35,280

 

3,904

 

Total current liabilities

 

363,436

 

309,286

 

 

 

 

 

 

 

Long-term debt, less debt issuance costs

 

616,317

 

586,956

 

Deferred income taxes

 

127,931

 

128,752

 

Postretirement and postemployment benefits

 

110,797

 

117,417

 

Other long-term liabilities

 

118,383

 

108,099

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value; Authorized shares — 10,000,000 Issued and outstanding shares — none

 

 

 

Common stock, $0.001 par value; Authorized shares — 340,000,000 Issued and outstanding shares - 72,944,908 and 73,789,608 at October 9, 2016 and January 3, 2016, respectively

 

73

 

74

 

Additional paid-in capital

 

499,615

 

502,304

 

Retained earnings

 

68,186

 

70,181

 

Accumulated other comprehensive loss

 

(6,530

)

(5,988

)

Total stockholders’ equity

 

561,344

 

566,571

 

Total liabilities and stockholders’ equity

 

$

1,898,208

 

$

1,817,081

 

 

See notes to condensed consolidated financial statements.

 

3



Table of Contents

 

Smart & Final Stores, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Operations and Comprehensive Income

(Unaudited)

(In Thousands, Except Share and Per Share Amounts)

 

 

 

Sixteen Weeks Ended

 

Forty Weeks Ended

 

 

 

October 9, 2016

 

October 4, 2015

 

October 9, 2016

 

October 4, 2015

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

1,394,429

 

$

1,246,063

 

$

3,341,163

 

$

2,973,354

 

Cost of sales, buying and occupancy

 

1,191,400

 

1,058,824

 

2,852,569

 

2,522,367

 

Gross margin

 

203,029

 

187,239

 

488,594

 

450,987

 

 

 

 

 

 

 

 

 

 

 

Operating and administrative expenses

 

183,402

 

157,040

 

447,303

 

378,122

 

Income from operations

 

19,627

 

30,199

 

41,291

 

72,865

 

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

9,977

 

9,333

 

24,729

 

25,007

 

Loss on early extinguishment of debt

 

4,978

 

 

4,978

 

2,192

 

Equity in earnings of joint venture

 

502

 

138

 

1,230

 

1,045

 

Income before income taxes

 

5,174

 

21,004

 

12,814

 

46,711

 

 

 

 

 

 

 

 

 

 

 

Income tax benefit (provision)

 

1,859

 

(8,624

)

387

 

(18,410

)

Net income

 

$

7,033

 

$

12,380

 

$

13,201

 

$

28,301

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.10

 

$

0.17

 

$

0.18

 

$

0.39

 

Diluted earnings per share

 

$

0.09

 

$

0.16

 

$

0.17

 

$

0.37

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

72,601,724

 

73,116,746

 

72,956,554

 

73,099,258

 

Diluted

 

77,705,917

 

77,404,466

 

78,468,330

 

77,025,990

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

Net income

 

$

7,033

 

$

12,380

 

$

13,201

 

$

28,301

 

Derivative instruments:

 

 

 

 

 

 

 

 

 

Gain (loss), net of income tax expense (benefit) of $460 and $(1,025), respectively, for sixteen weeks ended; $(251) and $(1,780), respectively, for the forty weeks ended

 

689

 

(1,538

)

(376

)

(2,670

)

Reclassification adjustments, net of income tax benefit (expense) of $2 and $(40), respectively, for sixteen weeks ended; $7 and $(23), respectively, for forty weeks ended

 

5

 

(61

)

12

 

(35

)

Foreign currency translation and employee benefit obligation adjustment

 

(76

)

13

 

(178

)

(781

)

Other comprehensive income (loss)

 

618

 

(1,586

)

(542

)

(3,486

)

Comprehensive income

 

$

7,651

 

$

10,794

 

$

12,659

 

$

24,815

 

 

See notes to condensed consolidated financial statements.

 

4



Table of Contents

 

Smart & Final Stores, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In Thousands)

 

 

 

Forty Weeks Ended

 

 

 

October 9, 2016

 

October 4, 2015

 

Operating activities

 

 

 

 

 

Net income

 

$

13,201

 

$

28,301

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

38,421

 

28,982

 

Amortization

 

26,094

 

22,688

 

Amortization of debt discount and debt issuance costs

 

2,040

 

2,114

 

Share-based compensation

 

7,248

 

8,081

 

Excess tax benefits related to share-based payments

 

 

(275

)

Deferred income taxes

 

(608

)

1,442

 

Equity in earnings of joint venture

 

(1,230

)

(1,045

)

Loss (gain) on disposal of property, plant, and equipment

 

34

 

(38

)

Asset impairment

 

790

 

562

 

Loss on early extinguishment of debt

 

4,978

 

2,192

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

(3,000

)

1,085

 

Inventories

 

(21,185

)

(8,814

)

Prepaid expenses and other assets

 

(6,469

)

15,620

 

Accounts payable

 

11,115

 

6,623

 

Accrued salaries and wages

 

1,681

 

201

 

Other accrued liabilities

 

12,905

 

6,835

 

Net cash provided by operating activities

 

86,015

 

114,554

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Purchases of property, plant, and equipment

 

(113,195

)

(101,025

)

Proceeds from disposal of property, plant, and equipment

 

443

 

8,103

 

Assets acquired in Haggen Transaction

 

(2,235

)

 

Investment in capitalized software

 

(2,752

)

(3,254

)

Other

 

(2,106

)

(1,252

)

Net cash used in investing activities

 

(119,845

)

(97,428

)

 

 

 

 

 

 

Financing activities

 

 

 

 

 

Proceeds from exercise of stock options

 

3,477

 

196

 

Payment of minimum withholding taxes on net share settlement of share-based compensation awards

 

(652

)

(694

)

Fees paid in conjunction with debt financings

 

(8,374

)

(1,236

)

Borrowings on bank line of credit

 

70,000

 

 

Payments on bank line of credit

 

(38,000

)

 

Issuance of bank debt, net of issuance costs

 

30,093

 

 

Payments of public offering costs

 

 

(214

)

Excess tax benefits related to share-based payments

 

 

275

 

Stock repurchases

 

(27,998

)

 

Net cash provided by (used in) financing activities

 

28,546

 

(1,673

)

 

 

 

 

 

 

Net (decrease) increase in cash and cash equivalents

 

(5,284

)

15,453

 

Cash and cash equivalents at beginning of period

 

59,327

 

106,847

 

Cash and cash equivalents at end of period

 

$

54,043

 

$

122,300

 

 

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

21,766

 

$

22,407

 

Income taxes

 

$

8,091

 

$

10,229

 

 

 

 

 

 

 

Non-cash investing and financing activities

 

 

 

 

 

Software development costs incurred but not paid

 

$

41

 

$

 

Construction in progress costs incurred but not paid

 

$

13,695

 

$

16,147

 

 

See notes to condensed consolidated financial statements.

 

5



Table of Contents

 

Smart & Final Stores, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Stockholders’ Equity

(Unaudited)

   (In Thousands, Except Share Amounts)

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

Common Stock

 

Additional

 

 

 

Other

 

 

 

 

 

Number

 

 

 

Paid-In

 

Retained

 

Comprehensive

 

 

 

 

 

of Shares

 

Amount

 

Capital

 

Earnings

 

Loss

 

Total

 

Balance at January 3, 2016

 

73,789,608

 

$

74

 

$

502,304

 

$

70,181

 

$

(5,988

)

$

566,571

 

Issuance of restricted stock awards

 

396,703

 

 

 

 

 

 

Forfeiture of restricted stock awards

 

(10,082

)

 

 

 

 

 

Share-based compensation

 

 

 

7,248

 

 

 

7,248

 

Stock option exercises

 

800,462

 

1

 

3,476

 

 

 

3,477

 

Vested restricted stock awards withheld on net share settlement

 

(49,555

)

 

(652

)

 

 

(652

)

Net income

 

 

 

 

13,201

 

 

13,201

 

Stock repurchases

 

(1,982,228

)

(2

)

(12,761

)

(15,196

)

 

(27,959

)

Other comprehensive loss

 

 

 

 

 

(542

)

(542

)

Balance at October 9, 2016

 

72,944,908

 

$

73

 

$

499,615

 

$

68,186

 

$

(6,530

)

$

561,344

 

 

See notes to condensed consolidated financial statements.

 

6



Table of Contents

 

Smart & Final Stores, Inc. and Subsidiaries

Notes to Unaudited Condensed Consolidated Financial Statements

 

1. Description of Business and Basis of Presentation

 

Business

 

Smart & Final Stores, Inc., a Delaware corporation (“SFSI” or the “Successor” and, collectively with its wholly owned consolidated subsidiaries, the “Company”), is engaged primarily in the business of selling fresh perishables and everyday grocery items, together with foodservice, packaging and janitorial products. The Company operates non-membership, warehouse-style stores offering products in a range of product sizes.

 

SFSI was formed in connection with the acquisition of the “Smart & Final” and “Cash & Carry” store businesses through the purchase of all of the outstanding common stock of Smart & Final Holdings Corp., a Delaware corporation (the “Predecessor” or “SFHC”), on November 15, 2012. The principal acquiring entities were affiliates of Ares Management, L.P. (“Ares”) and the acquisition is referred to as the “Ares Acquisition.”

 

The Company operates non-membership warehouse-style grocery stores under the “Smart & Final” banner and the “Cash & Carry” banner. As of October 9, 2016, the Company operated 304 stores throughout the Western United States (“U.S.”).

 

The Company owns a 50% joint venture interest in a Mexican domestic corporation, Smart & Final del Noreste, S.A. de C.V. (“SFDN”), which operated 15 “Smart & Final” format stores in northwestern Mexico as of October 9, 2016.

 

Secondary Public Offering

 

On April 24, 2015, certain of the Company’s stockholders completed a secondary public offering (the “Secondary Offering”) of 10,900,000 shares of common stock, par value $0.001 per share (“Common Stock”). The Company did not sell any shares in the Secondary Offering and did not receive any proceeds from the sales of shares by the selling stockholders. Following the Secondary Offering, affiliates of Ares held approximately 60% of the Company’s issued and outstanding shares of Common Stock.

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial statements, and Rule 10-01 of Regulation S-X of the Securities Act of 1933, as amended (the “Securities Act”). The unaudited condensed consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the periods indicated. All intercompany accounts and transactions have been eliminated in consolidation. Interim results are not necessarily indicative of results for a full fiscal year. The information included in these unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements as of and for the fiscal year ended January 3, 2016 that were included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2016.

 

Fiscal Years

 

The Company’s fiscal year is the 52- or 53-week period that ends on the Sunday closest to December 31. Each fiscal year typically consists of twelve-week periods in the first, second and fourth quarters and a sixteen-week period in the third quarter.

 

Fiscal year 2016 is a 52-week fiscal year. Fiscal year 2015 was a 53-week fiscal year and the fourth quarter consisted of a thirteen-week period.

 

2. Significant Accounting Policies

 

Cash and Cash Equivalents

 

The Company considers all highly liquid instruments purchased with an original maturity of three months or less to be cash equivalents. All credit card, debit card and electronic benefits transfer transactions that process in less than seven days are classified as cash equivalents. The carrying amount of cash equivalents is approximately the same as their respective fair values due to the short-term maturity of these instruments.

 

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Table of Contents

 

Accounts Receivable, Net

 

Accounts receivable generally represent billings to customers, billings to vendors for earned rebates and allowances, receivables from SFDN, and other items. The receivable from SFDN primarily relates to billings for the shipment of inventory product to SFDN.

 

The Company evaluates the collectability of accounts receivable and determines the appropriate reserve for doubtful accounts based on analysis of historical trends of write-offs and recoveries on various levels of aged receivables. When the Company becomes aware of the deteriorated collectability of a specific account, additional reserves are made to reduce the net recognized receivable to the amount reasonably expected to be collectible or zero. When the specific account is determined to be uncollectible, the net recognized receivable is written off in its entirety against such reserves.

 

The Company is exposed to credit risk on trade accounts receivable. The Company provides credit to certain trade customers in the ordinary course of business and performs ongoing credit evaluations. Concentrations of credit risk with respect to trade accounts receivable are limited due to the number of customers comprising the Company’s customer base. The Company currently believes the allowance for doubtful accounts is sufficient to cover customer credit risks.

 

Inventories

 

Inventories consist of merchandise purchased for resale which is stated at the weighted-average cost (which approximates first-in, first-out (“FIFO”)) or market. The Company provides for estimated inventory losses between physical inventory counts at its stores based upon historical inventory losses as a percentage of sales. The provision is adjusted periodically to reflect updated trends of actual physical inventory count results.

 

Prepaid Expenses and Other Current Assets

 

Prepaid expenses and other current assets include primarily prepaid rent, insurance, property taxes, income taxes receivable, and other current assets.

 

Property, Plant, and Equipment

 

Property, plant, and equipment is stated at cost or estimated fair value based on purchase accounting and depreciated or amortized using the straight-line method. Leased property meeting certain criteria is capitalized and the amortization is based on the straight-line method over the term of the lease.

 

The estimated useful lives are as follows:

 

Buildings and improvements

 

20 - 25 years

 

Fixtures and equipment

 

3 - 10 years

 

Leasehold improvements

 

Lesser of lease term or useful life of improvement

 

 

Costs of normal maintenance and repairs and minor replacements are charged to expense when incurred. Major replacements, remodeling or betterments of properties are capitalized. When assets are sold or otherwise disposed of, the costs and related accumulated depreciation and amortization are removed from the accounts, and any resulting gain or loss is included in the consolidated statements of operations and comprehensive income.

 

Included in property, plant, and equipment are costs associated with the selection and procurement of real estate sites. These costs are amortized over the remaining lease term of the successful sites with which they are associated.

 

The Company reviews its long-lived assets, including property, plant and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company groups and evaluates long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. The Company regularly reviews its stores’ operating performance for indicators of impairment. Factors it considers important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized to the extent the sum of the estimated discounted future cash flows from the use of the asset is less than the carrying value. The Company measured the fair value of its long-lived assets on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy. See Note 6, Fair Value Measurements.

 

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Table of Contents

 

During the third quarter ended October 9, 2016, the Company decided to sell two closed store properties. The properties were reclassified as properties held for sale and were measured at their fair values, less costs to sell, as of October 9, 2016. The reclassification resulted in impairment loss of $0.2 million, which was reported within “Operating and administrative expenses” on the accompanying condensed consolidated statements of operations and comprehensive income. As of October 9, 2016, the Company designated these two properties, in the amount of $3.3 million, as “Assets held for sale” on the accompanying condensed consolidated balance sheets.

 

Capitalized Software

 

Capitalized software costs are comprised of third-party purchased software costs, capitalized costs associated with internally developed software including internal direct labor costs, and installation costs. Such capitalized costs are amortized over the period that the benefits of the software are fully realizable and enhance the operations of the business, ranging from three to seven years, using the straight-line method.

 

Capitalized software costs, like other long-lived assets, are subject to review for impairment whenever events or changes in circumstances indicate that the carrying amount of the capitalized software may not be recoverable, whether it is in use or under development. Impairment is recognized to the extent the sum of the estimated discounted future cash flows from the use of the capitalized software is less than the carrying value.

 

Goodwill and Intangible Assets

 

In connection with the Ares Acquisition, the intangible assets were adjusted and recorded at fair market value in accordance with accounting guidance for business combinations. The recorded fair market value for each of the trade names was determined by estimating the amount of royalty income that could be generated from the trade name if it was licensed to a third-party owner and discounting the resulting cash flows using the weighted-average cost of capital for each respective trade name.

 

During the fourth quarter of 2015, the Company acquired certain assets, including 33 store leases and related fixtures, equipment and liquor licenses, of Haggen Operations Holdings, LLC and Haggen Opco South, LLC (together, “Haggen”). The Company recorded leasehold interests at fair value as of the acquisition dates. Acquired leasehold interests are finite-lived intangible assets amortized straight-line over their estimated useful benefit period which is typically the lease term.

 

The finite-lived intangible assets are amortized on a straight-line basis over their estimated useful benefit period and have the following weighted-average amortization periods:

 

Signature brands

 

20 years

 

Leasehold interests

 

23 years

 

 

Goodwill and intangible assets with indefinite lives are evaluated on an annual basis for impairment during the fourth quarter, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company evaluates goodwill for impairment by comparing the fair value of each reporting unit to its carrying value including the associated goodwill. The Company has designated its reporting units to be its Smart & Final stores and Cash & Carry stores. The Company determines the fair value of the reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the fair value of the reporting unit exceeds the carrying value of the net assets, including goodwill assigned to that unit, goodwill is not impaired. If the carrying value of the reporting unit’s net assets, including goodwill, exceeds the fair value of the reporting unit, then the Company determines the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied value, then an impairment of goodwill has occurred and the Company would recognize an impairment charge for the difference between the carrying amount and the implied fair value of goodwill.

 

The Company evaluates its indefinite-lived intangible assets associated with trade names by comparing the fair value of each trade name with its carrying value. The Company determines the fair value of the indefinite-lived trade names using a “relief from royalty payments” methodology. This methodology involves estimating reasonable royalty rates for each trade name and applying these royalty rates to a revenue stream and discounting the resulting cash flows to determine fair value.

 

Finite-lived intangible assets, like other long-lived assets are subject to review for impairment whenever events or changes in circumstances indicate that the carrying amount of the finite-lived intangible asset may not be recoverable. Impairment is recognized to the extent the sum of the discounted estimated future cash flows from the use of the finite-lived intangible asset is less than the carrying value.

 

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Asset Acquisition

 

An acquired group of assets that do not meet the definition of a business are accounted for as an asset acquisition. Asset acquisitions are accounted for using a cost accumulation approach, whereby the total consideration paid is allocated to the individual assets acquired and liabilities assumed on a relative fair value basis. See Note 14, Haggen Transaction.

 

These estimates of fair values, the allocation of the purchase price and other factors are subject to significant judgments and the use of estimates. The inputs used in the fair value analysis fall within Level 3 of the fair value hierarchy due to the use of significant unobservable inputs to determine fair value. See Note 6, Fair Value Measurements.

 

Other Assets

 

Other assets primarily consist of assets held in trusts for certain retirement plans (See Note 7, Retirement Benefit Plans and Postretirement and Postemployment Benefit Obligations), liquor licenses and other miscellaneous assets.

 

Accounts Payable

 

The Company’s banking arrangements provide for the daily replenishment and limited monthly advanced payments of vendor payable accounts as checks are presented or payments are demanded. The checks and the advanced payments outstanding in these bank accounts are included in “Accounts payable” on the accompanying condensed consolidated balance sheets.

 

Other Long-Term Liabilities

 

Other long-term liabilities include primarily general liabilities, workers’ compensation liabilities, liabilities for the deferred compensation plan, leasehold interests and other miscellaneous long-term liabilities. These leasehold interests are amortized over their estimated useful benefit periods, which is typically the lease term. The weighted-average amortization period is 14 years.

 

Lease Accounting

 

Certain of the Company’s operating leases provide for minimum annual payments that increase over the life of the lease. The aggregate minimum annual payments are charged to expense on a straight-line basis beginning when the Company takes possession of the property and extending over the term of the related lease. The amount by which straight-line rent expense exceeds actual lease payment requirements in the early years of the leases is accrued as deferred minimum rent and reduced in later years when the actual cash payment requirements exceed the straight-line expense. Accounting guidance for asset retirement obligations requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. Due to the nature of the Company’s business, its asset retirement obligation with respect to owned or leased properties is not significant.

 

Store Opening and Closing Costs

 

New store opening costs consisting primarily of rent, store payroll and general operating costs are charged to expense as incurred prior to the store opening.

 

In the event a leased store is closed before the expiration of the associated lease, the discounted remaining lease obligation less estimated sublease rental income, asset impairment charges related to improvements and fixtures, inventory write-downs and other miscellaneous closing costs associated with the disposal activity are recognized when the store closes.

 

During the third quarter ended October 9, 2016, the Company closed five operating stores, resulting in an asset impairment loss of $0.4 million and lease obligation expense of $1.0 million, which were reported within “Operating and administrative expenses” on the accompanying condensed consolidated statements of operations and comprehensive income.

 

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Share-Based Compensation

 

All share-based payments are recognized over the requisite service period in the statements of operations and comprehensive income as compensation expense based on the fair value of an award, taking into consideration estimated forfeiture rates.

 

The Company measures share-based compensation cost at the grant date based on the fair value of the award and recognizes share-based compensation cost as an expense over the award’s vesting period. As share-based compensation expense recognized in the consolidated statements of operations and comprehensive income of the Company is based on awards ultimately expected to vest, the amount of expense has been reduced for estimated forfeitures. The Company’s forfeiture rate assumption used in determining its share-based compensation expense is estimated primarily based upon historical data and consideration of future expected forfeiture rates. The actual forfeiture rate could differ from these estimates.

 

The Company uses the Black-Scholes-Merton option-pricing model to determine the grant date fair value for each stock option grant. The Black-Scholes-Merton option-pricing model requires extensive use of subjective assumptions. Application of alternative assumptions could produce significantly different estimates of the fair value of share-based compensation and, consequently, the related amounts recognized in the Company’s consolidated statements of operations and comprehensive income. The Company recognizes compensation cost for graded vesting awards as if they were granted in multiple awards. Management believes the use of this “multiple award” method is preferable because a stock option grant with graded vesting is effectively a series of individual grants that vests over various periods and management believes that this method provides for better matching of compensation costs with the associated services rendered throughout the applicable vesting periods. See Note 9, Share-Based Compensation.

 

Significant Accounting Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions. Such estimates and assumptions could affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Revenue Recognition

 

Revenues from the sale of products are recognized at the point of sale. Discounts provided to customers at the time of sale are recognized as a reduction in sales as the products are sold. Returns are also recognized as a reduction in sales and are immaterial in relation to total sales. The Company collects sales tax on taxable products purchased by its customers and remits such collections to the appropriate taxing authority in accordance with local laws. Sales tax collections are presented in the consolidated statements of operations and comprehensive income on a net basis and, accordingly, are excluded from reported revenues.

 

Proceeds from the sale of the Company’s Smart & Final gift cards are recorded as a liability at the time of sale, and recognized as sales when they are redeemed by the customer. The Smart & Final gift cards do not have an expiration date and the Company is not required to escheat the value of unredeemed gift cards in the applicable jurisdictions. The Company has determined a gift card breakage rate based upon historical redemption patterns. Estimated breakage amounts are accounted for under the redemption recognition method, which results in recognition of estimated breakage income in proportion to actual gift card redemptions.

 

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 the Company’s 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 the Company’s warehouses to its stores, and other costs of its distribution network. The Company does not exclude any material portion of these costs from cost of sales.

 

Vendor Rebates and Other Allowances

 

As a component of the Company’s consolidated procurement program, the Company frequently enters into contracts with vendors that provide for payments of rebates or other allowances. These vendor payments are reflected in the carrying value of the inventory when earned or as progress is made toward earning the rebate or allowance and as a component of cost of sales as the inventory is sold. Certain of these vendor contracts provide for rebates and other allowances that are contingent upon the Company meeting specified performance measures such as a cumulative level of purchases over a specified period of time. Such contingent rebates and other allowances are given accounting recognition at the point at which achievement of the specified performance measures are deemed to be probable and reasonably estimable.

 

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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. The Company charges to expense the costs of advertising as incurred.

 

Income Taxes

 

The Company recognizes deferred tax assets and liabilities based on the balance sheet method, which requires an adjustment to the deferred tax asset or liability to reflect income tax rates currently in effect. When income tax rates increase or decrease, a corresponding adjustment to income tax expense is recorded by applying the rate change to the cumulative temporary differences. The Company also determines whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recognized.

 

On March 30, 2016, the FASB issued Accounting Standards Update (“ASU”) No. 2016-09, Compensation-stock compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). ASU 2016-09 simplifies several aspects of the accounting for employee share-based payment transactions including the accounting for income taxes, forfeitures and statutory tax withholding requirements. Under the new guidance, companies will no longer record excess tax benefits and certain tax deficiencies in additional paid-in capital (“APIC”). Instead, they will record all excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement, and APIC pools will be eliminated. It also will allow an employer to make a policy election to account for forfeitures as they occur and to repurchase more of an employee’s shares than it can today for tax withholding purposes without triggering liability accounting. The new standard also amends the presentation of employee share-based payment-related items in the statement of cash flows by requiring that excess income tax benefits and deficiencies be classified in cash flows from operating activities (which we previously included in cash flows from financing activities), and that cash paid to taxing authorities arising from the withholding of shares from employees be classified in cash flows from financing activities (which is consistent with our past practice). ASU 2016-09 is effective for annual reporting periods beginning after December 15, 2016. Early adoption is permitted in any annual or interim period for which financial statements have not been issued, but all of the guidance must be adopted in the same period. The Company elected early adoption of ASU 2016-09 in the second quarter of 2016. As a result of the adoption of ASU 2016-09, for the twenty-four weeks ended June 19, 2016, the Company recognized excess tax benefits as income tax benefit. An income tax benefit of $1.1 million and $2.4 million was recognized in the sixteen and forty weeks ended October 9, 2016, respectively. There was no change to retained earnings with respect to excess tax benefits. The treatment of forfeitures has not changed as the Company has elected to continue its current practice of estimating the number of forfeitures. As such, the adoption of ASU 2016-09 had no cumulative effect on retained earnings. With the adoption of ASU 2016-09, the Company has elected to present the cash flow statement on a prospective transition method and no prior periods have been adjusted.

 

Foreign Currency Translations

 

The Company’s joint venture in Mexico uses the Mexican Peso as its functional currency. The joint venture’s assets and liabilities are translated into U.S. dollars at the exchange rates prevailing at the balance sheet dates. Revenue and expense accounts are translated into U.S. dollars at average exchange rates during the year. Foreign exchange translation adjustments are included in “Accumulated other comprehensive loss,” which is reflected as a separate component of stockholders’ equity, in the accompanying condensed consolidated balance sheets.

 

Derivative Financial Instruments

 

The Company uses interest rate swaps to manage its exposure to adverse fluctuations in interest rates. The contracts are accounted for in accordance with accounting guidance for derivatives and hedging, which requires every derivative instrument to be recorded in the Company’s consolidated balance sheets as either an asset or liability measured at its fair value. The Company designates its interest rate swaps as cash flow hedges and formally documents its hedge relationships, including identification of the hedging instruments and the hedged items, as well as its risk management objectives and strategies for undertaking the hedge transaction. Accordingly, changes in estimated fair value related to the interest rate swaps are recognized in “Accumulated other comprehensive loss” in the condensed consolidated statements of stockholders’ equity and recognized in the condensed consolidated statements of operations and comprehensive income when the hedged items affect earnings. See Note 5, Derivative Financial Instruments.

 

Debt Discount and Debt Issuance Costs

 

Costs incurred in connection with the placement of long-term debt paid directly to the Company’s lenders are treated as a debt discount. Costs incurred in connection with the placement of long-term debt paid to third parties are treated as debt issuance costs and are amortized to interest expense over the term of the related debt using the effective interest method.

 

Effective beginning January 4, 2016, the Company adopted ASU No. 2015-03, Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). As a result of the adoption of ASU 2015-03, the Company presented capitalized debt issuance costs in its condensed consolidated balance sheets as a direct reduction to debt and the new guidance was retrospectively applied to all prior periods presented in its condensed consolidated balance sheets. Prior to the adoption of ASU 2015-03, deferred financing costs were presented as an asset in the Company’s condensed consolidated balance sheets.

 

Self-Insurance

 

The Company purchases third-party insurance for workers’ compensation and general liability costs that exceed certain limits for each respective insurance program. The Company is responsible for the payment of claims in amounts less than these insured excess limits and establishes estimated accruals for its insurance programs based on available claims data, historical trends and experience, and projected ultimate costs of the claims. These accruals are based on estimates prepared with the assistance of outside actuaries and consultants, and the ultimate cost of these claims may vary from initial estimates and established accruals. The actuaries periodically update their estimates and the Company records such adjustments in the period in which such determination is made. These balances are included in “Other long-term liabilities” in the condensed consolidated balance sheets.

 

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Fair Value of Financial Instruments

 

The Company’s financial instruments recorded in the condensed consolidated balance sheets include cash and cash equivalents, accounts receivable, derivatives, investments in affiliates, accounts payable, accrued expenses and long-term variable rate debt. The carrying amounts of cash and cash equivalents, accounts receivable, derivatives, equity investment in joint venture, accounts payable and accrued expenses approximate fair value.

 

The Company’s debt is not listed or traded on an established market. For the purpose of determining the fair value of the Company’s first lien term loan facility (as amended, the “Term Loan Facility”), the administrative agent has provided to the Company the fair value of the Term Loan Facility based upon orderly trading activity and related closing prices for actual trades of the Company’s Term Loan Facility as well as indications of interest by prospective buyers and sellers and related bid/ask prices. As of October 9, 2016, the carrying value of the Term Loan Facility approximates fair value based upon valuations received from the administrative agent, which reflected a pricing valuation of 99.88% of carrying value. The carrying valuation of the Company’s Term Loan Facility was $625.0 million, compared to an indicated fair value of $624.2 million as of October 9, 2016. The Company’s estimates of the fair value of long-term debt were classified as Level 2 in the fair value hierarchy.

 

The Company’s condensed consolidated balance sheets reflect its investment in the common stock of Sprouts Farmers Market, Inc. (“Sprouts”) through the Company’s supplemental deferred compensation plan. The investment is presented at fair market value.

 

Accounting for Retirement Benefit Plans

 

The Company recognizes the overfunded or underfunded status of a defined benefit plan, measured as the difference between the fair value of plan assets and the plan’s benefit obligation, as an asset or liability in its consolidated balance sheets and recognizes changes to that funded status in the year in which the changes occur through accumulated other comprehensive loss. Measurement of the funded status of a plan is required as of the Company’s consolidated balance sheet dates.

 

Earnings per Share

 

Basic earnings per share is calculated by dividing net income by the weighted average number of shares outstanding during the fiscal period.

 

Diluted earnings per share is calculated by dividing net income by the weighted average number of shares outstanding, plus, where applicable, shares that would have been outstanding related to dilutive stock options and unvested restricted stock.

 

Reclassifications

 

Certain reclassifications were made to the prior period financial statements to conform to current period presentation. See Note 2, Significant Accounting Policies—Debt Discount and Debt Issuance Costs.

 

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3. Recent Accounting Pronouncements

 

Recently Issued Accounting Pronouncements Not Yet Adopted

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). ASU 2014-09 is a comprehensive new revenue recognition model that requires an entity to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. ASU 2014-09 also requires expanded disclosures about revenue recognition. In adopting ASU 2014-09, entities may use either a full retrospective or a modified retrospective approach. ASU 2014-09 was to be effective for the first interim period within annual reporting periods beginning after December 15, 2016, and early adoption is not permitted. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date, which defers the effective date of ASU 2014-09 for all entities by one year. The Company is currently evaluating this guidance and the impact it will have on its consolidated financial statements.

 

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). ASU 2014-15 provides guidance on determining when and how reporting entities must disclose going-concern uncertainties in their financial statements. The new standard requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date of issuance of the entity’s financial statements (or within one year after the date on which the financial statements are available to be issued, when applicable). Further, an entity must provide certain disclosures if there is “substantial doubt about the entity’s ability to continue as a going concern.” ASU 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods thereafter and early adoption is permitted. The Company does not expect the adoption of ASU 2014-15 will have a material impact on the Company’s consolidated financial statements.

 

In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory (“ASU 2015-11”). The amendments in ASU 2015-11 do not apply to inventory that is measured using last-in, first-out (“LIFO”) or the retail inventory method. The amendments apply to all other inventory, which includes inventory that is measured using FIFO or average cost. An entity should measure inventory within the scope of ASU 2015-11 at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. For public business entities, the amendments in ASU 2015-11 are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The Company does not expect the adoption of ASU 2015-11 will have a material impact on the Company’s consolidated financial statements.

 

In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”), which requires entities to present deferred tax assets and deferred tax liabilities as noncurrent in a classified balance sheet. ASU 2015-17 simplifies the current guidance in ASC Topic 740, Income Taxes , which requires entities to separately present deferred tax assets and liabilities as current and noncurrent in a classified balance sheet. ASU 2015-17 is effective for fiscal years beginning after December 15, 2016, and interim periods within those annual periods. Although early adoption is permitted for all entities as of the beginning of an interim or annual reporting period, the Company decided not to early adopt ASU 2015-17. The Company does not expect the adoption of ASU 2015-17 will have a material impact on the Company’s consolidated financial statements.

 

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The amendments in ASU 2016-01 require an entity to measure equity investments that do not result in consolidation and are not accounted for under the equity method at fair value with changes in fair value recognized in net income. The amendments also require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. The requirement to disclose the method(s) and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet has been eliminated by the amendments. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not expect the adoption of ASU 2016-01 will have a material impact on the Company’s consolidated financial statements.

 

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In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). ASU 2016-02 will require organizations that lease assets, referred to as “lessees”, to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. A lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months. Consistent with current GAAP, the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. However, unlike current GAAP, which requires only capital leases to be recognized on the balance sheet, ASU 2016-02 will require both types of leases to be recognized on the balance sheet. As a result, lessees will be required to put most leases on their balance sheets while recognizing expense on their income statements in a manner similar to current accounting. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. ASU 2016-02 also may require additional disclosures, including qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements. The Company is currently evaluating this guidance and the impact it will have on its consolidated financial statements.

 

On March 9, 2016, the FASB issued ASU No. 2016-04, Liabilities — Extinguishments of Liabilities (Subtopic 405-20): Recognition of Breakage for Certain Prepaid Stored-Value Products (“ASU 2016-04”). ASU 2016-04 requires issuers of prepaid stored-value products redeemable for goods, services or cash at third-party merchants to derecognize liabilities related to those products for breakage, or the value of prepaid stored-value products that is not redeemed by consumers for goods, services or cash. An entity that expects to be entitled to a breakage amount for a liability resulting from the sale of a prepaid stored-value product within the scope of ASU 2016-04 is required to derecognize the liability related to expected breakage in proportion to the pattern of rights expected to be exercised by the consumer only if it is probable that a significant reversal of the recognized breakage amount will not occur. If an entity does not expect to be entitled to a breakage amount, it is required to derecognize the related liability when the likelihood of a consumer exercising its remaining rights becomes remote. Entities will apply the guidance using either a modified retrospective approach with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption or a full retrospective approach. The guidance is for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-04 will have a material impact on the Company’s consolidated financial statements.

 

In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”). The update amends certain guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606). These amendments relate to: identifying performance obligations with respect to (a) immaterial promised goods or services, (b) shipping and handling activities and (c) identifying when promises represent performance obligations; and licensing implementation guidance with respect to (a) determining the nature of an entity’s promise in granting a license, (b) sales-based and usage-based royalties, (c) restrictions of time, geographic location, and use and (d) renewals of licenses that provide a right to use intellectual properties. The effective date and transition requirements for ASU 2016-10 are the same as the effective date and transition requirements for ASU 2014-09. The Company is currently evaluating this guidance and the impact it will have on its consolidated financial statements.

 

In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The update amends certain guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606). These amendments are intended to improve revenue recognition in the areas of collectability, presentation of sales tax and other similar taxes collected from customers, non-cash consideration, contract modifications and completed contracts at transition. The update also makes a transition technical correction stating that entities who elect to use the full retrospective transition method to adopt the new revenue standard will no longer be required to disclose the effect of the change in accounting principle on the period of adoption (as is currently required by ASC 250-10-50-1(b) (2)); however, entities will still be required to disclose the effects on pre-adoption periods that were retrospectively adjusted. The effective date and transition requirements for ASU 2016-10 are the same as the effective date and transition requirements for ASU 2014-09. The Company is currently evaluating this guidance and the impact it will have on its consolidated financial statements.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 replaces the incurred loss impairment methodology in current GAAP. The new guidance requires immediate recognition of estimated credit losses expected to occur for most financial assets and certain other instruments. For available-for-sale debt securities with unrealized losses, the losses will be recognized as allowances rather than reductions in the amortized cost of the securities. It is effective for annual reporting periods beginning after December 15, 2019 and interim periods within those annual periods. Early adoption for annual reporting periods beginning after December 15, 2018 is permitted. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first effective reporting period. The Company is currently evaluating this guidance and the impact it will have on its consolidated financial statements.

 

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In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). ASU 2016-15 is intended to reduce diversity in practice of how certain transactions are classified in the statement of cash flows. ASU 2016-15 addresses the classification of various transactions, including, among other things, debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments, contingent consideration payments made after a business combination, distributions received from equity method investments, and beneficial interests in securitization transactions. ASU 2016-15 is effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASU 2016-15 will have a material impact on the Company’s consolidated financial statements.

 

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”). ASU 2016-16 is intended to simplify the accounting for income taxes related to intra-entity asset transfers. It allows an entity to recognize the tax expense from the sale of an asset in the seller’s tax jurisdiction when the transfer occurs, even though the pre-tax effects of that transaction are eliminated in consolidation. ASU 2016-16 is effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted only in the first quarter of 2017. The Company is currently evaluating this guidance and the impact it will have on its consolidated financial statements.

 

4. Debt

 

Current portion of debt at October 9, 2016 and January 3, 2016 was as follows (in thousands):

 

 

 

October 9,
2016

 

January 3,
2016

 

Revolving Credit Facility

 

$

37,000

 

$

5,000

 

 

 

 

 

 

 

Less:

 

 

 

 

 

Debt issuance costs

 

1,720

 

1,096

 

Total current portion of debt

 

$

35,280

 

$

3,904

 

 

Long-term debt at October 9, 2016 and January 3, 2016 was as follows (in thousands):

 

 

 

October 9,
2016

 

January 3,
2016

 

Term Loan Facility

 

$

625,000

 

$

594,907

 

 

 

 

 

 

 

Less:

 

 

 

 

 

Debt issuance costs

 

(2,788

)

(3,112

)

Discount on debt issuance

 

(5,895

)

(4,839

)

Total long-term debt

 

$

616,317

 

$

586,956

 

 

In conjunction with the Ares Acquisition, Smart & Final Stores LLC (“Smart & Final Stores”) entered into three financing arrangements effective November 15, 2012, including two term loan agreements: the Term Loan Facility and a second lien term loan facility (the “Second Lien Term Loan Facility”) and an asset-based lending facility (as amended, the “Revolving Credit Facility”).

 

The Term Loan Facility originally had a term of seven years and originally provided financing of up to a maximum of $525.0 million in term loans. At November 15, 2012, the Term Loan Facility was drawn to provide $525.0 million in gross proceeds as a part of the funding for the Ares Acquisition.

 

All obligations under the Term Loan Facility are secured by (1) a first-priority security interest in substantially all of the property and assets of, as well as the equity interests owned by, Smart & Final Stores and SF CC Intermediate Holdings, Inc., a direct wholly owned subsidiary of SFSI (“Intermediate Holdings”), and the other guarantors, with certain exceptions, and (2) a second-priority security interest in the Revolving Credit Facility collateral.

 

Initially, borrowings under the Term Loan Facility bore interest at an applicable margin of 3.50% plus, at Smart & Final Stores’ option, a fluctuating rate equal to the highest of (1) the federal funds rate plus 0.50%, (2) a rate of interest published by The Wall Street Journal as the “Prime Rate,” and (3) a LIBOR loan rate based on LIBOR plus 1.00% (the “ABR Borrowings”). Eurocurrency Borrowings (as defined in the credit agreement governing the Term Loan Facility) bore interest at the adjusted LIBOR rate, which is the greater of (a) the LIBOR rate in effect for the applicable interest period divided by one, minus the Statutory Reserves (as defined in the credit agreement governing the Term Loan Facility) applicable to such Eurocurrency Borrowing, if any, and (b) 1.25% plus the applicable Eurocurrency (as defined in the credit agreement governing the Term Loan Facility) loan rate margin of 4.50%.

 

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The Term Loan Facility contains a provision for quarterly amortization of principal in the amount of 0.25% of the aggregate principal amount of the term loans outstanding under the Term Loan Facility beginning March 31, 2013. The Term Loan Facility has no financial covenant requirements. The Term Loan Facility contains covenants that would restrict the Company’s ability to pay cash dividends.

 

The Second Lien Term Loan Facility had a term of eight years and provided $195.0 million in gross proceeds at November 15, 2012.

 

Borrowings under the Second Lien Term Loan Facility bore interest at an applicable margin of 8.25% plus, at Smart & Final Stores’ option, a fluctuating rate equal to the highest of (1) the federal funds rate plus 0.50%, (2) a rate of interest published by The Wall Street Journal as the “Prime Rate,” or (3) a LIBOR loan rate based on LIBOR plus 1.00%.

 

During the second quarter of 2013, the Company amended the Term Loan Facility, reducing the ABR Borrowings applicable margin from 3.50% to 2.50%, reducing the Eurocurrency Borrowings applicable margin from 4.50% to 3.50% and reducing the Adjusted LIBOR floor rate from 1.25% to 1.00%. Additionally, the Company increased the size of the Term Loan Facility by $55.0 million through an incremental facility. The proceeds of this additional borrowing were used to reduce the amounts outstanding under the Second Lien Term Loan Facility by $55.0 million.

 

During the fourth quarter of 2013, the Company amended the Term Loan Facility, increasing the ABR Borrowings applicable margin from 2.50% to 2.75%, increasing the Eurocurrency Borrowings applicable margin from 3.50% to 3.75%, and reducing the size of the incremental borrowing facilities that may be incurred without regard to leverage-based limitations from $125.0 million to $75.0 million (the “Second Amendment”). Under the Second Amendment, the Term Loan Facility may be prepaid, in whole or in part, at any time subject to a prepayment premium of 1.00% of the principal amount of the term loans so prepaid if the prepayment occurs as a result of a repricing transaction and is effective within six months of the Second Amendment. Additionally, the Company increased the size of the Term Loan Facility by $140.0 million through an incremental facility. The proceeds of this borrowing were used to repay all amounts outstanding under the Second Lien Term Loan Facility, which was then terminated.

 

On September 29, 2014, the Company used the net proceeds from the IPO to repay borrowings of approximately $115.5 million under the Term Loan Facility. Quarterly amortization of the principal amount is no longer required.

 

During the second quarter of 2015, the Company amended the Term Loan Facility to reduce (i) the ABR Borrowings applicable margin from 2.75% to 2.25%, (ii) the Eurocurrency Borrowings applicable margin from 3.75% to 3.25% and (iii) the Adjusted LIBOR floor rate from 1.00% to 0.75% (the “Third Amendment”). The November 15, 2019 maturity date remained unchanged.

 

During the third quarter of 2016, the Company amended the Term Loan Facility (the “Fourth Amendment”) to increase the Eurocurrency Borrowings applicable margin from 3.25% to 3.50%. Additionally, the Company increased the size of the Term Loan Facility by $30.1 million, from $594.9 million to $625.0 million, and extended the original November 15, 2019 maturity date to November 15, 2022. Consequently, during the third quarter of 2016, the Company recorded a loss on the early extinguishment of debt of $5.0 million including $2.6 million of fees paid in connection with the amendment and the write-off of $2.4 million of unamortized debt discount and debt issuance costs. The Company incurred $7.2 million of fees in connection with the Fourth Amendment. Approximately $1.2 million of these fees were recorded as debt issuance costs and approximately $3.4 million of these fees were recorded as debt discount. They are both amortized over the remaining term of the Term Loan Facility. As of October 9, 2016 and January 3, 2016, the weighted-average interest rate on the amount outstanding under the Term Loan Facility was 4.31% and 4.00%, respectively.

 

The Revolving Credit Facility initially provided financing of up to $150.0 million (including up to $50.0 million for the issuance of letters of credit) subject to a borrowing base, for a term of five years. The borrowing base is a formula based on certain eligible inventory and receivables, minus certain reserves.

 

All obligations under the Revolving Credit Facility are secured by (1) a first-priority security interest in the accounts receivable, inventory, cash and cash equivalents, and related assets of Smart & Final Stores and Intermediate Holdings and the other guarantors under the facility, and (2) a second-priority security interest in substantially all of the other property and assets of, as well as the equity interests owned by, Smart & Final Stores and Intermediate Holdings and the other guarantors under the facility.

 

Borrowings under the Revolving Credit Facility bear interest at an applicable margin plus, at Smart & Final Stores’ option, a fluctuating rate equal to either (1) adjusted LIBOR (defined as a rate equal to the LIBOR rate in effect for the applicable interest period, as adjusted for statutory reserves) or (2) the alternate base rate (defined as a fluctuating rate equal to the highest of (x) the federal funds effective rate plus 0.50%, (y) the interest rate announced by the administrative agent as its “Prime Rate” and (z) the adjusted LIBOR rate for an interest period of one month plus 1.00%). The applicable margin is determined by a pricing grid based on the facility availability.

 

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During the third quarter of 2016, the Company amended the Revolving Credit Facility (the “Second Amendment”) to increase the committed amount to $200 million. Additionally, the maturity date was extended from November 15, 2017 to the earliest of (a) July 19, 2021 and (b) the date that is 60 days prior to the earliest maturity date of the Term Loan Facility, provided it has not been repaid. In addition, the applicable margin ranges were reduced with respect to (i) alternate base rate loans to 0.25% to 0.50% from 0.25% to 0.75% and (ii) LIBOR rate loans to 1.25% to 1.50% from 1.25% to 1.75%. The Company incurred $1.0 million of fees in connection with the Second Amendment. All of these fees were recorded as debt issuance costs and amortized over the remaining term of the Revolving Credit Facility.

 

At October 9, 2016 and January 3, 2016, the alternate base rate was 3.50%, and the applicable margin for alternate base rate loans was 0.25%, for a total rate of 3.75%. The calculated borrowing base of the Revolving Credit Facility was $186.1 million and $175.1 million at October 9, 2016 and January 3, 2016, respectively. As of October 9, 2016 and January 3, 2016, the amount outstanding under the Revolving Credit Facility was $37.0 million and $5.0 million, respectively.

 

The Revolving Credit Facility also provides for a $65.0 million sub-limit for letters of credit, of which the Company had $31.4 million and $25.1 million outstanding as of October 9, 2016 and January 3, 2016, respectively. As of October 9, 2016 and January 3, 2016, the amount available for borrowing under the Revolving Credit Facility was $117.7 million and $119.9 million, respectively. The Revolving Credit Facility does not include financial covenant requirements unless a defined covenant trigger event has occurred and is continuing. As of October 9, 2016 and January 3, 2016, no trigger event had occurred.

 

5. Derivative Financial Instruments

 

On April 15, 2013, the Company entered into a five-year interest rate swap agreement (the “Swap”) to fix the LIBOR component of interest under the Term Loan Facility at 1.7325% on a variable notional amount starting at $422.7 million and declining to $359.7 million for the period from September 30, 2014 through March 29, 2018. The Swap has been designated as a cash flow hedge against LIBOR interest rate movements and formally assessed, both at inception and at least quarterly thereafter, as to whether it was effective in offsetting changes in cash flows of the hedged item. The portion of the change in fair value attributable to hedge ineffectiveness was recorded in “Interest expense, net” in the condensed consolidated statements of operations and comprehensive income. The portion of the change in fair value attributable to hedge effectiveness, net of income tax effects, was recorded to “Accumulated other comprehensive loss” in the condensed consolidated statements of stockholders’ equity.

 

On May 30, 2013, the Company entered into an amendment to the Swap to change the fixed LIBOR component to 1.5995% and the floor rate to 1.00%. On May 12, 2015, the Company entered into a second amendment to the Swap to change the fixed LIBOR component to 1.47675% and the floor rate to 0.75% on a variable notional amount starting at $410.9 million for the period from June 30, 2015 through March 29, 2018.

 

As of October 9, 2016 and January 3, 2016, the fair value carrying amount of the Company’s interest rate swaps are recorded as follows (in thousands):

 

 

 

October 9,
2016

 

January 3,
2016

 

Other assets

 

$

 

$

542

 

Accrued expenses

 

(1,795

)

(2,177

)

Other long-term liabilities

 

(468

)

 

Total derivatives designated as hedging instruments

 

$

(2,263

)

$

(1,635

)

 

The following table summarizes the loss recognized in accumulated other comprehensive loss (“AOCI”) and the amount of gain reclassified from AOCI into earnings for the forty weeks ended October 9, 2016 (in thousands):

 

 

 

Amount of Loss
Recognized
in AOCI on
Derivative,
Net of Tax
(Effective Portion)

 

Amount of Gain
Recognized
in Earnings on
Derivative,
Net of Tax
(Ineffective Portion)

 

Interest rate swaps

 

$

(364

)

$

12

 

 

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6. Fair Value Measurements

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To estimate the fair values of our financial and nonfinancial assets and liabilities, we use valuation approaches within a hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances. The fair value hierarchy is divided into three levels based on the source of inputs as follows:

 

Level 1—Quoted prices for identical instruments in active markets

 

Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets

 

Level 3—Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable

 

The Company’s assets and liabilities measured at fair value on a recurring basis are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):

 

 

 

Fair Value Measurement at October 9, 2016

 

Description

 

Total as of
October 9,
2016

 

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

 

Significant
Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Financial assets

 

 

 

 

 

 

 

 

 

Other assets—cash and cash equivalents that fund supplemental executive retirement plan and deferred compensation plan

 

$

3,789

 

$

3,789

 

$

 

$

 

Other assets—assets that fund supplemental executive retirement plan

 

2,787

 

2,787

 

 

 

Other assets—deferred compensation plan investment in Sprouts

 

3,806

 

3,806

 

 

 

Financial liabilities

 

 

 

 

 

 

 

 

 

Derivatives

 

(2,263

)

 

(2,263

)

 

Other long-term liabilities—deferred compensation plan

 

(17,539

)

(2,415

)

(15,124

)

 

Total

 

$

(9,420

)

$

7,967

 

$

(17,387

)

$

 

 

Level 1 Investments include money market funds of $3.8 million, market index funds of $2.8 million and an investment in Sprouts of $3.8 million with the corresponding deferred compensation liabilities of $2.4 million. The fair values of these investments are based on quoted market prices in an active market.

 

Level 2 Liabilities include $15.1 million of deferred compensation liabilities, the fair value of which is based on quoted prices of similar assets traded in active markets, and $2.3 million of derivatives, which are interest rate hedges. The fair values of the derivatives are determined based primarily on a third-party pricing model that applies observable credit spreads to each exposure to calculate a credit risk adjustment and the inputs are changed only when corroborated by observable market data.

 

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Fair Value Measurement at January 3, 2016

 

Description

 

Total as of
January 3,
2016

 

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

 

Significant
Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Financial assets

 

 

 

 

 

 

 

 

 

Other assets—cash and cash equivalents that fund supplemental executive retirement plan and deferred compensation plan

 

$

2,027

 

$

2,027

 

$

 

$

 

Other assets—assets that fund supplemental executive retirement plan

 

2,643

 

2,643

 

 

 

Other assets—deferred compensation plan investment in Sprouts

 

4,787

 

4,787

 

 

 

Financial liabilities

 

 

 

 

 

 

 

 

 

Derivatives

 

(1,635

)

 

(1,635

)

 

Other long-term liabilities—deferred compensation plan

 

(21,401

)

(4,787

)

(16,614

)

 

Total

 

$

(13,579

)

$

4,670

 

$

(18,249

)

$

 

 

Level 1 Investments include money market funds of $2.0 million, market index funds of $2.6 million and an investment in Sprouts of $4.8 million with the corresponding deferred compensation liabilities of $4.8 million. The fair values of these investments are based on quoted market prices in an active market.

 

Level 2 Liabilities include $16.6 million of deferred compensation liabilities, the fair value of which is based on quoted prices of similar assets traded in active markets, and $1.6 million of derivatives, which are interest rate hedges. The fair values of the derivatives are determined based primarily on third-party pricing model that applies observable credit spreads to each exposure to calculate a credit risk adjustment and the inputs are changed only when corroborated by observable market data.

 

Certain assets are measured at fair value on a nonrecurring basis, which means the assets are not measured at fair value on an ongoing basis but, rather, are subject to fair value adjustments only in certain circumstances (for example, when there is evidence of impairment). See Note 2, Significant Accounting Policies — Property, Plant and Equipment, Capitalized Software and Goodwill and Intangible Assets. The fair value measurements were determined using available market capitalization rates and public comparable store sales data at the measurement dates. The Company classifies the measurements as Level 3.

 

7. Retirement Benefit Plans and Postretirement and Postemployment Benefit Obligations

 

Defined Benefit Retirement Plan

 

The Company has a funded noncontributory qualified defined benefit retirement plan (the “Single-Employer Plan”) that, prior to June 1, 2008, covered substantially all full-time employees following a vesting period of five years of service (the “Pension Participants”) and provided defined benefits based on years of service and final average salary. The Predecessor froze the accruing of future benefits for the Pension Participants (the “Frozen Pension Participants”) effective June 1, 2008, with the exception of approximately 450 hourly paid employees in the Company’s distribution and transportation operations who remain eligible for pension benefits under the prior terms. No new employees are eligible for participation in the Single-Employer Plan after June 1, 2008, with the exception of new hires in the Company’s eligible distribution and transportation operations. Frozen Pension Participants will continue to accrue service for vesting purposes only and future payments from the Single-Employer Plan will be in accordance with the Single-Employer Plan’s retirement payment provisions. The Company funds the Single-Employer Plan with annual contributions as required by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). The Company uses a measurement date of December 31 for the Single-Employer Plan.

 

The components included in the net periodic benefit cost for the periods indicated are as follows (in thousands):

 

 

 

Sixteen Weeks Ended

 

Forty Weeks Ended

 

 

 

October 9,

 

October 4,

 

October 9,

 

October 4,

 

 

 

2016

 

2015

 

2016

 

2015

 

Service cost

 

$

478

 

$

485

 

$

1,146

 

$

1,094

 

Interest cost

 

3,024

 

2,876

 

7,256

 

6,489

 

Expected return on plan assets

 

(2,992

)

(3,135

)

(7,180

)

(7,073

)

Net periodic benefit cost

 

$

510

 

$

226

 

$

1,222

 

$

510

 

 

During the forty weeks ended October 9, 2016, the Company made contributions of  $7.2 million to the Single-Employer Plan. The Company expects to fund minimum required contributions of $8.8 million during fiscal year 2016.

 

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Supplemental Executive Retirement Plan

 

The Company maintains a noncontributory, nonqualified defined benefit supplemental executive retirement plan (the “SERP”), which provides supplemental income payments for certain current and former corporate officers in retirement. No new participants are eligible for participation and service and compensation accruals were frozen effective June 1, 2008. Accordingly, the retirement benefit for SERP participants who remained employed by the Company was frozen, and future service or compensation increases will not adjust the SERP benefit amount.

 

To provide partial funding for the SERP, the Company invests in corporate-owned life insurance policies. The Company uses a measurement date of December 31 for the SERP.

 

The components included in the net periodic benefit cost for the periods indicated are as follows (in thousands):

 

 

 

Sixteen Weeks Ended

 

Forty Weeks Ended

 

 

 

October 9,

 

October 4,

 

October 9,

 

October 4,

 

 

 

2016

 

2015

 

2016

 

2015

 

Interest cost

 

$

356

 

$

339

 

$

890

 

$

847

 

Net periodic benefit cost

 

$

356

 

$

339

 

$

890

 

$

847

 

 

Postretirement and Postemployment Benefit Obligations

 

The Company provides health care benefits for certain retired employees. Prior to June 1, 2008, substantially all full-time employees could become eligible for such benefits if they reached retirement age while still working for the Company. The Company froze the accruing of benefits for eligible participants effective June 1, 2008. Participants who were eligible for a retiree medical benefit and retired prior to June 1, 2009 continued to be eligible for retiree medical coverage. The Company retains the right to make further amendments to the benefit formula and eligibility requirements. This postretirement health care plan is contributory with participants’ contributions adjusted annually. The plan limits benefits to the lesser of the actual cost for the medical coverage selected or a defined dollar benefit based on years of service, applicable to eligible retirees. The Company uses a measurement date of December 31 for this health care plan.

 

The components included in the postretirement benefit cost for the periods indicated are as follows (in thousands):

 

 

 

Sixteen Weeks Ended

 

Forty Weeks Ended

 

 

 

October 9,

 

October 4,

 

October 9,

 

October 4,

 

 

 

2016

 

2015

 

2016

 

2015

 

Service cost

 

$

123

 

$

123

 

$

308

 

$

308

 

Interest cost

 

215

 

215

 

538

 

538

 

Net periodic benefit cost

 

$

338

 

$

338

 

$

846

 

$

846

 

 

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8. Income Taxes

 

The Company’s effective tax rate for the forty weeks ended October 9, 2016 and October 4, 2015 was (3.17)% and 39.4%, respectively. The difference in the Company’s effective tax rate for the forty weeks ended October 9, 2016 compared to the forty weeks ended October 4, 2015 was primarily related to the release of (i) a $1.9 million uncertain tax benefit reserve due to a lapse of statute of limitations, (ii) a death benefit of $0.6 million related to company-owned life insurance policies, and (iii) excess tax benefits of $2.4 million from stock award exercises and vesting, as a result of the Company’s early adoption in the second quarter of 2016 of ASU 2016-09, a new accounting standard that requires that excess tax benefits and deficiencies that arise upon vesting or exercise of share-based payments be recognized as an income tax benefit and expense in the income statement. The adoption of this new accounting standard did not require adjustment of periods prior to the first quarter of 2016. As a result of the adoption of ASU 2016-09, for the sixteen weeks and forty weeks ended October 9, 2016, the Company recognized excess tax benefits as income tax benefit of $1.1 million and $2.4 million, respectively.

 

SFSI, or one of its subsidiaries, files income tax returns in the U.S. federal jurisdiction, various U.S. state jurisdictions and Mexico. The Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2009. The tax years which remain subject to examination or are being examined by major tax jurisdictions as of October 9, 2016 include fiscal years 2009 through 2015 for state purposes and 2012 through 2015 for federal purposes.

 

9. Share-Based Compensation

 

2014 Incentive Plan

 

Effective September 23, 2014, and in connection with the IPO, SFSI adopted the Smart & Final Stores, Inc. 2014 Stock Incentive Plan (the “2014 Incentive Plan”), which provides for the issuance of equity-based incentive awards not to exceed 5,500,000 shares of Common Stock to eligible employees, consultants and non-employee directors in the form of stock options, restricted stock, other stock-based awards and performance-based cash awards. In addition, a number of shares of Common Stock equal to the number of shares of Common Stock underlying stock options that were previously issued under the 2012 Incentive Plan (as defined below) and that expire, terminate or are cancelled for any reason without being exercised in full will be available for issuance under the 2014 Incentive Plan.

 

During the forty weeks ended October 9, 2016, 396,703 shares of restricted stock were granted to certain management employees and non-employee directors under the 2014 Incentive Plan. These awards have time-based vesting terms subject to continuous employment with the Company. Except for the shares granted to non-employee directors, which vest in equal tranches of 25% over a four-year period from the grant date, these grants vest in equal tranches of 33 1/3% each year over a three-year period from the grant date. During the forty weeks ended October 9, 2016, 49,555 shares of restricted stock have been retained by the Company to offset the grantee’s minimum income tax obligations in connection with the vesting of restricted stock awards.

 

On July 20, 2016, SFSI’s board of directors authorized and approved the modification of the exercise provisions of options and restricted stock awards granted to one management employee participant. Under the amendment, if the participant is terminated without cause, resigns for Good Reason or Retires, the participant will receive (i) 24 months of service credit with respect to any options to purchase common stock of the Company granted prior to the date of the termination of his employment and held by him on such date, and he will have two years after the date of termination to exercise vested options, and (ii) immediate vesting with respect to the lesser of (x) 50% of the total number of shares of restricted stock he has been awarded prior to the date of termination and (y) all of the shares of restricted stock he has been awarded prior to the date of termination that are still subject to restrictions as of the date of such termination.

 

The following table summarizes the restricted stock award activity under the 2014 Incentive Plan for the forty weeks ended October 9, 2016:

 

 

 

Shares

 

Weighted-Average
Grant Date
Fair Value

 

Outstanding at January 3, 2016

 

559,136

 

$

10.86

 

Granted

 

396,703

 

15.63

 

Forfeited

 

(10,082

)

13.39

 

Vested

 

(123,297

)

12.14

 

Outstanding at October 9, 2016

 

822,460

 

$

12.94

 

 

The Company recorded share-based compensation expense related to restricted stock awards of $1.8 million and $1.0 million for the sixteen weeks ended October 9, 2016 and October 4, 2015, respectively, and $3.2 million and $2.7 million for the forty weeks ended October 9, 2016 and October 4, 2015, respectively. As of October 9, 2016, the unrecognized compensation cost was $5.5 million and related weighted-average period over which restricted stock award expense was expected to be recognized was approximately 1.63 years.

 

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During the forty weeks ended October 9, 2016, stock options to purchase up to 587,173 shares of Common Stock were granted to certain management employees under the 2014 Incentive Plan. These awards vest in equal installments of 25% each year over a four-year period from the grant date subject to continuous employment with the Company. On April 21, 2016, SFSI’s board of directors authorized and approved the modification of the exercise provisions of options granted to one management employee participant. Under the amendment, if the participant’s termination is due to retirement, the portion of the option that is vested and exercisable on the date of the participant’s termination may be exercised by the participant at any time within a period beginning on the date of termination and ending on the earlier of (i) two years after the date of such termination and (ii) the expiration date of the stated term of the option, after which any unexercised portion of the option shall terminate.

 

The following table summarizes the Time-Based Option activity under the 2014 Incentive Plan for the forty weeks ended October 9, 2016, dollars in thousands except weighted average exercise price:

                                               

  

 

Shares

 

Weighted-
Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic Value

 

Outstanding at January 3, 2016

 

2,093,918

 

$

12.06

 

 

 

 

 

Granted

 

587,173

 

15.64

 

 

 

 

 

Forfeited

 

(50,000

)

12.00

 

 

 

 

 

Exercised

 

(34,259

)

12.00

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding at October 9, 2016

 

2,596,832

 

$

12.87

 

8.33 years

 

$

1,763

 

Exercisable at October 9, 2016

 

552,130

 

$

12.03

 

7.96 years

 

$

488

 

 

Aggregate intrinsic value represents the difference between the closing stock price of the Common Stock and the exercise price of outstanding, in-the-money options. The closing stock price as reported on the New York Stock Exchange as of October 7, 2016 was $12.89.

 

The Company recorded share-based compensation expense for Time-Based Options granted under the 2014 Incentive Plan of $1.3 million and $1.1 million for the sixteen weeks ended October 9, 2016 and October 4, 2015, respectively, and $2.4 million and $2.7 million for the forty weeks ended October 9, 2016 and October 4, 2015, respectively. As of October 9, 2016, the unrecognized compensation cost was $4.9 million and related weighted-average period over which Time-Based Option expense was expected to be recognized was approximately 2.14 years.

 

2012 Incentive Plan

 

Effective November 15, 2012, SFSI adopted the SF CC Holdings, Inc. 2012 Stock Incentive Plan (the “2012 Incentive Plan”), which provides for the issuance of equity-based incentive awards not to exceed 11,400,000 shares of Common Stock. Effective upon closing of the IPO, no new awards may be granted under the 2012 Incentive Plan.

 

The following table summarizes the Time-Based Option activity under the 2012 Incentive Plan for the forty weeks ended October 9, 2016, dollars in thousands except weighted average exercise price:

 

 

 

Shares

 

Weighted-
Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value

 

Outstanding at January 3, 2016

 

5,253,610

 

$

6.59

 

 

 

 

 

Forfeited

 

(33,592

)

6.59

 

 

 

 

 

Exercised

 

(321,900

)

6.64

 

 

 

 

 

Cancelled

 

 

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding at October 9, 2016

 

4,898,118

 

$

6.58

 

6.33 years

 

$

30,900

 

Exercisable at October 9, 2016

 

2,860,026

 

$

6.58

 

6.33 years

 

$

18,049

 

 

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Under the 2012 Incentive Plan and the Company’s standard form of stock option award agreement for the 2012 Incentive Plan, the Company had a right to repurchase from the participant all or a portion of the shares of Common Stock issued upon the exercise of a stock option prior to the IPO. As a result of the IPO and the related termination of various restrictions on the transfer of Common Stock, it was determined that the Company’s repurchase right is no longer in effect. Accordingly, as of the consummation of the IPO, it was considered probable that the participants could realize monetary benefit from the exercise of such stock options, and the Company started recording share-based compensation expense related to these option grants. The Company recorded share-based compensation expense for these Time-Based Options granted under the 2012 Incentive Plan of $0.7 million and $1.1 million for the sixteen weeks ended October 9, 2016 and October 4, 2015, respectively, and $1.6 million and $2.7 million for the forty weeks ended October 9, 2016 and October 4, 2015, respectively. As of October 9, 2016, the unrecognized compensation cost was $1.0 million and related weighted-average period over which Time-Based Option expense was expected to be recognized was 0.88 years.

 

In connection with the Ares Acquisition on November 15, 2012, certain stock options to purchase shares of common stock of the Predecessor were converted into 3,625,580 stock options to purchase Common Stock (the “Rollover Options”). For Common Stock issued upon exercise of a Rollover Option, prior to the IPO, the repurchase price was the fair market value of the Common Stock on the date of termination. In the event of a participant’s termination of employment for cause or upon discovery that the participant engaged in detrimental activity, if the Company elected to exercise its repurchase right, it was required to do so within a 180-day period commencing on the later of (i) the date of termination and (ii) the date on which such Rollover Option was exercised. In the event of a participant’s termination of employment for any other reason, the repurchase right was required to be exercised by the Company during the 90-day period following the date of termination.

 

The following table summarizes the Rollover Option activity for the forty weeks ended October 9, 2016, dollars in thousands except weighted average exercise price:

 

 

 

Shares

 

Weighted-
Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value

 

Outstanding at January 3, 2016

 

2,700,850

 

$

2.26

 

 

 

 

 

Forfeited

 

 

 

 

 

 

 

Exercised

 

(444,303

)

2.09

 

 

 

 

 

Cancelled

 

 

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding at October 9, 2016

 

2,256,547

 

$

2.29

 

1.44 years

 

$

23,911

 

Exercisable at October 9, 2016

 

2,256,547

 

$

2.29

 

1.44 years

 

$

23,911

 

 

10. Accumulated Other Comprehensive Loss

 

The following table represents the changes in AOCI by each component, net of tax, for the forty weeks ended October 9, 2016 (in thousands):

 

 

 

Defined Benefit
Retirement Plan

 

Cash Flow
Hedging Activity

 

Foreign Currency
Translation and Employee
Benefit Obligation
Adjustment

 

Total

 

Balance at January 3, 2016

 

$

(3,000

)

$

(1,022

)

$

(1,966

)

$

(5,988

)

OCI before reclassification

 

 

(376

)

(178

)

(554

)

Amounts reclassified out of AOCI

 

 

12

 

 

12

 

Net current period OCI

 

 

(364

)

(178

)

(542

)

Balance at October 9, 2016

 

$

(3,000

)

$

(1,386

)

$

(2,144

)

$

(6,530

)

 

The following table represents the items reclassified out of each component of AOCI and the related tax effects for the forty weeks ended October 9, 2016 (in thousands):

 

Details about AOCI
Components

 

Amount
Reclassified
from AOCI

 

Location within
Statement of Operations and
Comprehensive Income

 

Loss on cash flow hedges

 

 

 

 

 

Interest rate swaps

 

$

19

 

Interest income, net

 

 

 

19

 

Total before income taxes

 

 

 

7

 

Income tax expense

 

 

 

$

12

 

Reclassification adjustments, net of tax

 

Total reclassifications for the forty weeks ended October 9, 2016

 

$

12

 

Total reclassifications, net of tax

 

 

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11. Segment Information

 

The Company is a value-oriented retailer serving a diverse demographic of household and business customers through two complementary store banners. The “Smart & Final” business focuses on both household and business customers, and the “Cash & Carry” business focuses primarily on restaurants, caterers and a wide range of other foodservice businesses. The Company’s chief operating decision maker regularly reviews the operating performance of each of the store banners including measures of performance based on income (loss) from operations. The Company considers each of the store banners to be an operating segment and has further concluded that presenting disaggregated information of these two operating segments provides meaningful information as certain economic characteristics are dissimilar as well as the characteristics of the customer base served.

 

The “Corporate/Other” category is comprised primarily of corporate overhead support expenses and administrative expenses incidental to the activities of the reportable segments, interest expense and other costs associated with the Company’s debt obligations, equity earnings in its joint venture, and income taxes.

 

For the sixteen weeks ended October 9, 2016, the operating information and total assets for the reportable segments are as follows (in thousands):

 

 

 

Smart & Final

 

Cash & Carry

 

Corporate /
Other

 

Consolidated

 

Net sales

 

$

1,083,437

 

$

310,992

 

$

 

$

1,394,429

 

Cost of sales, distribution and store occupancy

 

922,201

 

266,238

 

2,961

 

1,191,400

 

Operating and administrative expenses

 

141,010

 

21,082

 

21,310

 

183,402

 

Income (loss) from operations

 

$

20,226

 

$

23,672

 

$

(24,271

)

$

19,627

 

As of October 9, 2016:

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,660,341

 

$

343,722

 

$

(105,855

)

$

1,898,208

 

Intercompany receivable (payable)

 

$

183,583

 

$

(439

)

$

(183,144

)

$

 

Investment in joint venture

 

$

 

$

 

$

14,090

 

$

14,090

 

Goodwill

 

$

406,662

 

$

204,580

 

$

 

$

611,242

 

For the sixteen weeks ended October 9, 2016:

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

38,345

 

$

3,957

 

$

1,914

 

$

44,216

 

Assets acquired in Haggen Transaction

 

$

8

 

$

 

$

 

$

8

 

Depreciation and amortization

 

$

24,115

 

$

1,184

 

$

2,429

 

$

27,728

 

 

For the sixteen weeks ended October 4, 2015, the operating information for the reportable segments is as follows (in thousands):

 

 

 

Smart & Final

 

Cash & Carry

 

Corporate /
Other

 

Consolidated

 

Net sales

 

$

940,168

 

$

305,895

 

$

 

$

1,246,063

 

Cost of sales, distribution and store occupancy

 

794,004

 

262,131

 

2,689

 

1,058,824

 

Operating and administrative expenses

 

116,276

 

19,964

 

20,800

 

157,040

 

Income (loss) from operations

 

$

29,888

 

$

23,800

 

$

(23,489

)

$

30,199

 

For the sixteen weeks ended October 4, 2015:

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

39,365

 

$

1,741

 

$

1,149

 

$

42,255

 

Depreciation and amortization

 

$

18,142

 

$

1,095

 

$

2,649

 

$

21,886

 

 

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For the forty weeks ended October 9, 2016, the operating information for the reportable segments is as follows (in thousands):

 

 

 

Smart & Final

 

Cash & Carry

 

Corporate /
Other

 

Consolidated

 

Net sales

 

$

2,604,505

 

$

736,658

 

$

 

$

3,341,163

 

Cost of sales, distribution and store occupancy

 

2,214,012

 

630,934

 

7,623

 

2,852,569

 

Operating and administrative expenses

 

344,251

 

51,132

 

51,920

 

447,303

 

Income (loss) from operations

 

$

46,242

 

$

54,592

 

$

(59,543

)

$

41,291

 

For the forty weeks ended October 9, 2016:

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

105,468

 

$

5,843

 

$

4,636

 

$

115,947

 

Assets acquired in Haggen Transaction

 

$

2,235

 

$

 

$

 

$

2,235

 

Depreciation and amortization

 

$

55,366

 

$

2,890

 

$

6,259

 

$

64,515

 

 

For the forty weeks ended October 4, 2015, the operating information for the reportable segments is as follows (in thousands):

 

 

 

Smart & Final

 

Cash & Carry

 

Corporate /
Other

 

Consolidated

 

Net sales

 

$

2,256,357

 

$

716,997

 

$

 

$

2,973,354

 

Cost of sales, distribution and store occupancy

 

1,898,841

 

616,646

 

6,880

 

2,522,367

 

Operating and administrative expenses

 

276,922

 

48,483

 

52,717

 

378,122

 

Income (loss) from operations

 

$

80,594

 

$

51,868

 

$

(59,597

)

$

72,865

 

For the forty weeks ended October 4, 2015:

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

93,415

 

$

6,060

 

$

4,804

 

$

104,279

 

Depreciation and amortization

 

$

42,643

 

$

2,501

 

$

6,526

 

$

51,670

 

 

12. Commitments and Contingencies

 

Legal Actions

 

On February 11, 2016, the Company received a subpoena from the District Attorney for the County of Yolo, State of California, seeking information concerning its handling, disposal and reverse logistics of potential hazardous waste at its stores and distribution centers in the State of California. The Company has provided information and is cooperating with the authorities from multiple counties in California in connection with this ongoing matter. While a loss related to this matter is reasonably possible, at this time, the Company cannot reasonably estimate the possible loss or range of loss that may arise from this matter or whether this matter will have a material impact on its financial condition or operating results.

 

The Company is engaged in various other legal actions, claims and proceedings in the ordinary course of business, including claims related to employment related matters, breach of contracts, products liabilities and intellectual property matters resulting from its business activities. The Company does not believe that the ultimate determination of these actions, claims and proceedings will either individually or in the aggregate have a material adverse effect on its consolidated results of operations or financial position.

 

13. Earnings Per Share

 

Basic earnings per share represents net income for the period shares of Common Stock were outstanding, divided by the weighted average number of shares of Common Stock outstanding for the applicable period. Diluted earnings per share represents net  income divided by the weighted average number of shares of Common Stock outstanding for the applicable period, inclusive of the effect of dilutive securities such as outstanding stock options and unvested restricted stock.

 

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A reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations is as follows (in thousands, except per share amounts):

 

 

 

Sixteen Weeks Ended

 

Forty Weeks Ended

 

 

 

October 9,

 

October 4,

 

October 9,

 

October 4,

 

 

 

2016

 

2015

 

2016

 

2015

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

7,033

 

$

12,380

 

$

13,201

 

$

28,301

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding for basic EPS

 

72,601,724

 

73,116,746

 

72,956,554

 

73,099,258

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Assumed exercise of time-based stock options and vesting of restricted stock

 

5,104,193

 

4,287,720

 

5,511,776

 

3,926,732

 

Weighted average shares and share equivalents outstanding for diluted EPS

 

77,705,917

 

77,404,466

 

78,468,330

 

77,025,990

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.10

 

$

0.17

 

$

0.18

 

$

0.39

 

Diluted earnings per share

 

$

0.09

 

$

0.16

 

$

0.17

 

$

0.37

 

 

Potentially dilutive securities representing 1,488,402 shares of Common Stock for the sixteen weeks ended October 9, 2016 were excluded from the computation of diluted earnings per share because their effect would have been antidilutive. Potentially dilutive securities representing 705,460 shares of Common Stock for the forty weeks ended October 9, 2016 were excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

 

The Company elected early adoption of ASU 2016-09 in the second quarter of 2016. Under the new guidance, the Company no longer records excess tax benefits in additional paid-in capital (APIC). Instead, the Company recognizes all excess tax benefits (“windfalls”) as income tax expense or benefit in the income statement. As a result of including income tax effects from windfalls in income tax expense, the calculation of both basic and diluted earnings per share was affected. Under the treasury stock method used to calculate diluted earnings per share, windfalls are included in the proceeds assumed to be used to purchase shares. Under the new guidance, windfalls are recognized in net income and thus no longer included in assumed proceeds under the treasury stock method. In effect, fewer shares are assumed to be repurchased. This generally increases the dilutive effect of share options and restricted stock.

 

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14. Haggen Transaction

 

On October 2, 2015, Smart & Final Stores entered into an Asset Purchase Agreement with Haggen whereby Smart & Final Stores agreed to become a “stalking horse bidder” to acquire certain assets, including 28 store leases and related assets, of Haggen. On November 24, 2015 and December 22, 2015, Smart & Final Stores entered into additional Asset Purchase Agreements to acquire five more store leases and related assets of Haggen (all collectively, the “Asset Purchase Agreements” and the transactions, collectively, the “Haggen Transaction”). The initial purchase price for all 33 store leases and related assets was $67.9 million, subject to certain adjustments. The Haggen Transaction closed in December 2015. During the forty weeks ended October 9, 2016, the purchase price was increased for additional acquisition-related transaction costs and adjustments of $0.5 million.

 

The aggregate consideration paid in the Haggen Transaction was as follows (in thousands):

 

Aggregate purchase price (excluding adjustments)

 

$

67,827

 

Less closing adjustments

 

(3,455

)

Cash paid pursuant to the Asset Purchase Agreements

 

64,372

 

Acquisition related costs

 

4,035

 

Total consideration paid

 

$

68,407

 

 

The cash consideration paid at the closing of the Haggen Transaction was based in part on estimated closing adjustments, including an estimated adjustment (i) related to repairs to roof, building structure and mechanical systems (including HVAC, plumbing and electrical but excluding refrigeration systems) and (ii) reasonably required to bring the properties into compliance with laws applicable to conducting a retail grocery business (the “Property Condition Adjustment”). The Property Condition Adjustment, which resulted in a reduction of $3.6 million to the total cash purchase price, is subject to certain caps and floors per property and is subject to adjustment, in each case as set forth in the applicable Asset Purchase Agreement. Any adjustment to the purchase price resulting from final agreement by the parties will be accounted for as an adjustment to the cost of the assets acquired and allocated based on their initial relative fair values.

 

Furthermore, direct acquisition-related transaction costs totaling $4.0 million, including success, consulting, legal and accounting fees were capitalized in the periods incurred and included in the total cost of acquiring the assets.

 

Pursuant to the Asset Purchase Agreements, the Company acquired certain leasehold interests in California, as well as associated improvements, fixtures, equipment, permits and licenses of Haggen. Haggen retained inventory, pharmacy assets, prescription files and certain other assets with respect to each of the stores. Prior to closing of the transaction, store operations were ceased and no customer base, employee base, market distribution system, operating rights (other than liquor licenses), physical facilities (other than the store lease and related fixed assets/equipment), or processes were acquired for value. As of the end of the second quarter of 2016, the Company had reopened the 33 stores under its Extra! store format. The Haggen Transaction did not meet the definition of a business acquisition and was accounted for as an asset acquisition using a cost accumulation approach. The total consideration paid was allocated to the individual assets acquired and liabilities assumed on a relative fair value basis. The determination of fair value used to allocate the total consideration paid is based on various factors including quoted market prices, expected future cash flows, current replacement costs, market rate assumptions, useful lives and appropriate discount and growth rates.

 

The total cost allocated to the assets acquired is as follows (in thousands):

 

Leasehold interests

 

$

55,148

 

Fixtures and equipment

 

11,257

 

Transferrable liquor licenses

 

2,002

 

Total cost of net assets acquired

 

$

68,407

 

 

Acquired leasehold interests are finite-lived intangible assets amortized over their estimated useful benefit period which is typically the lease term. Fixtures and equipment are finite-lived tangible assets which are depreciated or amortized over their estimated useful lives. Transferrable liquor licenses are indefinite-lived intangible assets which are evaluated for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. See Note 2, Significant Accounting Policies. The transaction will be treated as an asset acquisition for tax purposes.

 

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15. Share Repurchase Program

 

On August 31, 2015, SFSI’s board of directors authorized a share repurchase program of up to $25.0 million for repurchase of shares of Common Stock, to be financed from cash on hand and executed over a period of time. Repurchases under the share repurchase program commenced on November 20, 2015 and concluded on August 30, 2016.

 

During the third quarter ended October 9, 2016, the Board of Directors authorized a share repurchase program to repurchase up to $25.0 million, inclusive of commissions, of shares of Common Stock. Repurchases under the share repurchase program commenced on September 19, 2016 and may occur through August 31, 2017.

 

The specific timing and amount of the repurchases will be dependent on market conditions, applicable laws and other factors. In connection with the share repurchase program, the Company may acquire shares in open market transactions (including pursuant to plans adopted in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended) or privately negotiated transactions.

 

During the forty weeks ended October 9, 2016, the Company repurchased 1,982,228 shares of its common stock through open market purchases for an aggregate cost of $28.0 million. The repurchased shares are no longer deemed issued and outstanding.

 

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with Item 1, “Financial Statements” in Part I of this quarterly report on Form 10-Q.

 

Forward-Looking Statements

 

The discussion in this quarterly report, including under Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part I and Item 1A, “Risk Factors” of Part II, contains forward-looking statements within the meaning of federal securities laws. All statements other than statements of historical fact contained in this quarterly report, including statements regarding our future operating results and financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. In many cases, you can identify forward-looking statements by terms such as “may,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions.

 

The forward-looking statements contained in this quarterly report reflect our views as of the date hereof about future events and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results, performance or achievements to differ significantly from those expressed or implied in any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements in this quarterly report are reasonable, we cannot guarantee future events, results, performance or achievements. A number of important factors could cause actual results to differ materially from those indicated by the forward-looking statements in this quarterly report, including, without limitation, those factors described in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part I and Item 1A, “Risk Factors” of Part II. Some of the key factors that could cause actual results to differ from our expectations include the following:

 

·             competition in our industry is intense and our failure to compete successfully may adversely affect our sales, financial condition and operating results;

 

·             our continued growth depends on new store openings and our failure to successfully open new stores or successfully manage the potential difficulties associated with store growth could adversely affect our business and stock price;

 

·            our failure to successfully operate store properties acquired from Haggen could adversely affect our business and operating results;

 

·            real or perceived quality or food safety concerns could adversely affect our business, operating results and reputation;

 

·            we may be unable to maintain or increase comparable store sales, which could adversely affect our business and stock price;

 

·            the current geographic concentration of our stores and our net sales creates an exposure to local or regional downturns or catastrophic occurrences;

 

·            disruption of supplier relationships could adversely affect our business;

 

·            any significant interruption in the operations of our distribution centers or common carriers could disrupt our ability to deliver our products in a timely manner;

 

·            our failure to comply with laws, rules and regulations affecting us and our industry could adversely affect our financial condition and operating results;

 

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·            disruptions to or security breaches involving our information technology systems could harm our ability to run our business;

 

·            we have significant debt service obligations and may incur additional indebtedness in the future, which could adversely affect our financial condition and operating results and our ability to react to changes to our business; and

 

·            covenants in our debt agreements restrict our operational flexibility.

 

Readers are urged to consider these factors carefully in evaluating the forward-looking statements in this quarterly report and are cautioned not to place undue reliance on these forward-looking statements. All of the forward-looking statements in this quarterly report are based on information available to us on the date hereof. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as otherwise required by law.

 

Business Overview

 

We are a high-growth, value-oriented food retailer serving a diverse demographic of household and business customers through two complementary and productive store banners: Smart & Final and Cash & Carry. As of October 9, 2016, we operated 304 non-membership, warehouse-style stores throughout the Western United States, with an additional 15 stores in Northwestern Mexico in a joint venture. We have a differentiated merchandising strategy that emphasizes high quality perishables, a wide selection of private label products, products tailored to business and foodservice customers and products offered in a broad range of sizes.

 

We consider each of our store banners to be an operating segment, and have concluded that presenting disaggregated information for our two operating segments provides meaningful information because of differences in their respective economic characteristics and customer bases. For the forty weeks ended October 9, 2016, our Smart & Final and Cash & Carry segments represented approximately 78.0% and 22.0%, respectively, of our consolidated sales compared with 75.9% and 24.1%, respectively, for the forty weeks ended October 4, 2015.

 

Our Smart & Final segment is based in Commerce, California and includes, as of October 9, 2016, 83 legacy Smart & Final stores and 165 Extra! format stores, which focus on household and business customers and are located in California, Arizona and Nevada. Our legacy Smart & Final stores offer extensive selections of fresh perishables and everyday grocery items, together with a targeted selection of foodservice, packaging and janitorial products, under both national and private label brands. Our Extra! store format offers a one-stop shopping experience with a more expansive selection of items than our legacy Smart & Final stores and an emphasis on perishables and household items. The continued development of our Extra! store format, through additional new store openings and conversions and relocations of legacy Smart & Final stores, is the cornerstone of our growth strategy.

 

Our Cash & Carry segment is based in Portland, Oregon and includes, as of October 9, 2016, 56 Cash & Carry stores, which focus primarily on business customers and are located in Washington, Oregon, Northern California, Idaho and Nevada. Our Cash & Carry stores offer a wide variety of SKUs tailored to the core needs of foodservice customers such as restaurants, caterers and a wide range of other foodservice businesses in a flexible mix of “case quantity” or single unit purchases.

 

Outlook

 

We plan to expand our store footprint, primarily through opening new Extra! stores in existing and adjacent markets, and by entering new markets. We believe we have a scalable operating infrastructure to support our anticipated growth which, together with our flexible real estate strategy and advanced distribution capabilities, position us to capitalize on our growth opportunities. For the Smart & Final banner, our current plan is to achieve 10% unit store growth each year. We had the opportunity to pursue accelerated development of Smart & Final Extra! stores in fiscal year 2016 through the acquisition of 33 store leases and related assets in central and Southern California previously operated under the Haggen banner. Of these 33 store properties, we opened 29 new stores and relocated four existing legacy stores into acquired locations in the first half of fiscal year 2016. Additionally, we opened three new Extra! stores and relocated two existing legacy stores into the Extra! format in the first three quarters of 2016. Our fiscal year 2016 store development plans anticipate one additional new Extra! store. We plan to continue converting our larger legacy Smart & Final stores to our Extra! format and investing in our legacy Smart & Final stores that are not candidates for conversion to the Extra! format by completing major remodel projects and targeted relocations. In the third quarter of 2016, we opened one new Cash & Carry store and plan to open three additional new Cash & Carry stores in fiscal year 2016.

 

In addition, we plan to leverage our significant investments in management, information technology systems, infrastructure and marketing to grow our comparable store sales and enhance our operating margins through execution of a number of key initiatives, including initiatives to increase net sales of perishable products in our Smart & Final stores, to increase net sales of private label products in our Smart & Final and Cash & Carry stores, and to expand our marketing programs in our Smart & Final and Cash & Carry stores. We expect each of these key initiatives, if successful, to generate increased comparable store sales and also expect our initiative to increase net sales of private label products to enhance our operating margins, as private label products have historically generated higher gross margins relative to national branded products.

 

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Table of Contents

 

Factors Affecting Our Results of Operations

 

Various factors affect our results of operations during each period, including:

 

Store Openings

 

We expect that a primary driver of our growth in sales and gross margin will be the continued development of our Extra! format stores through new store openings, conversions and relocations. We also plan to open new Cash & Carry stores, which will further amplify sales and gross margin. Our results of operations have been and will continue to be materially affected by the timing and number of new store openings, including conversions and relocations of legacy Smart & Final stores to the Extra! format, and the amount of associated costs. For example, we typically incur higher than normal employee costs at the time of a new store opening, conversion or relocation associated with set-up and other related costs. Also, our operating margins are typically negatively affected by promotional discounts and other marketing costs associated with new store openings, conversions and relocations, as well as higher inventory markdowns and costs related to hiring and training new employees in new stores. Additionally, promotional activities may result in higher than normalized sales in the first several weeks following a new store opening. Our new Extra! and Cash & Carry stores typically build a customer base over time and reach a mature sales growth rate in the third and fourth year after opening, respectively. As a result, typically our new stores initially have lower margins and higher operating expenses, as a percentage of sales, than our more mature stores.

 

Based on our experience, we expect that certain of our new Extra! stores will impact sales at our existing stores in close proximity in the short-term. However, we believe that over the longer term any such sales impact will be more than offset by future sales growth and expanded market share.

 

During the forty weeks ended October 9, 2016, the Company opened 32 new Extra! format stores and relocated six legacy Smart & Final stores which reopened under the Extra! format.  These new and relocated stores were concentrated in key central and Southern California markets where the Company has an established base of stores.  As a result of the increased density, certain new store openings had an impact on the sales of nearby stores which negatively impacted comparable sales growth.  Additionally, sales transferred from existing stores to new stores typically were more profitable at the more mature existing store than at the less mature new store.

 

Developments in Competitive Landscape

 

We operate in the highly competitive food retail and foodservice industries. We compete on a combination of factors, including price, product selection, product quality, convenience, customer service, store format and location. Our principal competitors include conventional grocery banners such as Albertsons and Kroger, discounters and warehouse clubs such as Costco, mass merchandisers such as Walmart and Target, foodservice delivery companies such as Sysco and US Foods, as well as online retailers and other specialty stores. Some of our competitors may have greater financial or marketing resources than we do and may be able to devote greater resources to sourcing, promoting and selling their products. These competitors could use these advantages to take certain measures, including reducing prices that could adversely affect our competitive position, business, financial condition and operating results.

 

Pricing Strategy and Investments in “Everyday Low Prices”

 

We have a commitment to “everyday low prices,” which we believe positions both our Smart & Final and Cash & Carry stores as top of mind destinations for our target customers. Pricing in our Smart & Final stores is targeted to be substantially lower than that of conventional grocers and competitive with that of large discounters and warehouse clubs, with no membership fee requirement. Pricing in our Cash & Carry stores is targeted to be substantially lower than our foodservice delivery competitors, with no membership fee requirement and greater price transparency to customers and no minimum order size, and competitive with typical warehouse clubs.

 

Our pricing strategy is geared toward optimizing the pricing and promotional activities across our mix of higher-margin perishable items and everyday value-oriented traditional grocery items. This strategy involves determining prices that will improve our operating margins based upon our analysis of how demand varies at different price levels as well as our costs and inventory levels.

 

Expanded Private Label Offerings

 

Private label products are key components of our pricing and merchandising strategy, as we believe they build and deepen customer loyalty, enhance our value proposition, generate higher gross margins relative to national brands and improve the breadth and selection of our product offering. We believe that a strong private label offering has become an increasingly important competitive advantage in the food retail and foodservices industries.

 

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As of October 9, 2016, we had a portfolio of 3,100 private label items, which represented 28% of our Smart & Final banner sales for the forty weeks ended October 9, 2016. Typically, our private label products generate a higher gross margin as a percentage of sales as compared to a comparable national brand product.

 

General Economic Conditions and Changes in Consumer Behavior

 

The overall economic environment in the markets we serve, particularly California, and related changes in consumer behavior, have a significant impact on our business and results of operations. In general, positive conditions in the broader economy promote customer spending in our stores, while economic weakness results in reduced customer spending. Macroeconomic factors that can affect customer spending patterns, and thereby our results of operations, include employment rates, business conditions, changes in the housing market, the availability of consumer credit, interest rates, tax rates and fuel and energy costs.

 

Infrastructure Investment

 

Our historical results of operations reflect the impact of our ongoing investments in infrastructure to support our growth. We have made significant investments in senior management, information technology systems, supply chain systems and marketing. These investments include significant additions to our personnel, including experienced industry executives and management and merchandising teams to support our long-term growth objectives. We plan on continuing to make targeted investments in our infrastructure as necessary to support our growth.

 

Inflation and Deflation Trends

 

Inflation and deflation can impact our financial performance. During inflationary periods, our results of operations can be positively impacted in the short term, as we sell lower-priced inventory in a higher price environment. Conversely, in deflationary periods, our short-term sales and earnings growth can be negatively affected by pricing softness. The short-term impact of inflation and deflation is largely dependent on our ability to pass the effects through to our customers, which is subject to competitive market conditions.

 

In recent inflationary periods, market dynamics have generally allowed us to pass through most cost increases to customers.  Beginning in the second quarter of 2015 and continuing through the third quarter of 2016, we have experienced deflation in certain food and non-food commodities. Market dynamics have caused us to pass cost decreases through to customers, which has negatively impacted sales growth.  This in turn has negatively affected the results of operations as certain elements of operating costs do not change with product selling prices.

 

We estimate that the applicable deflation rate for the forty weeks ended October 9, 2016 was approximately 1.8% and we currently anticipate that the deflation rate will be approximately 2.0% for fiscal year 2016.  Deflation negatively affects our sales and comparable sales rates, as well as negatively impacting our income from operations due to the deleveraging impact of lower sales on our overall cost structure.

 

Components of Results of Operations

 

Net Sales

 

We recognize revenue from the sale of products at the point of sale. Discounts provided to customers at the time of sale are recognized as a reduction in sales as the products are sold. Sales tax collections are presented in the statement of operations and comprehensive income on a net basis and, accordingly, are excluded from reported sales revenues. Proceeds from the sale of our Smart & Final gift cards are recorded as a liability at the time of sale, and recognized as sales when they are redeemed by the customer. Our Smart & Final gift cards do not have an expiration date.

 

We regularly review and monitor comparable store sales growth to evaluate and identify trends in our sales performance. With respect to any fiscal period during any year, comparable store sales include sales for stores operating both during such fiscal period in such year and in the same fiscal period of the previous year. Sales from a store will be included in the calculation of comparable store sales after the 60th full week of operations, and sales from a store are also included in the calculation of comparable store sales if (i) the store has been physically relocated, (ii) the selling square footage has been increased or decreased or (iii) the store has been converted to a new format within a store banner (e.g., from a legacy Smart & Final store to the Extra! format). However, sales from an existing store will not be included in the calculation of comparable store sales if the store has been converted to a different store banner (e.g., from Smart & Final to Cash & Carry).

 

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Cost of Sales, Buying and Occupancy and Gross Margin

 

The major categories of costs included in cost of sales, buying and occupancy are cost of goods sold, 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. Store occupancy costs include store rental, common area maintenance, property taxes, property insurance, and depreciation.

 

Gross margin represents sales less cost of sales, buying and occupancy. Our gross margin may not be comparable to other retailers, since not all retailers include all of the costs related to their distribution network in cost of sales like we do. Some retailers exclude a portion of these costs (e.g., store occupancy and buying department costs) from cost of sales and include them in selling, general and administrative expenses.

 

Our cost of sales, buying and occupancy expense and gross margin are correlated to sales volumes. As sales increase, gross margin is affected by the relative mix of products sold, pricing strategies, inventory shrinkage and improved leverage of fixed costs.

 

Operating and Administrative Expenses

 

Operating and administrative expenses include direct store-level expenses associated with displaying and selling our products at the store level, including salaries and benefits for our store work force, fringe benefits, store supplies, advertising and marketing and other store-specific costs. Operating and administrative expenses also consist of store overhead costs and corporate administrative costs including salaries and benefits costs, share-based compensation, corporate occupancy costs, amortization expense, and other expenses associated with being a public company.

 

We expect that our operating and administrative expenses will increase in future periods resulting primarily from our store development program, including the growth in the number of our stores.

 

Income Tax Provision

 

We are subject to federal income tax as well as state income tax in various jurisdictions of the United States in which we conduct business. Income taxes are accounted for under the asset and liability method.

 

Equity in Earnings of Mexico Joint Venture

 

Our wholly owned subsidiary, Smart & Final de Mexico S.A. de C.V., is a Mexican holding company that owns a 50% interest in a joint venture. The remaining 50% of the joint venture is owned by Grupo Calimax S.A. de C.V., an entity comprising the investment interests of a family group who are also the owners of the Calimax grocery store chain in Mexico. As of October 9, 2016, this joint venture operated 15 Smart & Final stores in Northwestern Mexico, which are similar in concept to our legacy Smart & Final stores. This joint venture operates as a Mexican domestic corporation under the name Smart & Final del Noroeste, S.A. de C.V. Our interest in this joint venture is not consolidated and is reported using the equity method of accounting.

 

Factors Affecting Comparability of Results of Operations

 

Term Loan Facility Amendments

 

Our interest expense in any particular period is impacted by our overall level of indebtedness during that period and by changes in the applicable interest rates on such indebtedness. In connection with the Ares Acquisition, we entered into the Term Loan Facility and the Second Lien Term Loan Facility, consisting of $525.0 million and $195.0 million of term indebtedness, respectively, and our $150.0 million Revolving Credit Facility.

 

During the second quarter of 2015, we amended the Term Loan Facility to, among other things; decrease the applicable margin from 3.75% to 3.25%. We recorded a $2.2 million loss on the early extinguishment of debt in the second quarter of 2015. We also amended our Interest Rate Swap Agreement, effective June 30, 2015, to fix the LIBOR component of interest under the Term Loan Facility at 1.47675% and to mirror the Term Loan Facility’s floor rate of 0.75%.

 

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During the third quarter of 2016, we amended the Term Loan Facility and the Revolving Credit Facility.  The Term Loan Facility was amended to increase the term loan commitments from $594.9 million to $625.0 million, extend the maturity of the term loan from November 15, 2019 to November 15, 2022 and increase the Applicable Margin from 3.25% to 3.50%.  The Revolving Credit Facility was amended to extend the maturity from November 15, 2017 to July 19, 2021, and to increase the aggregate facility commitments from $150.0 million to $200.0 million.  In addition, the applicable margin ranges were reduced with respect to (i) alternate base rate loans to 0.25% to 0.50% from 0.25% to 0.75% and (ii) LIBOR rate loans to 1.25% to 1.50% from 1.25% to 1.75%. As of October 9, 2016, after giving effect to the Second Amendment, the alternate base rate was 3.50%, for a total rate of 3.75%.

 

Initial Public Offering and Secondary Public Offering

 

On September 29, 2014, we completed an initial public offering of our Common Stock, pursuant to which we sold an aggregate of 15,467,500 shares of Common Stock, after giving effect to the underwriters’ exercise in full of their option to purchase additional shares, at a price of $12.00 per share. We received aggregate net proceeds of $167.7 million after deducting underwriting discounts and commissions and other offering expenses. We used the net proceeds to repay borrowings of $115.5 million under the Term Loan Facility and we have used the remainder to fund growth initiatives and for general corporate purposes.

 

On April 24, 2015, certain of the Company’s stockholders completed a secondary public offering of 10,900,000 shares of Common Stock. The Company did not sell any shares in the secondary public offering.

 

Early Adoption of ASU 2016-09

 

We elected early adoption of ASU 2016-09 in the second quarter of 2016. As a result of the adoption of ASU 2016-09, for the forty weeks ended October 9, 2016, we recognized excess tax benefits related to stock option exercises and vesting of restricted stock as income tax benefit. An income tax benefit of $1.1 million and $2.4 million was recognized for the sixteen and forty weeks ended October 9, 2016, respectively. There was no change to retained earnings with respect to excess tax benefits. The treatment of forfeitures has not changed as we have elected to continue our current practice of estimating the number of forfeitures. As such, the adoption of ASU 2016-09 had no cumulative effect on retained earnings. With the adoption of ASU 2016-09, we have elected to present the cash flow statement on a prospective transition method and no prior periods have been adjusted.

 

Basis of Presentation

 

Our fiscal year is the 52- or 53-week period ending on the Sunday closest to December 31. Each of our 52-week 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 last completed fiscal year ended on January 3, 2016 and was a 53-week period. The fourth quarter of fiscal year 2015 included a thirteen-week period.

 

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Results of Operations

 

The following table summarizes key components of our results of operations for the periods indicated, both in dollars and as a percentage of sales.

 

Consolidated Statements of Operations Data

 

 

 

Sixteen Weeks Ended

 

Forty Weeks Ended

 

 

 

October 9, 2016

 

October 4, 2015

 

October 9, 2016

 

October 4, 2015

 

 

 

(Dollars in thousands, except per share)

 

Net sales

 

$

1,394,429

 

100.0

%

$

1,246,063

 

100.0

%

$

3,341,163

 

100.0

%

$

2,973,354

 

100.0

%

Cost of sales, buying and occupancy

 

1,191,400

 

85.4

%

1,058,824

 

85.0

%

2,852,569

 

85.4

%

2,522,367

 

84.8

%

Gross margin

 

203,029

 

14.6

%

187,239

 

15.0

%

488,594

 

14.6

%

450,987

 

15.2

%

Operating and administrative expenses

 

183,402

 

13.2

%

157,040

 

12.6

%

447,303

 

13.4

%

378,122

 

12.7

%

Income from operations

 

19,627

 

1.4

%

30,199

 

2.4

%

41,291

 

1.2

%

72,865

 

2.5

%

Interest expense, net

 

9,977

 

0.7

%

9,333

 

0.7

%

24,729

 

0.7

%

25,007

 

0.8

%

Loss on early extinguishment of debt

 

4,978

 

0.3

%

 

%

4,978

 

0.1

%

2,192

 

0.1

%

Equity in earnings of joint venture

 

502

 

%

138

 

%

1,230

 

%

1,045

 

%

Income before income taxes

 

5,174

 

0.4

%

21,004

 

1.7

%

12,814

 

0.4

%

46,711

 

1.6

%

Income tax benefit (provision)

 

1,859

 

0.1

%

(8,624

)

(0.7

)%

387

 

%

(18,410

)

(0.6

)%

Net income