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 March 25, 2018

 

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, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

 

 

Emerging growth company o

 

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

 

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 April 30, 2018

common stock, $0.001 par value

 

74,426,473

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

 

 

PAGE

 

 

 

PART I - FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

Condensed Consolidated Balance Sheets as of March 25, 2018 (unaudited) and December 31, 2017

3

 

 

 

 

Condensed Consolidated Statements of Operations and Comprehensive Loss for the twelve weeks ended March 25, 2018 and March 26, 2017 (unaudited)

4

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the twelve weeks ended March 25, 2018 and March 26, 2017 (unaudited)

5

 

 

 

 

Condensed Consolidated Statements of Stockholders’ Equity for the twelve weeks ended March 25,
2018 (unaudited)

6

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

7

 

 

 

Item 2.

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

24

 

 

 

 

Forward-Looking Statements

24

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

37

 

 

 

Item 4.

Controls and Procedures

37

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

38

 

 

 

Item 1A.

Risk Factors

38

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

38

 

 

 

Item 3.

Defaults Upon Senior Securities

38

 

 

 

Item 4.

Mine Safety Disclosures

38

 

 

 

Item 5.

Other Information

38

 

 

 

Item 6.

Exhibits

38

 

 

 

Signatures

 

40

 

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)

 

 

 

March 25, 2018

 

December 31, 2017

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

55,790

 

$

71,671

 

Accounts receivable, less allowances of $175 and $177 at March 25, 2018 and December 31, 2017, respectively

 

29,567

 

33,019

 

Inventories

 

287,740

 

289,712

 

Prepaid expenses and other current assets

 

47,926

 

54,241

 

Total current assets

 

421,023

 

448,643

 

 

 

 

 

 

 

Property, plant, and equipment:

 

 

 

 

 

Land

 

10,044

 

10,076

 

Buildings and improvements

 

54,771

 

53,965

 

Leasehold improvements

 

350,602

 

346,181

 

Fixtures and equipment

 

428,539

 

421,912

 

Construction in progress

 

15,428

 

8,242

 

 

 

859,384

 

840,376

 

Less accumulated depreciation and amortization

 

359,988

 

338,149

 

 

 

499,396

 

502,227

 

 

 

 

 

 

 

Capitalized software, net of accumulated amortization of $17,991 and $17,325 at March 25, 2018 and December 31, 2017, respectively

 

25,559

 

21,984

 

Other intangible assets, net

 

360,927

 

362,536

 

Goodwill

 

385,918

 

385,918

 

Equity investment in joint venture

 

15,796

 

15,380

 

Other assets

 

73,456

 

73,249

 

Total assets

 

$

1,782,075

 

$

1,809,937

 

 

 

 

 

 

 

Liabilities and stockholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

220,690

 

$

245,009

 

Accrued salaries and wages

 

31,076

 

36,216

 

Accrued expenses

 

107,801

 

100,639

 

Current portion of debt, less debt issuance costs

 

69,613

 

81,512

 

Total current liabilities

 

429,180

 

463,376

 

 

 

 

 

 

 

Long-term debt, less debt issuance costs

 

618,194

 

617,867

 

Deferred income taxes

 

37,793

 

38,095

 

Postretirement and postemployment benefits

 

127,574

 

127,649

 

Other long-term liabilities

 

170,235

 

159,904

 

 

 

 

 

 

 

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 - 74,212,215 and 74,120,113 at March 25, 2018 and December 31, 2017, respectively

 

74

 

74

 

Additional paid-in capital

 

509,654

 

506,098

 

Retained deficit

 

(85,254

)

(78,160

)

Accumulated other comprehensive loss

 

(25,375

)

(24,966

)

Total stockholders’ equity

 

399,099

 

403,046

 

Total liabilities and stockholders’ equity

 

$

1,782,075

 

$

1,809,937

 

 

See notes to condensed consolidated financial statements.

 

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Table of Contents

 

Smart & Final Stores, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

(In Thousands, Except Share and Per Share Amounts)

 

 

 

Twelve Weeks Ended

 

 

 

March 25, 2018

 

March 26, 2017

 

 

 

 

 

 

 

Net sales

 

$

1,016,237

 

$

967,017

 

Cost of sales, buying and occupancy

 

869,975

 

833,906

 

Gross margin

 

146,262

 

133,111

 

 

 

 

 

 

 

Operating and administrative expenses

 

147,430

 

135,674

 

Loss from operations

 

(1,168

)

(2,563

)

 

 

 

 

 

 

Interest expense, net

 

9,251

 

8,174

 

Equity in earnings of joint venture

 

577

 

167

 

Loss before income taxes

 

(9,842

)

(10,570

)

 

 

 

 

 

 

Income tax benefit

 

2,748

 

5,978

 

Net loss

 

$

(7,094

)

$

(4,592

)

 

 

 

 

 

 

Basic loss per share

 

$

(0.10

)

$

(0.06

)

Diluted loss per share

 

$

(0.10

)

$

(0.06

)

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

Basic

 

72,231,171

 

72,287,891

 

Diluted

 

72,231,171

 

72,287,891

 

 

 

 

 

 

 

Comprehensive income:

 

 

 

 

 

Net loss

 

$

(7,094

)

$

(4,592

)

Derivative instruments:

 

 

 

 

 

(Loss) gain, net of income tax (benefit) expense of $(48) and $250, respectively

 

(133

)

377

 

Reclassification adjustments, net of income tax expense (benefit) of $5 and $(1), respectively

 

15

 

(2

)

Foreign currency translation

 

(291

)

(118

)

Other comprehensive (loss) income

 

(409

)

257

 

Comprehensive loss

 

$

(7,503

)

$

(4,335

)

 

See notes to condensed consolidated financial statements.

 

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Table of Contents

 

Smart & Final Stores, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In Thousands)

 

 

 

Twelve Weeks Ended

 

 

 

March 25, 2018

 

March 26, 2017

 

 

 

 

 

 

 

Operating activities

 

 

 

 

 

Net loss

 

$

(7,094

)

$

(4,592

)

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

 

 

 

 

 

Depreciation

 

13,880

 

12,783

 

Amortization

 

9,412

 

8,900

 

Amortization of debt discount and debt issuance costs

 

459

 

445

 

Share-based compensation

 

3,285

 

1,814

 

Deferred income taxes

 

(257

)

284

 

Equity in earnings of joint venture

 

(577

)

(167

)

(Gain) loss on disposal of property, plant, and equipment

 

(32

)

21

 

Asset impairment

 

1,425

 

325

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

3,452

 

2,663

 

Inventories

 

1,972

 

12,020

 

Prepaid expenses and other assets

 

7,520

 

(11,524

)

Accounts payable

 

(24,319

)

(8,453

)

Accrued salaries and wages

 

(5,140

)

(487

)

Other accrued liabilities

 

14,209

 

7,279

 

Net cash provided by operating activities

 

18,195

 

21,311

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Purchases of property, plant, and equipment

 

(25,478

)

(24,570

)

Proceeds from disposal of property, plant, and equipment

 

33

 

1,785

 

Investment in capitalized software

 

(3,523

)

(4,524

)

Other

 

(19

)

(55

)

Net cash used in investing activities

 

(28,987

)

(27,364

)

 

 

 

 

 

 

Financing activities

 

 

 

 

 

Proceeds from exercise of stock options

 

336

 

2,335

 

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

 

(65

)

(106

)

Fees paid in conjunction with debt financing

 

(31

)

(31

)

Borrowings on bank line of credit

 

27,000

 

28,000

 

Payments on bank line of credit

 

(39,000

)

(22,000

)

Cash received from landlord related to financing lease obligations

 

6,671

 

 

Stock repurchases

 

 

(5,995

)

Net cash (used in) provided by financing activities

 

(5,089

)

2,203

 

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(15,881

)

(3,850

)

Cash and cash equivalents at beginning of period

 

71,671

 

54,235

 

Cash and cash equivalents at end of period

 

$

55,790

 

$

50,385

 

 

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

1,116

 

$

2,340

 

 

 

 

 

 

 

Non-cash investing and financing activities

 

 

 

 

 

Software development costs incurred but not paid

 

$

2,115

 

$

344

 

Construction in progress costs incurred but not paid

 

14,888

 

11,537

 

Property acquired through financing lease obligations

 

232

 

 

 

See notes to condensed consolidated financial statements.

 

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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

 

Deficit

 

Loss

 

Total

 

Balance at December 31, 2017

 

74,120,113

 

$

74

 

$

506,098

 

$

(78,160

)

$

(24,966

)

$

403,046

 

Forfeiture of restricted stock awards

 

(1,045

)

 

 

 

 

 

Share-based compensation

 

 

 

3,285

 

 

 

3,285

 

Stock option exercises

 

101,471

 

 

336

 

 

 

336

 

Vested restricted stock awards withheld on

 

 

 

 

 

 

 

 

 

 

 

 

 

net share settlement

 

(8,324

)

 

(65

)

 

 

(65

)

Net loss

 

 

 

 

(7,094

)

 

(7,094

)

Other comprehensive loss

 

 

 

 

 

(409

)

(409

)

Balance at March 25, 2018

 

74,212,215

 

$

74

 

$

509,654

 

$

(85,254

)

$

(25,375

)

$

399,099

 

 

See notes to condensed consolidated financial statements.

 

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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” 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”), 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 Smart Foodservice” banner. As of March 25, 2018, the Company operated 323 stores throughout the Western United States (“U.S.”).

 

The Company owns a 50% joint venture interest in a Mexican domestic corporation, Smart & Final del Noroeste, S.A. de C.V. (“SFDN”), which operated 15 “Smart & Final” format stores in northwestern Mexico as of March 25, 2018.

 

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 December 31, 2017 that were included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 16, 2018.

 

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 2018 is, and fiscal year 2017 was, a 52-week fiscal year.

 

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, properties held for sale and other current assets.

 

As of March 25, 2018, the Company designated a property as held for sale in the amount of $9.2 million.

 

Property, Plant, and Equipment

 

Property, plant, and equipment is stated at cost or estimated fair value based on purchase accounting less accumulated depreciation 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 loss.

 

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

 

8



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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. As a result of such reviews, the Company recorded a pre-tax impairment loss of $1.2 million for the quarter ended March 25, 2018 in the Smart & Final segment.  The impairment loss was reported within “operating and administrative expenses” on the Company’s consolidated statements of operations and comprehensive loss.

 

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

 

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 Smart Foodservice 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, an impairment charge is recognized for the amount by which that carrying amount exceeds the fair value of the reporting unit.

 

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.

 

As of the annual impairment assessment date of December 3, 2017, the Company continued to experience a sustained decline in its share price and market capitalization from mid-2017. Additionally, the market multiples of publicly traded peer companies also experienced a sustained decline over this time period reflecting an increasingly competitive environment. As a result of the changed market conditions the Company updated its short-term operating plan in the fourth quarter 2017 to reflect this environment. The annual evaluation of impairment for fiscal year 2017 was performed as of December 3, 2017 resulting in a goodwill impairment charge of $180.0 million associated with the Smart & Final reporting unit recorded in the fourth quarter of 2017.

 

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

 

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Signature brands

 

20 years

Leasehold interests

 

24 years

 

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.

 

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), insurance recovery receivables related to self-insurance, 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” in the accompanying condensed consolidated balance sheets.

 

Other Long-Term Liabilities

 

Other long-term liabilities include primarily general liability reserves, workers’ compensation reserves, liabilities for the deferred compensation plan, leasehold interests, financing obligations for “build-to-suit” lease arrangements 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.

 

The Company records an asset and related financing lease obligation for the estimated construction costs under “build-to-suit” lease arrangements where it is considered, in substance, to be the owner of the building due to the Company’s involvement in the building’s construction. Upon occupancy and shortly thereafter, the Company assesses whether these arrangements qualify for sales recognition under the sale-leaseback accounting guidance. If the Company continues to be deemed the owner of the building, the Company will continue to account for the arrangement as a financing lease.

 

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.

 

Share-Based Compensation

 

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

 

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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 loss 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. 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 loss. 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 or restricted stock grant with graded vesting is effectively a series of individual grants that vest 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 loss on a net basis and, accordingly, are excluded from reported revenues.

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amended the existing accounting standards for revenue recognition. ASU 2014-09 establishes principles for recognizing revenue upon the transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. The Company adopted ASU 2014-09 in the first quarter of 2018 using the modified retrospective approach. Because the Company’s primary source of revenues is from the sale of products which are recognized at the point of sale, the impact on its consolidated financial statements is not material.

 

In March 2016, the FASB issued ASU No. 2016-08, Principal Versus Agent Considerations (Reporting Revenue Gross Versus Net) (“ASU 2016-08”), which amended existing accounting standards for revenue recognition. The Company adopted ASU 2016-08 in the first quarter of 2018 using the modified retrospective approach. The Company performed a detailed review of key contracts and comparison of historical accounting policies and practices to the new standard including principal versus agent considerations as amended through ASU 2016-08. The Company’s analysis of its contracts under the new standard supports the recognition of revenue at the point of sale, consistent with its current revenue policy. Furthermore, the Company evaluated the principal versus agent considerations as it relates to certain arrangements with third parties and determined that there would be no impact to the presentation of gross or net revenue reporting.

 

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

 

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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.

 

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 liability 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.

 

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 a portion of 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 loss 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.

 

The Company presents capitalized debt issuance costs in its condensed consolidated balance sheets as a direct reduction to debt.

 

Self-Insurance

 

The Company has various insurance programs related to its risks and costs associated with workers’ compensation and general liability claims. The Company has elected to purchase third-party insurance to cover the risk in excess of certain dollar limits established for each respective program. The Company 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. Included in the aggregate accrual are amounts related to the risk in excess of certain dollar limits related to the Company’s workers’ compensation California self-insured program and its general liability program. The Company has also recorded a corresponding insurance recovery receivable from its third-party insurance carriers related to the risk in excess of certain reinsurance dollar limits related to such programs. The accrued obligation for these self-insurance programs and the

 

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corresponding insurance recovery receivable are included in “Other long-term liabilities” and “Other Assets,” respectively, in the condensed consolidated balance sheets.

 

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 Term Loan Facility as well as indications of interest by prospective buyers and sellers and related bid/ask prices. As of March 25, 2018, 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 98.5% of carrying value. The carrying value of the Term Loan Facility was $625.0 million, compared to an indicated fair value of $615.6 million as of March 25, 2018. 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 financial statements reflect its investment in 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 (Loss) per Share

 

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

 

Diluted loss per share is calculated by dividing net loss by the weighted average number of shares outstanding during the fiscal period.

 

Potentially dilutive securities representing 6,266,238 shares of Common Stock for the twelve weeks ended March 25, 2018 and 5,699,439 shares of Common Stock for the twelve weeks ended March 26, 2017 were excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

 

3. Recent Accounting Pronouncements

 

Recently Issued Accounting Pronouncements Not Yet Adopted

 

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 financing 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. The Company anticipates that the adoption of ASU 2016-02 will materially affect its consolidated balance sheets, with no material impact to its consolidated statements of operations. The Company is in the process of implementing changes to its systems and processes in conjunction with its review of existing lease agreements. The Company plans to use the proposed optional transition method allowed by ASU 2016-02, which allows the Company to apply Accounting Standards Codification (“ASC”) 840, Leases, in the comparative periods presented in the year of adoption. The cumulative effect of adoption would be recorded in the opening balance sheet in the period of adoption. The Company also plans to elect to use the package of practical expedients which permits the Company to not reassess whether: a contract is or contains a lease, lease classification, and initial direct costs. The ultimate impact of adopting ASU 2016-02 will depend on the Company’s lease portfolio as of the adoption date of December 31, 2018.

 

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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 under 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.

 

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). The new guidance amends the hedge accounting model to enable entities to better portray the economics of their risk management activities in the financial statements and enhance the transparency and understandability of hedge results. The amendments expand an entity’s ability to hedge nonfinancial and financial risk components and reduce complexity in fair value hedges of interest rate risk. The guidance eliminates the requirement to separately measure and report hedge ineffectiveness and generally requires the entire change in the fair value of a hedging instrument to be presented in the same income statement line as the hedged item. The guidance also eases certain documentation and assessment requirements and modifies the accounting for components excluded from the assessment of hedge effectiveness. ASU 2017-12 is effective for annual and interim periods beginning after December 15, 2018 with early adoption permitted. The amended presentation and disclosure guidance is to be applied on a prospective basis. The Company does not expect the adoption of ASU 2017-12 will have a material impact on its consolidated financial statements.

 

In February 2018, the FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”), which permits entities to reclassify tax effects stranded in accumulated other comprehensive income as a result of tax reform to retained earnings. Companies that elect to reclassify these amounts must reclassify stranded tax effects for all items accounted for in accumulated other comprehensive income. ASU 2018-02 is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted.  The Company does not expect the adoption of ASU 2018-02 will have a material impact on its consolidated financial statements.

 

4. Debt

 

Current portion of debt at March 25, 2018 and December 31, 2017 was as follows (in thousands):

 

 

 

March 25, 2018

 

December 31, 2017

 

Revolving Credit Facility

 

$

69,000

 

$

81,000

 

Promissory Note

 

1,775

 

1,775

 

 

 

 

 

 

 

Less:

 

 

 

 

 

Debt issuance costs

 

(1,162

)

(1,263

)

Total current portion of debt

 

$

69,613

 

$

81,512

 

 

Long-term debt at March 25, 2018 and December 31, 2017 was as follows (in thousands):

 

 

 

March 25, 2018

 

December 31, 2017

 

Term Loan Facility

 

$

625,000

 

$

625,000

 

 

 

 

 

 

 

Less:

 

 

 

 

 

Debt issuance costs

 

(2,181

)

(2,298

)

Discount on debt issuance

 

(4,625

)

(4,835

)

Total long-term debt

 

$

618,194

 

$

617,867

 

 

In conjunction with the Ares Acquisition, Smart & Final Stores LLC (“Smart & Final Stores”) entered into financing arrangements effective November 15, 2012, including the Term Loan Facility and an asset-based lending facility (the “Revolving Credit Facility”).

 

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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.

 

During the third quarter of 2016, the Company amended the Term Loan Facility (the “Fourth Amendment”) to increase the size of the Term Loan Facility by $30.1 million, from $594.9 million to $625.0 million, and to extend the original November 15, 2019 maturity date to November 15, 2022. Additionally, in connection with the Fourth Amendment, the Eurocurrency Borrowings applicable margin increased from 3.25% to 3.50%. As of March 25, 2018 and December 31, 2017, the weighted-average interest rate on the amount outstanding under the Term Loan Facility was 5.19% and 5.20%, respectively.

 

The Revolving Credit Facility originally 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.

 

During the third quarter of 2016, the Company amended the Revolving Credit Facility (the “Second Amendment”) to increase the committed amount to $200.0 million. Additionally, the maturity date was extended from November 15, 2017 to the earlier of (a) July 19, 2021 and (b) to the extent the Term Loan Facility (and any refinancing of the Term Loan Facility) has not been paid in full, the date that is 60 days prior to the earliest scheduled maturity date of the Term Loan Facility (or such refinancing of the Term Loan Facility). 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%.

 

At March 25, 2018 and December 31, 2017, the alternate base rate was 4.75% and 4.5%, respectively and the applicable margin for alternate base rate loans was 0.25%, for a total rate of 5.00% and 4.75%, respectively. The calculated borrowing base of the Revolving Credit Facility was $199.9 million and $206.9 million at March 25, 2018 and December 31, 2017, respectively. As of March 25, 2018 and December 31, 2017, the amount outstanding under the Revolving Credit Facility was $69.0 million and $81.1 million, respectively.

 

The Revolving Credit Facility also provides for a $65.0 million sub-limit for letters of credit, of which the Company had $36.2 million outstanding as of March 25, 2018 and December 31, 2017. As of March 25, 2018 and December 31, 2017, the amount available for borrowing under the Revolving Credit Facility was $94.8 million and $82.8 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 March 25, 2018 and December 31, 2017, no trigger event had occurred.

 

During the third quarter of 2017, the Company entered into a Promissory Note to purchase certain real property for $1.8 million that is financed by the seller. The Promissory Note bears interest at 5.00% per annum and is due one year from its effective date.

 

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 loss. 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.

 

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As of March 25, 2018 and December 31, 2017, the fair value carrying amount of the Company’s interest rate swap are recorded as follows (in thousands):

 

 

 

March 25, 2018

 

December 31, 2017

 

Other assets

 

$

8

 

$

190

 

Total derivatives designated as hedging instruments

 

$

8

 

$

190

 

 

The following table summarizes the loss recognized in accumulated other comprehensive loss (“AOCL”) and the amount of gain reclassified from AOCL into earnings for the twelve weeks ended March 25, 2018 (in thousands):

 

 

 

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

 

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

 

Interest rate swaps

 

$

(118

)

$

15

 

 

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 its financial and nonfinancial assets and liabilities, the Company uses 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 March 25, 2018

 

Description

 

Total as of
March 25, 2018

 

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

 

$

541

 

$

541

 

$

 

$

 

Other assets—assets that fund supplemental executive retirement plan

 

3,464

 

3,464

 

 

 

Other assets—deferred compensation plan investment in Sprouts

 

2,271

 

2,271

 

 

 

Derivatives

 

9

 

 

9

 

 

Financial liabilities

 

 

 

 

 

 

 

 

 

Other long-term liabilities—deferred compensation plan

 

(18,237

)

(2,399

)

(15,838

)

 

Total

 

$

(11,952

)

$

3,877

 

$

(15,829

)

$

 

 

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Level 1 Investments include money market funds of $0.5 million, market index funds of $3.5 million and an investment in Sprouts of $2.3 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 $15.8 million of deferred compensation liabilities, the fair value of which is based on quoted prices of similar assets traded in active markets, and $9,000 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.

 

 

 

Fair Value Measurement at December 31, 2017

 

Description

 

Total as of
December 31,
2017

 

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

 

$

540

 

$

540

 

$

 

$

 

Other assets—assets that fund supplemental executive retirement plan

 

3,497

 

3,497

 

 

 

Other assets—deferred compensation plan investment in Sprouts

 

2,387

 

2,387

 

 

 

Derivatives

 

190

 

 

190

 

 

Financial liabilities

 

 

 

 

 

 

 

 

 

Other long-term liabilities—deferred compensation plan

 

(18,938

)

(2,268

)

(16,670

)

 

Total

 

$

(12,324

)

$

4,156

 

$

(16,480

)

$

 

 

Level 1 Investments include money market funds of $0.5 million, market index funds of $3.5 million and an investment in Sprouts of $2.4 million with the corresponding deferred compensation liabilities of $2.3 million. The fair values of these investments are based on quoted market prices in an active market.

 

Level 2 Liabilities include $16.7 million of deferred compensation liabilities, the fair value of which is based on quoted prices of similar assets traded in active markets, and $0.2 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.

 

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, Summary of 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, estimated discounted cash flows and public company comparable market multiples 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 majority of the Pension Participants (the “Frozen Pension Participants”) effective June 1, 2008.  As of March 25, 2018, there were approximately 450 hourly paid employees in the Company’s distribution and transportation operations accruing future benefits under the plan and 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 distribution and transportation operations. After June 1, 2008 Frozen Pension Participants continued 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

 

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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):

 

 

 

Twelve Weeks Ended

 

 

 

March 25,

 

March 26,

 

 

 

2018

 

2017

 

Service cost

 

$

402

 

$

381

 

Interest cost

 

1,798

 

1,865

 

Expected return on plan assets

 

(2,142

)

(1,965

)

Amortization of net actuarial loss

 

38

 

120

 

Net periodic benefit cost

 

$

96

 

$

401

 

 

In March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU 2017-07”). ASU 2017-07 requires the service cost component of net periodic benefit cost be presented in the same income statement line item as other employee compensation costs arising from services rendered during the period and other components of the net periodic benefit cost be presented separately from the line item that includes the service cost and outside of any subtotal of operating income. The Company adopted ASU 2017-07 in the first quarter of 2018 and continues to record service costs as a component of distribution costs included in cost of sales, buying and occupancy. Other components of the net periodic benefit cost are included in cost of sales, buying and occupancy and operating and administrative expenses in the condensed consolidated statements of operations and comprehensive loss.

 

During the twelve weeks ended March 25, 2018, the Company made a $0.4 million contribution to the Single-Employer Plan. The Company expects to fund a minimum required total contribution of approximately $8.8 million during fiscal year 2018.

 

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):

 

 

 

Twelve Weeks Ended

 

 

 

March 25,

 

March 26,

 

 

 

2018

 

2017

 

Interest cost

 

$

231

 

$

252

 

Net periodic benefit cost

 

$

231

 

$

252

 

 

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):

 

 

 

Twelve Weeks Ended

 

 

 

March 25,

 

March 26,

 

 

 

2018

 

2017

 

Service cost

 

$

115

 

$

115

 

Interest cost

 

138

 

139

 

Net periodic benefit cost

 

$

253

 

$

254

 

 

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8. Income Taxes

 

On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was signed into law. The Tax Act includes a number of provisions, including (1) the lowering of the U.S. corporate tax rate from 35% to 21%; (2) elimination of the corporate alternative minimum tax (AMT); (3) the creation of the base erosion anti-abuse tax (BEAT, a new minimum tax), a general elimination of U.S. federal income taxes on dividends from foreign subsidiaries; (4) a new provision designed to tax global intangible low-taxed income (GILTI), which allows for the possibility of using foreign tax credits (FTCs) and a deduction of up to 50 percent to offset the income tax liability (subject to some limitations); (5) a new limitation on deductible interest expense; (6) the repeal of the domestic production activity deduction; and (7) limitations on the deductibility of certain executive compensation.

 

The Company’s effective tax rate for the twelve weeks ended March 25, 2018 and March 26, 2017 was 27.9% and 56.6%, respectively.  Income tax expense in the first quarter of 2018 was different than the U.S. federal statutory income tax rate of 21% primarily due to the impact of the new executive compensation limitations and state income tax expense. In 2017, the income tax expense in the first quarter of 2017 was different than the U.S. federal statutory income tax rate of 35% primarily due to state income tax expense and tax deductions related to share-based compensation.

 

On the enactment date of the Tax Act, the SEC issued Staff Accounting Bulletin No. 118 (“SAB 118”) to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. As of December 31, 2017, the Company was able to reasonably estimate certain Tax Act effects and, therefore, recorded provisional adjustments associated with the deemed repatriation transition tax and remeasurement of certain deferred tax assets and liabilities. As of March 25, 2018 the Company’s accounting for the Tax Act is incomplete and the previously disclosed provisional amounts (transition tax and remeasurement of deferred taxes) continue to be provisional.

 

The Company files income tax returns in the U.S. federal jurisdiction, various U.S. state jurisdictions and Mexico. The Company’s federal tax return for the 2016 fiscal year is currently under examination by the Internal Revenue Service. 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 2013. The tax years which remain subject to examination or are being examined by major tax jurisdictions as of March 25, 2018 include fiscal years 2013 through 2016 for state purposes and 2014 through 2016 for federal purposes.

 

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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”). Effective March 13, 2017, the 2014 Incentive Plan was amended and restated to increase the number of shares that may be issued thereunder. The 2014 Incentive Plan provides for the issuance of equity-based incentive awards not to exceed 9,200,000 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 twelve weeks ended March 25, 2018, 8,324 shares of restricted stock were surrendered to the Company to cover the grantee’s income tax obligations in connection with the vesting of restricted stock awards.

 

The following table summarizes the restricted stock award activity under the 2014 Incentive Plan for the twelve weeks ended March 25, 2018:

 

 

 

Shares

 

Weighted-Average
Grant Date
Fair Value

 

Outstanding at December 31, 2017

 

1,954,604

 

$

11.38

 

Granted

 

 

 

Forfeited

 

(1,045

)

12.00

 

Vested

 

(24,412

)

13.42

 

Outstanding at March 25, 2018

 

1,929,147

 

$

11.36

 

 

The Company recorded share-based compensation expense related to the restricted stock awards of $2.4 million and $1.0 million for the twelve weeks ended March 25, 2018 and March 26, 2017, respectively. As of March 25, 2018, the unrecognized compensation cost was $11.3 million and related weighted-average period over which restricted stock award expense was expected to be recognized was approximately 2.07 years.

 

The following table summarizes the time-based option activity under the 2014 Incentive Plan for the twelve weeks ended March 25, 2018 (dollars in thousands except weighted average exercise price):

 

  

 

Shares

 

Weighted-
Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic Value

 

Outstanding at December 31, 2017

 

3,254,544

 

$

12.89

 

7.67 years

 

 

Granted

 

 

 

 

 

 

 

Forfeited

 

(33,334

)

12.00

 

 

 

 

 

Exercised

 

 

 

 

 

 

 

Expired

 

(1,831

)

15.65

 

 

 

 

 

Outstanding at March 25, 2018

 

3,219,379

 

$

12.89

 

7.45 years

 

$

 

Exercisable at March 25, 2018

 

1,355,196

 

$

12.44

 

6.69 years

 

$

 

 

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 March 23, 2018 (the last trading day of the first quarter of 2018) was $5.80.

 

The Company recorded share-based compensation expense for time-based options granted under the 2014 Incentive Plan of $0.7 million and $0.6 million for the twelve weeks ended March 25, 2018 and March 26, 2017, respectively. As of March 25, 2018, the unrecognized compensation cost was $3.7 million and related weighted-average period over which time-based option expense was expected to be recognized was approximately 1.86 years.

 

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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 twelve weeks ended March 25, 2018 (dollars in thousands except weighted average exercise price):

 

 

 

Shares

 

Weighted-
Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value

 

Outstanding at December 31, 2017

 

4,482,570

 

$

6.58

 

5.10 years 

 

$

8,809

 

Forfeited

 

 

 

 

 

 

 

Exercised

 

(34,911

)

5.27

 

 

 

 

 

Cancelled

 

 

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding at March 25, 2018

 

4,447,659

 

$

6.60

 

4.87 years

 

$

1,170

 

Exercisable at March 25, 2018

 

4,447,659

 

$

6.60

 

4.87 years

 

$

1,170

 

 

The Company recorded share-based compensation expense for time-based options granted under the 2012 Incentive Plan of $0.1 million and $0.2 million for the twelve weeks ended March 25, 2018 and March 26, 2017, respectively. As of March 25, 2018, there was no unrecognized compensation cost.

 

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”). 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 twelve weeks ended March 25, 2018 (dollars in thousands except weighted average exercise price):

 

 

 

Shares

 

Weighted-
Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value

 

Outstanding at December 31, 2017

 

1,127,920

 

$

2.50

 

0.99 years

 

$

6,827

 

Forfeited

 

 

 

 

 

 

 

Exercised

 

(66,560

)

2.28

 

 

 

 

 

Cancelled

 

 

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding at March 25, 2018

 

1,061,360

 

$

2.51

 

0.79 years

 

$

3,491

 

Exercisable at March 25, 2018

 

1,061,360

 

$

2.51

 

0.79 years

 

$

3,491

 

 

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10. Accumulated Other Comprehensive Loss

 

The following table represents the changes in AOCL by each component for the twelve weeks ended March 25, 2018, net of tax:

 

(in thousands)

 

Defined Benefit
Retirement Plan

 

Cash Flow
Hedging Activity

 

Foreign Currency
Translation and Employee
Benefit Obligation
Adjustment

 

Total

 

Balance at December 31, 2017

 

$

(22,776

)

$

101

 

$

(2,291

)

$

(24,966

)

OCI before reclassification

 

 

(133

)

(291

)

(424

)

Amounts reclassified out of AOCL

 

 

15

 

 

15

 

Net current period OCI

 

 

(118

)

(291

)

(409

)

Balance at March 25, 2018

 

$

(22,776

)

$

(17

)

$

(2,582

)

$

(25,375

)

 

The following table represents the items reclassified out of each component of AOCL and the related tax effects for the twelve weeks ended March 25, 2018 (in thousands):

 

Details about AOCL
Components

 

Amount
Reclassified
from AOCL

 

Location within
Statement of Operations and
Comprehensive Loss

 

Income on cash flow hedges

 

 

 

 

 

Interest rate swaps

 

$

20

 

Interest income (expense)

 

 

 

20

 

Total before income taxes

 

 

 

(5

)

Income tax (provision) benefit

 

 

 

$

15

 

Reclassification of adjustments, net of tax

 

Total reclassifications for the twelve weeks ended March 25, 2018

 

$

15

 

Total reclassifications, net of tax

 

 

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 Smart Foodservice” business focuses primarily on restaurants, caterers and a wide range of other foodservice businesses. The Company’s chief operating decision maker (“CODM”) regularly reviews the operating performance of each of the store banners including measures of performance based on loss (income) 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 twelve weeks ended March 25, 2018, the operating information and total assets for the reportable segments are as follows (in thousands):

 

 

 

Smart & Final

 

Cash & Carry
Smart Foodservice

 

Corporate /
Other

 

Consolidated

 

Net sales

 

$

795,192

 

$

221,045

 

$

 

$

1,016,237

 

Cost of sales, distribution and store occupancy

 

678,615

 

189,471

 

1,889

 

869,975

 

Operating and administrative expenses

 

109,569

 

17,796

 

20,065

 

147,430

 

Income (loss) from operations

 

$

7,008

 

$

13,778

 

$

(21,954

)

$

(1,168

)

As of March 25, 2018:

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,702,671

 

$

406,831

 

$

(327,427

)

$

1,782,075

 

Intercompany receivable (payable)

 

$

322,587

 

$

48,413

 

$

(371,000

)

$

 

Investment in joint venture

 

$

 

$

 

$

15,796

 

$

15,796

 

Goodwill

 

$

181,338

 

$

204,580

 

$

 

$

385,918

 

For the twelve weeks ended March 25, 2018:

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

23,859

 

$

1,270

 

$

3,872

 

$

29,001

 

Depreciation and amortization

 

$

20,498

 

$

1,254

 

$

1,540

 

$

23,292

 

 

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For the twelve weeks ended March 26, 2017, the operating information for the reportable segments is as follows (in thousands):

 

 

 

Smart & Final

 

Cash & Carry
Smart Foodservice

 

Corporate /
Other

 

Consolidated

 

Net sales

 

$

764,969

 

$

202,048

 

$

 

$

967,017

 

Cost of sales, distribution and store occupancy

 

656,792

 

175,133

 

1,981

 

833,906

 

Operating and administrative expenses

 

103,906

 

16,166

 

15,602

 

135,674

 

Income (loss) from operations

 

$

4,271

 

$

10,749

 

$

(17,583

)

$

(2,563

)

For the twelve weeks ended March 26, 2017:

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

20,974

 

$

2,873

 

$

5,247

 

$

29,094

 

Depreciation and amortization

 

$

18,747

 

$

1,095

 

$

1,841

 

$

21,683

 

 

12. Commitments and Contingencies

 

Legal Actions

 

On February 11, 2016, the Company received a subpoena from the District Attorney for the County of Yolo, California, seeking information concerning its handling, disposal and reverse logistics of potential hazardous waste at our stores and distribution centers in California. The Company has provided information and is cooperating with the authorities from multiple counties in California in connection with this ongoing matter. In the fourth quarter of 2016, the Company recorded a loss related to this matter in an amount considered to be immaterial. In the second quarter of 2017 and the first quarter of 2018, the Company recorded additional losses related to this matter in amounts considered to be immaterial. Due to the developing status of this matter and the uncertainty of its outcome, the Company cannot reasonably estimate possible additional loss or range of additional 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 resolution of these pending claims will have a material adverse effect on its business, financial condition, results of operations and cash flows. However, litigation is subject to many uncertainties, and the outcome of certain individual litigated matters may not be reasonably predictable and any related damages may not be estimable. Some litigation matters could result in an adverse outcome to the Company, and any such adverse outcome could have a material adverse effect on its business, financial condition, results of operations and cash flows.

 

13. Loss Per Share

 

Basic loss per share represents net loss 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 loss per share is calculated by dividing net loss by the weighted average number of shares of Common Stock outstanding for the applicable period.

 

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

 

 

 

Twelve Weeks Ended

 

 

 

March 25,

 

March 26,

 

 

 

2018

 

2017

 

 

 

 

 

 

 

Net loss

 

$

(7,094

)

$

(4,592

)

 

 

 

 

 

 

Weighted average shares outstanding for basic EPS

 

72,231,171

 

72,287,891

 

Effect of dilutive securities:

 

 

 

 

 

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

 

 

 

Weighted average shares and share equivalents outstanding for diluted EPS

 

72,231,171

 

72,287,891

 

 

 

 

 

 

 

Basic loss per share

 

$

(0.10

)

$

(0.06

)

Diluted loss per share

 

$

(0.10

)

$

(0.06

)

 

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Potentially dilutive securities representing 6,266,238 shares of Common Stock for the twelve weeks ended March 25, 2018 and 5,699,439 shares of Common Stock for the twelve weeks ended March 26, 2017 were excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

 

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 growth depends in part 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;

 

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

 

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

 

·                  inflation and deflation can impact our net sales, inventory, costs of goods sold and gross margin and operating leverage;

 

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

 

·                  if we are unable to attract, train and retain, or maintain satisfactory relations with, our employees could impact our ability to grow or successfully operate our business;

 

·                  disruption of supplier relationships could adversely affect our business;

 

·                  changes in commodity prices and availability may affect our financial condition and operating results;

 

·                  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;

 

·                  disruptions to or security breaches involving our information technology systems, including disruptions related to implementation of new systems or enhancements to existing systems, could harm our ability to run our business;

 

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·             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;

 

·             covenants in our debt agreements restrict our operational flexibility; and

 

·             if our goodwill becomes impaired, we may be required to record a significant charge to earnings.

 

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 value-oriented food retailer serving a diverse and dynamic demographic of household and business customers through two complementary and highly productive store banners. Our Smart & Final stores focus on both household and business customers, and our Cash & Carry Smart Foodservice stores focus primarily on business customers. As of March 25, 2018, we operated 323 convenient, non-membership, smaller-box, warehouse-style stores throughout the Western United States, with an additional 15 stores in Northwestern Mexico operated through 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 product sizes, all at “everyday low prices.”

 

As of March 25, 2018, we operated 260 Smart & Final stores in California, Arizona and Nevada, which 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. Customers can choose from a broad range of product sizes, including an assortment of standard-sized products typically found at conventional grocers, and a large selection of larger sized offerings (including uniquely sized national brand products) more typical of warehouse club style stores. Pricing in our Smart & Final stores is targeted to be substantially lower than that of conventional grocers and competitive with that of large discount store operators and warehouse clubs. We believe we offer higher quality produce at lower prices than typically found at large discounters. We also believe our Smart & Final stores provide a better everyday value to household and business customers than typical warehouse clubs by offering greater product selection at competitive prices, with no membership fee requirement, in a convenient, easy-to-shop format.

 

Within the Smart & Final banner we operate both Extra! and legacy Smart & Final stores. Beginning in late 2008, we launched an initiative to convert our larger legacy Smart & Final stores to our Extra! format. With a larger store footprint and an expanded merchandise selection, our Extra! format offers a one-stop shopping experience with over 16,000 SKUs, over 4,000 more SKUs than our legacy Smart & Final stores, with an emphasis on perishables and household items. As of March 25, 2018, we operated 194 Extra! stores of which 102 represent conversions or relocations of legacy Smart & Final stores and 92 represent new store openings. In recent years we have significantly increased the number of Extra! stores, facilitated primarily by our acquisition of a dedicated perishables warehouse, our acquisition of a group of stores in fiscal year 2016, and by our continued investments in distribution capabilities and in-store merchandising. The continued development of our Extra! store format, through additional new store openings and expansions and relocations of legacy Smart & Final stores to the Extra! store format, is expected to be the cornerstone of future Smart & Final banner growth.

 

As of March 25, 2018, we also operated 63 Cash & Carry Smart Foodservice stores focused primarily on restaurants, caterers and a wide range of other foodservice businesses such as food trucks and coffee houses. We offer customers the opportunity to shop for their everyday foodservice needs in a convenient, no-frills warehouse shopping environment. These stores are located in Washington, Oregon, Northern California, Idaho, Montana, Nevada and Utah. Pricing in our Cash & Carry Smart Foodservice stores is targeted to be substantially lower than that of our foodservice delivery competitors, with greater price transparency to customers and with no minimum order size. Pricing is also competitive with typical warehouse clubs, with no membership fee requirement. Since late 2014, we have opened 11 new Cash & Carry Smart Foodservice stores in existing and new market areas, and are actively pursuing additional growth opportunities for this store banner.

 

In both store banners, we are actively investing in increasing online and other digital sales channels, including both direct delivery to customers through partner services and using buy online, pick up in store models. As of March 25, 2018, we offered digital sales options in over 80% of our Smart & Final banner and Cash & Carry Smart Foodservice stores.

 

We believe that our “everyday low prices,” unique merchandising strategy and convenient locations enable us to offer a differentiated food shopping experience with broad appeal to a diverse and dynamic customer demographic.

 

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Outlook

 

We plan to expand our store footprint, primarily through opening new Extra! stores in existing and adjacent markets, and over time 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. During the first quarter of 2018 we did not open any new Extra! stores, and did not relocate any legacy Smart & Final stores to Extra! format stores, nor convert any legacy Smart & Final stores to Extra! format stores. Our 2018 store development plans anticipate three to five additional new Extra! stores. We plan to opportunistically continue to expand our larger legacy Smart & Final stores to our Extra! format and invest in our legacy Smart & Final stores that are not candidates for conversion to the Extra! format by completing major remodel projects and targeted relocations. We also plan to open three to five Cash & Carry Smart Foodservice stores in 2018.

 

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 Smart Foodservice stores, and to expand our marketing programs in our Smart & Final and Cash & Carry Smart Foodservice 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.

 

Factors Affecting Our Results of Operations

 

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 and expansions and relocations. We also plan to opportunistically open new Cash & Carry Smart Foodservice 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 Smart Foodservice 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, our new stores generally 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.

 

Developments in Competitive Landscape

 

We operate in the highly competitive U.S. food retail and foodservices industry. We compete on a combination of factors, including price, product selection, product quality, convenience, customer service, store format and location, and digital commerce options. Our principal competitors include conventional grocers such as Albertsons/Safeway and Kroger, warehouse clubs and discounters such as Costco and Aldi, mass merchandisers such as Walmart and Target, foodservice delivery companies such as Sysco and US Foods, online retailers such as Amazon, as well as 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 Smart Foodservice 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 Smart Foodservice 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.

 

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Table of Contents

 

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.

 

As of March 25, 2018, we had a portfolio of approximately 3,000 private label items, which represented 28% of our Smart & Final banner sales for the twelve weeks ended March 25, 2018. 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 continue to make significant investments in senior management, information technology systems, modernizing our supply chain systems and marketing across multiple print and digital channels. 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 as we sell lower-priced inventory in a higher price environment. In contrast, food deflation could negatively impact our results of operations by reducing sales growth and earnings if our competitors react by lowering their retail pricing. The short-term impact of inflation and deflation is largely dependent on whether or not we pass the effects through to our customers, which is subject to competitive market conditions. In recent inflationary periods, we have generally been able to pass through most cost increases. Beginning in the second quarter of fiscal year 2015 and continuing through the first quarter of fiscal year 2017, we experienced deflation in certain food and non-food commodities. Market dynamics caused us to pass cost decreases through to customers, which negatively impacted sales growth and income from operations in certain categories, primarily in proteins, but also in high volume categories like cheese and fresh produce. In the second quarter of fiscal year 2017, we began to experience modest inflation in some of the food and non-food products we sell. This inflation has continued through the first quarter of fiscal year 2018 and we expect overall inflation to continue for the remaining of fiscal year 2018.

 

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).

 

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Table of Contents

 

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 from our store development program, including the growth in the number of our stores and as a result of additional legal, accounting, insurance and other expenses associated with being a public company.

 

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 March 25, 2018, 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 and Revolving Credit Facility

 

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.

 

2017 Tax Cuts and Jobs Act

 

On December 22, 2017, the Tax Act was enacted into law, which changed various corporate federal income tax provisions of the Internal Revenue Code. Substantially all the provisions of the Tax Cuts and Jobs Act are effective for taxable years beginning after December 31, 2017. We expect that the most significant changes that will impact the Company are the reduction in the corporate federal income tax rate from 35% to 21% and 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. In a manner consistent with ASC 740-10-25-47, the effect of a change in tax law or rates shall be recognized at the date of enactment. Accordingly, the Company accounted for the corporate federal income tax rate reduction in the fourth quarter of 2017 (see Note 8, Income Taxes, in the accompanying notes to our consolidated financial statements).

 

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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 December 31, 2017 and was a 52-week period.

 

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

 

 

 

Twelve Weeks Ended

 

 

 

March 25, 2018

 

March 26, 2017

 

 

 

(Dollars in thousands, except per share)

 

Net sales

 

$

1,016,237

 

100.0

%

$

967,017

 

100.0

%

Cost of sales, buying and occupancy

 

869,975

 

85.6

%

833,906

 

86.2

%

Gross margin

 

146,262

 

14.4

%

133,111

 

13.8

%

Operating and administrative expenses

 

147,430

 

14.5

%

135,674

 

14.1

%

Income (loss) from operations

 

(1,168

)

-0.1

%

(2,563

)

-0.3

%

Interest expense, net

 

9,251

 

1.0

%

8,174

 

0.8

%

 

 

 

 

 

 

 

 

 

 

Equity in earnings of joint venture

 

577

 

0.1

%

167

 

%

Loss before income taxes

 

(9,842

)

-1.0

%

(10,570

)

-1.1

%

Income tax benefit

 

2,748

)

0.3

%

5,978

 

0.6

%

Net loss

 

$

(7,094

)

-0.7

%

$

(4,592

)

-0.5

%

Per Share Data:

 

 

 

 

 

 

 

 

 

Loss per share:

 

 

 

 

 

 

 

 

 

Net loss per share - Basic

 

$

(0.10

)

 

 

$

(0.06

)

 

 

Net loss per share - Diluted

 

$

(0.10

)

 

 

$

(0.06

)

 

 

 

 

 

 

 

 

 

 

 

 

Other Operating Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comparable store sales growth

 

1.2

%

 

 

(2.5

)%

 

 

Smart & Final banner

 

0.0

%

 

 

(2.5

)%

 

 

Cash & Carry Smart Foodservice banner

 

5.8

%

 

 

(2.4

)%

 

 

Stores at end of period

 

323

 

 

 

308

 

 

 

Smart & Final banner

 

260

 

 

 

248

 

 

 

Extra! format

 

194

 

 

 

174

 

 

 

Cash & Carry Smart Foodservice banner

 

63

 

 

 

60

 

 

 

 

Twelve Weeks Ended March 25, 2018 Compared to the Twelve Weeks Ended March 26, 2017

 

Net Sales

 

Net sales for the twelve weeks ended March 25, 2018 increased $49.2 million, or 5.1%, to $1,016.2 million as compared to $967.0 million for the twelve weeks ended March 26, 2017. This increase in net sales was attributable to net sales of $37.7 million from the opening of eighteen new stores in fiscal 2017 and a comparable store sales increase of $11.5 million in our store banners.

 

For the twelve weeks ended March 25, 2018, comparable store sales increased 1.2% as compared to the twelve weeks ended March 26, 2017. This increase in comparable store sales was attributable to a decrease in comparable transaction count of 1.7% and an increase in comparable average transaction size of 2.9%.

 

For the twelve weeks ended March 25, 2018, net sales for our Smart & Final segment increased $30.2 million, or 4.0%, to $795.2 million as compared to $765.0 million for the twelve weeks ended March 26, 2017. Comparable store sales for our Smart & Final segment was flat as compared to the twelve weeks ended March 26, 2017, attributable to a decrease in comparable transaction count of 1.9% and an increase in comparable average transaction size of 1.9%.

 

For the twelve weeks ended March 25, 2018, net sales for our Cash & Carry Smart Foodservice segment increased $19.0 million, or 9.4%, to $221.0 million as compared to $202.0 million for the twelve weeks ended March 26, 2017. Comparable store sales for our Cash & Carry Smart Foodservice segment increased 5.8% as compared to the twelve weeks ended March 26, 2017, attributable to an increase in comparable average transaction size of 5.1% and an increase in comparable transaction count of 0.7%.

 

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As a result of our store growth in existing markets, we also have experienced sales transfer from certain existing stores to new stores. In comparable store sales, we believe that the principal effect of this sales transfer is evidenced in the comparable sales transaction count.

 

Gross Margin

 

Gross margin for the twelve weeks ended March 25, 2018 increased $13.2 million, or 9.9%, to $146.3 million as compared to $133.1 million for the twelve weeks ended March 26, 2017. The increase in gross margin attributable to increased sales was $6.8 million, and $6.4 million was attributable to increased gross margin rate. As a percentage of sales, gross margin was 14.4% for the twelve weeks ended March 25, 2018 as compared to 13.8% for the twelve weeks ended March 26, 2017. Compared to the twelve weeks ended March 26, 2017, gross margin as a percentage of sales for the twelve weeks ended March 25, 2018 included higher merchandise product margin rates (including the effect of inventory losses) as a percentage of sales, accounting for an increase of 0.68% (consisting of a 0.35% increase related to our Cash & Carry Smart Foodservice segment, and a 0.33% increase related to our Smart & Final segment). Warehouse and transportation costs as a percentage of sales decreased 0.03% (representing a 0.03% decrease related to our Smart & Final segment and no change related to our Cash & Carry Smart Foodservice segment). Store occupancy costs as a percentage of sales increased 0.09% (consisting of an increase of 0.07% related to our Smart & Final segment and a 0.02% increase related to our Cash & Carry Smart Foodservice segment). Buying department costs decreased 0.02% in our Smart & Final segment.

 

Operating and Administrative Expenses

 

Operating and administrative expenses for the twelve weeks ended March 25, 2018 increased $11.7 million, or 8.7%, to $147.4 million, as compared to $135.7 million for the twelve weeks ended March 26, 2017. The increase in operating and administrative expenses was primarily due to $6.3 million increase in wages, fringe benefits and incentive bonus costs, $0.3 million increase in other store direct expenses, $1.5 million increase in share-based compensation expense associated with our equity compensation program, $0.8 million increase in expense associated with cash surrender values on corporate-owned life insurance policies and other expenses of the SERP, a $0.8 million increase in costs associated with store closures and asset impairment costs, and a $2.5 million increase in other expenses mainly due to increases in consulting fees, system upgrade costs and legal fees. These increases were partially offset by a $0.3 million decrease in marketing costs and a $0.2 million decrease in public company costs.

 

As a percentage of sales, operating and administrative expenses for the twelve weeks ended March 25, 2018 increased 0.5% to 14.5% as compared to 14.0% for the twelve weeks ended March 26, 2017. Operating and administrative expenses, as a percentage of sales, increased by 0.19% due to increased wages, benefits and incentive bonuses (including a 0.09% increase related to our Smart & Final segment and 0.1% increase related to our Cash & Carry Smart Foodservice segment), 0.14% due to increased share-based compensation expense associated with our equity compensation program, 0.09% due to increase in expense associated with cash surrender values on corporate-owned life insurance policies and other expenses of the SERP, 0.08% increase in costs related to store closures and asset impairment costs and 0.19% due to increased other expenses mostly related to increases in consulting fees, system upgrade costs and legal fees. These increases were offset by a 0.13% decrease in other store direct expenses primarily related to our Smart & Final segment, a 0.07% decrease in marketing costs and 0.02% decrease in public company costs.

 

Interest Expense, Net

 

Interest expense for the twelve weeks ended March 25, 2018 increased $1.1 million, or 13.2%, to $9.3 million as compared to $8.2 million for the twelve weeks ended March 26, 2017. This increase in interest expense was primarily due to increased average debt outstanding and a slight increase in interest rate.

 

Income Tax Provision

 

Our income tax benefit for the twelve weeks ended March 25, 2018 decreased $3.2 million to a $2.7 million income tax benefit  as compared to a $5.9 million income tax benefit for the twelve weeks ended March 26, 2017. The effective income tax rate for the twelve weeks ended March 25, 2018 was an income tax benefit of 27.9% as compared to an income tax benefit of 56.5% for the twelve weeks ended March 26, 2017. The lower effective tax rate for the twelve weeks ended March 25, 2018 as compared to the twelve weeks ended March 26, 2017 was primarily related to the federal corporate income tax rate cut from 35% to 21% effective for 2018 under the tax act. The twelve weeks ended March 26, 2017 also benefited from greater excess tax benefits from stock option award exercises and restricted stock vesting and other discrete items.

 

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Equity in Earnings of Joint Venture

 

Equity in earnings of our joint venture for the twelve ended March 25, 2018 was $0.6 million as compared to $0.2 million for the twelve weeks ended March 26, 2017.

 

Liquidity and Capital Resources

 

Historically, our primary source of liquidity has been cash flows from operations. Additionally, we have the availability to make borrowings under our Credit Facilities. Our primary uses of cash are for purchases of inventory, operating expenses, capital expenditures primarily for opening, converting or remodeling stores and debt service. As of March 25, 2018, we had $69.0 million drawn under our Revolving Credit Facility and $55.8 million of cash and cash equivalents.

 

The following table sets forth the major sources and uses of cash for each of the periods set forth below, as well as our cash and cash equivalents at the end of each period.

 

(dollars in thousands)

 

Twelve
Weeks Ended
March 25, 2018

 

Twelve
Weeks Ended
March 26, 2017

 

Cash and cash equivalents at end of period

 

$

55,790

 

$

50,385

 

Cash provided by operating activities

 

18,195

 

21,311

 

Cash used in investing activities

 

(28,987

)

(27,364

)

Cash (used in) provided by financing activities

 

(5,089

)

2,203

 

 

Operating Activities

 

Cash flows from operating activities consist of net loss adjusted for non-cash items including depreciation and amortization, and share-based compensation and the effect of working capital changes. The increase or decrease in cash provided by operating activities for the twelve weeks ended March 25, 2018 and March 26, 2017 reflects our operating performance before non-cash expenses and charges and including the timing of receipts and disbursements.

 

Cash provided by operating activities for the twelve weeks ended March 25, 2018 decreased $3.1 million to $18.2 million as compared to 21.3 million for the twelve weeks ended March 26, 2017. This decrease was primarily attributable to the greater net loss reported for the twelve weeks ended March 25, 2018 as compared to the prior year period. During the twelve weeks ended March 25, 2018, we made cash interest payments of $1.1 million and cash pension contributions of $0.4 million, as compared to cash interest payments of $2.3 million and cash pension contributions of $1.6 million during the twelve weeks ended March 26, 2017.

 

Investing Activities

 

Cash used in investing activities increased $1.6 million to $29.0 million for the twelve weeks ended March 25, 2018 as compared to $27.4 million in the twelve weeks ended March 26, 2017. This increase was primarily attributable to a $0.9 million increase in capital expenditures for property, plant and equipment, a $1.7 million decrease in proceeds on sale of assets, partially offset by a $1.0 million decrease in capital expenditures for capitalized software.

 

Financing Activities

 

Cash (used in) provided by financing activities decreased $7.3 million to cash used of $5.1 million for the twelve weeks ended March 25, 2018, as compared to cash provided of $2.2 million for the twelve weeks ended March 26, 2017. This decrease was attributable to  a $18.0 million reduction in net borrowings on our Revolving Credit Facility and a $2.0 million decrease in proceeds from exercise of stock options, partially offset by a $6.0 million decrease in cash used for repurchases of Common Stock and a $6.7 million increase in cash received from landlords related to financing lease obligations.

 

At March 25, 2018, we had cash and cash equivalents of $55.8 million, stockholders’ equity of $399.1 million and debt, less debt issuance costs, of $687.8 million. At March 25, 2018, we had working capital deficit of $8.2 million as compared to $1.1 million of working capital at March 26, 2017, primarily due to increased payments on our Revolving Credit Facility.

 

Contractual Obligations

 

The following table sets forth our future payments due by period of our contractual obligations as of March 25, 2018, in thousands:

 

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Table of Contents

 

 

 

Total

 

Less than
one year

 

1 - 3 Years

 

3 - 5 Years

 

Thereafter

 

Long-term debt

 

$

694,000

 

$

69,000

 

$

 

$

625,000

 

$

 

Interest on long-term debt

 

184,216

 

41,100

 

77,642

 

65,474

 

 

Promissory note

 

1,775

 

1,775

 

 

 

 

Operating leases

 

1,464,038

 

133,612

 

268,721

 

229,007

 

832,698

 

Financing lease obligations

 

17,566

 

1,098

 

2,196

 

2,257

 

12,015

 

Total contractual obligations

 

$

2,361,595

 

$

246,585

 

$

348,559

 

$

921,738

 

$

844,713

 

 

The primary changes in our contractual obligations as of March 25, 2018 as compared to our contractual obligations as of December 31, 2017 relate to payments made in the twelve weeks ended March 25, 2018.

 

The interest payments on our Term Loan Facility outstanding as of March 25, 2018 incorporate the effect of the interest rate swap, which effectively converts the variable rate under the Term Loan Facility to a fixed rate. The five-year interest rate swap fixed the LIBOR component of interest at 1.47675% on a variable notional amount through March 29, 2018. See Note 4, Debt, and Note 5, Derivative Financial Instruments, to our unaudited condensed consolidated financial statements for additional information on our interest requirements and interest rate swap contract.

 

Purchase orders or contracts for the purchase of goods for resale in our stores and other goods and services are not included in the table above. We are not able to reasonably determine the aggregate amount of such purchase orders that may constitute established contractual obligations, as purchase orders may represent individual authorizations to purchase rather than binding agreements. Other than with respect to Unified Grocers (as described immediately below), we do not have significant agreements for the purchase of goods for resale in our stores or other goods and services that exceed our expected requirements or that are not cancelable on short notice.

 

We have a contractual obligation under our supply agreement with Unified Grocers, who was acquired by SuperValu Inc. in June 2017, to purchase a minimum amount of food and related items during any twelve-month period covered by the agreement. This contractual obligation does not exceed our expected requirements over any twelve-month period covered by the agreement. This agreement expires in December 2018. The related amounts are not included in the above table.

 

The table above also excludes funding of pension and other postretirement benefit and postemployment obligations. See Note 7, Retirement Benefit Plans and Postretirement and Postemployment Benefit Obligations, to our unaudited condensed consolidated financial statements for additional information on funding of our plans.

 

We also have asset retirement obligations with respect to owned or leased properties. Due to the nature of our business, such asset retirement obligation is immaterial.

 

Off-Balance Sheet Arrangements

 

As of March 25, 2018, we had no off-balance sheet arrangements.

 

Critical Accounting Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported assets, liabilities, sales and expenses in the accompanying financial statements. Critical accounting estimates are those that require the most subjective and complex judgments, often employing the use of estimates about the effect of matters that are inherently uncertain. These critical accounting estimates, under different conditions or using different assumptions or estimates, could show materially different results on our financial condition and results of operations. The following are considered our most critical accounting estimates that, under different conditions or using different assumptions or estimates, could show materially different results on our financial condition and results of operations.

 

Share-Based Compensation

 

We account for share-based compensation in accordance with ASC 718, Compensation—Stock Compensation (“ASC 718”). ASC 718 requires all share-based payments to be recognized in the statements of operations and comprehensive income as compensation expense based on their fair values over the requisite service period of the award, taking into consideration estimated forfeiture rates.

 

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We use the Black-Scholes-Merton option-pricing model to estimate the fair value of the options on the date of each grant. The Black-Scholes-Merton option-pricing model utilizes highly subjective and complex assumptions to determine the fair value of share-based compensation, including the option’s expected term and price volatility of the underlying stock. The methods used to develop our assumptions are discussed further in Note 12, Share-Based Compensation, in the accompanying notes to our audited consolidated financial statements.

 

In addition to assumptions used in the Black-Scholes-Merton option pricing model, we must also estimate a forfeiture rate to calculate the share-based compensation cost for our awards. Our forfeiture rate is based on an analysis of our actual historical forfeitures and consideration of future expected forfeiture rates.

 

The assumptions referred to above represent management’s best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. If these assumptions change and different factors are used, our share-based compensation expense could be materially different in the future. We do not believe there is a reasonable likelihood that changes in the assumptions used in our estimates will have a material effect on our financial condition or results of operations in future periods. Changes in future share-based compensation expense related to these awards may result from changes in forfeiture rates. However, we do not believe there is a reasonable likelihood that such changes will be material.

 

We recognize compensation cost for graded vesting awards as if they were granted in multiple awards. We believe the use of this “multiple award” method is preferable because a stock option grant or a restricted stock grant with graded vesting is effectively a series of individual grants that vests over various periods. Management also believes that this provides for better matching of compensation costs with the associated services rendered throughout the applicable vesting periods.

 

Inventories

 

Inventories consist of merchandise purchased for resale which is stated at the lower of the weighted-average cost (which approximates first-in, first-out (“FIFO”) or market. We provide for estimated inventory losses between physical inventory counts at our stores based upon historical inventory losses as a percentage of sales. Physical inventory counts are conducted on a recurring and frequent basis throughout the year. The provision for inventory loss is adjusted periodically to reflect updated trends of actual physical inventory count results. Historically, our actual physical inventory count results have shown our estimates to be materially reliable. We do not believe there is a reasonable likelihood that changes in our estimates will have a material effect on our financial condition or results of operations in future periods.

 

The proper valuation of inventory also requires us to estimate the net realizable value of our slow-moving inventory at the end of each period. We base net realizable values upon many factors, including historical recovery rates, the aging of inventories on hand, the inventory movement of specific products and the current economic conditions. When we have determined inventory to be slow-moving, the inventory is reduced to its net realizable value by recording an obsolescence valuation allowance. We believe these risks are largely mitigated because our inventory typically turns on average in less than three months.

 

With regard to the proper valuation of inventories, we review our valuation methodologies on a recurring basis and make refinements where the facts and circumstances dictate.

 

Goodwill and Intangible Assets

 

We account for goodwill and identified intangible assets in accordance with ASC 350, Intangibles—Goodwill and Other. Goodwill and identifiable intangible assets with indefinite lives are not amortized, but instead are evaluated on an annual basis for impairment, or more frequently if events or changes in circumstances indicate that the asset might be impaired.

 

We evaluate goodwill for impairment by comparing the fair value of each reporting unit to its carrying value including the associated goodwill. We have designated our reporting units to be our Smart & Final banner and our Cash & Carry Smart Foodservice banner. We determine the fair value of the reporting units using a combination of the income approach methodology of valuation that utilizes the discounted cash flow method as well as other generally accepted valuation methodologies including the market comparable and market transaction methods.

 

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Determining market values using a discounted cash flow method requires that we make significant estimates and assumptions, including long-term projections of cash flows, market conditions and appropriate market rates. Our judgments are based on historical experience, current market trends and other information. In estimating future cash flows, we rely on internally generated forecasts for operating profits and cash flows, including capital expenditures. Critical assumptions include projected comparable store sales growth, timing and number of new store openings, operating profit rates, general and administrative expenses, direct store expenses, capital expenditures, discount rates, royalty rates and terminal growth rates. We determine discount rates based on the weighted average cost of capital of a market participant. Such estimates are derived from our analysis of peer companies and consider the industry weighted average return on debt and equity from a market participant perspective. We also use comparable market earnings multiple data and market transaction data in determining market values. Factors that could cause us to change our estimates of future cash flows include a prolonged economic crisis, successful efforts by our competitors to gain market share in our core markets, our inability to compete effectively with other retailers or our inability to maintain price competitiveness. We also evaluate the market capitalization of the Company in corroborating the reasonableness of the underlying reporting unit valuations. In the fourth quarter of fiscal year 2017, we completed our quantitative assessment of potential goodwill impairment and concluded that the fair value of the Cash & Carry Smart Foodservice reporting unit exceeded its carrying value, by over 109%. Based on this excess of fair value over carrying value, we believe that reasonable variations in the estimates and assumptions used in our impairment analysis for the Cash & Carry Smart Foodservice reporting unit would not result in an indication that the reporting unit’s goodwill may be impaired. In the fourth quarter of fiscal year 2017, we also completed our quantitative assessment of potential goodwill impairment associated with the Smart & Final reporting unit and concluded that the fair value fell short of its carrying value, resulting in a goodwill impairment charge of $180.0 million. This is discussed further in Note 2, Significant Accounting Policies—Goodwill and Intangible Assets in the accompanying notes to our audited consolidated financial statements. If certain future events occur, such as changes to the Company’s long-term store growth and development plans, changes in the assumptions used to estimate the fair value of the Smart & Final banner reporting unit or a prolonged depression of the Company’s market capitalization, the Smart & Final banner reporting unit’s goodwill may require a subsequent impairment charge to be taken.

 

We evaluate our indefinite-lived intangible assets associated with trade names using a two-step approach. The first step screens for potential impairment by comparing the fair value of each trade name with its carrying value. The second step measures the amount of impairment. We determine 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. In the periods presented, we did not recognize any indefinite-lived trade name impairment loss as a result of such evaluation.

 

Finite-lived intangible assets, like other long-lived assets as required by ASC 360 (as defined below), 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.

 

Impairments of Long-Lived Assets

 

In accordance with ASC 360, Property, Plant, and Equipment, (“ASC 360”), we assess our long-lived assets, including property, plant and equipment and assets under capital leases, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We believe that impairment assessment of long-lived assets is critical to the financial statements because the recoverability of the amounts, or lack thereof, could significantly affect our results of operations. Determining whether an impairment has occurred typically requires various estimates and assumptions, including determining which cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, amount of such cash flows, and the asset’s residual value, if any. In turn, measurement of an impairment loss requires a determination of fair value, which is based on the best information available. We use internal discounted cash flow estimates and independent appraisals as appropriate to determine fair value. We derive the required cash flow estimates from our historical experience and our internal business plans and apply an appropriate discount rate. We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual identifiable cash flows are available. We regularly review our stores’ operating performance for indicators of impairment, which include a significant underperformance relative to expected historical or projected future results of operations 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 the future undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its future undiscounted cash flows, an impairment charge is recognized equal to the excess of the carrying value over the estimated fair value of the asset. We measure the fair value of our long-lived assets on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy.

 

Capitalized software costs 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 future discounted cash flows from the use of the capitalized software is less than the carrying value.

 

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Application of alternative assumptions, such as changes in estimates of future cash flows, could produce significantly different results. Because of the significance of the judgments and estimation processes, it is likely that materially different amounts could be recorded if we used different assumptions or if the underlying circumstances were to change.

 

Income Taxes

 

Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. We are subject to income taxes in the United States and Mexico.

 

Income taxes are accounted for under the balance sheet model for recording current and deferred taxes. Deferred tax assets and liabilities are measured using currently enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in income in the period that includes the enactment date. Under applicable accounting guidance, we are required to evaluate the realizability of our deferred tax assets. The realization of our deferred tax assets is dependent upon all available evidence, both positive and negative, including reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies and results of recent operations. The assumptions about future taxable income require the use of significant judgment and are consistent with the plans and estimates we are using to manage our underlying businesses. We consider objective historical evidence when evaluating future taxable income, including three years of cumulative operating income (loss). Applicable accounting guidance requires that we recognize a valuation allowance when it is more likely than not that all or a portion or all of a deferred tax asset will not be realized due to the inability to generate sufficient taxable income in future periods. Accordingly, significant accounting judgment is required in our assessment of deferred tax assets and valuation allowances when determining the provision for income taxes and related accruals.

 

The calculation of our tax liabilities involves uncertainties in the application of complex tax laws and regulations in different jurisdictions. A tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, which includes resolution of any related appeals or litigation processes, on the basis of the technical merits.

 

We record unrecognized tax benefits as liabilities and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our estimates of unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available.

 

Self-Insurance

 

We have various insurance programs related to our risks and costs associated with workers’ compensation and general liability claims. We have elected to purchase third-party insurance to cover the risk in excess of certain dollar limits established for each respective insurance program.

 

We are also responsible for the payment of claims less than the insured amount. We establish estimated accruals for our insurance programs based on certain factors, including available claims data, historical trends and experience, as well as projected ultimate costs of the claims. These accruals are based on estimates prepared with the assistance of outside actuaries, and the ultimate cost of these claims may vary from initial estimates and established accruals. We believe that the use of actuarial studies to determine self-insurance accruals represents a consistent method of measuring these subjective estimates. The actuaries periodically update their estimates and we record such adjustments in the period in which such determination is made. The inherent uncertainty of future loss projections could cause actual claims to differ from our estimates. Because of the significance of the judgments and estimation processes, it is likely that materially different amounts could be recorded if we used different assumptions or if the underlying circumstances were to change. For example, a 5% change in our insurance and self-insured claims liabilities at December 31, 2017, excluding the risk in excess of certain dollar limits related to self-insured program with our third-party insurance carriers, would have affected pre-tax income by approximately $2.3 million for fiscal year 2017. Historically, periodic adjustments to our estimates have not been material.

 

Closed Store Reserve

 

We maintain reserves for costs associated with closures of operating stores and other properties that are no longer being utilized in current operations. 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.

 

Adjustments to closed stores and other properties reserves primarily relate to changes in estimated timing and amounts of subtenant income or actual exit costs differing from original estimates. Adjustments are made for changes in estimates in the period in which the changes become known. Because of the significance of the judgments and estimation processes, it is likely that materially different amounts could be recorded if we used different assumptions or if the underlying circumstances were to change. For example, a 5% change in our closed stores and other properties reserves at December 31, 2017, would have affected pre-tax income by approximately $0.4 million for fiscal year 2017.

 

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Retirement Benefit Plans and Postretirement Benefit Plans

 

Certain of our employees are covered by a funded noncontributory qualified defined benefit pension plan. U.S. GAAP requires that we measure the benefit obligations and fair value of plan assets that determine our plans’ funded status as of our fiscal year end date.

 

The determination of our obligation and expense for retirement benefit plans and postretirement benefit plans is dependent, in part, on our selection of certain assumptions used by us and our actuaries in calculating such amounts. Those assumptions are described in Note 8, Retirement Benefit Plans and Postretirement and Postemployment Benefit Obligations, in our Annual Report on Form 10-K filed with the SEC on March 16, 2018. Pension assumptions are significant inputs to the actuarial models that measure pension benefit obligations and related effects on operations. Three assumptions, among others—discount rate, expected long-term return on plan assets and rate of compensation increases—are important elements of plan expense and asset/liability measurement. We evaluate these critical assumptions at least annually. We periodically evaluate other assumptions involving demographic factors, such as retirement age, mortality and turnover, and update them to reflect our experience and expectations for the future. In 2017, the Society of Actuaries released revised mortality scales, which update life expectancy assumptions. In consideration of these scales, we modified the mortality assumptions used in determining our retirement benefit plans and postretirement benefit plans as of December 31, 2017. The impact of these updated mortality assumptions resulted in a slight decrease to our pension, supplemental executive retirement plan (“SERP”) and postretirement benefit plan obligations and a slight decrease in future related expense. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.

 

In accordance with U.S. GAAP, the amount by which actual results differ from the actuarial assumptions is accumulated and amortized over future periods and, therefore, affects recognized expense in such future periods. While we believe our assumptions are appropriate, significant differences in actual results or significant changes in our assumptions may materially affect our pension and other postretirement obligations and future expenses.

 

We determine the discount rate using current investment yields on high quality fixed-income investments. The discount rate assumption used to determine the year-end projected benefit obligation is increased or decreased to be consistent with the change in yield rates for high quality fixed-income investments for the expected period to maturity of the pension benefits. A lower discount rate increases the present value of benefit obligations and increases pension expense. The discount rate used to determine benefit obligations for our defined benefit pension plan as of December 31, 2017 was 3.75%. The discount rate used to determine benefit obligations under our SERP as of December 31, 2017 was 3.19%. The discount rate used to determine benefit obligations under our postretirement benefit plan as of December 31, 2017 was 3.70%.

 

We determine the expected long-term rate of return on plan assets for our defined benefit pension plan using an allocation approach that considers diversification and rebalancing for a portfolio of assets invested over a long-term time horizon. The approach relies on the historical returns of the plan’s portfolio as well as relationships between equities and fixed income investments, consistent with the widely accepted capital market principle that a diversified portfolio with a larger allocation to equity investments have historically generated a greater long term return. For fiscal year 2017, the Company’s assumed rate of return for our defined benefit pension plan was 6.75%.

 

Sensitivity to changes in the major assumptions for our benefit plans are as follows (dollars in thousands):

 

Assumption

 

Change

 

Projected benefit
obligation
(decrease)increase

 

Expense
(decrease)
increase

 

Defined benefit pension plan:

 

 

 

 

 

 

 

Discount rate

 

+/- 50 bps

 

$(20,886)/$23,799

 

$(40)/$414

 

Expected long-term return on plan assets

 

+/- 50 bps

 

 

(858)858

 

SERP:

 

 

 

 

 

 

 

Discount rate

 

+/- 50 bps

 

(1,316)/1,416

 

108/547

 

Postretirement benefit plan:

 

 

 

 

 

 

 

Discount rate

 

+/- 50 bps

 

(1,119)/1,251

 

(7)/6

 

 

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Vendor Rebates and Other Allowances

 

As a component of our consolidated procurement program and consistent with standard practices in the retail industry, we frequently enter into contracts with vendors that provide for payments of rebates or other allowances. These rebates and allowances are primarily comprised of volume or purchase-based incentives, advertising allowances and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs we incur for stocking, advertising, promoting and selling the vendor’s products.

 

As prescribed by U.S. GAAP, 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 us 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. We review the relevant or significant factors affecting proper performance measures, rebates and other allowances on a recurring basis and make adjustments where the facts and circumstances dictate. We do not believe there is a reasonable likelihood that changes in the assumptions used in our estimate will have a material effect on our financial condition or results of our operations in future periods.

 

Recently Issued Accounting Pronouncements

 

See Note 3, Recent Accounting Pronouncements, to our accompanying unaudited condensed consolidated financial statements contained elsewhere in this Quarterly Report on Form 10-Q. We have determined that all other recently issued accounting standards will not have a material impact on our consolidated financial statements, or do not apply to our operations.

 

Item 3.   Quantitative and Qualitative Disclosures about Market Risk.

 

Market risk represents the risk of changes in the value of market risk sensitive instruments caused by fluctuations in interest rates, foreign exchange rates and commodity prices. Changes in these factors could cause fluctuations in the results of our operations and cash flows. In the ordinary course of business, we are primarily exposed to foreign currency and interest rate risks. We do not use derivative financial instruments in connection with these commodity market risks.

 

Commodity Risk

 

We are subject to volatility in food costs as a result of market risk associated with commodity prices. Although we typically are able to mitigate these cost increases, our ability to continue to do so, either in whole or in part, may be limited by the competitive environment we operate in.

 

Interest Rate Market Risk

 

Based on our variable rate debt balance as of March 25, 2018, a 1% increase in interest rates would increase our annual interest cost by approximately $4.8 million. This impact reflects any offset from our current hedging activities. A decrease of 1% in interest rates would decrease our annual interest cost by $4.8 million due to an interest rate floor that exists on the Term Loan Facility and current hedging activities.

 

Foreign Currency Exchange Rate Market Risk

 

We are exposed to market risks relating to fluctuations in foreign exchange rates between the U.S. dollar and other foreign currencies, primarily the Mexican Peso. Our exposure to foreign currency risk is limited to our operations in Mexico and the equity earnings of our joint venture. Such exposure, as of March 25, 2018, is primarily related to our $15.8 million equity investment in the Mexico joint venture. The remainder of our business is conducted in U.S. dollars and thus is not exposed to fluctuation in foreign currency. We do not hedge our foreign currency exposure and therefore are not exposed to such hedging risk.

 

Item 4. Controls and Procedures.

 

Evaluation of Disclosure Controls and Procedures

 

Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a- 15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed in the reports that we file or submit under the Exchange Act has been appropriately recorded, processed, summarized and reported on a timely basis and are effective in ensuring that such information is accumulated and communicated to the Company’s management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Based on such evaluation, our CEO and CFO have concluded that, as of March 25, 2018, our disclosure controls and procedures are effective.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in the Company’s internal control over financial reporting for the twelve weeks ended March 25, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Part II - OTHER INFORMATION

 

Item 1.   Legal Proceedings.

 

On February 11, 2016, we received a subpoena from the District Attorney for the County of Yolo, California, seeking information concerning our handling, disposal and reverse logistics of potential hazardous waste at our stores and distribution centers in California. We have provided information and are cooperating with the authorities from multiple counties in California in connection with this ongoing matter. In the fourth quarter of 2016, we recorded a loss related to this matter in an amount considered to be immaterial. In the second quarter of 2017 and the first quarter of 2018, the Company recorded additional losses related to this matter in amounts considered to be immaterial. Due to the developing status of this matter and the uncertainty of its outcome, we cannot reasonably estimate possible additional loss or range of additional loss that may arise from this matter or whether this matter will have a material impact on our financial condition or operating results.

 

We are 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 our business activities. We do not believe that the ultimate resolution of these pending claims will have a material adverse effect on our business, financial condition, results of operations or cash flows. However, litigation is subject to many uncertainties, and the outcome of certain individual litigated matters may not be reasonably predictable and any related damages may not be estimable. Some litigation matters could result in an adverse outcome to the Company, and any such adverse outcome could have a material adverse effect on its business, financial condition, results of operations or cash flows.

 

Item 1A.   Risk Factors.

 

For a discussion of our potential risks and uncertainties, see the information in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K, for the year ended December 31, 2017 filed with the SEC on March 16, 2018. There have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K.

 

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds.

 

None.

 

Item 3.   Defaults Upon Senior Securities.

 

None.

 

Item 4.   Mine Safety Disclosures.

 

Not applicable.

 

Item 5.  Other Information.

 

None.

 

Item 6.   Exhibits.

 

Exhibit

 

 

No.

 

Description

 

 

 

3.1

 

Second Amended and Restated Certificate of Incorporation of Smart & Final Stores, Inc. (1)

3.2

 

Second Amended and Restated Bylaws of Smart & Final Stores, Inc. (1)

31.1

 

Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2

 

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

32.1

 

Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

101.INS

 

XBRL Instance Document*

101.SCH

 

XBRL Taxonomy Extension Schema Document*

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document*

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document*

 

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101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document*

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document*

 


* Filed herewith

 

(1) Filed as an exhibit to Amendment No. 5 to the Registrant’s Registration Statement on Form S-1 (File No. 333-196931) filed with the SEC on September 22, 2014, and incorporated herein by reference.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the persons undersigned thereunto duly authorized.

 

 

SMART & FINAL STORES, INC.

 

(Registrant)

 

 

May 2, 2018

/s/ DAVID G. HIRZ

 

David G. Hirz

 

Chief Executive Officer

 

(Principal Executive Officer)

 

 

May 2, 2018

/s/ RICHARD N. PHEGLEY

 

Richard N. Phegley

 

Chief Financial Officer

 

(Principal Financial Officer)

 

40


Exhibit 31.1

 

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER

PURSUANT TO SECTION 302

OF THE SARBANES-OXLEY ACT OF 2002

 

I, David G. Hirz, certify that:

 

1.                                       I have reviewed this Form 10-Q of Smart & Final Stores, Inc.;

 

2.                                       Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.                                       Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.                                       The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

(a)                               Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

(b)                               Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 

(c)                                Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

(d)                               Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.                                       The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions);

 

(a)                               All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

(b)                               Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Date: May 2, 2018

 

 

 

 

/s/ DAVID G. HIRZ

 

David G. Hirz

 

Chief Executive Officer

 

(Principal Executive Officer)

 


Exhibit 31.2

 

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER

PURSUANT TO SECTION 302

OF THE SARBANES-OXLEY ACT OF 2002

 

I, Richard N. Phegley, certify that:

 

1.                                       I have reviewed this Form 10-Q of Smart & Final Stores, Inc.;

 

2.                                       Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.                                       Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.                                       The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

(a)                               Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

(b)                               Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 

(c)                                Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

(d)                               Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.                                       The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions);

 

(a)                               All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

(b)                               Any fraud, whether or not material, that involves management or other employees who have a significant role in the