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EX-32.1 - EXHIBIT 32.1 - Diversified Restaurant Holdings, Inc.ex32110q.htm

U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
  
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 
EXCHANGE ACT OF 1934
 
For the quarterly period ended March 29, 2015  
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 
EXCHANGE ACT OF 1934
 
For the transition period from
 
Commission File No.  000-53577
 
DIVERSIFIED RESTAURANT HOLDINGS, INC.
(Exact name of registrant as specified in its charter) 
Nevada
03-0606420
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification Number)
 
27680 Franklin Road
Southfield, Michigan 48034
(Address of principal executive offices)
 
Registrant’s telephone number: (248) 223-9160
 
No change
(Former name, former address and former
fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [X] No [  ]
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
 
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:  26,189,944 shares of $.0001 par value common stock outstanding as of May 5, 2015.
 
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. 
Large accelerated filer
[   ]
Accelerated filer
[ X ]
 
 
 
 
Non-accelerated filer
[   ]
Smaller reporting company
[   ]
 
(Do not check if a smaller reporting company)        
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]








APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS
 
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes [  ]       No [  ]



INDEX
 






PART I.  FINANCIAL INFORMATION
 
Item 1.  Financial Statements
 
DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS (unaudited)
ASSETS
 
March 29, 2015
 
December 28, 2014
Current assets
 
 
 
 
Cash and cash equivalents
 
$
19,334,527

 
$
18,688,281

Investments
 

 
2,917,232

Accounts receivable
 
402,182

 
1,417,510

Inventory
 
1,421,557

 
1,335,774

Prepaid assets
 
306,496

 
397,715

Total current assets
 
21,464,762

 
24,756,512

 
 
 
 
 
Deferred income taxes
 
3,249,734

 
2,960,640

Property and equipment, net
 
73,387,487

 
71,508,950

Intangible assets, net
 
2,933,973

 
2,916,498

Goodwill
 
10,998,630

 
10,998,630

Other long-term assets
 
360,910

 
305,804

Total assets
 
$
112,395,496

 
$
113,447,034

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities
 
 
 
 
Accounts payable
 
$
3,530,511

 
$
7,043,143

Accrued compensation
 
2,019,674

 
2,786,830

Other accrued liabilities
 
1,651,025

 
1,357,510

Current portion of long-term debt
 
8,815,098

 
8,155,903

Current portion of deferred rent
 
285,711

 
377,812

Total current liabilities
 
16,302,019

 
19,721,198

 
 
 
 
 
Deferred rent, less current portion
 
3,152,137

 
3,051,445

Unfavorable operating leases
 
674,871

 
693,497

Other long-term liabilities
 
3,709,236

 
3,212,376

Long-term debt, less current portion
 
55,373,623

 
53,612,496

Total liabilities
 
79,211,886

 
80,291,012

 
 
 
 
 
Commitments and contingencies (Notes 9 and 10)
 

 

 
 
 
 
 
Stockholders' equity
 
 
 
 
Common stock - $0.0001 par value; 100,000,000 shares authorized; 26,152,569 and 26,149,824, respectively, issued and outstanding
 
2,582

 
2,582

Additional paid-in capital
 
35,743,016

 
35,668,001

Accumulated other comprehensive loss
 
(485,225
)
 
(175,156
)
Accumulated deficit
 
(2,076,763
)
 
(2,339,405
)
Total stockholders' equity
 
33,183,610

 
33,156,022

 
 
 
 
 
Total liabilities and stockholders' equity
 
$
112,395,496

 
$
113,447,034

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

2


DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (unaudited)
 
 
 
Three Months Ended
 
 
 
March 29, 2015
 
March 30, 2014
 
Revenue
 
$
39,440,332

 
$
30,473,014

 
 
 
 
 
 
 
Operating expenses
 
 
 
 
 
Restaurant operating costs (exclusive of depreciation and amortization shown separately below):
 
 
 
 
 
Food, beverage, and packaging costs
 
11,447,903

 
8,705,423

 
Compensation costs
 
10,154,792

 
7,993,667

 
Occupancy costs
 
2,372,467

 
1,655,551

 
Other operating costs
 
7,960,549

 
6,280,095

 
General and administrative expenses
 
2,496,887

 
2,112,562

 
Pre-opening costs
 
1,093,500

 
544,021

 
Depreciation and amortization
 
3,157,322

 
2,247,460

 
Loss on disposal of property and equipment
 
148,408

 
156,065

 
Total operating expenses
 
38,831,828

 
29,694,844

 
 
 
 
 
 
 
Operating profit
 
608,504

 
778,170

 
 
 
 
 
 
 
Interest expense
 
(432,223
)
 
(476,401
)
 
Other income, net
 
17,003

 
13,030

 
 
 
 
 
 
 
Income before income taxes
 
193,284

 
314,799

 
 
 
 
 
 
 
Income tax benefit
 
(69,358
)
 
(53,058
)
 
 
 
 
 
 
 
Net income
 
$
262,642

 
$
367,857

 
 
 
 
 
 
 
Basic earnings per share
 
$
0.01

 
$
0.01

 
Fully diluted earnings per share
 
$
0.01

 
$
0.01

 
 
 
 
 
 
 
Weighted average number of common shares outstanding
 
 
 
 
 
Basic
 
26,149,184

 
26,048,805

 
Diluted
 
26,248,424

 
26,153,595

 
 
 













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

3


DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (unaudited)
 
 
 
Three Months Ended
 
 
 
March 29, 2015
 
March 30, 2014
 
 
 
 
 
 
 
Net income
 
$
262,642

 
$
367,857

 
 
 
 
 
 
 
Other comprehensive income (loss)
 
 
 
 
 
Unrealized changes in fair value of interest rate swaps, net of tax of $161,691, and $15,633, respectively
 
(313,873
)
 
30,347

 
Unrealized changes in fair value of investments, net of tax of $1,959 and $11,876, respectively
 
3,804

 
23,055

 
Total other comprehensive income (loss)
 
(310,069
)
 
53,402

 
 
 
 
 
 
 
Comprehensive income (loss)
 
$
(47,427
)
 
$
421,259

 
 
 




































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

 

4


DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (unaudited)
 
 
 
 
 
 
Additional
 
Accumulated
Other
 
Retained
Earnings
 
Total
 
Common Stock
 
Paid-in
 
Comprehensive
 
(Accumulated
 
Stockholders'
 
Shares
 
Amount
 
Capital
 
Income (Loss)
 
Deficit)
 
Equity
Balances - December 29, 2013
26,049,578

 
$
2,580

 
$
35,275,255

 
$
(245,364
)
 
$
(1,070,908
)
 
$
33,961,563

 
 
 
 
 
 
 
 
 
 
 
 
Forfeitures of restricted shares
(1,500
)
 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
Employee stock purchase plan
3,045

 

 
15,015

 

 

 
15,015

 
 
 
 
 
 
 
 
 
 
 
 
Share-based compensation

 

 
85,320

 

 

 
85,320

 
 
 
 
 
 
 
 
 
 
 
 
Other comprehensive income

 

 

 
53,402

 

 
53,402

 
 
 
 
 
 
 
 
 
 
 
 
Net income

 

 

 

 
367,857

 
367,857

 
 
 
 
 
 
 
 
 
 
 
 
Balances - March 30, 2014
26,051,123

 
$
2,580

 
$
35,375,590

 
$
(191,962
)
 
$
(703,051
)
 
$
34,483,157

 
 
 
 
 
 
 
 
 
 
 
 
Balances - December 28, 2014
26,149,824

 
$
2,582

 
$
35,668,001

 
$
(175,156
)
 
$
(2,339,405
)
 
$
33,156,022

 
 
 
 
 
 
 
 
 
 
 
 
Forfeitures of restricted shares
(1,917
)
 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
Employee stock purchase plan
4,662

 

 
19,222

 

 

 
19,222

 
 
 
 
 
 
 
 
 
 
 
 
Share-based compensation

 

 
55,793

 

 

 
55,793

 
 
 
 
 
 
 
 
 
 
 
 
Other comprehensive loss

 

 

 
(310,069
)
 

 
(310,069
)
 
 
 
 
 
 
 
 
 
 
 
 
Net income

 

 

 

 
262,642

 
262,642

 
 
 
 
 
 
 
 
 
 
 
 
Balances - March 29, 2015
26,152,569

 
$
2,582

 
$
35,743,016

 
$
(485,225
)
 
$
(2,076,763
)
 
$
33,183,610

 
 













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



5


DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
 
 
 
Three Months Ended
 
 
March 29, 2015
 
March 30, 2014
Cash flows from operating activities
 
 
 
 
Net income
 
$
262,642

 
$
367,857

Adjustments to reconcile net income to net cash provided by operating activities
 
 
 
 
Depreciation and amortization
 
3,157,322

 
2,247,460

Amortization of loan fees
 
6,954

 
21,525

Realized loss on investments
 

 
19,175

Amortization of gain on sale-leaseback
 
39,302

 

Loss on disposal of property and equipment
 
148,408

 
156,065

Share-based compensation
 
55,793

 
85,320

Deferred income taxes
 
(129,358
)
 
(92,337
)
Changes in operating assets and liabilities that provided (used) cash
 
 
 
 
Accounts receivable
 
1,015,328

 
666,918

Inventory
 
(85,783
)
 
(74,185
)
Prepaid assets
 
91,219

 
250,660

Intangible assets
 
(68,796
)
 
(27,849
)
Other long-term assets
 
(55,106
)
 
(21,635
)
Accounts payable
 
(904,717
)
 
(1,175,071
)
Accrued liabilities
 
(486,179
)
 
368,723

Deferred rent
 
8,591

 
(138,327
)
Net cash provided by operating activities
 
3,055,620

 
2,654,299

 
 
 
 
 
Cash flows from investing activities
 
 
 
 
Purchases of investments
 

 
(2,500,600
)
Proceeds from sale of investments
 
2,917,522

 
3,955,969

Purchases of property and equipment
 
(7,766,440
)
 
(5,626,473
)
Net cash used in investing activities
 
(4,848,918
)
 
(4,171,104
)
 
 
 
 
 
Cash flows from financing activities
 
 
 
 
Proceeds from issuance of long-term debt
 
4,420,322

 
2,240,580

Repayments of long-term debt
 
(2,000,000
)
 
(1,657,683
)
Payment of loan fees
 

 
(118,739
)
Proceeds from employee stock purchase plan
 
19,222

 
15,015

Net cash provided by financing activities
 
2,439,544

 
479,173

 
 
 
 
 
Net increase (decrease) in cash and cash equivalents
 
646,246

 
(1,037,632
)
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
18,688,281

 
9,562,473

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
19,334,527

 
$
8,524,841

 



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


6

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.           BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Nature of Business
 
Diversified Restaurant Holdings, Inc. (“DRH”) is a fast-growing restaurant company operating two complementary concepts:  Bagger Dave’s Burger Tavern ® (“Bagger Dave’s”) and Buffalo Wild Wings ® Grill & Bar (“BWW”).  As the creator, developer, and operator of Bagger Dave’s and as one of the largest franchisees of BWW, we provide a unique guest experience in a casual and inviting environment.  We were incorporated in 2006 and are headquartered in the Detroit metropolitan area.  As of March 29, 2015, we had 68 locations in Florida, Illinois, Indiana, and Michigan.
  
DRH and its wholly-owned subsidiaries (collectively, the “Company”), AMC Group, Inc. (“AMC”), AMC Wings, Inc. (“WINGS”), AMC Burgers, Inc. (“BURGERS”), and AMC Real Estate, Inc. (“REAL ESTATE”) own, operate, and manage Bagger Dave's and DRH-owned BWW restaurants located throughout Florida, Illinois, Indiana, and Michigan.
 
DRH originated the Bagger Dave’s concept with our first restaurant opening in January 2008 in Berkley, Michigan.  Currently, there are 26 Bagger Dave’s, 17 in Michigan and nine in Indiana. The Company expects to operate between 38 and 42 Bagger Dave’s locations by the end of 2017.
 
DRH is also one of the largest BWW franchisees and currently operates 42 DRH-owned BWW restaurants (19 in Michigan, 14 in Florida, four in Illinois, and five in Indiana), including the nation’s largest BWW, based on square footage, in downtown Detroit, Michigan. We remain on track to fulfill our area development agreement (“ADA”) with Buffalo Wild Wings International, Inc. (“BWLD”) and expect to operate 52 DRH-owned BWW restaurants by the end of 2017, exclusive of potential additional BWW restaurant acquisitions. 
 
The following organizational chart outlines the current corporate structure of DRH.  A brief textual description of the entities follows the organizational chart. DRH is incorporated in Nevada.   
 
AMC was formed on March 28, 2007 and serves as our operational and administrative center. AMC renders management, operational support, and advertising services to WINGS, BURGERS, REAL ESTATE and their subsidiaries. Services rendered by AMC include marketing, restaurant operations, restaurant management consultation, hiring and training of management and staff, and other management services reasonably required in the ordinary course of restaurant operations.
 

7

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

BURGERS was formed on March 12, 2007 and serves as a holding company for our Bagger Dave’s restaurants.  Bagger Dave’s Franchising Corporation, a subsidiary of BURGERS, was formed to act as the franchisor for the Bagger Dave’s concept and has rights to franchise in Illinois, Indiana, Kentucky, Michigan, Missouri, Ohio, and Wisconsin.  We do not intend to pursue franchise development at this time.  
 
WINGS was formed on March 12, 2007 and serves as a holding company for our DRH-owned BWW restaurants.  We are economically dependent on retaining our franchise rights with BWLD.  The franchise agreements have specific initial term expiration dates ranging from September 2020 through February 2025, depending on the date each was executed and the duration of its initial term.  The franchise agreements are renewable at the option of the franchisor and are generally renewable if the franchisee has complied with the franchise agreement.  When factoring in any applicable renewals, the franchise agreements have specific expiration dates ranging from December 2025 through February 2050.  We believe we are in compliance with the terms of these agreements.  

REAL ESTATE was formed on March 18, 2013 and serves as the holding company for the real estate properties owned by DRH. REAL ESTATE’s portfolio currently includes three properties, two Bagger Dave’s restaurants and one DRH-owned BWW restaurants. The DRH-owned BWW and one of the Bagger Dave's will be sold as part of the sale leaseback transaction occurring in Second Quarter 2015. The DRH-owned BWW is currently under construction and the Bagger Dave's restaurants are open and operated by DRH. For additional information pertaining to the sale-leaseback transaction, refer to the 2014 10-K filed on March 13, 2015.
 
Basis of Presentation
 
The consolidated financial statements as of March 29, 2015 and December 28, 2014, and for the three-month periods ended March 29, 2015 and March 30, 2014, have been prepared by the Company pursuant to accounting principles generally accepted in the United States of America (“GAAP”) and the rules and regulations of the Securities and Exchange Commission ("SEC"). The financial information as of March 29, 2015 and for the three-month periods ended March 29, 2015 and March 30, 2014 is unaudited, but, in the opinion of management, reflects all adjustments and accruals necessary for a fair presentation of the financial position, results of operations, and cash flows for the interim periods.
 
The consolidated financial information as of December 28, 2014 is derived from our audited consolidated financial statements and notes thereto for the fiscal year ended December 28 2014, which is included in Item 8 in the Fiscal 2014 Annual Report on Form 10-K, and should be read in conjunction with such consolidated financial statements.
 
The results of operations for the three-month period ended March 29, 2015 are not necessarily indicative of the results of operations that may be achieved for the entire year ending December 27, 2015.
 
Segment Reporting
 
The Company has two operating segments, Bagger Dave’s and BWW. The brands operate within the ultra-casual, full-service dining industry, providing similar products to similar customers. The brands also possess similar economic characteristics, resulting in similar long-term expected financial performance. Sales from external customers are derived principally from food and beverage sales. We do not rely on any major customers as a source of sales. We believe we meet the criteria for aggregating our operating segments into a single reporting segment.
 
Concentration Risks
 
Approximately 84.8% and 81.4% of the Company's revenues are generated from food and beverage sales of restaurants located in the Midwest region during the three-month periods ended March 29, 2015 and March 30, 2014, respectively.
 
Investments
 
The Company’s investment securities are classified as available-for-sale. Investments classified as available-for-sale are available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates, tax strategies, and asset-liability management strategies, among other reasons. Available-for-sale securities are reported at fair value, with unrealized gains and losses, net of taxes, reported in the accumulated other comprehensive income (loss) component of stockholders’ equity, and accordingly, have no effect on net income. Realized gains or losses on sale of investments are determined on the basis of specific costs of the investments. Dividend income is recognized when declared and interest income is recognized when earned. Discount

8

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

or premium on debt securities purchased at other than par value are amortized using the effective yield method. See Note 2 for details.

Goodwill
 
Goodwill is not amortized and represents the excess of cost over the fair value of identified net assets of businesses acquired. Goodwill is subject to an annual impairment analysis or more frequently if indicators of impairment exist. At March 29, 2015 and December 28, 2014, we had goodwill of $11.0 million, respectively that was assigned to our BWW operating segment.
 
The impairment analysis, if necessary, consists of a two-step process. The first step is to compare the fair value of the reporting unit to its carrying value, including goodwill. We estimate fair value using market information (market approach) and discounted cash flow projections (income approach). The income approach uses the reporting unit’s projection of estimated operating results and cash flows that is discounted using a weighted-average cost of capital that reflects market conditions. The projection uses management’s best estimates of projected revenue, costs and cash expenditures, including an estimate of new restaurant openings and related capital expenditures. Other significant estimates also include terminal growth rates and working capital requirements. We supplement our estimate of fair value under the income approach by using a market approach which estimates fair value by applying multiples to the reporting unit’s projected operating performance. The multiples are derived from comparable publicly traded companies with similar characteristics to the reporting unit. If the fair value of the reporting unit is less than its carrying value, the second step of the impairment analysis must be performed in order to determine the amount of impairment loss, if any. The second step compares the implied fair value of goodwill with the carrying amount of that goodwill. If the carrying amount of the goodwill exceeds its implied fair value, an impairment charge is recognized in an amount equal to that excess. As of December December 28, 2014, based on our quantitative analysis, goodwill was considered recoverable. At March 29, 2015, there were no impairment indicators warranting an analysis.
  
Impairment of Long-Lived Assets and Definite-Lived Intangible Assets
  
We review long-lived assets and definite-live intangible assets quarterly to determine if triggering events have occurred which would require a test to determine if the carrying amount of these assets may not be recoverable based on estimated future cash flows. Assets are reviewed at the lowest level for which cash flows can be identified, which is at the individual restaurant level. In the absence of extraordinary circumstances, restaurants are included in the impairment analysis after they have been open for two years. We evaluate the recoverability of a restaurant’s long-lived assets, including buildings, intangibles, leasehold improvements, furniture, fixtures, and equipment over the remaining life of the primary asset in the asset group, after considering the potential impact of planned operational improvements, marketing programs, and anticipated changes in the trade area. In determining future cash flows, significant estimates are made by management with respect to future operating results for each restaurant over the remaining life of the primary asset in the asset group. If assets are determined to be impaired, the impairment charge is measured by calculating the amount by which the asset carrying amount exceeds its fair value based on our estimate of discounted future cash flows. The determination of asset fair value is also subject to significant judgment. No impairments were recognized for quarter-ended March 29, 2015 or year ended December 28, 2014. We are currently monitoring several restaurants in regards to the valuation of long-lived assets and have developed plans to improve operating results. Based on our current estimates of the future operating results of these restaurants, we believe that the assets at these restaurants are not impaired. As we periodically refine our estimated future operating results, changes in our estimates and assumptions may cause us to realize impairment charges in the future that could be material.

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

Interest Rate Swap Agreements
 
The Company utilizes interest rate swap agreements with RBS Citizens, N.A. (“RBS”) to fix interest rates on a portion of the Company’s portfolio of variable rate debt, which reduces exposure to interest rate fluctuations.  The Company does not use any other types of derivative financial instruments to hedge such exposures, nor does it use derivatives for speculative purposes. The Company’s interest rate swap agreements qualify for hedge accounting. As such, the Company records the change in the fair value of its swap agreements as a component of accumulated other comprehensive income (loss), net of tax. The Company records the

9

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

fair value of its interest swaps on the Consolidated Balance Sheet in other long-term assets or other long-term liabilities depending on the fair value of the swaps. See Note 6 and Note 13 for additional information on the interest rate swap agreements.
 
Recent Accounting Pronouncements
 
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"), which supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP.  The standard is currently effective for annual periods beginning after December 15, 2016, and interim periods therein.  We evaluated the impact of the pending adoption of ASU 2014-09, and based on the nature of our business we do not expect the standard will have a significant impact on our consolidated financial statements.  

2.           INVESTMENTS
 
Investments consist of available-for-sale securities that are carried at fair value. Available-for-sale securities are classified as current assets based upon our intent and ability to use any and all of the securities as necessary to satisfy the operational requirements of our business. Based on the call date of the investments, all securities have maturities of one year or less. Unrealized losses are charged against net earnings when a decline in fair value is determined to be other than temporary. In the First Quarter 2015, DRH opted to discontinue investing in debt securities and determined investing in a highly liquid money market account was better fit for the Company's liquidity needs. As of March 29, 2015, the outstanding investments as of December 28, 2014 had fully matured and have been redeemed.
  
The amortized cost, gross unrealized holding gains, gross unrealized holding loss, and fair value of available-for-sale securities by type are as follows: 
 
 
December 28, 2014
 
 
 Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Loss
 
Estimated
Fair Value
Debt securities:
 
 
 
 
 
 
 
 
Obligations of states/municipals
 
1,190,261

 

 
(4,278
)
 
1,185,983

Corporate securities
 
1,732,734

 

 
(1,485
)
 
1,731,249

Total debt securities
 
$
2,922,995

 
$

 
$
(5,763
)
 
$
2,917,232

 
As of December 28, 2014, $2.9 million of investments were in a loss position with a cumulative unrealized loss of $5,763. The Company may had incurred future impairment charges if decline in market values continued and/or worsened and the impairments would no longer be considered temporary. All investments with unrealized losses have been in such position for less than 12 months.
 
Gross unrealized gains and losses on available-for-sale securities, recorded in accumulated other comprehensive income (loss), as of December 28, 2014, was as follows:
 
 
 
December 28,
2014
Unrealized gains
 
 
$

Unrealized loss
 
 
(5,763
)
Net unrealized loss
 
 
(5,763
)
Deferred federal income tax benefit
 
 
1,959

Net unrealized loss on investments, net of deferred income tax
 
 
$
(3,804
)

10

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


3.          PROPERTY AND EQUIPMENT
 
Property and equipment are comprised of the following assets:
 
 
March 29, 2015
 
December 28, 2014
Land
 
$
3,087,514

 
$
3,087,514

Building
 
2,339,219

 
2,339,219

Equipment
 
31,196,205

 
29,251,119

Furniture and fixtures
 
7,919,393

 
7,458,292

Leasehold improvements
 
61,049,580

 
56,971,815

Restaurant construction in progress
 
1,305,099

 
4,731,045

Total
 
106,897,010

 
103,839,004

Less accumulated depreciation
 
(33,509,523
)
 
(32,330,054
)
Property and equipment, net
 
$
73,387,487

 
$
71,508,950


4.        INTANGIBLE ASSETS
 
Intangible assets are comprised of the following:
 
 
March 29, 2015
 
December 28, 2014
Amortized intangibles:
 
 
 
 
Franchise fees
 
$
640,641

 
$
647,363

Trademark
 
66,826

 
64,934

Non-compete agreement
 
76,560

 
76,560

Favorable lease
 
239,000

 
239,000

Loan fees
 
130,377

 
130,377

Total
 
1,153,404

 
1,158,234

Less accumulated amortization
 
(410,534
)
 
(377,839
)
Amortized intangibles, net
 
742,870

 
780,395

 
 
 
 
 
Unamortized intangibles:
 
 
 
 
Liquor licenses
 
2,191,103

 
2,136,103

Total intangibles, net
 
$
2,933,973

 
$
2,916,498

 
Amortization expense for the three-month periods ended March 29, 2015 and March 30, 2014 was $25,742 and $14,378, respectively. Amortization of favorable leases and loan fees are reflected as part of occupancy and interest expense, respectively.
 
Based on the current intangible assets and their estimated useful lives, future intangible-related expense for the next five years is projected as follows:
Year
Amount
Remainder of 2015
$
76,813

2016
86,276

2017
84,740

2018
83,065

2019
80,334

2020 and thereafter
331,642

Total
$
742,870

 
The aggregate weighted-average amortization period for intangible assets is 7.3 years.  

11

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


5.           RELATED PARTY TRANSACTIONS
 
Fees for monthly accounting and financial statement services are paid to an entity owned by a member of the DRH Board of Directors and a stockholder of the Company. Fees paid during the three-month periods ended March 29, 2015 and March 30, 2014, were $138,620, and $125,988, respectively.
 
See Note 9 for related party operating lease transactions.

6.           LONG-TERM DEBT
 
Long-term debt consists of the following obligations:
 
 
March 29, 2015
 
December 28, 2014
Note payable - $56.0 million term loan; payable to RBS with a senior lien on all the Company’s personal property and fixtures. Scheduled monthly principal payments are approximately $666,667 plus accrued interest through maturity in December 2019. Interest is charged based on one-month LIBOR plus an applicable margin, which ranges from 2.25% to 3.15%, depending on the lease adjusted leverage ratio defined in the terms of the agreement. The rate at March 29, 2015 was approximately 2.7%.

 
$
54,000,000

 
56,000,000

 
 
 
 
 
Note payable - $20.0 million development line of credit; payable to RBS with a senior lien on all the Company’s personal property and fixtures. Payments are due monthly once fully drawn and matures in December 2019. Interest is charged based on one-month LIBOR plus an applicable margin, which ranges from 2.25% to 3.15%, depending on the lease adjusted leverage ratio defined in the terms of the agreement. Once fully drawn, payments will be due monthly; the note matures December 2019.
 
$
10,188,721

 
5,768,399

 
 
 
 
 
Total long-term debt
 
64,188,721

 
61,768,399

 
 
 
 
 
Less current portion
 
(8,815,098
)
 
(8,155,903
)
 
 
 
 
 
Long-term debt, net of current portion
 
$
55,373,623

 
$
53,612,496

 
On December 16, 2014, the Company entered into a $77.0 million senior secured credit facility with RBS (the “December 2014 Senior Secured Credit Facility”).  The December 2014 Senior Secured Credit Facility consist of a $56.0 million term loan (the “December 2014 Term Loan”), a $20.0 million development line of credit (the “December 2014 DLOC”), and a $1.0 million revolving line of credit (the “December 2014 RLOC”). The Company used approximately $35.5 million of the December 2014 Term Loan to refinance existing outstanding debt with RBS and used approximately $20.0 million of the December 2014 Term Loan to refinance and term out the outstanding balance of the existing development line of credit loan between the Company and RBS.   The remaining balance of the December 2014 Term Loan, approximately $0.5 million, was used to pay the fees, costs, and expenses associated with the closing of the December 2014 Senior Secured Credit Facility.  The December 2014 Term Loan is for a period of 5 years.  Payments of principal are based upon an 84-month straight-line amortization schedule, with monthly principal payments of $666,667 plus accrued interest.  The interest rate for the December 2014 Term Loan is LIBOR plus an applicable margin, which ranges from 2.25% to 3.15%, depending on the lease adjusted leverage ratio defined in the terms of the agreement.  The entire remaining outstanding principal and accrued interest on the December 2014 Term Loan is due and payable on the maturity date of December 16, 2019.  The December 2014 DLOC is for a term of two years and is convertible upon maturity into a term note based on the terms of the agreement at which time monthly principal payments will be due based on a 84-month straight-line amortization schedule, plus interest, through maturity on December 16, 2014. The December 2014 RLOC is for a term of two years and no amounts were outstanding as of March 29, 2015.
 

12

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Based on the long-term debt terms that existed at March 29, 2015, the scheduled principal maturities for the next five years and thereafter are summarized as follows:
 
Year
Amount
Remainder of 2015
$
6,407,549

2016
9,630,195

2017
9,630,195

2018
9,630,195

2019
28,890,587

2020 and thereafter

Total
$
64,188,721

 
For the three-month periods ended March 29, 2015 and March 30, 2014, interest expense was $432,223 and $476,401, respectively.
 
The current debt agreement contains various customary financial covenants generally based on the performance of the specific borrowing entity and other related entities. The more significant covenants consist of a minimum debt service coverage ratio and a maximum lease adjusted leverage ratio, both of which we are in compliance with as of March 29, 2015.
  
At March 29, 2015, the Company has five interest rate swap agreements to fix a portion of the interest rates on its variable rate debt. The swap agreements all qualify for hedge accounting. The swap agreements have a combined notional amount of $57.4 million at March 29, 2015. Under the swap agreements, the Company receives interest at the one-month LIBOR and pays a fixed rate. The April 2012 swap has a rate of 1.4% (notional amount of $9.3 million) and expires April 2019, the October 2012 swap has a rate of 0.9% (notional amount of $3.9 million) and expires October 2017, the July 2013 swap has a rate of 1.4% (notional amount of $10.8 million) and expires April 2018, the May 2014 forward swap has a rate of 1.54% (notional amount of $12.9 million) and expires April 2018, and a January 2015 forward swap has a rate of 1.82% (notional amount of $20.5 million) and expires December 2019. The fair value of these swap agreements was a liability of $735,190 and $259,626 at March 29, 2015 and December 28, 2014, respectively. Since these swap agreements qualify for hedge accounting, the changes in fair value are recorded in other comprehensive income (loss), net of tax. See Note 1 and Note 13 for additional information pertaining to interest rate swaps.

7.            STOCK-BASED COMPENSATION
 
The Company established a Stock Incentive Plan in 2011 (“Stock Incentive Plan”) to attract and retain directors, consultants, and team members and to align their interests with the interests of the Company’s shareholders through the opportunity for increased stock ownership.  The plan permits the grant and award of 750,000 shares of common stock by way of stock options and/or restricted stock.  Stock options must be awarded at exercise prices at least equal to or greater than 100.0% of the fair market value of the shares on the date of grant. The options will expire no later than ten years from the date of grant, with vesting terms to be defined at grant date, ranging from a vesting schedule based on performance to a vesting schedule that extends over a period of time as selected by the Compensation Committee of the Board of Directors (the “Committee”) or another committee as determined by the Board of Directors. The Committee also determines the grant, issuance, retention, and vesting timing and conditions of awards of restricted stock. The Committee may place limitations, such as continued employment, passage of time, and/or performance measures, on restricted stock. Awards of restricted stock may not provide for vesting or settlement in full of restricted stock over a period of less than one year from the date the award is made.
 
During the first fiscal quarter of 2015 and 2014, no restricted shares were granted.  Restricted shares are granted with a per share purchase price at 100.0% of the fair market value on the date of grant. Based on the Stock Award Agreement, shares vest ratably over a 3 years or 1 year period or upon the 3 years anniversary of the granted shares, the vesting terms are determined by the Committee.  Unrecognized stock-based compensation expense of $484,437 at March 29, 2015 will be recognized over the remaining weighted-average vesting period of 1.7 years. The total fair value of shares vested during the three-month periods ended March 29, 2015 and March 30, 2014 was $15,436 and $46,167, respectively.  Under the Stock Incentive Plan, there are 498,720 shares available for future awards at March 29, 2015.
 
The Company also reserved 250,000 shares of common stock for issuance under the Employee Stock Purchase Plan (“ESPP”). The ESPP is available to team members subject to employment eligibility requirements. Participants may purchase common stock at 85.0% of the lesser of the start or end price for the offering period. The plan has four offering periods, each start/end dates

13

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

coincide with the fiscal quarter and are awarded on the last day of the offering period. During the three-month periods ended March 29, 2015 and March 30, 2014, we issued 4,662 and 3,045 shares, respectively. Under the ESPP, there are 229,550 shares available for future awards at March 29, 2015.

The following table presents the restricted shares transactions during the three months ended March 29, 2015:
 
Number of
Restricted
Stock Shares
Unvested, December 28, 2014
164,867

Granted

Vested
(3,334
)
Expired/Forfeited
(1,917
)
Unvested, March 29, 2015
159,616

 
The following table presents the restricted shares transactions during the three months ended March 30, 2014:
 
Number of
Restricted
Stock Shares
Unvested, December 39, 2013
116,667

Granted

Vested
(11,875
)
Expired/Forfeited
(1,500
)
Unvested, March 30, 2014
103,292

   
On July 30, 2010, DRH granted options for the purchase of 210,000 shares of common stock to the directors of the Company.  These options are fully vested and expire six years from issuance, July 30, 2016.  Once vested, the options can be exercised at a price of $2.50 per share. At March 29, 2015, 210,000 shares of authorized common stock are reserved for issuance to provide for the exercise of these options. The intrinsic value of outstanding options is $338,100 and $525,000 as of March 29, 2015 and March 30, 2014, respectively.
 
Stock-based compensation of $55,793 and $85,320 was recognized during the three-month periods ended March 29, 2015 and March 30, 2014, respectively, as compensation cost in the Consolidated Statements of Operations and as additional paid-in capital on the Consolidated Statement of Stockholders' Equity to reflect the fair value of shares vested.
   
The Company has authorized 10,000,000 shares of preferred stock at a par value of $0.0001.  No preferred shares are issued or outstanding as of March 29, 2015.  Any preferences, rights, voting powers, restrictions, dividend limitations, qualifications, and terms and conditions of redemption shall be set forth and adopted by a Board of Directors' resolution prior to issuance of any series of preferred stock.

14

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


8.           INCOME TAXES
 
The benefit for income taxes consists of the following components for the three-month periods ended March 29, 2015 and March 30, 2014, respectively:
 
 
Three Months Ended
 
 
 
March 29, 2015
 
March 30, 2014
 
Federal:
 
 
 
 
 
Current
 
$

 
$

 
Deferred
 
(148,937
)
 
(61,703
)
 
State:
 
 
 
 
 
Current
 
60,000

 
39,279

 
Deferred
 
19,579

 
(30,634
)
 
Income tax benefit
 
$
(69,358
)
 
$
(53,058
)
 
 
The benefit for income taxes is different from that which would be obtained by applying the statutory federal income tax rate to income before income taxes before income taxes.  The items causing this difference are as follows:
 
 
March 29, 2015
 
March 30, 2014
Income tax provision at federal statutory rate
 
$
65,716

 
$
107,032

State income tax provision
 
79,579

 
5,706

Permanent differences
 
96,095

 
67,754

Tax credits
 
(310,748
)
 
(233,550
)
Income tax benefit
 
$
(69,358
)
 
$
(53,058
)
 
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  The Company expects the deferred tax assets to be fully realizable within the next several years. Significant components of the Company's deferred income tax assets and liabilities are summarized as follows:
 
 
March 29, 2015
 
December 28, 2014
Deferred tax assets:
 
 
 
 
Net operating loss carry forwards
 
$
412,768

 
$
915,900

Deferred rent expense
 
471,869

 
481,543

Start-up costs
 
96,769

 
99,261

Tax credit carry forwards
 
3,728,464

 
3,417,716

Interest rate swaps
 
249,968

 
88,121

Investments
 

 
1,959

Sale leaseback deferred gain
 
774,832

 
788,195

Stock-based compensation
 
330,977

 
310,790

Other
 
437,586

 
397,117

Total deferred tax assets
 
6,503,233

 
6,500,602

 
 
 
 
 
Deferred tax liabilities:
 
 
 
 
Tax depreciation in excess of book
 
2,720,374

 
3,069,315

Goodwill and other
 
533,125

 
470,647

Total deferred tax liabilities
 
3,253,499

 
3,539,962

 
 
 
 
 
Net deferred income tax asset
 
$
3,249,734

 
$
2,960,640


15

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
If deemed necessary by management, the Company establishes valuation allowances in accordance with the provisions of Accounting Standards Codification (“ASC”) 740, Income Taxes ("ASC 740") issued by FASB. Management continually reviews the likelihood that deferred tax assets will be realized and the Company recognizes these benefits only as reassessment indicates that it is more likely than not that such tax benefits will be realized. 
 
The Company expects to use net operating loss and general business tax credit carryforwards before their 20-year expiration. As of March 29, 2015, the Company has available federal net operating loss carryforwards of approximately $1.8 million. Of that amount, approximately $0.6 million relates to stock-based compensation tax deductions in excess of book compensation expense that will be credited to additional paid in capital in future periods when such deductions reduce taxes payable as determined based on a "with-and-without" approach.  Net operating losses relating to such benefits are not included in the table above. General business tax credits of $3.7 million will expire between 2028 and 2036
 
The Company applies the provisions of ASC 740 regarding the accounting for uncertainty in income taxes.  There are no amounts recorded on the Company's consolidated financial statements for uncertain positions.  The Company classifies all interest and penalties as income tax expense.  There are no accrued interest amounts or penalties related to uncertain tax positions as of March 29, 2015.

The Company files income tax returns in the United States federal jurisdiction and various state jurisdictions, and is subject to U.S. Federal, state, and local income tax examinations for tax years 2011 through 2013.

9.           OPERATING LEASES (INCLUDING RELATED PARTY)
 
Lease terms range from five to 24 years, generally include renewal options, and frequently require us to pay a proportionate share of real estate taxes, insurance, common area maintenance, and other operating costs. Some restaurant leases provide for contingent rental payments based on sales thresholds.
 
Total rent expense was $1.9 million and $1.3 million for the three-month periods ended March 29, 2015 and March 30, 2014, respectively (of which $0 and $34,821, respectively, were paid to a related party).  
 
Scheduled future minimum lease payments for each of the five years and thereafter for non-cancelable operating leases with initial or remaining lease terms in excess of one year at March 29, 2015 are summarized as follows: 
Year
Amount
Remainder of 2015
$
5,974,021

2016
8,006,510

2017
7,771,040

2018
7,416,526

2019
6,912,322

2020 and thereafter
39,319,097

Total
$
75,399,516

 
Scheduled future minimum lease payments for each of the five years and thereafter for non-cancelable operating leases for restaurants under development with initial or remaining lease terms in excess of one year at March 29, 2015 are summarized as follows:
Year
Amount
Remainder of 2015
$
263,039

2016
753,689

2017
754,536

2018
755,382

2019
743,108

2020 and thereafter
5,331,672

Total
$
8,601,426



16

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10.           COMMITMENTS AND CONTINGENCIES
 
The Company’s ADA requires DRH to open 32 restaurants by March 1, 2017.  Failure to develop restaurants in accordance with the schedule detailed in the agreement could lead to potential penalties of up to $50,000 for each undeveloped restaurant, payment of the initial franchise fees for each undeveloped restaurant, and loss of rights to development territory.  As of March 29, 2015 we have opened 24 of the 32 restaurants required by the ADA.  With the remaining eight restaurants, along with two additional franchise agreements, we expect the Company will operate 52 BWW restaurants by 2017, exclusive of potential additional BWW restaurant acquisitions.  
  
The Company is required to pay BWLD royalties (5.0% of net sales) and advertising fund contributions (3.0% of net sales globally and 0.5% of net sales for certain cities) for the term of the individual franchise agreements.  The Company incurred royalty fees of $1.6 million and $1.3 million for the three-month periods ended March 29, 2015 and March 30, 2014, respectively.  Advertising fund contribution expenses were $1.0 million and $767,157 for the three-month periods ended March 29, 2015 and March 30, 2014, respectively.

The Company is required by its various BWLD franchise agreements to modernize the restaurants during the term of the agreements.  The individual agreements generally require improvements between the fifth and tenth year to meet the most current design model that BWLD has approved.  The modernization costs for a restaurant can range from approximately $50,000 to approximately $1.1 million depending on an individual restaurant's needs.
 
The Company is subject to ordinary and routine legal proceedings, as well as demands, claims and threatened litigation, which arise in the ordinary course of its business.  The ultimate outcome of any litigation is uncertain.  While unfavorable outcomes could have adverse effects on the Company's business, results of operations, and financial condition, management believes that the Company is adequately insured and does not believe an unfavorable outcome of any pending or threatened proceedings is probable or reasonably possible.  Therefore, no separate reserve or disclosure has been established for these types of legal proceedings. 

11.          EARNINGS PER SHARE
 
The following is a reconciliation of basic and fully diluted earnings per common share for the three months ended March 29, 2015 and March 30, 2014:
 
 
Three months ended
 
 
March 29, 2015
 
March 30, 2014
Income available to common stockholders
 
$
262,642

 
$
367,857

 
 
 
 
 
Weighted-average shares outstanding
 
26,149,184

 
26,048,805

Effect of dilutive securities
 
99,240

 
104,790

Weighted-average shares outstanding - assuming dilution
 
26,248,424

 
26,153,595

 
 
 
 
 
Earnings per share
 
$
0.01

 
$
0.01

Earnings per share - assuming dilution
 
$
0.01

 
$
0.01


12.            SUPPLEMENTAL CASH FLOWS INFORMATION
 
Other Cash Flows Information
 
Cash paid for interest was $419,674 and $464,115 during the three-month periods ended March 29, 2015 and March 30, 2014 respectively.
 
Cash paid for income taxes was $60,000 and $0 during the three-month periods ended March 29, 2015 and March 30, 2014, respectively.


17

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Supplemental Schedule of Non-Cash Operating, Investing, and Financing Activities
 
Noncash investing activities for property and equipment not yet paid during the three months ended March 29, 2015 and March 30, 2014, was $0.4 million and $1.0 million, respectively.  

13.           FAIR VALUE OF FINANCIAL INSTRUMENTS
 
The guidance for fair value measurements, FASB ASC 820, Fair Value Measurements and Disclosures, establishes the authoritative definition of fair value, sets out a framework for measuring fair value, and outlines the required disclosures regarding fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We use a three-tier fair value hierarchy based upon observable and non-observable inputs as follows:
 
 
Level 1
Quoted market prices in active markets for identical assets and liabilities;
 
 
 
 
Level 2
Inputs, other than level 1 inputs, either directly or indirectly observable; and
 
 
 
 
Level 3
Unobservable inputs developed using internal estimates and assumptions (there is little or no market data) which reflect those that market participants would use.
 
As of March 29, 2015 and December 28, 2014, respectively, our financial instruments consisted of cash and cash equivalents; including money market funds, accounts receivable, available-for-sale investments, accounts payable, and debt. The fair value of cash and cash equivalents, accounts receivable, and accounts payable approximate carrying value, due to their short-term nature.
  
The fair value of our interest rate swaps is determined based on valuation models, which utilize quoted interest rate curves to calculate the forward value and then discount the forward values to the present period. The Company measures the fair value using broker quotes which are generally based on market observable inputs including yield curves and the value associated with counterparty credit risk. Our interest rate swaps are classified as a Level 2 measurement as these securities are not actively traded in the market, but are observable based on transactions associated with bank loans with similar terms and maturities. See Note 1 and Note 6 for additional information pertaining to interest rates swaps.
 
The estimated fair values of the Company’s investment portfolio are based on prices provided by a third party pricing service and a third party investment manager. The prices provided by these services are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The third party pricing service and the third party investment manager provide a single price or quote per security and the Company has not historically adjusted security prices. The Company obtains an understanding of the methods, models and inputs used by the third party pricing service and the third party investment manager, and has controls in place to validate that amounts provided represent fair values. Our investments are classified as a Level 2 measurement as these securities are not actively traded in the market, but are observable based on the quoted prices provided by our Portfolio managers.
 
As of March 29, 2015 and December 28, 2014, our total debt was approximately $64.2 million and $61.8 million, respectively, which approximated fair value. The Company estimates the fair value of its fixed-rate debt using discounted cash flow analysis based on the Company’s incremental borrowing rate (Level 2).
 
There were no transfers between levels of the fair value hierarchy during the three months ended March 29, 2015 and the fiscal year ended December 28, 2014.


18

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table presents the fair values for those assets and liabilities measured on a recurring basis as of March 29, 2015:
 
FAIR VALUE MEASUREMENTS
Description
 
Level 1
 
Level 2
 
Level 3
 
Asset/(Liability)
Total
Cash equivalents
 
$
10,000,000

 
$

 
$

 
$
10,000,000

Interest rate swaps
 

 
(735,190
)
 

 
(735,190
)
Total
 
$
10,000,000

 
$
(735,190
)
 
$

 
$
9,264,810

 
 
The following table presents the fair values for those assets and liabilities measured on a recurring basis as of December 28, 2014:
 
FAIR VALUE MEASUREMENTS
Description
 
Level 1
 
Level 2
 
Level 3
 
Asset/(Liability)
Total
Interest rate swaps
 
$

 
$
(259,626
)
 
$

 
$
(259,626
)
Debt securities
 
 
 
 
 
 
 
 
Obligations of states/municipals
 

 
1,185,983

 

 
1,185,983

Corporate securities
 

 
1,731,249

 

 
1,731,249

Total debt securities
 

 
2,917,232

 

 
2,917,232

Total
 
$

 
$
2,657,606

 
$

 
$
2,657,606

 

14. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
 
The following table summarizes each component of Accumulated Other Comprehensive Income (loss):
 
 
Three Months Ended March 29, 2015
 
 
Interest Rate Swap
 
Investments
 
Total
Beginning balance
 
$
(171,352
)
 
$
(3,804
)
 
$
(175,156
)
 
 
 
 
 
 
 
Gain(loss) recorded to other comprehensive income
 
(475,564
)
 
5,763

 
(469,801
)
Tax benefit (expense)
 
$
161,691

 
$
(1,959
)
 
$
159,732

Other comprehensive income (loss)
 
(313,873
)
 
3,804

 
(310,069
)
 
 
 
 
 
 
 
Accumulated OCI
 
$
(485,225
)
 
$

 
$
(485,225
)

 
 
Three Months Ended March 30, 2014
 
 
Interest Rate Swap
 
Investments
 
Total
Beginning balance
 
$
(216,188
)
 
$
(29,176
)
 
$
(245,364
)
 
 
 
 
 
 
 
Gain recorded to other comprehensive income
 
45,980

 
34,931

 
80,911

Tax expense
 
$
(15,633
)
 
$
(11,876
)
 
$
(27,509
)
Other comprehensive income
 
30,347

 
23,055

 
53,402

 
 
 
 
 
 
 
Accumulated OCI
 
$
(185,841
)
 
$
(6,121
)
 
$
(191,962
)


19

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



15.           SUBSEQUENT EVENTS

On February 17, 2015, the Company entered into an Asset Purchase Agreement (the “Purchase Agreement”) to acquire substantially all of the assets of Screamin' Hot Concepts, LLC, Screamin' Hot Nampa, LLC, Screamin’ Hot Twin Falls, LLC, each an Idaho limited liability company, and Screamin’ Hot Reno, LLC, a Nevada limited liability company. BWLD had the right of first refusal, exercisable for a period of 45 days, to acquire the restaurants on the same terms proposed in the Purchase Agreement. On April 8, 2015, we received notice from the BWLD of its intent to exercise its right of first refusal. As a result, the Company is relieved of its obligations under the Purchase Agreement.

On April 2, 2015, the Company entered into an program to repurchase up to $1.0 million of the Company’s common stock from time to time in open market transactions at prevailing market prices or by other means in accordance with applicable regulations of the SEC. The Company has entered into a Rule 10b5-1 purchase plan with a broker to facilitate the repurchase program.



20


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated interim financial statements and related notes included in Item 1 of Part 1 of this Quarterly Report and the audited consolidated financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results from Operations contained in our Form 10-K, for the fiscal year ended December 28, 2014. Information included in this discussion and analysis includes commentary on company-owned restaurant, restaurant sales, and same store sales. Management believes such sales information is an important measure of our performance, and is useful in assessing consumer acceptance of the Bagger Dave’s Tavern® (“Bagger Dave’s”) and Buffalo Wild Wings® Grill & Bar (“BWW”) concept and the overall health of the concepts. However, same store sales information does not represent sales, in accordance with accounting principles generally accepted in the United States of America (“GAAP”), should not be considered in isolation or as a substitute for other measures of performance prepared in accordance with GAAP and may not be comparable to financial information as defined or used by other companies.
 
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
 
Statements contained in this “Quarterly Report on Form 10-Q” may contain information that includes or is based upon certain “forward-looking statements” relating to our business. These forward-looking statements represent management’s current judgment and assumptions, and can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are frequently accompanied by the use of such words as “anticipates,” “plans,” “believes,” “expects,” “projects,” “intends,” and similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors, including, while it is not possible to predict or identify all such risks, uncertainties, and other factors, those relating to our ability to secure the additional financing adequate to execute our business plan; our ability to locate and start up new restaurants; acceptance of our restaurant concepts in new market places; and the cost of food and other raw materials.  Any one of these or other risks, uncertainties, other factors, or any inaccurate assumptions may cause actual results to be materially different from those described herein or elsewhere by us. We caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date they were made. Certain of these risks, uncertainties, and other factors may be described in greater detail in our filings from time to time with the Securities and Exchange Commission, which we strongly urge you to read and consider. Subsequent written and oral forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth above and elsewhere in our reports filed with the SEC. We expressly disclaim any intent or obligation to update any forward-looking statements.
 
OVERVIEW
 
Diversified Restaurant Holdings, Inc. (“DRH”) is a fast-growing restaurant company operating two complementary concepts:  Bagger Dave’s and BWW.  As the creator, developer, and operator of Bagger Dave’s and as one of the largest franchisees of BWW, we provide a unique guest experience in a casual and inviting environment.  We were incorporated in 2006 and are headquartered in the Detroit metropolitan area.  As of March 29, 2015, we had 68 locations in Florida, Illinois, Indiana, and Michigan.
  
DRH and its wholly-owned subsidiaries (collectively, the “Company”), AMC Group, Inc. (“AMC”), AMC Wings, Inc. (“WINGS”), AMC Burgers, Inc. (“BURGERS”), and AMC Real Estate, Inc. (“REAL ESTATE”) own, operate, and manage Bagger Dave's and DRH-owned BWW restaurants located throughout Florida, Illinois, Indiana, and Michigan.
 
DRH originated the Bagger Dave’s concept with our first restaurant opening in January 2008 in Berkley, Michigan.  Currently, there are 26 Bagger Dave’s, 17 in Michigan and nine in Indiana. The Company expects to operate between 38 and 42 Bagger Dave’s locations by the end of 2017.
 
DRH is also one of the largest BWW franchisees and currently operates 42 DRH-owned BWW restaurants (19 in Michigan, 14 in Florida, four in Illinois, and five in Indiana), including the nation’s largest BWW, based on square footage, in downtown Detroit, Michigan. We remain on track to fulfill our area development agreement (“ADA”) with Buffalo Wild Wings International, Inc. (“BWLD”) and expect to operate 52 DRH-owned BWW restaurants by the end of 2017, exclusive of potential additional BWW restaurant acquisitions. 


21


RESTAURANT OPENINGS
 
The following table outlines the restaurant unit information for each fiscal year from 2011 through 2015.
 
 
2015
(estimate)
 
2014
 
2013
 
2012
 
2011
Summary of restaurants open at the beginning of year
 
 
 
 
 
 
 
 
 
 
DRH-owned BWW
 
42

 
36

 
33

 
22

 
19

Bagger Dave’s
 
24

 
18

 
11

 
6

 
3

Total
 
66

 
54

 
44

 
28

 
22

 
 
 
 
 
 
 
 
 
 
 
Openings:
 
 
 
 
 
 
 
 
 
 
DRH-owned BWW
 
3

 
3

 
3

 
3

 
3

Bagger Dave’s
 
5-6

 
6

 
7

 
5

 
3

BWW Acquisitions
 

 
3

 

 
8

 

Closures
 

 

 

 

 

Total restaurants
 
74-75

 
66

 
54

 
44

 
28


RESULTS OF OPERATIONS
 
For the three-month period ended March 29, 2015 ("First Quarter 2015"), revenue was generated from the operations of 42 BWW restaurants and 26 Bagger Dave’s restaurants. For the three-month period ended March 30, 2014 ("First Quarter 2014"), revenue was generated from the operations of 36 BWW restaurants and 18 Bagger Dave’s restaurants. Quarterly and annual operating results may fluctuate significantly as a result of a variety of factors, including the timing and number of new restaurant openings and related expenses, increases or decreases in same store sales, changes in commodity prices, general economic conditions, and seasonal fluctuations. As a result, our quarterly results of operations are not necessarily indicative of the results that may be achieved for any future period. Same store sales is defined as a restaurants comparable sales in the first full month following the 18th month of operations. Changes in comparable restaurant sales reflect changes in sales for the comparable group of restaurants over a specified period of time. Our comparable restaurant base consisted of 50 and 36 restaurants at March 29, 2015 and March 30, 2014, respectively.
 
Results of Operations for the Three Months Ended March 29, 2015 and March 30, 2014
 
 
 
Three Months Ended
 
 
March 29, 2015
 
March 30, 2014
Total revenue
 
100.0
%
 
100.0
%
 
 
 
 
 
Operating expenses
 
 
 
 
Restaurant operating costs:
 
 
 
 
Food, beverage, and packaging costs
 
29.0
%
 
28.6
%
Compensation costs
 
25.7
%
 
26.2
%
Occupancy costs
 
6.0
%
 
5.4
%
Other operating costs
 
20.2
%
 
20.6
%
General and administrative expenses
 
6.3
%
 
6.9
%
Pre-opening costs
 
2.8
%
 
1.8
%
Depreciation and amortization
 
8.0
%
 
7.4
%
Loss on disposal of property and equipment
 
0.4
%
 
0.5
%
Total operating expenses
 
98.4
%
 
97.4
%
 
 
 
 
 
Operating profit
 
1.6
%
 
2.6
%

Revenue for First Quarter 2015 was $39.4 million, an increase of $9.0 million, or 29.4%, over the $30.5 million of revenue generated during First Quarter 2014. The increase was attributable to increased same store sales, acquisition of three BWW locations, and

22


the opening of 11 DRH-owned restaurants (eight Bagger Dave’s and three BWW restaurants). $2.3 million was attributable to the 8.0% same store sales increase of 37 BWW and 13 Bagger Dave’s restaurants. $1.7 million was attributable to the acquisition of three BWW restaurants on June 30, 2014. The remaining $5.0 million is a result of restaurants opening within the last 18-months, including 13 Bagger Dave’s (two were built in the First Quarter 2015) and five BWW restaurants. The Company's 8.0% increase in same store sales is a result of an increase of 11.2% same store sales for Bagger Dave's (7.3% increase in customer traffic) and 7.6% same store sales for BWW (0.6% increase in customer traffic).
 
 
Food, beverage, and packaging costs increased by $2.7 million, or 31.5%, to $11.4 million in First Quarter 2015 from $8.7 million in First Quarter 2014.  The increase was primarily due to an increased number of restaurants operating in 2015. Food, beverage, and packaging costs as a percentage of revenue increased to 29.0% in First Quarter 2015 from 28.6% in First Quarter 2014 primarily due to higher chicken wing prices, partially offset by an increase in menu pricing. Average cost per pound for bone-in chicken wings was $1.89 in First Quarter 2015 compared to $1.33 in First Quarter 2014.
 
Compensation costs increased by $2.2 million, or 27.0%, to $10.2 million in First Quarter 2015 from $8.0 million in First Quarter 2014.  The increase was primarily due to an increased number of restaurants operating in 2015.  Compensation costs as a percentage of sales decreased to 25.7% in First Quarter 2015 from 26.2% in First Quarter 2014 as a result of increased sales over the same period last year, helping offset minimum wage increases.  
 
Occupancy costs increased by $0.7 million, or 43.3%, to $2.4 million in First Quarter 2015 from $1.7 million in First Quarter 2014.  This increase is primarily due to the increased number of restaurants operating in 2015. Occupancy as a percentage of sales increased to 6.0% in First Quarter 2015 from 5.4% in First Quarter 2014 primarily due to the execution of the sale leaseback of DRH-owned properties in late 2014.
 
Other operating costs increased by $1.7 million, or 26.8%, to $8.0 million in First Quarter 2015 from $6.3 million in First Quarter 2014.  The increase was primarily due to an increased number of restaurants operating in 2015. Other operating costs as a percentage of sales decreased to 20.2% in First Quarter 2015 from 20.6% in First Quarter 2014.
 
General and administrative expenses increased by $0.4 million, or 18.2%, to $2.5 million in First Quarter 2015 from $2.1 million in First Quarter 2014.  This increase was primarily due to the timing of our marketing expenses compared to prior year. General and administrative expenses as a percentage of sales decreased to 6.3% in First Quarter 2015 from 6.9% in First Quarter 2014.
 
Pre-opening costs increased by $0.6 million, or 101.0%, to $1.1 million in First Quarter 2015 from $0.5 million First Quarter 2014.   The Company opened two new restaurants and had one relocation in First Quarter 2015 compared to no openings in First Quarter 2014. There were five openings in the previous year Fourth Quarter 2014 and Fourth Quarter 2013, which contributed to carry-over costs in First Quarter 2015 and 2014.  Pre-opening costs as a percentage of sales increased to 2.8% in First Quarter 2015 from 1.8% in First Quarter 2014.
 
Depreciation and amortization increased by $0.9 million, or 40.5%, to $3.2 million in First Quarter 2015 from $2.2 million in First Quarter 2014.  This increase was primarily due to an increased number of restaurants operating in 2015.  Depreciation and amortization as a percentage of sales increased to 8.0% in First Quarter 2015 from 7.4% in First Quarter 2014 primarily due to the increased investment in ground-up development of our restaurant buildings. 
 
Loss on disposal of property and equipment decreased by $7,657, or (4.9)%, to $148,408 in First Quarter 2015 from $156,065 in First Quarter 2014. Loss on disposal of property and equipment as a percentage of sales decreased to 0.4% in First Quarter 2015 from 0.5% in First Quarter 2014.
 
INTEREST AND TAXES
 
Interest expense was $432,223 and $476,401 during First Quarter 2015 and First Quarter 2014, respectively. The decrease was primarily due to a reduction in interest rates and a $5.1 million debt reduction from the proceeds of the sale leaseback transaction. 
 
For First Quarter 2015, DRH had an income tax benefit of $69,358 compared to  First Quarter 2014 income tax benefit of $53,058.  The First Quarter 2015 income tax benefit primarily relates to the increase in tip credits for the period. 

LIQUIDITY AND CAPITAL RESOURCES; EXPANSION PLANS
 
On December 16, 2014, the Company entered into a $77.0 million senior secured credit facility with RBS Citizens, N.A. ("RBS") (the “December 2014 Senior Secured Credit Facility”).  The December 2014 Senior Secured Credit Facility consist of a $56.0

23


million term loan (the “December 2014 Term Loan”), a $20.0 million development line of credit (the “December 2014 DLOC”), and a $1.0 million revolving line of credit (the “December 2014 RLOC”). The Company used approximately $35.5 million of the December 2014 Term Loan to refinance existing outstanding debt with RBS and used approximately $20.0 million of the December 2014 Term Loan to refinance and term out the outstanding balance of the existing development line of credit loan between the Company and RBS.   The remaining balance of the December 2014 Term Loan, approximately $0.5 million, was used to pay the fees, costs, and expenses associated with the closing of the December 2014 Senior Secured Credit Facility.  The December 2014 Term Loan is for a period of five years.  Payments of principal are based upon an 84-month straight-line amortization schedule, with monthly principal payments of $666,667 plus accrued interest.  The interest rate for the December 2014 Term Loan is LIBOR plus an applicable margin, which ranges from 2.25% to 3.15%, depending on the lease adjusted leverage ratio defined in the terms of the agreement.  The entire remaining outstanding principal and accrued interest on the December 2014 Term Loan is due and payable on the maturity date of December 16, 2019.  The December 2014 DLOC is for a term of two years and is convertible upon maturity into a term note based on the terms of the loan agreement at which time monthly principal payments will be due on a 84-month straight-line amortization schedule, plus interest through maturity on December 16, 2019. The December 2014 RLOC is for a term of two years and no amount was outstanding as of March 29, 2015.
 
We believe the cash flow from operations, proceeds from the sale-lease-back agreement of $24.6 million, and availability of credit will be sufficient to meet our operational funding, development, and obligations for at least the next 12 months.
 
Our capital requirements are primarily dependent upon the pace of our new restaurant growth plan. The new restaurant growth plan is primarily dependent upon economic conditions, the real estate market, and resources to both develop and operate new restaurants.  In addition to new restaurants, our capital expenditure outlays are also dependent on costs for maintenance, facility upgrades, capacity enhancements, information technology, and other general corporate capital expenditures.

The amount of capital required to open a new restaurant is largely dependent on whether we build-out an existing leased space or build from the ground up.  Our preference is to find leased space for new restaurant locations but depending on the availability of real estate in specific markets, we will take advantage of alternative strategies which may include land purchases, land leases, and ground up construction of a building to house our restaurant operation.  Excluding land and building, we expect the build-out of a new Bagger Dave’s restaurant will, on average, require a total cash investment of $1.1 million to $1.4 million (excluding potential tenant incentives). Similarly, we expect the build-out of a new DRH-owned BWW restaurant will require an estimated cash investment of $1.9 million to $2.1 million (excluding potential tenant incentives).  We expect to spend approximately $250,000 to $275,000 per restaurant for pre-opening expenses.  Depending on individual lease negotiations, we may receive cash tenant incentives of up to $400,000.  The projected cash investment per restaurant is based on recent opening costs and future projections and may fluctuate based on construction costs specific to new restaurant locations.
 
We target a cash on cash return on our initial total capital investment of less than four years. The expected payback is subject to how quickly we reach our target sales volume and the cost of construction.
 
Cash flow from operations for First Quarter 2015 was $3.1 million compared with $2.7 million for First Quarter 2014. Net cash provided by operating activities consisted primarily of net earnings adjusted for non-cash expenses.

Opening new restaurants, including real estate investments, is our primary use of capital and is estimated to be over 80.0% of our planned capital expenditures in 2015. For 2015, we estimate capital expenditures to be between $35.0 million and $40.0 million. We plan to use the capital as follows: nearly one half for new restaurant openings, one third for real estate (including the purchase of land and construction of buildings) associated with new restaurant openings; and the remaining for restaurant remodels, upgrades, relocations and other general corporate purposes.
  
Although investments in new restaurants are an integral part of our strategic and capital expenditures plan, we also believe that reinvesting in existing restaurants is an important factor and necessary to maintain the overall positive dining experience for our guests. Depending on the age of the existing restaurants, upgrades range from $50,000 (for minor interior refreshes) to $1.1 million (for a full remodel of the restaurant). Restaurants are typically upgraded after approximately five to seven years of operation and fully remodeled after approximately 10 years of operation.

Mandatory Upgrades
 
In fiscal year 2015, we will complete four mandatory remodels of existing DRH-owned BWW restaurant, which will be funded with cash from operations.
 

24


Discretionary Upgrades and Relocations
 
In fiscal year 2015, the Company will invest additional capital to provide minor upgrades to a number of its existing locations, all of which will be funded by cash from operations. These improvements will primarily consist of refreshing interior building finishes audio/visual equipment upgrades, and patio upgrades. In fiscal year 2015, we relocated one DRH-owned BWW location in the First Quarter 2015 in lieu of a remodel. The decision to relocate is typically driven by timing of our current lease agreements and the availability of real estate that we deem to be a better long-term investment. Relocations are funded by a combination of cash from operations and borrowing from our credit facility.

Contractual Obligations
 
The following table presents a summary of our contractual obligations as of March 29, 2015:
 
 
Total
 
Less than
one year
 
1 - 3 years
 
3 - 5 years
 
After 5 years
Long-term debt1
 
$
64,188,721

 
$
8,815,098

 
$
19,260,390

 
$
36,113,233

 
$

Operating lease obligations
 
75,399,516

 
7,996,613

 
15,683,507

 
14,116,739

 
37,602,657

Commitments for restaurants under development 2
 
21,990,481

 
13,840,410

 
1,508,649

 
1,492,353

 
5,149,069

 
 
$
161,578,718

 
$
30,652,121

 
$
36,452,546

 
$
51,722,325

 
$
42,751,726

 
1 

Amount represents the expected principal cash payments relating to our long-term debt and do not include any fair value adjustments or discounts/premiums or interest rate payments due to the variable of the rates. See Note 6 for additional details. 
2 

Amount represents capital expenditures DRH is obligated to pay for restaurants under development in addition to noncancelable operating leases for these restaurants. 


Inflation
 
Our profitability is dependent, among other things, on our ability to anticipate and react to changes in the costs of key operating resources, including food and other raw materials, labor, energy, and other supplies and services. Substantial increases in costs and expenses could impact our operating results to the extent that such increases cannot be passed along to our restaurant guests.  The impact of inflation on food, labor, energy, and occupancy costs can significantly affect the profitability of our restaurant operations.
 
All of our restaurant staff members are paid hourly rates based on the federal minimum wage.  Certain operating costs, such as taxes, insurance, and other outside services continue to increase with the general level of inflation or higher and may also be subject to other cost and supply fluctuations outside of our control.
 
While we have been able to partially offset inflation and other changes in the costs of key operating resources by gradually increasing prices for our menu items, more efficient purchasing practices, productivity improvements, and greater economies of scale, there can be no assurance that we will be able to continue to do so in the future. From time to time, competitive conditions could limit our menu pricing flexibility.  In addition, macroeconomic conditions could make additional menu price increases imprudent.  There can be no assurance that all future cost increases can be offset by increased menu prices or that increased menu prices will be fully absorbed by our restaurant guests without any resulting changes in their visit frequencies or purchasing patterns. There can be no assurance that we will continue to generate increases in comparable restaurant sales in amounts sufficient to offset inflationary or other cost pressures.

OFF-BALANCE SHEET ARRANGEMENTS
 
The Company assumed, from a related entity, an ADA in which the Company was to open 23 BWW restaurants within its designated "development territory”. On December 12, 2008, this agreement was amended, adding nine additional restaurants and extending the date of fulfillment to March 1, 2017. Failure to develop restaurants in accordance with the schedule detailed in the agreement could lead to potential penalties of up to $50,000 for each undeveloped restaurant, payment of the initial franchise fees for each undeveloped restaurant, and loss of rights to development territory. Failure to develop restaurants in accordance with the schedule detailed in the agreement could lead to potential penalties of $50,000 for each undeveloped restaurant and loss of rights to the development territory. As of March 29, 2015, 24 of the required 32 ADA restaurants had been opened for business. We remain on track to fulfill our obligation under the amended ADA, and we expect to operate a total of 52 BWW by the end of 2017, exclusive of potential acquisitions of additional BWW restaurants.
 

25


CRITICAL ACCOUNTING ESTIMATES
 
We prepare our consolidated financial statements in conformity with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Our critical accounting policies have not changed materially from those previously reported in our Annual Report on Form 10-K for the fiscal year ended December 28, 2014.

26


Item 3. Quantitative and Qualitative Disclosure About Market Risks
 
Debt Securities
 
We were exposed to market risk related to our debt securities. To manage our exposure, we invested our excess cash in highly liquid short-term investments with maturities of less than one year. The investments were not held for trading or other speculative purposes. In the First Quarter 2015, DRH opted to discontinue investing in debt securities and determined investing in a highly liquid market money account was better fit for our liquidity needs. As of March 29, 2015, the outstanding investments had matured and investments redeemed. See Notes 1, 2, and 13 of our unaudited consolidated financial statements in Part I Item 1 of this report for additional information.
 
Interest Rate Risk
 
As a result of our normal borrowing activities, our operating results are exposed to fluctuations in interest rates. DRH has short-term and long-term debt with both fixed and variable interest rates. The short-term debt comprises the current portion of long-term debt maturing within twelve months from the balance sheet date. Long-term debt includes secured notes payable, two lines of credit and a revolving line of credit which is used to finance working capital requirements. To manage our exposure, we have entered into interest rate swap agreements. The derivative instruments are not held for trading or other speculative purposes.
 
As of March 29, 2015, DRH had $64.2 million of variable-rate debt with a weighted average interest rate of 2.7%, which approximates fair value. Interest based on the debt agreement is based on one-month LIBOR plus an applicable margin, which ranges from 2.25% to 3.15%, depending on the lease adjusted leverage ratio defined in the terms of the agreement. DRH currently estimates that a 100 basis point fluctuation in LIBOR would result in an approximate $0.6 million fluctuation in pretax income. See Notes 1, 6 and 13 of our unaudited consolidated financial statements in Part I Item 1 of this report for additional information.
 
Inflation
 
The primary inflationary factors affecting our operations are food, labor, and restaurant operating costs. Substantial increases in these costs could impact operating results to the extent that such increases cannot be passed along through higher menu prices. A large number of our restaurant personnel are paid at rates based on the applicable federal and state minimum wages, and increases in the minimum wage rates and tip-credit wage rates could directly affect our labor costs. Many of our leases require us to pay taxes, maintenance, repairs, insurance, and utilities, all of which are generally subject to inflationary increases.
 
Commodity Price Risk
 
Many of the food products purchased by us are affected by weather, production, availability, and other factors outside our control. We believe almost all of our food and supplies are available from several sources, which helps to control food product risks. Our purchasing department for Bagger Dave’s negotiates directly with our independent suppliers for our supply of food and paper products. As negotiated by BWLD, our DRH-owned BWW restaurants have a distribution contract with a BWLD selected vendor for our supply of food, paper, and non-food products. We have minimum purchase requirements with some of our vendors, but the terms of the contracts and our historical use of the products are such that we believe these minimum purchase requirements do not create a material market risk. One of the primary food products used by our BWW restaurants is chicken wings. We work to counteract the effect of the volatility of chicken wing prices, which can significantly change our cost of sales and cash flow, with the introduction of new menu items, effective marketing promotions, focused efforts on food costs and waste, and menu price increases. We also explore purchasing strategies to reduce the severity of cost increases and fluctuations. For the three-month periods ended March 29, 2015 and March 30, 2014 chicken wings accounted for approximately 31.4% and 28.6% of cost of sales, with an average price per pound of $1.89 and $1.33, respectively.

27



Item 4. Controls and Procedures
 
(a) Evaluation of disclosure controls and procedures.
 
We are required to maintain disclosure controls and procedures designed to ensure that material information related to us, including our consolidated subsidiaries, is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms. Management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.
 
Conclusion regarding the effectiveness of disclosure controls and procedures
 
As of March 29, 2015, an evaluation was performed under the supervision of and with the participation of our management, including our principal executive and principal financial officers, of the effectiveness of the design and operation of our disclosure controls and procedures.  Based on that evaluation, our management, including our principal executive and principal financial officers, concluded that our disclosure controls and procedures were effective as of March 29, 2015.
 
(b) Changes in internal control over financial reporting.
 
Remedial Measures

As reported in our Form 10-K for the year ended December 28, 2014 we did not maintain effective internal control over financial reporting as of December 31, 2014.   Our management determined that our internal control related to financial reporting was not effective to ensure the effective design of internal control and that an effective evaluation and review of complex accounting matters had occurred prior to presentation to our external auditors.  We are in the process of remediating the identified deficiency in internal control over financial reporting. However, we have not completed all of the corrective remediation actions that we believe are necessary.
 
Management believes that significant progress has been made as of the date of this report, in remediating the underlying causes of the material weakness. We have taken, and will continue to take, a number of actions to remediate this material weakness. Among other things, we have engaged third party accounting advisors to assist with non-recurring and complex accounting matters. 
 
We will continue to develop and implement policies and procedures to improve the overall effectiveness of internal control over financial reporting. Management believes the foregoing efforts will effectively remediate the material weakness. As we continue to evaluate and work to improve our internal control over financial reporting, management may determine to take additional measures to address the control deficiency or determine to modify the remediation plan described above.
Changes in Internal Control over Financial Reporting
Other than the steps taken to remediate the material weakness described above, there have been no changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 29, 2015 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

28


PART II. OTHER INFORMATION
 
Item 1. Legal Proceedings 
 
Occasionally, we are a defendant in litigation arising in the ordinary course of our business, including claims arising from personal injuries, contract claims, dram shop claims, employment-related claims, and claims from guests or team members alleging injury, illness, or other food quality, health, or operational concerns. To date, none of these types of litigation, most of which are entirely or predominantly covered by insurance, has had a material effect on our financial condition or results of operations. We have insured and continue to insure against most of these types of claims. A judgment on any claim not covered by or in excess of our insurance coverage could materially adversely affect our financial condition or results of operations. As of the date of this Quarterly Report, we are not a party to any material pending legal proceedings and are not aware of any claims that could have a materially adverse effect on our financial position, results of operations or cash flows. 

Item 1A. Risk Factors
 
There have been no material changes in our risk factors from those previously disclosed in our annual report on Form 10-K for the year ended December 28, 2014.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
Not Applicable.

Item 3. Defaults Upon Senior Securities
 
None.
Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information
 
None.

29


Item 6. Exhibits
 
(a) Exhibits:
 
3.1
Certificate of Incorporation (filed as an exhibit to the Company's Registration Statement on Form S-1, as filed with the Securities and Exchange Commission on August 10, 2007, and incorporated herein by this reference).
 
 
3.2
Amended and Restated Bylaws (filed as an exhibit to the Company's Form 8-K, as filed with the Securities and Exchange Commission on August 29, 2012, and incorporated herein by this reference).
 
 
3.3
First Amendment to the Amended and Restated Bylaws (filed as an exhibit to the Company's Form 8-K, as filed with the Securities and Exchange Commission on October 31, 2012, and incorporated herein by this reference).
 
 
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a).
 
 
31.2
Certification Chief Financial Officer pursuant to Rule 13a-14(a).
 
 
32.1
Certification Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
 
 
32.2
Certification Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
 
 
101.INS
XBRL Instance Document
 
 
101.SCH
XBRL Taxonomy Extension Schema Document
 
 
101.CAL
XBRL Taxonomy Extension Calculation Document
 
 
101.DEF
XBRL Taxonomy Extension Definition Document
 
 
101.LAB
XBRL Taxonomy Extension Label Document
 
 
101.PRE
XBRL Taxonomy Extension Presentation Document

30


SIGNATURES
 
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, there unto duly authorized.
 
 
DIVERSIFIED RESTAURANT HOLDINGS, INC.
 
 
 
 
Dated: May 8, 2015
By:
/s/ T. Michael Ansley
 
T. Michael Ansley
 
President and Chief Executive
 
Officer (Principal Executive Officer)
 
 
 
 
 
By:
/s/ David G. Burke
 
David G. Burke
 
Chief Financial Officer and Treasurer
 
(Principal Financial and Accounting Officer)


31



EXHIBIT INDEX
 
Exhibit No.
Exhibit Description
 
 
3.1
Certificate of Incorporation (filed as an exhibit to the Company's Registration Statement on Form S-1, as filed with the Securities and Exchange Commission on August 10, 2007, and incorporated herein by this reference).
 
 
3.2
Amended and Restated Bylaws (filed as an exhibit to the Company's Form 8-K, as filed with the Securities and Exchange Commission on August 29, 2012, and incorporated herein by this reference).
 
 
3.3
First Amendment to the Amended and Restated Bylaws (filed as an exhibit to the Company's Form 8-K, as filed with the Securities and Exchange Commission on October 31, 2012, and incorporated herein by this reference).
 
 
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a).
 
 
31.2
Certification Chief Financial Officer pursuant to Rule 13a-14(a).
 
 
32.1
Certification Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
 
 
32.2
Certification Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
 
 
101.INS
XBRL Instance Document
 
 
101.SCH
XBRL Taxonomy Extension Schema Document
 
 
101.CAL
XBRL Taxonomy Extension Calculation Document
 
 
101.DEF
XBRL Taxonomy Extension Definition Document
 
 
101.LAB
XBRL Taxonomy Extension Label Document
 
 
101.PRE
XBRL Taxonomy Extension Presentation Document

32