UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

(Mark One)

 

 

For the quarterly period ended September 28, 2014

 

OR

 

 

For the transition period from to

 

Commission File Number 001-35880

 

Fairway Group Holdings Corp.

(Exact name of registrant as specified in its charter)

 

 

2284 12th Avenue

New York, New York 10027

(646) 616-8000

(Registrant’s telephone number, including area code)

 

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  ☐ No

 

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  ☐ No

 

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

 

 

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

 

As of October 31, 2014, the registrant had 29,234,001 shares of Class A common stock and 14,225,455 shares of Class B common stock outstanding.

 

 

 

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Fairway Group Holdings Corp.

Quarterly Report on Form 10-Q

For the quarterly period ended September 28, 2014

Table of Contents

 

 

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains forward-looking statements that are subject to risks and uncertainties. All statements other than statements of historical fact included in this report are forward-looking statements. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “forecast,” “continue,” “plan,” “intend,” “believe,” “may,” “will,” “should,” “can have,” “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events. For example, all statements we make relating to our estimated and projected store openings, costs, expenditures, cash flows, growth rates and financial results, our plans and objectives for future operations, growth or initiatives, strategies or the expected outcome or impact of pending or threatened litigation are forward-looking statements. All forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we expected, including:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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We derive many of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and it is impossible for us to anticipate all factors that could affect our actual results. Important factors that could cause actual results to differ materially from our expectations or cautionary statements are disclosed under the sections entitled “Item 1A—Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended March 30, 2014 and “Part I—Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report. All written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the cautionary statements as well as other cautionary statements that are made from time to time in our other filings with the Securities and Exchange Commission (“SEC”) and public communications. You should evaluate all forward-looking statements made in this report in the context of these risks and uncertainties, and you should not rely upon forward-looking statements as predictions of future events.

 

We caution you that the important factors described in the Risk Factors and Management’s Discussion and Analysis of Financial Condition and Results of Operations may not be all of the factors that are important to you. In addition, we cannot assure you that we will realize the results or developments we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our operations in the way we expect. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the

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extent to which any factor, or combination of factors, may cause actual results to differ materially and adversely from those contained in any forward-looking statements we may make. The forward-looking statements included in this Quarterly Report on Form 10-Q are made only as of the date hereof. We undertake no obligation to publicly update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law.

 

Unless we state otherwise or the context otherwise requires, the terms “we,” “us,” “our,” “Fairway,” “Fairway Market,” “the Company,” “our business” and “our company” refer to Fairway Group Holdings Corp. and its consolidated subsidiaries as a combined entity.

 

 

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Part I — Financial Information

Item 1. FINANCIAL STATEMENTS

 

FAIRWAY GROUP HOLDINGS CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

(In thousands, except per share amounts)

 

 

 

The accompanying notes are an integral part of these consolidated financial statements

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FAIRWAY GROUP HOLDINGS CORP. AND SUBSIDIARIES

Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 

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FAIRWAY GROUP HOLDINGS CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these consolidated financial statements

 

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FAIRWAY GROUP HOLDINGS CORP. AND SUBSIDIARIES

Consolidated Statement of Changes in Stockholders’ (Deficit) Equity

(In thousands)

(Unaudited)

 

 

The accompanying notes are an integral part of these financial statements

 

 

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FAIRWAY GROUP HOLDINGS CORP. AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

 

1.DESCRIPTION OF BUSINESS AND ORGANIZATION

 

Fairway Group Holdings Corp. was incorporated in the State of Delaware on September 29, 2006 and is controlled by investment funds managed by Sterling Investment Partners and affiliates (collectively, “Sterling”).

 

Fairway Group Holdings Corp. and subsidiaries (the “Company” or “Fairway”) operates in the retail food industry, selling fresh, natural and organic products, prepared foods and hard to find specialty and gourmet offerings along with a full assortment of conventional groceries.  The Company operates fifteen stores in the Greater New York metropolitan area, three of which include Fairway Wine & Spirits locations.  Twelve of the stores were in operation prior to the beginning of the fiscal year ended March 30, 2014 (“fiscal 2014”), two stores were opened during fiscal 2014 (one store was opened during the thirteen weeks ended September 29, 2013, and one store was opened subsequent to the thirteen weeks ended September 29, 2013) and one store was opened during the thirteen weeks ended September 28, 2014.    Seven of the Company’s food stores, which the Company refers to as “urban stores,” are located in New York City and the remainder, which the Company refers to as “suburban stores,” are located in New York (outside of New York City), New Jersey and Connecticut. The Company has determined that it has one reportable segment.  Substantially all of the Company’s revenue comes from the sale of items at its retail food stores.

 

On April 22, 2013, the Company completed its initial public offering (“IPO”) of 15,697,500 shares of its Class A common stock at a price of $13.00 per share, which included 13,407,632 new shares sold by Fairway and the sale of 2,289,868 shares by existing stockholders (including 2,047,500 sold pursuant to the underwriters exercise of their over-allotment option). The Company received approximately $158.8 million in net proceeds from the IPO after deducting the underwriting discount and expenses related to the IPO. The Company did not receive any of the proceeds from the sale of shares by the selling stockholders. In connection with the IPO, the Company issued 15,504,296 shares of Class B common stock (of which 33,576 shares automatically converted into 33,576 shares of Class A common stock) in exchange for all outstanding preferred stock and all accrued dividends not paid in cash with the proceeds of the IPO.

 

2.BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, these financial statements do not include all of the information and footnotes required for complete financial statements in accordance with US GAAP, pursuant to such rules and regulations. Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the fiscal year ended March 30, 2014.

 

The accompanying unaudited consolidated financial statements as of September 28, 2014, and for the thirteen and twenty-six weeks ended September 28, 2014 and September 29, 2013 reflect all adjustments (consisting only of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position and operating results of the Company. All material intercompany accounts and transactions have been eliminated in the unaudited consolidated financial statements. The results of operations for any interim period may not necessarily be indicative of the results that may be expected for the entire fiscal year.

 

There have been no changes to the Company’s significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended March 30, 2014 that have had a material impact on the Company’s unaudited interim consolidated financial statements and related notes.

 

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3.NET LOSS PER COMMON SHARE

 

Basic and diluted net loss per common share is calculated by dividing net loss attributable to common stockholders by the weighted average common shares outstanding for the fiscal period.  Diluted net loss per common share is calculated by dividing net loss attributable to common stockholders by the weighted average common shares outstanding for the fiscal period plus the effect of any potential common shares that have been issued if these additional shares are dilutive.  For all periods presented, basic and diluted net loss per common share are the same, as any additional common stock equivalents would be anti-dilutive.

 

The following table is a summary of the share amounts (in thousands) used in computing earnings per share:

 

 

As of September 28, 2014, all of the options to purchase shares of Class A common stock have exercise prices in excess of the Company’s publicly quoted stock price and therefore are not considered potentially dilutive.

 

4.GOODWILL AND INTANGIBLE ASSETS

 

The Company’s annual goodwill impairment test is conducted on the first day of the fourth quarter of each fiscal year and interim evaluations are performed when it is determined that events or changes in circumstances exist that would more likely than not reduce the fair value of its goodwill below its carrying value.  During the thirteen weeks ended September 28, 2014, due to a continued decline in the market price of the Company’s stock and revisions in expected operating performance, it was determined that such events and circumstances exist, which would require an interim evaluation of goodwill for impairment. As a result of these developments, the Company has accelerated the timing of its goodwill impairment test, which is expected to be completed during the third quarter of fiscal year 2015, at which time a determination may be made that some or all of the carrying value of goodwill is impaired.

 

There were no goodwill or intangible asset impairments recorded in the twenty-six weeks ended September 28, 2014 and September 29, 2013.   As of September 28, 2014 the carrying value of goodwill and tradenames were $95.4 million and $23.6 million, respectively.

 

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5.LONG-TERM DEBT

 

A summary of long-term debt is as follows (in thousands):

 

 

 

 

A summary of interest expense is as follows (in thousands):

 

 

 

 

2013 Senior Credit Facility

 

In February 2013, Fairway Group Holdings Corp. and its wholly-owned subsidiary, Fairway Group Acquisition Company, as the borrower, entered into a senior secured credit facility consisting of a $275 million term loan (the “2013 Term Facility”) and a $40 million revolving credit facility, which includes a $40 million letter of credit sub-facility (the “2013 Revolving Facility” and together with the 2013 Term Facility, the “2013 Senior Credit Facility”) with the 2013 Term Facility maturing in August 2018 and the 2013 Revolving Facility maturing in August 2017. The Company used the proceeds from the 2013 Term Facility to repay the $264.5 million of outstanding borrowings (including accrued interest) under its 2012 Senior Credit Facility and pay fees and expenses.  On May 3, 2013, the 2013 Senior Credit Facility was amended to, among other things, lower the interest rate margins and eliminate the interest coverage ratio financial covenant.

 

Borrowings under the 2013 Senior Credit Facility, as amended, bear interest, at the option of the Company, at (i) adjusted LIBOR (subject to a 1.0% floor) plus 4.0% or (ii) an alternate base rate plus 3.0%. In addition, there is a fee payable quarterly in an amount equal to 1.0% per annum of the undrawn portion of the 2013 Revolving Facility, calculated based on a 360-day year. Interest is payable quarterly in the case of base rate loans and on the maturity dates or every three months, whichever is shorter, in the case of adjusted LIBOR loans. The 4.0% and 3.0% margins will each be reduced by 50 basis points at any time when the Company’s corporate family rating from Moody’s Investor Services Inc. is B2 or higher and the Company’s corporate rating from Standard & Poors Rating Service is B or higher, in each case with a stable outlook, and as long as certain events of default have not occurred.  Prior to the May 2013 amendment, borrowings under the 2013 Senior Credit Facility bore interest, at the option of the Company, at (i) adjusted LIBOR (subject to a 1.25% floor) plus 5.50% or (ii) an alternate base rate plus 4.50%.

 

All of the borrower’s obligations under the 2013 Senior Credit Facility, as amended, are unconditionally guaranteed (the “Guarantees”) by Fairway Group Holdings Corp. and subsidiaries (other than the borrower and any future unrestricted subsidiaries as the Company may designate, at its discretion, from time to time) (the “Guarantors”).

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Additionally, the 2013 Senior Credit Facility and the Guarantees are secured by a first-priority perfected security interest in substantially all present and future assets of the borrower and each Guarantor, including accounts receivable, property and equipment, merchandise inventories, general intangibles, leases, intellectual property, investment property and intercompany notes among Guarantors.

 

Mandatory prepayments under the 2013 Senior Credit Facility, as amended, are required with: (i) 50% of adjusted excess cash flow (which percentage shall be reduced to 25% upon achievement and maintenance of a leverage ratio of less than 5.0:1.0, and to 0% upon achievement and maintenance of a leverage ratio of less than 4.0:1.0); (ii) 100% of the net cash proceeds of asset sales or other dispositions of property by the Company and certain of its subsidiaries (subject to certain exceptions and reinvestment provisions); and (iii) 100% of the net cash proceeds of issuances, offerings or placements of debt obligations (subject to certain exceptions).

 

The 2013 Senior Credit Facility, as amended, contains negative covenants, including restrictions on: (i) the incurrence of additional debt; (ii) liens and sale-leaseback transactions; (iii) loans and investments; (iv) guarantees and hedging agreements; (v) the sale, transfer or disposition of assets and businesses; (vi) dividends on, and redemptions of, equity interests and other restricted payments, including dividends and distributions to the Company by its subsidiaries; (vii) transactions with affiliates; (viii) changes in the business conducted by the Company; (ix) payment or amendment of subordinated debt and organizational documents; and (x) maximum capital expenditures. The Company is also required to comply with a maximum total leverage ratio financial covenant.

 

The Company was in compliance with all applicable affirmative, negative and financial covenants of the 2013 Senior Credit Facility at September 28, 2014.  Because the Company’s recent operating performance has been below the Company’s expectations at the time that the financial covenants in its senior credit facility were established, if the Company’s financial performance does not improve it is possible that the Company will not meet the maximum total leverage ratio financial covenant at some point within the next twelve months. In the event of a covenant violation that remains uncured, the lenders have the right to declare all outstanding debt under the Senior Credit Facility immediately due and payable.  The Company has the ability to exercise equity cure rights, which allows for the issuance of additional equity and for the proceeds to be treated as EBITDA for purposes of the covenant, subject to certain restrictions, including that the amount of equity that can be used as EBITDA cannot exceed the EBITDA shortfall, the proceeds must be used to repay debt, and the equity cure can only be used twice within a four quarter period and only four times during the term of the loan.

 

The 2013 Senior Credit Facility resulted in the Company capitalizing new deferred financing fees of approximately $800,000 in fiscal 2013, to be amortized over the life of the loan on the effective interest method. These costs included administrative fees, advisory fees, title fees, and legal and accounting fees.

 

The Company reviewed the terms of the 2013 Senior Credit Facility and ascertained that the conditions had been met, pursuant to the FASB’s guidance, to treat the transaction as a debt modification.  In connection with the modification of the 2012 senior credit facility, (i) the unamortized original issue discount of approximately $11.8 million relating to the 2012 senior credit facility and (ii) debt placement fees of approximately $3.6 million in connection with the 2013 Senior Credit Facility are collectively reflected as original issue discount, to be amortized over the life of the loan on the effective interest method.

 

The amendment of the 2013 Senior Credit Facility in May 2013 resulted in the Company capitalizing new deferred financing fees of approximately $500,000 in fiscal 2014, to be amortized over the remaining life of the loan using the effective interest method.  Additionally, as a result of the accounting treatment applied to this amendment of debt modification, (i) the unamortized original issue discount of approximately $14.7 million relating to the 2013 Senior Credit Facility and (ii) debt placement fees of approximately $3.4 million in connection with the amendment, are collectively reflected as original issue discount, to be amortized over the life of the loan using the effective interest method.

 

At September 28, 2014, the Company had $28.1 million of outstanding letters of credit, and $11.9 million of availability under the 2013 Revolving Facility, all of which was available for letters of credit. 

 

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6.REDEEMABLE PREFERRED STOCK, COMMON STOCK AND WARRANTS

 

On April 12, 2013, the Company amended and restated its certificate of incorporation to increase the number of shares the Company is authorized to issue to 150,000,000 shares of Class A common stock, 31,000,000 shares of Class B common stock and 5,000,000 shares of preferred stock. The amendment and restatement of the certificate of incorporation implemented an internal recapitalization pursuant to which the Company effected a 118.58-for-one stock split on its outstanding common stock and reclassified its outstanding common stock into shares of Class A common stock. The Class A common stock and Class B common stock have identical rights, except voting and conversion rights. Each share of Class A common stock is entitled to one vote. Each share of Class B common stock is entitled to ten votes and is convertible at any time into one share of Class A common stock.

 

On April 22, 2013, the Company completed its IPO of 15,697,500 shares of its Class A common stock at a price of $13.00 per share, which included 13,407,632 new shares sold by Fairway and the sale of 2,289,868 shares (including 95,386 shares issued upon exercise of outstanding warrants) by existing stockholders (including 2,047,500 sold pursuant to the underwriters exercise of their over-allotment option). In connection with the Company’s IPO, the Company issued 15,504,296 shares of Class B common stock (of which 33,576 shares automatically converted into 33,576 shares of Class A common stock) in exchange for all outstanding preferred stock and all accrued dividends not paid in cash with the proceeds of the IPO.    The Company used a portion of the net proceeds from its IPO to repay approximately $19.1 million of accrued but unpaid dividends on its Series A preferred stock and approximately $57.7 million of accrued but unpaid dividends on its Series B preferred stock.  Because the Company and the preferred stockholders had entered into an agreement to exchange the preferred stock for a fixed number of shares of Class B common stock based on (i) an assumed IPO price of $11.00 per share, (ii) an assumption that $65.0 million of accrued dividends would be paid in cash with the proceeds of the IPO and (iii) the fact that the number of shares of Class B common stock to be issued in the exchange would not change if the Company decreased or increased the amount of accrued dividends that it paid in cash with the net proceeds of the offering, and because the IPO price was greater than $11.00 per share and the amount of dividends paid in cash with the proceeds of the offering increased, the Company recognized an incremental dividend of approximately $42.8 million, consisting of approximately $11.8 million, representing the additional cash proceeds used to pay dividends, and approximately $31.0 million, representing an amount equal to the number of shares of Class B common stock the Company issued multiplied by $2.00, the difference between the $13.00 IPO price and the $11.00 price the Company used to calculate the number of shares of Class B common stock to be issued by the Company in exchange for the preferred stock and accrued but unpaid dividends.

 

As of September 28, 2014 there were no warrants outstanding.

 

7.STOCK-BASED COMPENSATION

 

The Company accounts for stock-based compensation awards in accordance with the provisions of FASB Accounting Standards Codification (“ASC”) Topic 718 — Compensation — Stock Compensation (“ASC 718”), which requires companies to estimate the fair value of share-based payment awards on the date of grant. The value of the portion of the awards ultimately expected to vest is recognized as expense over the requisite service period. The Company recognized total stock-based compensation of $4.2 million and $2.8 million for the thirteen weeks ended September 28, 2014 and September 29, 2013, respectively, and $7.0 million and $4.8 million for the twenty-six weeks ended September 28, 2014 and September 29, 2013, respectively, as general and administrative expenses in the Company’s Consolidated Statements of Operations.

 

Included in the amounts recorded for the thirteen weeks and twenty-six weeks ended September 28, 2014 are: (i) approximately $96,000 and $192,000, respectively, representing the value of restricted stock units issued to certain directors during such period in payment of the directors’ fees for each of the corresponding calendar quarters ended June 30, 2014 and September 30, 2014; (ii) approximately $41,000 and $82,000, respectively, representing the value of restricted stock units issued during such period to our executive chairman in payment of his fees for serving as executive chairman for each of the corresponding calendar quarters; and  (iii) $187,500 and $375,000, respectively, representing the value of restricted stock units granted in such period to an executive officer in partial payment of his salary for each of the corresponding calendar quarters.  All of these restricted stock units are vested upon issuance but will be settled in shares of Class A common stock in the future.

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The Company’s 2007 Equity Compensation Plan (the “2007 Plan”), which provided for the grant of stock options and restricted shares, and the 2013 Long-Term Incentive Plan (the “2013 Plan”), which provides for the grant of stock options, restricted stock units, restricted stock, other stock-based awards and other cash-based awards, are more fully described in the Company’s Annual Proxy Statement for its 2014 annual meeting of stockholders filed with the Securities and Exchange Commission on June 26, 2014 under the caption “Executive Compensation—Equity Compensation Plans.”  Changes in equity awards outstanding under the 2007 Plan and 2013 Plan during the thirteen and twenty-six weeks ended September 28, 2014 are summarized as follows:

 

2007 Equity Compensation Plan 

 

As of September 28, 2014, there was $236,000 of unrecognized compensation expense related to the restricted stock awards granted under the 2007 Plan.

 

The status of the Company’s unvested restricted stock grants for the twenty-six weeks ended September 28, 2014 is summarized as follows:

 

 

 

 

2013 Long-Term Incentive Plan

 

Restricted Stock Units

 

As of September 28, 2014, there was $17.2 million of unrecognized compensation expense related to the restricted stock unit awards granted under the 2013 Plan.

 

The status of the Company’s unvested restricted stock units for the twenty-six weeks ended September 28, 2014 is summarized as follows:

 

 

 

During the thirteen weeks ended September 28, 2014, the Company settled 57,395 outstanding restricted stock units upon their vesting in exchange for $260,000 of cash, which approximates the fair value of the shares at the vesting date.  The amount of cash paid was recorded as a reduction of the stock-based compensation charge as a component of additional paid-in capital.

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Stock Options

 

As of September 28, 2014, there was $2.4 million of unrecognized compensation expense related to the stock option compensation awards granted under the 2013 Plan.

 

A summary of stock option activity for the twenty-six weeks ended September 28, 2014 is as follows:

 

 

 

Stock options outstanding as of September 28, 2014 had no aggregate intrinsic value.  Aggregate intrinsic value represents the value of the Company’s stock based on the closing stock price on the last trading day of the fiscal period in excess of the weighted average exercise price multiplied by the number of options outstanding or exercisable.  No options were exercised during the twenty-six weeks ended September 28, 2014.

 

8.RELATED PARTY TRANSACTIONS

 

Operating Leases and Utility Services

 

A director and executive officer of the Company:

 

 

 

 

Total amounts related to the foregoing included $1.5 million and $1.4 million in costs of sales and $0.1 million and $0.1 million in general and administrative expenses for the thirteen weeks ended September 28, 2014 and September 29, 2013, respectively, and $2.9 million in cost of sales and $0.3 million in general and administrative expenses for each of the twenty-six weeks ended September 28, 2014 and September 29, 2013.  At September 28, 2014 and March 30, 2014, amounts payable to related parties included in accrued expenses were  $1.1 million and $0.9 million,  respectively, and receivables of $0.3 million and $0, respectively, were included in accounts receivable.    

 

Management Agreement

 

Prior to the Company’s IPO, pursuant to a management agreement, the Company paid Sterling Investment Partners Advisers, LLC, an affiliate of the Company’s controlling stockholders, an annual management advisory fee and fees in connection with certain debt and equity financings (other than the IPO).  The management agreement was terminated as part of the IPO in exchange for a payment of $9.2 million.

 

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9.INCOME TAXES

 

The reconciliation of the U.S. statutory rate with the Company’s effective tax rate for the thirteen and twenty-six weeks ended September 28, 2014 and September 29, 2013 is summarized as follows:

 

 

 

 

As a result of historical net operating losses (“NOLs”), the Company currently provides a full valuation allowance against its net deferred tax assets.  For the thirteen and twenty-six weeks ended September 28, 2014 and September 29, 2013, income tax expense was computed at the estimated annual effective rate based on the total estimated annual tax provision which included state income taxes and a deferred tax provision related to amortization of certain indefinite-lived intangible assets.  

 

Based on management’s assessment, the Company has placed a valuation reserve against its deferred tax assets as it is more likely than not that the Company may not generate sufficient taxable income during the carryforward period to utilize the NOLs.  The Company regularly reviews the net deferred tax valuation allowance to determine if available evidence continues to support the position that it is more likely than not that a portion of or the entire deferred tax asset will not be realized in the future. As of September 28, 2014, management could not conclude that it is more likely than not that the deferred tax assets will be realized. As a result, the Company will continue to maintain a full valuation allowance against its deferred tax assets. The Company will continue to assess its position in future periods to determine if it is appropriate to reduce a portion of its valuation allowance in the future.

 

For more information regarding the Company’s valuation allowance against its deferred tax assets, please see note 13 to the Company’s audited financial statements included in its Annual Report on Form 10-K for the fiscal year ended March 30, 2014.

 

The valuation allowance was 103.1 million and $90.7 million as of September 28, 2014 and March 30, 2014, respectively.

 

10.COMMITMENTS AND CONTINGENCIES

 

Operating Leases 

 

The Company occupies premises pursuant to non-cancelable lease agreements, including the lease agreements with related parties as described in Note 8, which were assigned to the Company as of January 18, 2007.  These leases expire through 2039.  Rent under these lease agreements, except for certain lease years when the rent is determined by arbitration, increases annually by a combination of escalation clauses and either 50% of the percentage increase in the consumer price index, or by the percentage increase in the consumer price index of up to 5%.  Lease agreements with non-related parties include various escalation clauses.

 

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The aggregate minimum rental commitments under all operating leases, for which the Company has possession, as of September 28, 2014 are as follows for the fiscal years ending (in thousands):

 

 

 

In addition, the Company has signed certain leases for which the Company’s obligation is not yet established because the Company does not yet have possession of the site. 

 

Rent expense for the twenty-six weeks ended September 28, 2014 and September 29, 2013 was approximately $21.7 million and $18.3 million, respectively.  Rent expense for the thirteen weeks ended September 28, 2014 and September 29, 2013 was approximately $11.4 million and $9.5 million, respectively.

 

Other Contingencies 

 

The Company obtains its utility services for the Red Hook store from an entity which is 16.67% owned by an individual who is a Company director and executive officer.  The Company believes that the entity has overcharged for utilities since its initial occupancy of the premises.  Since November 2008, with the exception of the post-Hurricane Sandy period through fiscal 2014, when the Company received utilities from the local utility provider because the co-generation plant was not operational, the Company has taken deductions from the utility invoices based on the methodology that the Company believes represents the parties’ original intentions with respect to the utility calculations.  The Company believes that it will be successful in negotiating an amicable resolution of this matter between the parties.  The Company also believes that the resolution of this matter will not have a material adverse effect on its financial condition and results of operations.

 

In February and March 2014, three purported securities class action lawsuits alleging violation of the federal securities laws were filed in the United States District Court for the Southern District of New York against the Company and certain of its current and former officers, certain of its directors and the underwriters for its initial public offering. The actions were consolidated on June 3, 2014 under the caption In re Fairway Group Holdings Corp. Securities Litigation, No. 14-cv-0950. On July 18, 2014, an amended class action complaint was filed, adding affiliates of Sterling Investment Partners as defendants. The complaint seeks unspecified damages and alleges misleading statements in the registration statement and prospectus for the Company’s initial public offering and in subsequent communications regarding its business and financial results. On September 5, 2014, the Company and the other defendants moved to dismiss the amended class action complaint. In April 2014, a purported stockholder derivative action was filed against certain of the Company’s directors in New York state court, asserting claims for breach of fiduciary duties and gross mismanagement based on substantially similar allegations as in the securities class action. In June 2014, the Company and the other defendants moved to dismiss the derivative complaint. On July 30, 2014, plaintiffs filed an amended complaint, adding affiliates of Sterling Investment Partners as defendants and asserting claims against them for breach of fiduciary duty and unjust enrichment. On September 29, 2014, the Company and the other defendants moved to dismiss the amended derivative complaint.  While the Company believes the claims are without merit and intends to defend these lawsuits vigorously, the Company cannot predict the outcome of these lawsuits.

 

In May 2014, a purported wage and hour class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company and certain of its current and former officers and employees.  This suit alleges, among other things, that certain of the Company’s past and current employees were not properly compensated in accordance with the overtime provisions of the Fair Labor Standards Act.  While the Company believes that these claims are without merit and intends to defend the matter vigorously, the Company cannot predict the outcome of this litigation.

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The Company, from time to time, is and may be subject to legal proceedings and claims which arise in the ordinary course of its business.  The Company has not accrued any amounts in connection with these uncertainties, including those discussed above, as the Company has determined that losses from these uncertainties are not probable.  For all matters, including unasserted claims, where a loss is reasonably possible, the aggregate range of estimated losses is not material to the financial position, results of operations, liquidity or cash flows of the Company.

 

Regardless of the outcome, these matters or future litigation may require significant attention from management and could result in significant legal expenses, settlement costs or damage awards that could have a material impact on the Company’s financial position, results of operations and cash flows.

 

11.RECENTLY ISSUED ACCOUNTING STANDARDS

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers.  ASU 2014-09 amends existing revenue recognition requirements and provides a new comprehensive revenue recognition model requiring entities to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period.  This guidance will be effective for the Company in the first quarter of its fiscal year ending April 1, 2018.  The Company is currently evaluating the potential impact of ASU No. 2014-09 on its financial statements.

 

In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.  ASU 2014-15 requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. ASU 2014-15 is effective for the fiscal years ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. The Company is currently evaluating the new guidance to determine the impact it will have on its consolidated financial statements.    

 

 

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

 

You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended March 30, 2014, as filed with the Securities and Exchange Commission. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q.  See “Special Note on Forward Looking Statements” above. The results of operations for the thirteen and twenty-six weeks ended September 28, 2014 may not necessarily be indicative of the results that may be expected for the entire fiscal year ending March 29, 2015.

 

Our fiscal year is the 52- or 53-week period ending on the Sunday closest to March 31. For ease of reference, we identify our fiscal years by reference to the calendar year in which the fiscal year ends. Accordingly, “fiscal 2014” refers to our fiscal year ended on March 30, 2014 and “fiscal 2015” refers to our fiscal year ending March 29, 2015.

 

Overview

 

Fairway Market is a growth-oriented food retailer offering customers a differentiated one-stop shopping experience “Like No Other Market”. Since beginning as a small neighborhood market in the 1930s, Fairway has established itself as a leading food retailing destination in the Greater New York City metropolitan area, an approximately $30 billion food retail market that is the largest in the United States. Our stores emphasize an extensive selection of fresh, natural and organic products, prepared foods and hard-to-find specialty and gourmet offerings, along with a full assortment of conventional groceries. Our prices typically are lower than natural/specialty stores and competitive with conventional supermarkets. We believe that the combination of our broad product selection, in-store experience and value pricing creates a premier food shopping experience that appeals to a broad demographic.

 

We operate 15 locations in New York, New Jersey and Connecticut, three of which include Fairway Wines & Spirits locations.  Twelve of the stores were in operation prior to the beginning of fiscal 2014, two stores were opened during fiscal 2014 (one during the thirteen weeks ended September 29, 2013, and one subsequent to September 29, 2013) and one store was opened during the thirteen weeks ended September 28, 2014. 

 

Outlook

 

We plan to continue our growth by improving sales at existing stores and expanding our store base in our existing geographic footprint.  Our current outlook is based on our near-term focus on improving operations at our existing stores, as well as balancing our real estate pipeline with our desire to ensure that we have adequate capital resources.  Over time, we also plan to expand Fairway’s presence into new, high-density metropolitan markets. Based on demographic research conducted for us in 2012 by the Buxton Company, a customer analytics research firm, we believe, based on these demographics, we have the opportunity to more than triple the number of stores in our existing marketing region of the Greater New York City metropolitan area, the Northeast market (from New England to the District of Columbia) can support up to 90 stores and the U.S. market can support more than 300 additional stores (including stores in the Northeast) operating under our current format.

 

We believe that we are well positioned to capitalize on evolving consumer preferences and other key trends currently shaping the food retail industry. These trends include an increasing consumer focus on the shopping experience and on healthy eating choices and fresh, quality offerings, including locally sourced products, as well as growing interest in high-quality, value-oriented private label product offerings.

 

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We also intend to improve our operating margins over time through improved business processes, the use of technology, improvements in shrink and procurement and better cost discipline, as well as enhancements to our merchandising and marketing.  We also expect to benefit from economies of scale as our store base grows over time.

 

Factors Affecting Our Operating Results

 

Various factors affect our operating results during each period, including:

 

Store Openings

 

Our results of operations have been and will continue to be materially affected by the timing and number of new store openings and the amount of new store opening costs. For example, we typically incur higher than normal costs at the time of a new store opening associated with set-up and other opening costs. New store operating margins are also affected by promotional discounts and other marketing costs and strategies associated with new store openings, as well as higher shrink and costs related to hiring and training new employees. Additionally, promotional activities may result in higher than normal net sales in the first several weeks following a new store opening. A new store typically builds its sales volume and its customer base over time and, as a result, generally has lower margins and higher operating expenses, as a percentage of sales, than our more mature stores. A new store can take more than a year to achieve a level of operating performance comparable to our similarly existing stores. Stores that we have opened in higher density urban markets typically have generated higher sales volumes and margins than stores in suburban areas.

 

We believe our differentiated format and destination one-stop shopping appeal attracts customers from as far as 25 miles away. As we open new stores in closer proximity to our customers who currently travel longer distances to shop at our stores, we expect some of these customers to take advantage of the convenience of our new locations. As a result, we have experienced in the past, and expect to experience in the future, some sales transfer from our existing stores to our new stores as some of our existing customers switch to these new, closer locations. While sales transfer adversely affects same store sales comparisons, we believe that by making shopping at our stores for those customers who travel longer distances more convenient, our overall sales to these customers will increase as they increase the frequency and amount of purchases from our stores.

 

Infrastructure Investment

 

Our historical operating results reflect the impact of our ongoing investments in infrastructure to support our growth. We have made significant investments in management, information technology systems, infrastructure, compliance and marketing. These investments include significant additions to our company’s personnel, including experienced industry executives and the next generation management and merchandising teams to support our long-term growth objectives.

 

Pricing Strategy

 

Our strategy is to price our broad selection of fresh, natural and organic foods, hard-to-find specialty and gourmet items and prepared foods at prices typically lower than those of natural / specialty stores. We price our full assortment of conventional groceries at prices competitive with those of conventional supermarkets.

 

Changes in Interest Expense

 

Our interest expense in any particular period is impacted by our overall level of indebtedness during that period and changes in the interest rates payable on such indebtedness. In February 2013, we refinanced our $300 million credit facility with a new senior credit facility, consisting of $275 million of term debt and a revolving credit facility of $40 million, principally to lower the interest rate we pay.  In May 2013, we amended our senior credit facility to lower the interest rate we pay, which reduced our annualized cash interest payments by approximately $4.8 million. The fees and expenses incurred in connection with the amendment were recovered through reduced interest payments by the end of fiscal 2014.

 

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Effect of Hurricane Sandy

 

We temporarily closed all of our stores as a result of Hurricane Sandy, which struck the Greater New York City metropolitan area on October 29, 2012.  While all but one of our stores were able to reopen within a day or two following the storm, we experienced business disruptions due to inventory delays as a result of transportation issues, loss of electricity at certain of our locations and the inability of some of our employees to travel to work due to transportation issues.  Our Red Hook, Brooklyn, NY store sustained substantial damage from the effects of Hurricane Sandy, and did not reopen until March 1, 2013.  We experienced higher than normal sales at the Red Hook store during the twenty-six weeks ended September 29, 2013, which may affect the comparability of our results of operations for the twenty-six weeks ended September 28, 2014 and September 29, 2013.

 

Following Hurricane Sandy we have seen increases in the market rate for insurance resulting in increased insurance premiums.

 

How We Assess the Performance of Our Business

 

In assessing performance, we consider a variety of performance and financial measures, principally growth in net sales, gross profit and Adjusted EBITDA and Central Services as a percentage of net sales. The key measures that we use to evaluate the performance of our business are set forth below:

 

Net Sales

 

We evaluate sales because it helps us measure the impact of economic trends and inflation or deflation, the effectiveness of our merchandising, marketing and promotional activities, the impact of new store openings and the effect of competition over a given period. Our net sales comprise gross sales net of coupons and discounts. We do not record sales taxes as a component of retail revenues as we consider ourselves a pass-through conduit for collecting and remitting sales taxes.

 

We do not consider same store sales, which controls for the effects of new store openings, to be as meaningful a measure for us as it may be for other retailers because as a destination food retailer in a concentrated market area we have in the past experienced, and in the future expect to experience, sales transfer from our existing stores to our newly opened stores that are in closer proximity to some of our customers. Our practice is to include sales from a store (including its related wine and spirits locations) in same-store sales beginning on the first day of the fifteenth full month following the store’s opening.  This practice may differ from the methods that our competitors use to calculate same-store or “comparable” sales. As a result, data in this report regarding our same-store sales may not be comparable to similar data made available by our competitors.

 

Various factors may affect our same-store sales, including:

 

 

 

 

 

 

 

 

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The food retail industry and our sales are affected by general economic conditions and seasonality, as well as the other factors discussed below, that affect store sales performance. Consumer purchases of high-quality perishables and specialty food products are particularly sensitive to a number of factors that influence the levels of consumer spending, including economic conditions, the level of disposable consumer income, consumer debt, interest rates and consumer confidence. In addition, our business is seasonal and, as a result, our average weekly sales fluctuate during the year and are usually highest in our third fiscal quarter, from October through December, when customers make holiday purchases, and typically lower during the summer months in our second fiscal quarter.

 

Gross Profit

 

We use gross profit to measure the effectiveness of our pricing and procurement strategies as well as the initiatives we utilize to increase sales of higher margin items and to reduce our shrink. We calculate gross profit as net sales less cost of sales and occupancy costs. Gross margin measures gross profit as a percentage of our net sales. Cost of sales includes the cost of merchandise inventory sold during the period (net of discounts and allowances), distribution costs, food preparation costs (primarily labor), shipping and handling costs, and shrink. Occupancy costs include store rental costs and property taxes. The components of our cost of sales and occupancy costs may not be identical to those of our competitors. As a result, data in this report regarding our gross profit and gross margin may not be comparable to similar data made available by our competitors.

 

Changes in the mix of products sold may impact our gross margin. Unlike natural / specialty stores, we also carry a full assortment of conventional groceries, which generally have lower margins than fresh, natural and organic foods, prepared foods and specialty and gourmet items. We expect to enhance our gross margins through:

 

 

 

 

 

 

Stores that we operate in higher density urban markets typically have generated higher sales volumes and margins than stores that we operate in suburban areas. As the percentage of our sales volumes provided by our suburban stores increases, our overall gross margins may decline.

 

Direct Store Expenses

 

Direct store expenses consist of store-level expenses such as salaries and benefits for our store work force, supplies, store depreciation and store-specific advertising and marketing costs. Store-level labor costs are generally the largest component of our direct store expenses. Direct store expenses, as a percentage of net sales, at our new stores are typically higher than at our more established stores during the first few quarters of operations. The components of our

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direct store expenses may not be identical to those of our competitors. As a result, data in this report regarding our direct store expenses may not be comparable to similar data made available by our competitors.

 

General and Administrative Expenses

 

General and administrative expenses consist primarily of personnel costs that are not store specific, corporate sales advertising and marketing expenses (including pre-opening advertising and marketing costs), depreciation and amortization expense as well as other expenses associated with our corporate headquarters, management expenses and expenses for accounting, information systems, legal, business development, human resources, purchasing and other administrative departments. We have made significant investments in management, information technology systems, infrastructure, compliance and marketing to support our growth strategy. Our general and administrative expenses for the twenty-six weeks ended September 29, 2013 include contractual IPO bonuses to certain members of our management and a fee to terminate our management agreement with, and management fees paid to an affiliate of Sterling Investment Partners, which ceased upon consummation of our IPO in April 2013.

 

The components of our general and administrative expenses may not be identical to those of our competitors. As a result, data regarding our general and administrative expenses may not be comparable to similar data made available by our competitors. We expect that our general and administrative expenses will increase in future periods due to additional legal, accounting, insurance and other expenses we expect to incur as a result of being a public company.

 

Store Opening Costs

 

Store opening costs include rent expense incurred during construction of new stores and costs related to new location openings, including costs associated with hiring and training personnel, supplies, the costs associated with our dedicated store opening team and other miscellaneous costs. Rent expense is recognized upon receiving possession of a store site, which generally ranges from three to six months before the opening of a store, although in some situations the possession period can exceed twelve months. Store opening costs vary among locations due to several key factors, including the length of time between possession date and the date on which the location opens for business along with the time designated as the training period for new staff for the store. Accordingly, we expect store opening costs to vary from period to period depending on the number of new stores opened in the period, whether such stores opened early or late in the period and whether new stores will open early in the following period. Store opening costs are expensed as incurred.

 

Income from Operations

 

Income from operations consists of gross profit minus direct store expenses, general and administrative expenses, store opening costs and production center start-up costs. Income from operations will vary from period to period based on a number of factors, including the number of stores open and the number of stores in the process of being opened in each period.

 

Adjusted EBITDA

 

We present Adjusted EBITDA, a non-GAAP measure, in this report to provide investors with a supplemental measure of our operating performance. We believe that Adjusted EBITDA is a useful performance measure to evaluate our core on-going operations and we use it to facilitate a comparison of our core on-going operating performance on a consistent basis from period-to-period and to provide for a more complete understanding of factors and trends affecting our business than GAAP measures alone can provide. Our board of directors and management also use Adjusted EBITDA as one of the primary methods for planning and forecasting overall expected performance and for evaluating on a quarterly and annual basis actual results against such expectations, and as a performance evaluation metric in determining achievement of certain compensation programs and plans for employees, including our senior executives. Our board of directors and management also use Adjusted EBITDA as one of the key measures in determining the value of any strategic, investing or financing opportunity. In addition, the financial covenants in our senior credit facility are based on Adjusted EBITDA, subject to dollar limitations on certain adjustments. The adjustments and related amounts included in Adjusted EBITDA are in substantial accordance with Consolidated EBITDA as defined in our existing

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senior credit agreement, subject to dollar limitations on certain adjustments. Consolidated EBITDA as computed under our existing senior credit agreement for the four fiscal quarter period ended September 28, 2014 and September 29, 2013 was $46.4 million and $52.8 million, respectively, compared to Adjusted EBITDA for the four fiscal quarter period ended September 28, 2014 and September 29, 2013 of $43.3 million and $49.2 million, respectively. Other companies in our industry may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.

 

We define Adjusted EBITDA as earnings before interest expense, income taxes, depreciation and amortization expense, amortization of deferred financing costs, equity compensation charges, store opening costs (including pre-opening advertising costs), production center start-up costs, gain on insurance recovery, severance related expenses, foundation funding, loss on early extinguishment of debt, non-recurring charges, organizational realignment costs, IPO related expenses, transaction expenses and bonuses and management fees. Omitting interest, taxes and the other items provides a financial measure that facilitates comparisons of our results of operations with those of companies having different capital structures. Since the levels of indebtedness and tax structures that other companies have are different from ours, we omit these amounts to facilitate investors’ ability to make these comparisons. Similarly, we omit depreciation and amortization because other companies may employ a greater or lesser amount of owned property, and because in our experience, whether a store is new or one that is fully or mostly depreciated does not necessarily correlate to the contribution that such store makes to operating performance. We ceased paying management fees upon consummation of our IPO. Items such as production center start-up costs, gain on insurance recovery, severance-related expenses, foundation funding, loss on early extinguishment of debt, non-recurring charges, organizational realignment costs, IPO-related expenses and transaction expenses and bonuses were incurred and associated with discrete and different events not relating to our core on-going operations, including our initial public offering, which was consummated just after the end of fiscal 2013, an organizational realignment to remove redundant costs and streamline parts of our business model to enhance overall productivity that we began in the fourth quarter of fiscal 2014 and the refinancings of our senior credit facility and Hurricane Sandy. We also believe that investors, analysts and other interested parties view our ability to generate Adjusted EBITDA as an important measure of our operating performance and that of other companies in our industry. Adjusted EBITDA should not be considered as an alternative to net income for the periods indicated as a measure of our performance.

 

The use of Adjusted EBITDA has limitations as an analytical tool and you should not consider this performance measure in isolation from, or as an alternative to, US GAAP measures such as net income (loss). Adjusted EBITDA is not a measure of liquidity under US GAAP or otherwise, and is not an alternative to cash flow from continuing operating activities. Our presentation of Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by the expenses that are excluded from that term or by unusual or non-recurring items. The limitations of Adjusted EBITDA include: (i) it does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; (ii) it does not reflect changes in, or cash requirements for, our working capital needs; (iii) it does not reflect income tax payments we may be required to make; (iv) it does not reflect the cash requirements necessary to service interest or principal payments associated with indebtedness; and (v) although depreciation and amortization are non-cash charges, the assets being depreciated and amortized often will have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements.

 

To properly and prudently evaluate our business, we encourage you to review our consolidated financial statements included elsewhere in this report and the reconciliation to Adjusted EBITDA from net loss, the most directly comparable financial measure presented in accordance with US GAAP, set forth in the table below. All of the items included in the reconciliation from net loss to Adjusted EBITDA are either (i) non-cash items or (ii) items that management does not consider in assessing our on-going operating performance. In the case of the non-cash items, management believes that investors may find it useful to assess our comparative operating performance because the measures without such items are less susceptible to variances in actual performance resulting from depreciation, amortization and other non-cash charges and more reflective of other factors that affect operating performance. In the case of the other items that management does not consider in assessing our on-going operating performance, management believes that investors may find it useful to assess our operating performance if the measures are presented without these items because their financial impact may not reflect on-going operating performance.

 

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Central Services

 

We have made significant investments in management, information technology systems, infrastructure, compliance and marketing.  These investments include significant additions to our company’s personnel, including experienced industry executives and the next generation management and merchandising teams to support our long-term growth objectives.  We believe that Central Services as a percentage of net sales is a useful performance measure and we use it to facilitate an evaluation of our infrastructure investment without distortions that may result from general and administrative expenses that do not directly relate to the operation of our business.  We define Central Services as general and administrative expenses less: depreciation and amortization related to general and administrative activities, management fees, transaction expenses, equity compensation charges and other non-operating expenses.  To properly and prudently evaluate our business, we encourage you to review our consolidated financial statements included elsewhere in this report and the reconciliation to Central Services from general and administrative expenses, the most directly comparable financial measure presented in accordance with US GAAP.

 

Organizational Realignment

 

In the fourth quarter of fiscal 2014, we initiated an organizational realignment to remove redundant costs and streamline parts of the business model to enhance overall productivity.  Net of reinvestments back into the business, we expect to achieve annualized cost savings of approximately $3.5 million.  In connection with the plan, we incurred charges of $3.3 million in fiscal 2014 and expect to incur charges, primarily severance, of approximately $3.7 million in fiscal 2015.  In the thirteen and twenty-six weeks ended September 28, 2014, we incurred approximately $1.3 million in stock-based compensation charges, and $0.8 million and $1.6 million, respectively, in severance charges, in connection with the organizational realignment.  We will continue to evaluate our cost structure and it is possible that the actual costs related to organizational realignment will exceed the estimates provided.

 

Goodwill Impairment

 

Our annual goodwill impairment test is conducted on the first day of the fourth quarter of each fiscal year and interim evaluations are performed when we determine that events or changes in circumstances exist that would more likely than not reduce the fair value of our goodwill below its carrying value.  During the thirteen weeks ended September 28, 2014, due to a continued decline in the market price of our stock and revisions in expected operating performance, we have determined that such events and circumstances exist, which would require an interim evaluation of goodwill for impairment.  As a result of these developments, we have accelerated our goodwill impairment test, which is expected to be finalized during the third quarter of fiscal 2015, at which time a determination may be made that some or all of our goodwill is impaired.  An impairment would result in a non-cash charge to income and would not impact our debt covenant compliance calculations in future periods. 

 

There were no goodwill or intangible asset impairments recorded in the twenty-six weeks ended September 28, 2014 and September 29, 2013. As of September 28, 2014, the carrying value of goodwill was $95.4 million

 

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Results of Operations

 

The following tables summarize key components of our results of operations for the periods indicated, both in dollars and as a percentage of net sales and have been derived from our consolidated financial statements.

 

 

 

 

Thirteen Weeks Ended September 28, 2014 Compared With Thirteen Weeks Ended September 29, 2013

 

Net Sales

 

We had net sales of $194.0 million in the thirteen weeks ended September 28, 2014, an increase of $10.8 million, or 5.9%, from $183.2 million in the thirteen weeks ended September 29, 2013.  This increase was attributable to net sales from the three stores which opened subsequent to June 30, 2013. 

 

Comparable store sales decreased 3.9% in the thirteen weeks ended September 28, 2014 compared to the thirteen weeks ended September 29, 2013, in large part due to the decrease in sales at our Red Hook store.  The decrease in the same store sales rate, on a quarter sequential basis, from the thirteen weeks ended June 29, 2014 to the thirteen weeks ended September 28, 2014 is primarily due to the full quarter impact of lost sales at our Red Hook, Brooklyn (“Red Hook”) location as a result of a competitive opening.  The Red Hook store was closed for eighteen weeks beginning on October 29, 2012, due to damage sustained from Hurricane Sandy, and re-opened on March 1, 2013.  Due to the timing of the Red Hook re-opening, it was not included in the same store sales base for the first nine weeks of the thirteen week period ended June 29, 2014.  Customer transactions in our comparable stores decreased by 3.0%, and the average transaction size at our comparable stores decreased by 0.9%.

 

Gross Profit

 

Gross profit was $59.3 million for the thirteen weeks ended September 28, 2014 compared to $59.4 million for the thirteen weeks ended September 29, 2013.  Our gross margin decreased approximately 180 basis points to 30.6% for the thirteen weeks ended September 28, 2014 from 32.4% for the thirteen weeks ended September 29, 2013.  The decrease in gross margin is due to an approximate 130 basis points of lower merchandise margins and an approximate 50 basis points of higher occupancy costs, as a percentage of sales, at new locations as well as increased occupancy costs at several locations open in both periods.   The drop in merchandise margin is primarily due to higher shrink, targeted price reductions, and increased cost inflation across several of our perishable departments which was not able to be passed on to customers for competitive reasons.  In addition, gross profit was adversely impacted by a shift in store mix as a result of the two suburban stores we opened subsequent to September 29, 2013.

 

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Gross profit in the thirteen weeks ended September 28, 2014 included a $1.2 million benefit in connection with the accelerated recognition of a deferred vendor discount resulting from the early termination of the related vendor contract due to vendor non-performance.  Excluding the effect of this discount, the gross profit for the thirteen weeks ended September 28, 2014 was $58.1 million and the gross margin was 29.9%.

 

Direct Store Expenses

 

Direct store expenses were $48.6 million in the thirteen weeks ended September 28, 2014, an increase of $3.2 million, or 6.9%, from $45.5 million for the thirteen weeks ended September 29, 2013.  The increase in direct store expenses was primarily attributable to the three new stores we opened subsequent to June 30, 2013.  With more stores in operation during the thirteen weeks ended September 28, 2014, our store labor expenses increased $0.9 million and our other store operating expenses increased $1.6 million compared to the thirteen weeks ended September 29, 2013.  The portion of our depreciation expense included in direct store expenses, which includes amortization of prepaid rent, increased $0.7 million to $6.2 million for the thirteen weeks ended September 28, 2014, compared to direct store depreciation expense for the thirteen weeks ended September 29, 2013 of $5.5 million.  The increase in direct store depreciation expense for the thirteen weeks ended September 28, 2014 compared with the thirteen weeks ended September 29, 2013 is attributable to the increase in the number of stores.

 

Direct store expenses, as a percentage of net sales, increased approximately 30 basis points to 25.1% in the thirteen weeks ended September 28, 2014 from 24.8% in the thirteen weeks ended September 29, 2013.  Excluding depreciation and amortization, store expenses as a percentage of sales were 21.9% in the thirteen weeks ended September 28, 2014 compared to 21.8% in the thirteen weeks ended September 29, 2013.  The increase in store expenses as a percentage of sales was primarily due to higher store operating expenses as a percentage of sales at our three new locations that opened subsequent to June 30, 2013, partially offset by lower store expenses, as a percentage of sales, at existing stores. 

 

General and Administrative Expenses

 

General and administrative expenses were $17.7 million for the thirteen weeks ended September 28, 2014, an increase of $2.7 million, or 17.7%, from $15.1 million for the thirteen weeks ended September 29, 2013. The increase in general and administrative expenses is primarily attributable to a $4.2 million equity compensation charge and a $0.9 million severance expense in the thirteen weeks ended September 28, 2014, an increase of $1.4 million and $0.4 million, respectively, from the thirteen weeks ended September 29, 2013.  The increase in general and administrative expenses was partially offset by lower pre-opening advertising costs and non-operating expenses in the thirteen weeks ended September 28, 2014 of $0.4 million and $0.3 million, respectively, compared to the thirteen weeks ended September 29, 2013.  The portion of depreciation and amortization included in general and administrative expenses was $1.0 million for the thirteen weeks ended September 28, 2014, a decrease of $0.1 million from $1.1 million for the thirteen weeks ended September 29, 2013. The Central Services component of general and administrative expenses increased $1.4 million in the thirteen weeks ended September 28, 2014 compared to the same period in the prior year.  

 

General and administrative expenses, as a percentage of net sales, increased to 9.1% for the thirteen weeks ended September 28, 2014, from 8.2% for the thirteen weeks ended September 29, 2013. 

 

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The following table sets forth a reconciliation to Central Services from general and administrative expenses:

 

 

 

Store Opening Costs

 

Store opening costs were $2.7 million for the thirteen weeks ended September 28, 2014, a decrease of $1.2 million, or 31.6%, from $3.9 million for the thirteen weeks ended September 29, 2013.  Store opening costs for the thirteen weeks ended September 28, 2014 consisted of $1.5 million in connection with the store we opened in Lake Grove, New York in July 2014 and $1.2 million in connection with the store in TriBeCa which has not opened.  Store opening costs for the thirteen weeks ended September 29, 2013 consisted of approximately $1.9 million in connection with the store that opened in the Chelsea neighborhood of Manhattan in July 2013 and $2.0 million in connection with the store we opened in Nanuet, New York in October 2013.  Approximately $1.2 million and $0.6 million of store opening costs for the thirteen weeks ended September 28, 2014 and September 29, 2013, respectively, did not require the expenditure of cash in the period, primarily due to deferred rent.

 

Production Center Start-up Costs

 

Start-up costs for the new production center in the Hunts Point area of the Bronx were $1.7 million for the thirteen weeks ended September 28, 2014, an increase of $0.4 million from $1.3 million for the thirteen weeks ended September 29, 2013.  Approximately $0.1 million and $0.4 million of these costs for the thirteen weeks ended September 28, 2014 and September 29, 2013, respectively, did not require the expenditure of cash in the period, primarily due to deferred rent.

 

Loss from Operations

 

For the thirteen weeks ended September 28, 2014, our operating loss was $11.5 million, an increase of $5.0 million from a loss of $6.4 million for the thirteen weeks ended September 29, 2013.  The increase in the loss from operations was primarily attributable to increases in direct store expenses, equity compensation expenses, severance expense and production center start-up costs, partially offset by lower store opening costs, pre-opening advertising and non-operating expenses.

 

Interest Expense

 

Interest expense decreased 3.3%, or $0.2 million, to $4.8 million for the thirteen weeks ended September 28, 2014, from $5.0 million for the thirteen weeks ended September 29, 2013, primarily due to income gained on interest of $0.2 million.  The cash portion of interest expense for the thirteen weeks ended September 28, 2014 and September 29, 2013 was $3.7 million and $3.7 million, respectively.

 

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Income Taxes

 

We recorded an income tax provision of $0.9 million the thirteen weeks ended September 28, 2014 compared to a provision of $0.8 million the thirteen weeks ended September 29, 2013.  We record an income tax provision although we incur pretax losses in both periods because we do not record any income tax benefit related to the operating losses and recognize income tax expense related to indefinite-lived intangible assets.

 

Net Loss

 

Our net loss was $17.2 million for the thirteen weeks ended September 28, 2014, an increase $5.0 million from a net loss of $12.2 million for the thirteen weeks ended September 29, 2013. The increase in net loss was primarily attributable to increases in direct store expenses, equity compensation expenses, severance expense and production center start-up costs, partially offset by lower store opening costs, pre-opening advertising and non-operating expenses.

 

Our adjusted net loss was $9.1 million for the thirteen weeks ended September 28, 2014, an increase of $3.2 million from the thirteen weeks ended September 29, 2013.  We define adjusted net loss as net loss plus any transaction expenses, expenses that did not continue after the IPO, non-cash charges, one-time charges and non-operating expenses which we believe may distort period to period comparison.

 

The following table sets forth a reconciliation to adjusted net loss from net loss:

 

 

 

Twenty-Six Weeks Ended September 28, 2014 Compared With Twenty-Six Weeks Ended September 29, 2013

 

The comparability of the financial data for September 28, 2014 and September 29, 2013 may be affected by the fact that the Easter and Passover holidays occurred during the twenty-six weeks ended September 28, 2014 but not during the twenty-six weeks ended September 29, 2013.

 

Net Sales

 

We had net sales of $392.2 million in the twenty-six weeks ended September 28, 2014, an increase of $22.3 million, or 6.0%, from $370.0 million in the twenty-six weeks ended September 29, 2013.  This increase was primarily attributable to net sales from the three stores which opened subsequent to March 31, 2013.  Net sales for the twenty-six weeks ended September 29, 2013 were positively impacted by higher than normal sales at our Red Hook store following its re-opening on March 1, 2013 after being closed for 18 weeks due to damage sustained from Hurricane Sandy.

 

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Comparable store sales decreased 2.8% in the twenty-six weeks ended September 28, 2014 compared to the twenty-six weeks ended September 29, 2013, in large part due to the decrease in sales at our Red Hook store as a result of a recent competitive opening.  The Red Hook store was closed for eighteen weeks beginning on October 29, 2012 due to damage sustained from Hurricane Sandy, and re-opened on March 1, 2013.  Due to the timing of the Red Hook store re-opening, it was not included in the same store sales base for the first nine weeks of the twenty-six week period ended September 28, 2014.  Customer transactions in our comparable stores decreased by 3.0%, although the average transaction size at our comparable stores increased by 0.2%. 

 

Gross Profit

 

Gross profit was $120.7 million for the twenty-six weeks ended September 28, 2014 as compared to $120.8 million for the twenty-six weeks ended September 29, 2013.  Our gross margin decreased approximately 190 basis points to 30.8% for the twenty-six weeks ended September 28, 2014 from 32.6% for the twenty-six weeks ended September 29, 2013.  The decrease in gross margin is due primarily to an approximate 130 basis points of lower merchandise margins and an approximate 50 basis points of higher occupancy costs, as a percentage of sales, at new locations as well as increased occupancy costs at several locations open in both periods.   The drop in merchandise margin is primarily due to higher shrink and targeted price reductions.  In addition, gross margin was adversely impacted by increased cost inflation across several of our perishable departments and the shift in store mix as a result of the two suburban stores we opened subsequent to September 29, 2013.

 

Gross profit in the thirteen weeks ended September 28, 2014 included a $1.2 million benefit in connection with the accelerated recognition of a deferred vendor discount resulting from the early termination of the related vendor contract due to vendor non-performance.  Excluding the effect of this discount, the gross profit for the twenty-six weeks ended September 28, 2014 was $119.5 million and the gross margin was 30.5%.

 

Direct Store Expenses

 

Direct store expenses were $95.6 million in the twenty-six weeks ended September 28, 2014, an increase of $6.0 million, or 6.7%, from $89.6 million for the twenty-six weeks ended September 29, 2013.  The increase in direct store expenses was primarily attributable to the three new stores we opened subsequent to March 31, 2013.  With more stores in operation during the twenty-six weeks ended September 28, 2014, our store labor expenses increased $1.9 million and our other store operating expenses increased $2.7 million compared to the twenty-six weeks ended September 29, 2013.  The portion of our depreciation expense included in direct store expenses, which includes amortization of prepaid rent, increased $1.4 million to $12.2 million for the twenty-six weeks ended September 28, 2014, compared to direct store depreciation expense for the twenty-six weeks ended September 29, 2013 of $10.8 million.  The increase in direct store depreciation expense for the twenty-six weeks ended September 28, 2014 compared with the twenty-six weeks ended September 29, 2013 is attributable to the increase in the number of stores.

 

Direct store expenses, as a percentage of net sales, increased approximately 20 basis points to 24.4% in the twenty-six weeks ended September 28, 2014 from 24.2% in the twenty-six weeks ended September 29, 2013. The increase in store expenses as a percentage of sales was primarily due to higher store operating expenses as a percentage of sales at our three new locations that opened subsequent to March 31, 2013, partially offset by lower store expenses, as a percentage of sales, at existing stores.  Excluding depreciation and amortization, store expenses, as a percentage of sales was 21.2% in the twenty-six weeks compared to 21.3% in the twenty-six weeks ended September 29, 2013.

 

General and Administrative Expenses

 

General and administrative expenses were $33.0 million for the twenty-six weeks ended September 28, 2014, a decrease of $16.0 million, or 32.6%, from $49.0 million for the twenty-six weeks ended September 29, 2013. The decrease in general and administrative expenses is primarily attributable to $18.1 million of expenses incurred in the twenty-six weeks ended September 29, 2013 related to our IPO, including $9.2 million to terminate the management agreement upon consummation of the IPO, $8.1 million of contractual bonuses paid to certain members of management upon consummation of the IPO and $0.8 million of other IPO related expenses, the elimination of management fees paid to an affiliate of Sterling, which was $0.9 million in the twenty-six weeks ended September 29, 2013 and a reduction in

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pre-opening advertising and non-operating expenses of $1.4 million, collectively.  These items were partially offset by $7.0 million dollars of equity compensation expense and $1.6 million of severance expense during the twenty-six weeks ended September 28, 2014, increases of $2.2 million and $1.4 million, respectively, compared to the same period of the prior year.  The portion of depreciation and amortization included in general and administrative expenses was $2.0 million for the twenty-six weeks ended September 28, 2014, a decrease of $0.2 million, or 7.0%, from $2.2 million for the twenty-six weeks ended September 29, 2013. The Central Services component of general and administrative expenses increased $0.9 million to $19.6 million in the twenty-six weeks ended September 28, 2014 compared to $18.7 million in the same period of the prior year. 

 

General and administrative expenses, as a percentage of net sales, decreased to 8.4% for the twenty-six weeks ended September 28, 2014, from 13.2% for the twenty-six weeks ended September 29, 2013.  Excluding fees and expenses related to the IPO and management fees, which terminated in connection with the IPO, general and administrative expenses, as a percentage of net sales, increased approximately 10 basis points to 8.4% for the twenty-six weeks ended September 28, 2014 from 8.3% for the twenty-six weeks ended September 29, 2013.

 

The following table sets forth a reconciliation to Central Services from general and administrative expenses:

 

 

 

Store Opening Costs

 

Store opening costs were $4.4 million for the twenty-six weeks ended September 28, 2014, a decrease of $2.5 million, or 36.8%, from $6.9 million for the twenty-six weeks ended September 29, 2013.  Store opening costs for the twenty-six weeks ended September 28, 2014 primarily consisted of $3.2 million in connection with the store we opened in Lake Grove, New York in July 2014 and $1.2 million in connection with the store in TriBeCa which has not opened.  Store opening costs for the twenty-six weeks ended September 29, 2013 consisted of approximately $4.8 million in connection with the store that opened in the Chelsea neighborhood of Manhattan in July 2013 and $2.1 million in connection with the store that opened in Nanuet, New York in October 2013.  Approximately $1.6 million and $1.3 million of store opening costs for the twenty-six weeks ended September 28, 2014 and September 29, 2013, respectively, did not require the expenditure of cash in the period, primarily due to deferred rent.

 

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Production Center Start-up Costs

 

Start-up costs for the new production center in the Hunts Point area of the Bronx were $3.2 million for the twenty-six weeks ended September 28, 2014, an increase of $1.3 million from $1.8 million for the twenty-six weeks ended September 29, 2013.  Approximately $0.4 million and $0.5 million of these costs for the twenty-six weeks ended September 28, 2014 and September 29, 2013, respectively, did not require the expenditure of cash in the period, primarily due to deferred rent.

 

Loss from Operations

 

For the twenty-six weeks ended September 28, 2014, our operating loss was $15.4 million, a decrease of $11.1 million from a loss from operations of $26.6 million for the twenty-six weeks ended September 29, 2013.  The decrease in the loss from operations was primarily attributable to the $18.1 million of IPO-related expenses incurred during the twenty-six weeks ended September 29, 2013, the elimination of management fees and lower store-opening costs, non-operating expenses and pre-opening advertising, partially offset by increases in direct store expenses, equity compensation expenses, production center start-up costs and severance expenses.

 

Excluding fees and expenses related to the IPO and management fees which terminated upon consummation of the IPO, our loss from operations increased $7.8 million to $15.4 million in the twenty-six weeks ended September 28, 2014 from a loss from operations of $7.6 million in the twenty-six weeks ended September 29, 2013.

 

Interest Expense

 

Interest expense decreased 7.4%, or $0.8 million, to $9.6 million for the twenty-six weeks ended September 28, 2014, from $10.4 million for the twenty-six weeks ended September 29, 2013, primarily due to the May 2013 amendment to our existing senior credit facility that lowered our interest rates, partially offset by an increase in the amortization of deferred financing fees and original issue discount.  The cash portion of interest expense for the twenty-six weeks ended September 28, 2014 and September 29, 2013 was $7.5 million and $7.9 million, respectively.

 

Income Taxes

 

We recorded an income tax provision of $1.9 million the twenty-six weeks ended September 28, 2014 compared to a provision of $3.2 million the twenty-six weeks ended September 29, 2013.  We record an income tax provision although we incur pretax losses in both periods because we do not record any income tax benefit related to the operating losses and recognize income tax expense related to indefinite-lived intangible assets.

 

Net Loss

 

Our net loss was $26.9 million for the twenty-six weeks ended September 28, 2014, a decrease of $13.2 million, or 33.0%, from a net loss of $40.2 million for the twenty-six weeks ended September 29, 2013. The decrease in net loss was primarily attributable to the $18.1 million of IPO-related expenses incurred during the twenty-six weeks ended September 29, 2013, the elimination of management fees and lower store-opening costs, non-operating expenses and pre-opening advertising, partially offset by increases in direct store expenses, equity compensation expenses, production center start-up costs and severance expenses. Excluding fees and expenses related to the IPO and management fees which terminated upon consummation of the IPO, our net loss increased $5.7 million to $26.9 million in the twenty-six weeks ended September 28, 2014 from net loss of $21.2 million in the twenty-six weeks ended September 29, 2013.

 

Our adjusted net loss was $12.3 million for the twenty-six weeks ended September 28, 2014, an increase of $3.9 million, from an adjusted net loss of $8.4 million for the twenty-six weeks ended September 29, 2013.  We define adjusted net loss as net loss plus any transaction expenses, expenses that did not continue after the IPO, non-cash charges, one-time charges and non-operating expenses which we believe may distort period to period comparison.

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The following table sets forth a reconciliation to adjusted net loss from net loss:

 

 

 

 

Liquidity and Capital Resources

 

Overview

 

Our primary sources of liquidity are cash generated from operations and borrowings under our senior credit facility and, in the past fiscal year, proceeds from our IPO. Our primary uses of cash are purchases of merchandise inventories, operating expenses, capital expenditures, primarily for opening new stores and infrastructure, and debt service. We believe that our cash on hand and the cash generated from operations, together with the borrowing availability under our senior credit facility, will be sufficient to meet our normal working capital needs for at least the next twelve months, including investments made, and expenses incurred, in connection with opening new stores. Our ability to continue to fund these items may be affected by general economic, competitive and other factors, many of which are outside of our control. If our future cash flow from operations and other capital resources are insufficient to fund our liquidity needs, we may be forced to reduce or delay our expected new store openings, sell assets, obtain additional debt or equity capital or refinance all or a portion of our debt. Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day or, in the case of credit or debit card transactions, within a few business days of the related sale.

 

At September 28, 2014, we had $37.4 million in cash and cash equivalents and $11.9 million in borrowing availability pursuant to our senior credit facility.

 

As of September 28, 2014, we were in compliance with all debt covenants.  Because our recent operating performance has been below our expectations at the time that the financial covenants in our senior credit agreement were established, if our financial performance does not improve it is possible that we will not meet the maximum total leverage ratio financial covenant at some point within the next twelve months.  We have the ability to exercise equity cure rights, which allows us to issue additional equity and treat the proceeds as EBITDA for purposes of the covenant, subject to certain restrictions, including that the amount of equity that can be used as EBITDA cannot exceed the EBITDA shortfall, the proceeds must be used to repay debt and the equity cure an only be used twice within a four quarter period and only four times during the term of the loan.  In the event of a covenant violation that remains uncured, the lenders have the right to declare all outstanding debt under the Senior Credit Facility immediately due and payable.

 

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While we believe we have sufficient liquidity and capital resources to meet our current operating requirements and expansion plans over the next 12 months, we may elect to pursue additional expansion opportunities that could require additional debt or equity financing. If we are unable to secure additional financing at favorable terms in order to pursue such additional expansion opportunities, our ability to pursue such opportunities could be materially adversely affected.

 

A summary of our operating, investing and financing activities are shown in the following table:

 

 

 

Operating Activities

 

Net cash used in operating activities consists primarily of net loss adjusted for non-cash items, including depreciation and amortization, stock compensation, and changes in deferred income taxes and the effect of working capital changes.

 

We had cash provided by operating activities of $5.2 million during the twenty-six weeks ended September 28, 2014, while operating activities used $13.2 million of cash during the twenty-six weeks ended September 29, 2013. The increase in cash provided by operating activities is primarily related to the non-recurring costs of $18.1 million associated with our IPO in the twenty-six weeks ended September 29, 2013, and decreased working capital needs.

 

Investing Activities

 

Cash used in investing activities consists primarily of capital expenditures for opening new stores and infrastructure, as well as investments in information technology and merchandising enhancements.

 

We made capital expenditures of $24.9 million in the twenty-six weeks ended September 28, 2014, of which $10.7 million was in connection with the store we opened in Lake Grove, New York in July 2014 and $10.9 million was in connection with our new production facility.  The remaining approximately $3.3 million of capital expenditures was for merchandising initiatives and equipment upgrades and enhancements to existing stores.

 

We made capital expenditures of $26.5 million in the twenty-six weeks ended September 29, 2013, of which $10.8 million was in connection with the store we opened in July 2013, $9.6 million was in connection with the store we opened in October 2013 and $1.3 million was in connection with our new production facility.  The remaining approximately $4.8 million of capital expenditures includes $1.0 million related to re-opening our Red Hook store, $0.7 million related to the opening of our Kips Bay store and the remaining $3.1 million was for merchandising initiatives and equipment upgrades and enhancements to existing stores.

 

We plan to spend approximately $20 million to $25 million on capital expenditures during the remainder of fiscal 2015, primarily related to our new central production facility, the new store in the TriBeCa neighborhood of Manhattan and equipment upgrades and enhancements at existing stores.

 

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Financing Activities

 

Cash flows from financing activities consists principally of borrowings and payments under our senior credit facility, and proceeds from the issuance of capital stock, net of equity issuance costs. We currently do not intend to pay cash dividends on our common stock.

 

 

 

Net cash used in financing activities during the twenty-six weeks ended September 28, 2014 was $1.6 million, consisting primarily of principal payments on our outstanding debt.

 

Net cash provided by financing activities during the twenty-six weeks ended September 29, 2013 was $76.8 million, consisting principally of $158.8 million of net proceeds received from our IPO, less the $76.8 million cash dividend payment on our preferred stock made with the proceeds of such offering and $3.9 million of costs related to our debt re-pricing as well as principal payments on our outstanding debt of $1.4 million.

 

On April 22, 2013, we completed our IPO of 15,697,500 shares of our common stock at a price of $13.00 per share, which included 13,407,632 new shares sold by Fairway and the sale of 2,289,868 shares by existing stockholders (including 2,047,500 sold pursuant to the underwriters’ exercise of their over-allotment option). We received approximately $158.8 million in net proceeds from the IPO after deducting the underwriting discount and expenses related to our IPO. We used the net proceeds that we received from the IPO to (i) pay accrued but unpaid dividends on our Series A preferred stock totaling approximately $19.1 million, (ii) pay accrued but unpaid dividends on our Series B preferred stock totaling approximately $57.7 million, (iii) pay $9.2 million to an affiliate of Sterling in connection with the termination of our management agreement with such affiliate and (iv) pay contractual IPO bonuses to certain members of our management totaling approximately $8.1 million. During fiscal 2014 and the thirteen weeks ended June 29, 2014, we used the remaining $64.7 million of the net proceeds as follows: $15.4 million for capital expenditures and pre-opening costs in connection with our new store in the Chelsea neighborhood of Manhattan, which opened in July 2013, approximately $17.9 million for capital expenditures and pre-opening costs in connection with the store we opened in October 2013 in Nanuet, NY, approximately $6.1 million in connection with the store we opened in Lake Grove, NY in July 2014, approximately $8.8 million in connection with capital expenditures in our other stores and approximately $16.5 million in connection with capital expenditures and start-up costs at our new production facility.  We did not receive any of the proceeds from the sale of shares by the selling stockholders.

 

Senior Credit Facility

 

In February 2013, we and our wholly-owned subsidiary Fairway Group Acquisition Company, as the borrower, entered into a senior secured credit facility consisting of a $275 million term loan (the “Term Facility”) and a $40 million revolving credit facility, which includes a $40 million letter of credit subfacility (the “Revolving Facility” and together with the Term Facility, as amended by the May 2013 amendment referred to below, the “Credit Facility”), with the Term Facility maturing in August 2018 and the Revolving Facility maturing in August 2017. We used the proceeds from the Term Facility to repay the $264.5 million of outstanding borrowings (including accrued interest) under our prior senior credit facility, pay fees and expenses and provide us with $3.5 million to repay our outstanding subordinated note, which we repaid in March 2013. In May 2013, we amended the Credit Facility to, among other

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things,  further reduce the interest rate we pay under the Credit Facility and eliminate the interest coverage ratio financial covenant.

 

Borrowings under the Credit Facility bear interest, at our option, at (i) adjusted LIBOR (subject to a 1.0% floor) plus 4.0% or (ii) an alternate base rate plus 3.0%. The 4.0% and 3.0% margins will each be reduced by 50 basis points at any time when our public corporate family rating from Moody’s Investor Services Inc. is B2 or higher and our public corporate rating from Standard & Poors rating service is B or higher, in each case with a stable outlook, and as long as certain events of default have not occurred. In addition, there is a fee payable quarterly in an amount equal to 1% per annum of the undrawn portion of the Revolving Facility, calculated based on a 360-day year. Interest is payable quarterly in the case of base rate loans and on maturity dates or every three months, whichever is shorter, in the case of adjusted LIBOR loans.

 

All of the borrower’s obligations under the Credit Facility are unconditionally guaranteed (the “Guarantees”) by us and each of our direct and indirect subsidiaries (other than the borrower and any future unrestricted subsidiaries as we may designate, at our discretion, from time to time) (the “Guarantors”). Additionally, the Credit Facility and the Guarantees are secured by a first-priority perfected security interest in substantially all present and future assets of the borrower and each Guarantor, including accounts receivable, equipment, inventory, general intangibles, leases, intellectual property, investment property and intercompany notes among Guarantors.

 

Mandatory prepayments under the Credit Facility are required with (i) 50% of adjusted excess cash flow (which percentage will decrease to 25% upon achievement and maintenance of a leverage ratio of less than 5.0:1.0, and to 0% upon achievement and maintenance of a leverage ratio of less than 4.0:1.0); (ii) 100% of the net cash proceeds of assets sales or other dispositions of property by us and our restricted subsidiaries (subject to certain exceptions and reinvestment provisions); and (iii) 100% of the net cash proceeds of issuances, offerings or placements of debt obligations (subject to certain exceptions). In addition, the Credit Facility required that by May 15, 2013, we either fully repay our outstanding subordinated note or make a $7.7 million repayment of the outstanding term loan.  On March 7, 2013, we repaid in full our outstanding subordinated promissory note in the aggregate principal amount of $7.3 million, together with all accrued interest aggregating $440,000.

 

The Credit Facility contains customary affirmative covenants, including (i) maintenance of legal existence and compliance with laws and regulations; (ii) delivery of consolidated financial statements and other information; (iii) maintenance of properties in good working order; (iv) payment of taxes; (v) delivery of notices of defaults, litigation, ERISA events and material adverse changes; (vi) maintenance of adequate insurance; and (vii) inspection of books and records.

 

The Credit Facility also contains customary negative covenants, including restrictions on (i) the incurrence of additional debt; (ii) liens and sale-leaseback transactions; (iii) loans and investments; (iv) guarantees and hedging agreements; (v) the sale, transfer or disposition of assets and businesses; (vi) dividends on, and redemptions of, equity interests and other restricted payments, including dividends and distributions to the issuer by its subsidiaries; (vii) transactions with affiliates; (viii) changes in the business conducted by us; (ix) payment or amendment of subordinated debt and organizational documents; and (x) maximum capital expenditures. We are also required to comply with a maximum total leverage ratio financial covenant, however, we have the ability to exercise equity cure rights, which allows us to issue additional equity and treat the proceeds as EBITDA for purposes of the covenant, subject to certain restrictions, including that the amount of equity that can be used as EBITDA cannot exceed the EBITDA shortfall, the proceeds must be used to repay debt and the equity cure can only be used twice within a four quarter period and only four times during the term of the loan.

 

Events of default under the Credit Facility include:

 

 

 

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In the event of a covenant violation or other default that remains uncured, the lenders have the right to declare all outstanding debt under the Senior Credit Facility immediately due and payable.

 

The foregoing is a brief summary of the material terms of the Credit Facility and is qualified in its entirety by reference to the Credit Facility filed as an exhibit to our Annual Report on Form 10-K for the fiscal year ended March 30, 2014.

 

Critical Accounting Policies and Estimates

 

The preparation of our financial statements in conformity with US GAAP requires us to make estimates, assumptions and judgments that affect amounts of assets and liabilities reported in the consolidated financial statements, the disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the year. We believe our estimates and assumptions are reasonable; however, future results could differ from those estimates under different assumptions or conditions.

 

Critical accounting policies are policies that reflect material judgment and uncertainty and may result in materially different results using different assumptions or conditions. We identified the following critical accounting policies and estimates: merchandise inventories, goodwill and other intangible assets, impairment of long-lived assets, income taxes and stock-based compensation.  For a detailed discussion of accounting policies, refer to our Annual Report on Form 10-K for the fiscal year ended March 30, 2014.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

There have been no material changes in our exposure to market risk from the information provided in Item 7A. Quantitative and Qualitative Disclosures About Market Risk of our Annual Report on Form 10-K for the fiscal year ended March 30, 2014.

 

Item 4. Controls and Procedures

 

As required by Rule 13a-15 under the Securities Exchange Act of 1934 (the “Exchange Act”), our chief executive officer and chief financial officer, together with our management, evaluated Fairway’s disclosure controls and procedures as of September 28, 2014, the end of the period covered by this report. Based on that evaluation, our chief executive officer and chief financial officer concluded that Fairway’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) were effective as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

 

In connection with the evaluation described above, there were no changes in our internal control over financial reporting during the quarter ended September 28, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.

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Part II — Other Information

 

Item 1. Legal Proceedings 

 

We are subject to various legal claims and proceedings which arise in the ordinary course of our business, including employment related claims, involving routine claims incidental to our business. Although the outcome of these routine claims cannot be predicted with certainty, we do not believe that the ultimate resolution of these claims will have a material adverse effect on our results of operations, financial condition or cash flows.

 

In February and March 2014, three purported class action lawsuits alleging the violation of the federal securities laws were filed in the United States District Court for the Southern District of New York against us and certain of our current and former officers, certain of our directors and the underwriters for our initial public offering. The actions were consolidated on June 3, 2014 under the caption In re Fairway Group Holdings Corp. Securities Litigation, No. 14-cv-0950. On July 18, 2014, an amended class action complaint was filed, adding affiliates of Sterling Investment Partners as defendants. The complaint seeks unspecified damages and alleges misleading statements in the registration statement and prospectus for our initial public offering and in subsequent communications regarding our business and financial results. On September 5, 2014, the we and the other defendants moved to dismiss the amended class action complaint.  In April 2014, a purported stockholder derivative action was filed against certain of our directors in New York state court, asserting claims for breach of fiduciary duties and gross mismanagement based on substantially similar allegations as in the securities class action. In June 2014, we and the other defendants moved to dismiss the derivative complaint. On July 30, 2014, plaintiffs filed an amended complaint, adding affiliates of Sterling Investment Partners as defendants and asserting claims against them for breach of fiduciary duty and unjust enrichment. On September 29, 2014, we and the other defendants moved to dismiss the amended derivative complaint.  While we believe the claims are without merit and intend to defend these lawsuits vigorously, we cannot predict the outcome of these lawsuits.

 

In May 2014, a purported wage and hour class action lawsuit was filed in the United States District Court for the Southern District of New York against us and certain of our current and former officers and employees.  This suit alleges, among other things, that certain of our past and current employees were not properly compensated in accordance with the overtime provisions of the Fair Labor Standards Act.  While we believe that these claims are without merit and intend to defend the matter vigorously, we cannot predict the outcome of this litigation.

 

Monitoring and defending against legal actions, whether or not meritorious, is time-consuming for our management and detracts from our ability to fully focus our internal resources on our business activities and we cannot predict how long it may take to resolve these matters. In addition, legal fees and costs incurred in connection with such activities may be significant and we could, in the future, be subject to judgments or enter into settlements of claims for significant monetary damages. A decision adverse to our interests on these actions or resulting from these matters could result in the payment of substantial damages and could have a material adverse effect on our cash flow, results of operations and financial position.

 

With respect to any litigation, our insurance may not reimburse us or may not be sufficient to reimburse us for the expenses or losses we may suffer in contesting and concluding such lawsuits. Substantial litigation costs or an adverse result in any litigation may adversely impact our business, operating results or financial condition.

 

Item 1A. Risk Factors

 

There were no material changes in risk factors for the Company in the period covered by this report. See the discussion of risk factors in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended March 30, 2014.

 

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

 

Sales of Unregistered Securities

 

From March 31, 2014 through September 28, 2014, we issued to certain of our non-employee directors 54,601 restricted stock units in payment of their cash compensation for the two calendar quarters ended June 30, 2014 and September 30, 2014,  52,736 restricted stock units to an employee director in respect of a portion of his cash compensation for the two calendar quarters ended March 31, 2014 and June 30, 2014 pursuant to his employment agreement, and granted to our officers, directors, employees and consultants an aggregate of 690,000 restricted stock units to be settled in shares of our Class A common stock under our 2013 Long-Term Incentive Plan.

 

Use of Proceeds

Not Applicable.

 

Issuer Purchases of Equity Securities

 

Not applicable.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

Item 4. Mine Safety Disclosures

 

None.

 

Item 5. Other Information

 

In connection with employment of Mr. Jack Murphy as our chief executive officer, Mr. Charles Santoro stepped down as executive chairman but continues to serve as chairman of the board of directors.

 

On November 6, 2014, the Company received a written letter of resignation from William Selden stating that he resigned, effective immediately, from his position on the Board of Directors of the Company.  Mr. Selden’s resignation was not the result of any dispute or disagreement with the Company.

 

Item 6. Exhibits

 

Reference is made to the separate exhibit index contained on page 44 filed herewith.