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EX-31.2 - EXHIBIT 31.2 - Diversified Restaurant Holdings, Inc.ex31210q-3272016.htm
EX-32.2 - EXHIBIT 32.2 - Diversified Restaurant Holdings, Inc.ex32210q-3272016.htm
EX-32.1 - EXHIBIT 32.1 - Diversified Restaurant Holdings, Inc.ex32110q-3272016.htm
EX-31.1 - EXHIBIT 31.1 - Diversified Restaurant Holdings, Inc.ex31110q-3272016.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 27, 2016 
 
[_] 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:  26,334,193 shares of $.0001 par value common stock outstanding as of May 4, 2016.
 
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
ASSETS
 
March 27, 2016
 
December 27, 2015
 
 
(unaudited)
 
Current assets
 
 
 
 
Cash and cash equivalents
 
$
5,336,494

 
$
14,200,528

Accounts receivable
 
844,198

 
620,942

Inventory
 
1,936,541

 
1,934,584

Prepaid assets
 
1,290,527

 
1,618,429

Total current assets
 
9,407,760

 
18,374,483

 
 
 
 
 
Deferred income taxes
 
14,000,323

 
13,320,177

Property and equipment, net
 
82,335,422

 
79,189,661

Intangible assets, net
 
3,521,846

 
3,638,716

Goodwill
 
50,097,081

 
50,097,081

Other long-term assets
 
1,194,170

 
1,152,377

Total assets
 
$
160,556,602

 
$
165,772,495

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities
 
 
 
 
Accounts payable
 
$
7,444,625

 
$
7,807,552

Accrued compensation
 
1,862,394

 
3,087,883

Other accrued liabilities
 
3,482,503

 
3,663,211

Current portion of long-term debt
 
9,842,417

 
9,891,825

Current portion of deferred rent
 
332,948

 
396,113

Total current liabilities
 
22,964,887

 
24,846,584

 
 
 
 
 
Deferred rent, less current portion
 
2,905,992

 
2,826,210

Unfavorable operating leases
 
651,477

 
671,553

Other long-term liabilities
 
5,684,827

 
4,463,631

Long-term debt, less current portion
 
112,259,339

 
116,364,165

Total liabilities
 
144,466,522

 
149,172,143

 
 
 
 
 
Commitments and contingencies (Notes 9 and 10)
 

 

 
 
 
 
 
Stockholders' equity
 
 
 
 
Common stock - $0.0001 par value; 100,000,000 shares authorized; 26,297,068 and 26,298,725, respectively, issued and outstanding
 
2,585

 
2,584

Additional paid-in capital
 
36,244,464

 
36,136,332

Accumulated other comprehensive loss
 
(2,055,477
)
 
(1,006,667
)
Accumulated deficit
 
(18,101,492
)
 
(18,531,897
)
Total stockholders' equity
 
16,090,080

 
16,600,352

 
 
 
 
 
Total liabilities and stockholders' equity
 
$
160,556,602

 
$
165,772,495

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 27, 2016
 
March 29, 2015
 
Revenue
 
$
48,412,799

 
$
39,440,332

 
 
 
 
 
 
 
Operating expenses
 
 
 
 
 
Restaurant operating costs (exclusive of depreciation and amortization shown separately below):
 
 
 
 
 
Food, beverage, and packaging costs
 
13,695,543

 
11,447,903

 
Compensation costs
 
12,511,941

 
10,154,792

 
Occupancy costs
 
3,170,755

 
2,372,467

 
Other operating costs
 
10,038,844

 
7,960,549

 
General and administrative expenses
 
2,662,758

 
2,496,887

 
Pre-opening costs
 
272,364

 
1,093,500

 
Depreciation and amortization
 
4,307,717

 
3,157,322

 
Loss on disposal of property and equipment
 
66,128

 
148,408

 
Total operating expenses
 
46,726,050

 
38,831,828

 
 
 
 
 
 
 
Operating profit
 
1,686,749

 
608,504

 
 
 
 
 
 
 
Interest expense
 
(1,444,940
)
 
(432,223
)
 
Other income, net
 
45,272

 
17,003

 
 
 
 
 
 
 
Income before income taxes
 
287,081

 
193,284

 
 
 
 
 
 
 
Income tax benefit
 
(143,324
)
 
(69,358
)
 
 
 
 
 
 
 
Net income
 
$
430,405

 
$
262,642

 
 
 
 
 
 
 
Basic earnings per share
 
$
0.02

 
$
0.01

 
Fully diluted earnings per share
 
$
0.02

 
$
0.01

 
 
 
 
 
 
 
Weighted average number of common shares outstanding
 
 
 
 
 
Basic
 
26,298,034

 
26,149,184

 
Diluted
 
26,298,034

 
26,248,424

 
 
 













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

3


DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (unaudited)
 
 
 
Three Months Ended
 
 
 
March 27, 2016
 
March 29, 2015
 
 
 
 
 
 
 
Net income
 
$
430,405

 
$
262,642

 
 
 
 
 
 
 
Other comprehensive loss
 
 
 
 
 
Unrealized changes in fair value of interest rate swaps, net of tax of $540,296, and $161,691, respectively
 
(1,048,810
)
 
(313,873
)
 
Unrealized changes in fair value of investments, net of tax of $0 and $1,959 , respectively
 

 
3,804

 
Total other comprehensive loss
 
(1,048,810
)
 
(310,069
)
 
 
 
 
 
 
 
Comprehensive loss
 
$
(618,405
)
 
$
(47,427
)
 
 
 




































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 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

 
 
 
 
 
 
 
 
 
 
 
 
Balances - December 27, 2015
26,298,725

 
$
2,584

 
$
36,136,332

 
$
(1,006,667
)
 
$
(18,531,897
)
 
$
16,600,352

 
 
 
 
 
 
 
 
 
 
 
 
Issuance of restricted shares
3,500

 

 
 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
Forfeitures of restricted shares
(10,766
)
 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
Employee stock purchase plan
5,609

 
1

 
10,706

 

 

 
10,707

 
 
 
 
 
 
 
 
 
 
 
 
Share-based compensation

 

 
97,426

 

 

 
97,426

 
 
 
 
 
 
 
 
 
 
 
 
Other comprehensive loss

 

 

 
(1,048,810
)
 

 
(1,048,810
)
 
 
 
 
 
 
 
 
 
 
 
 
Net income

 

 

 

 
430,405

 
430,405

 
 
 
 
 
 
 
 
 
 
 
 
Balances - March 27, 2016
26,297,068

 
$
2,585

 
$
36,244,464

 
$
(2,055,477
)
 
$
(18,101,492
)
 
$
16,090,080

 
 













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 27, 2016
 
March 29, 2015
Cash flows from operating activities
 
 
 
 
Net income
 
$
430,405

 
$
262,642

Adjustments to reconcile net income to net cash provided by operating activities
 
 
 
 
Depreciation and amortization
 
4,307,717

 
3,157,322

Amortization of debt discount and loan fees
 
50,880

 
6,954

Amortization of gain on sale-leaseback
 
(39,302
)
 
(39,302
)
Loss on disposal of property and equipment
 
66,128

 
148,408

Share-based compensation
 
97,426

 
55,793

Deferred income taxes
 
(139,850
)
 
(129,358
)
Changes in operating assets and liabilities that provided (used) cash
 
 
 
 
Accounts receivable
 
(223,256
)
 
1,015,328

Inventory
 
(1,957
)
 
(85,783
)
Prepaid assets
 
327,902

 
91,219

Intangible assets
 
57,659

 
(68,796
)
Other long-term assets
 
(41,793
)
 
(55,106
)
Accounts payable
 
(353,333
)
 
(904,717
)
Accrued liabilities
 
(1,734,805
)
 
(407,575
)
Deferred rent
 
16,617

 
8,591

Net cash provided by operating activities
 
2,820,438

 
3,055,620

 
 
 
 
 
Cash flows from investing activities
 
 
 
 
Proceeds from sale of investments
 

 
2,917,522

Purchases of property and equipment
 
(7,506,410
)
 
(7,766,440
)
Net cash used in investing activities
 
(7,506,410
)
 
(4,848,918
)
 
 
 
 
 
Cash flows from financing activities
 
 
 
 
Proceeds from issuance of long-term debt
 
3,311,231

 
4,420,322

Repayments of long-term debt
 
(7,500,000
)
 
(2,000,000
)
Proceeds from employee stock purchase plan
 
10,707

 
19,222

Net cash (used in) provided by financing activities
 
(4,178,062
)
 
2,439,544

 
 
 
 
 
Net (decrease) increase in cash and cash equivalents
 
(8,864,034
)
 
646,246

 
 
 
 
 
Cash and cash equivalents, beginning of period
 
14,200,528

 
18,688,281

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
5,336,494

 
$
19,334,527

 



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


6

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS


1.           BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Nature of Business
 
Diversified Restaurant Holdings, Inc. (“DRH”) is a restaurant company operating two complementary concepts:   Buffalo Wild Wings ® Grill & Bar (“BWW”) and Bagger Dave’s Burger Tavern ® (“Bagger Dave’s”).  As the largest franchisee of BWW and the creator, developer, and operator of Bagger Dave’s, 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 27, 2016, we had 80 locations in Florida, Illinois, Indiana, Michigan, Missouri and Ohio.
  
DRH is the largest BWW franchisee and currently operates 63 DRH-owned BWW restaurants (20 in Michigan, 16 in Florida, seven in Illinois, five in Indiana and 15 in Missouri), 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 77 DRH-owned BWW restaurants by the end of 2020, exclusive of potential additional BWW restaurant acquisitions. 

DRH originated the Bagger Dave’s concept with our first restaurant opening in January 2008 in Berkley, Michigan.  Currently, there are 19 Bagger Dave’s, 16 in Michigan and one in Indiana and two in Ohio.
 
Basis of Presentation
 
The consolidated financial statements as of March 27, 2016 and December 27, 2015, and for the three-month periods ended March 27, 2016 and March 29, 2015, have been prepared by DRH and its wholly-owned subsidiaries (collectively, the "Company") pursuant to accounting principles generally accepted in the United States of America (“GAAP”) and the rules and regulations of the SEC. The financial information as of March 27, 2016 and for the three-month periods ended March 27, 2016 and March 29, 2015 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 27, 2015 is derived from our audited consolidated financial statements and notes thereto for the fiscal year ended December 27, 2015, which is included in Item 8 in the Fiscal 2015 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 27, 2016 are not necessarily indicative of the results of operations that may be achieved for the entire fiscal year ending December 25, 2016.
 
Segment Reporting
 
During the First Quarter 2016, the Company reorganized segment reporting from one reportable segment to two reportable segments, BWW and Bagger Dave's, due to differences that have developed in the economic characteristics between the two concepts. All prior period information was recast to reflect this change. The Company’s reportable segments are organized based on restaurant concept. Resources are allocated and performance is assessed for the concepts by the Company’s Chief Executive Officer, Chief Financial Officer and Chief Operating Officer whom the Company has determined to be its Chief Operating Decision Makers. See Note 15 for additional information.

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 27, 2016 and December 27, 2015, we had goodwill of $50.1 million, 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.

7

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

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 27, 2015, based on our quantitative analysis, goodwill was considered recoverable. At March 27, 2016, there were no impairment indicators warranting an analysis.
  
Impairment or Disposal of Long-Lived Assets

We review long-lived 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 impairment was recognized for quarter-ended March 27, 2016. As of December 27, 2015 based on impairment indicators and subsequent analysis the Company recorded a fixed asset impairment of $2.8 million related to four underperforming Bagger Dave's locations. We continue to monitor several other restaurants for potential impairment of long-lived assets while we continue to develop plans to improve operating results. As such, 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. For additional details refer to the 2015 10-K filed on March 11, 2015.

We account for exit or disposal activities, including restaurant closures, in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 420, Exit or Disposal Cost Obligations. Such costs include the cost of disposing of the assets as well as other facility-related expenses from previously closed restaurants. These costs are generally expensed as incurred. Additionally, at the date we cease using a property under an operating lease, we record a liability for the net present value of any remaining lease obligations, net of estimated sublease income. Any subsequent adjustments to that liability as a result of lease termination or changes in estimates of sublease income are recorded in the period incurred. During fiscal 2015, the Company decided to close 12 underperforming locations, eight in Indiana, three in Michigan and one in Florida. The Company closed the restaurants during the third and fourth quarters of 2015. In connection with the 2015 closures, the Company recorded a liability of $1.3 million, for the net present value of any remaining lease obligations, net of estimated sublease income. As of March 27, 2016, a liability of $830,361 remains on our Consolidated Balance Sheet and is classified as Other accrued liabilities and Other long-term liabilities. For additional details refer to the 2015 10-K filed on March 11, 2015.

Indefinite-Lived Intangible Assets

Liquor licenses, also a component of intangible assets, are deemed to have an indefinite life and, accordingly, are not amortized. Management reviews liquor license assets on an annual basis (at year-end) to determine whether carrying values have been impaired. We identify potential impairments for liquor licenses by comparing the fair value with its carrying amount. If the fair value exceeds the carrying amount, the liquor licenses are not impaired. If the carrying amount exceeds the fair value, an impairment loss is recorded for the difference.  If the fair value of the asset is less than the carrying amount, an impairment is recorded. No impairments were recognized for quarter-ended March 27, 2016 or fiscal year ended December 27, 2015.

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.


8

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

Interest Rate Swap Agreements
 
The Company utilizes interest rate swap agreements with Citizens Bank, N.A. (“Citizens”) 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 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 March 2016, the FASB issued Accounting Standards Update ("ASU") 2016-09, Topic 718: Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"). ASU 2016-09 simplifies several aspects of accounting for share-based payment award transactions, including income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. ASU 2016-09 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, with early adoption permitted. The Company is in the process of assessing the impact of adoption of ASU 2016-09 on its consolidated financial statements.

In February 2016, FASB issued ASU 2016-02, Leases ("ASU 2016-02"). ASU 2016-02 requires that lease arrangements longer than 12 months result in a lessee recognizing a lease asset and liability. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The updated guidance is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. We are currently evaluating the impact of the updated guidance on our consolidated financial statements.
 
In May 2014, the FASB issued ASU 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 effective for annual periods beginning after December 15, 2017, and interim periods therein.  We are currently evaluating the impact of our pending adoption of ASU 2014-09, although based on the nature of our business we do not expect the standard will have a significant impact on our consolidated financial statements.  
 
We reviewed all other significant newly-issued accounting pronouncements and concluded that they either are not applicable to our operations or that no material effect is expected on our consolidated financial statements as a result of future adoption.

Recently Adopted Accounting Standards

In November 2015, the FASB issued ASU 2015-17, Topic 740: Balance Sheet Classification of Deferred Taxes (“ASU No. 2015-17”), which simplifies the presentation of deferred income taxes. ASU No. 2015-17 provides presentation requirements to classify deferred tax assets and liabilities as noncurrent in a classified statement of financial position. The Company adopted this standard as of December 27, 2015, with prospective application. The adoption of ASU No. 2015-17 had no impact on the Company’s Consolidated Statements of Income and Comprehensive Loss.

In April 2015, the FASB issued ASU No. 2015-03, Interest-Imputation of Interest, which updates guidance on the presentation of debt issuance costs. The guidance requires debt issuance costs to be presented as a direct deduction of debt balances on the statement of financial position, similar to the presentation of debt discounts. The guidance is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015. We retrospectively adopted this guidance in First Quarter 2016. This resulted in a reclassification of the December 27, 2015 Consolidated Balance Sheet of $345,317 from Intangible assets, net to Current portion of long-term debt and Long-term debt, $27,002 and $318,315, respectively.
 

9

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS


2.          PROPERTY AND EQUIPMENT
 
Property and equipment are comprised of the following assets:
 
 
March 27, 2016
 
December 27, 2015
Land
 
$
37,500

 
$
37,500

Building
 
2,339,219

 
2,339,219

Equipment
 
33,759,598

 
32,912,992

Furniture and fixtures
 
8,481,222

 
8,194,060

Leasehold improvements
 
73,272,456

 
72,148,545

Restaurant construction in progress
 
5,410,138

 
1,768,027

Total
 
123,300,133

 
117,400,343

Less accumulated depreciation
 
(40,964,711
)
 
(38,210,682
)
Property and equipment, net
 
$
82,335,422

 
$
79,189,661

At March 27, 2016 and December 27, 2015, $0.6 million and $0.9 million, respectively, of fixed and intangible assets for the closed locations are held for sale, which is recorded in Property and equipment on the Consolidated Balance Sheets. We anticipate auctioning the remaining assets held for sale in Second Quarter 2016. See Note 1 for additional information.

3.        INTANGIBLE ASSETS
 
Intangible assets are comprised of the following:
 
 
March 27, 2016
 
December 27, 2015
Amortized intangibles:
 
 
 
 
Franchise fees
 
$
1,278,142

 
$
1,278,142

Trademark
 
70,576

 
66,826

Non-compete agreement
 
76,560

 
76,560

Favorable lease
 
351,344

 
351,344

Loan fees - Revolving line of credit and DLOC
 
368,084

 
368,084

Total
 
2,144,706

 
2,140,956

Less accumulated amortization
 
(580,177
)
 
(519,858
)
Amortized intangibles, net
 
1,564,529

 
1,621,098

 
 
 
 
 
Unamortized intangibles:
 
 
 
 
Liquor licenses
 
1,957,317

 
2,017,618

Total intangibles, net
 
$
3,521,846

 
$
3,638,716

 
Amortization expense for the three-month periods ended March 27, 2016 and March 29, 2015 was $22,790 and $25,742, respectively. Amortization of favorable leases and loan fees are reflected as part of occupancy and interest expense, respectively.
 
The aggregate weighted-average amortization period for intangible assets is 10.8 years at March 27, 2016.  

4.           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 27, 2016 and March 29, 2015, were $41,682, and $138,620, respectively.
 

10

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS


5.     OTHER ACCRUED LIABILITES
 
 
March 27, 2016
 
December 27, 2015
Sales tax payable
 
$
954,111

 
$
987,795

Accrued interest
 
481,549
 
 
495,365
 
Closure liability - current
 
823,264
 
 
1,008,707
 
Other
 
1,223,579
 
 
1,171,344
 
Total other accrued liabilities
 
$
3,482,503
 
 
$
3,663,211
 


6.           LONG-TERM DEBT
 
Long-term debt consists of the following obligations:
 
 
March 27, 2016
 
December 27, 2015
Note payable - $120.0 million term loan; payable to Citizens with a senior lien on all the Company’s personal property and fixtures. Scheduled monthly principal payments are approximately $833,333 plus accrued interest through maturity in June 2020. Interest is charged based on one-month LIBOR plus an applicable margin, which ranges from 2.25% to 3.5%, depending on the lease adjusted leverage ratio defined in the terms of the agreement. The rate at March 27, 2016 was approximately 3.94%.

 
$
108,333,333

 
$
115,833,333

 
 
 
 
 
Note payable - $30.0 million development line of credit; payable to Citizens with a senior lien on all the Company’s personal property and fixtures. Payments are due monthly once fully drawn and matures in June 2020. Interest is charged based on one-month LIBOR plus an applicable margin, which ranges from 2.25% to 3.5%, depending on the lease adjusted leverage ratio defined in the terms of the agreement. The rate at March 27, 2016 was approximately 3.94%.
 
14,401,554

 
11,090,323

 
 
 
 
 
Unamortized discount and debt issuance costs
 
(633,131
)
 
(667,666
)
 
 
 
 
 
Total debt
 
122,101,756

 
126,255,990

 
 
 
 
 
Less current portion
 
(9,842,417
)
 
(9,891,825
)
 
 
 
 
 
Long-term debt, net of current portion
 
$
112,259,339

 
$
116,364,165

 
On June 29, 2015, the Company entered into a $155.0 million senior secured credit facility with Citizens (the “June 2015 Senior Secured Credit Facility”).  The June 2015 Senior Secured Credit Facility consists of a $120.0 million term loan (the “June 2015 Term Loan”), a $30.0 million development line of credit (the “June 2015 DLOC”), and a $5.0 million revolving line of credit (the “June 2015 RLOC”). The Company used approximately $65.5 million of the June 2015 Term Loan to refinance existing outstanding debt and used approximately $54.0 million of the June 2015 Term Loan to refinance an acquisition occurring in second quarter 2015.   The remaining balance of the June 2015 Term Loan, approximately $0.5 million, was used to pay the fees, costs, and expenses associated with the closing of the June 2015 Senior Secured Credit Facility.  The June 2015 Term Loan is for a period of five years.  Payments of principal are based upon an 12-month straight-line amortization schedule, with monthly principal payments of $833,333 plus accrued interest.  The interest rate for the June 2015 Term Loan is LIBOR plus an applicable margin, which ranges from 2.25% to 3.5%, depending on the lease adjusted leverage ratio defined in the terms of the agreement.  The entire remaining outstanding principal and accrued interest on the June 2015 Term Loan is due and payable on the maturity date of June 29, 2020.  The June 2015 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 12-month straight-line amortization schedule, plus interest, through maturity on June 29, 2020. The June 2015 RLOC is for a term of two years and no amounts were outstanding as of March 27, 2016.

Fees related to the term debt are recorded as debt discount and fees related to the DLOC and RLOC are capitalized as intangible assets. Debt issuance costs represents legal, consulting, and financial costs associated with debt financing. Debt discount and debt issuance cost related to term debt totaled $633,131, net of accumulated amortization at March 27, 2016. Unamortized debt issuance costs related to the DLOC and RLOC totaled $368,084 at March 27, 2016. Debt discount and debt issuance cost are amortized

11

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

over the life of the debt and are recorded in interest expense using the effective interest method. The Company’s evaluation of the June 2015 debt refinancing concluded that the terms of the debt were not substantially modified.
  
For the three-month periods ended March 27, 2016 and March 29, 2015, interest expense was $1,444,940 and $432,223, 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 27, 2016.
  
At March 27, 2016, the Company has six 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. Under the swap agreements, the Company receives interest at the one -month LIBOR and pays a fixed rate. 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.

The following summarizes the fair values of derivative instruments designated as cash flow hedges which were outstanding:

 
 
 
March 27, 2016
 
 
 
Notional amounts
 
Derivative assets
 
Derivative liabilities
Interest rate swaps
Rate
Expires
 
 
 
 
 
April 2012
1.4%
April 2019
$
7,047,619

 
 
$

 
$
82,875

 
October 2012
0.9%
October 2017
3,000,000
 
 
 
 
 
10,955
 
 
July 2013
1.4%
April 2018
7,333,333
 
 
 
 
 
70,855
 
 
May 2014
1.5%
April 2018
10,892,857
 
 
 
 
 
163,058
 
 
January 2015
1.8%
December 2019
20,690,476
 
 
 
 
 
830,482
 
 
August 2015
2.3%
June 2020
49,696,875
 
 
 
 
 
1,956,136
 
 
Total
 
 
$
98,661,160

 
 
$

 
$
3,114,361

 

 
 
 
December 27, 2015
 
 
 
Notional amounts
 
Derivative assets
 
Derivative liabilities
Interest rate swaps
Rate
Expires
 
 
 
 
April 2012
1.4%
April 2019
$
7,619,048

 
 
$

 
$
56,280

 
October 2012
0.9%
October 2017
3,214,286
 
 
 
 
 
3,027
 
 
July 2013
1.4%
April 2018
8,190,476
 
 
 
 
 
60,164
 
 
May 2014
1.5%
April 2018
11,428,571
 
 
 
 
 
122,716
 
 
January 2015
1.8%
December 2019
20,547,619
 
 
 
 

 
 
415,459

 
August 2015
2.3%
June 2020
49,696,875
 
 
 
 
 
867,609
 
 
Total
 
 
$
100,696,875

 
 
$

 
$
1,525,255

 

7.            STOCK-BASED COMPENSATION

Restricted stock awards

In First Quarter 2016 restricted shares were granted to certain team members and board members at a weighted-average fair value of $2.66 per share and in first quarter 2015 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 year or 1 year period or upon the 3 year anniversary of the granted shares, the vesting terms are determined by the Compensation Committee of the Board of Directors.  Unrecognized stock-based compensation expense of $421,967 at March 27, 2016 will be recognized over the remaining weighted-average vesting period of 1.9 years. The total fair value of shares vested

12

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

during the three-month periods ended March 27, 2016 and March 29, 2015 was $59,631 and $15,436, respectively.  Under the Stock Incentive Plan, there are 393,056 shares available for future awards at March 27, 2016.

The following table presents the restricted shares transactions during the three months ended March 27, 2016:
 
Number of
Restricted
Stock Shares
Unvested, December 27, 2015
241,124

Granted
3,500

Vested
(30,945
)
Expired/Forfeited
(10,766
)
Unvested, March 27, 2016
202,913

 
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

   
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. On August 13, 2015, 30,000 shares were exercised at a price of $2.50 per share The intrinsic value of options exercised is $6,300. At March 27, 2016, 180,000 shares of authorized common stock are reserved for issuance to provide for the exercise of these options. The intrinsic value of outstanding options is $0 and $338,100 as of March 27, 2016 and March 29, 2015, respectively.

Employee stock purchase plan

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 ESPP has four offering periods, each start/end dates coincide with the fiscal quarter and are awarded on the last day of the offering period. During the three-month periods ended March 27, 2016 and March 29, 2015, we issued 5,609 and 4,662 shares, respectively. Under the ESPP, there are 206,980 shares available for future awards at March 27, 2016.

Share Repurchase Program

In March 2015, the Board of Directors authorized a program to repurchase up to $1.0 million of the Company's common stock in open market transactions at market prices or otherwise. In April 2015, we repurchased $98,252 in outstanding shares, representing 24,500 shares. The weighted average purchase price per share was $4.01. Upon receipt, the repurchased shares were retired and restored to authorized but unissued shares of common stock.

Stock-Based Compensation
 
Stock-based compensation of $97,426 and $55,793 was recognized during the three-month periods ended March 27, 2016 and March 29, 2015, respectively, as compensation cost in the Consolidated Statements of Income 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 27, 2016.  Any preferences, rights, voting powers, restrictions, dividend limitations, qualifications, and

13

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

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.

8.           INCOME TAXES
 
The effective income tax rate for the three months ended March 27, 2016 and March 29, 2015 was (49.9)% and (35.9)%, respectively. The change in the effective income tax rate for March 27, 2016 as compared to the three months ended March 29, 2015 is primarily attributable to the increase in estimated tip tax credits for 2016. The effective income tax rate is negative due to the estimated tip tax credits being larger than the tax expense generated by operating income

9.           OPERATING LEASES
 
Base 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 $2.5 million and $1.9 million for the three-month periods ended March 27, 2016 and March 29, 2015, respectively.
 
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 27, 2016 are summarized as follows: 
Year
Amount
Remainder of 2016
$
8,248,554

2017
10,932,225

2018
10,458,132

2019
9,614,494

2020
9,354,108

2021 and thereafter
45,528,165

Total
$
94,135,678



10.           COMMITMENTS AND CONTINGENCIES
 
The Company’s ADA requires DRH to open 42 restaurants by April 1, 2021.   As of March 27, 2016 we have opened 27 of the 42 restaurants required by the ADA.  With the remaining 15 restaurants, we expect the Company will operate 77 BWW restaurants by 2020, exclusive of potential additional BWW restaurant acquisitions.  
  
The Company is required to pay BWLD royalties (5.0% of net sales) and advertising fund contributions (between 3.15% and 3.25% of net sales globally) for the term of the individual franchise agreements.  The Company incurred royalty fees of $2.2 million and $1.6 million for the three-month periods ended March 27, 2016 and March 29, 2015, respectively.  Advertising fund contribution expenses were $1.4 million and $1.0 million for the three-month periods ended March 27, 2016 and March 29, 2015, 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 $1.3 million depending on an individual restaurant's needs.
On December 18, 2015, a collective action was filed against AMC Wings, Inc., and the Company in the U.S. District Court for the Southern District of Illinois by plaintiffs, David, et. al. A Sure Wing, LLC, the seller of the 18 St. Louis BWW restaurants acquired by the Company on June 29, 2015, was also named as a defendant. Plaintiffs primarily allege that former and current tipped workers at the above-mentioned companies were assigned to perform tasks outside the scope of their tipped positions, in violation of Illinois and federal law. The defendant companies filed their answers to the complaint on February 22, 2016, and during the status hearing on March 18, 2016 the Court ruled on the sequencing of discovery and ordered the parties to draft a proposed joint scheduling order.  The Court adopted the parties’ joint scheduling order at the next status hearing on March 24,

14

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

2016.  On April 11, 2016, plaintiffs filed a motion for conditional certification pursuant to 29 U.S.C. §216(b).  Defendant companies’ opposition to that motion is due May 11, 2016.
At this stage in the process, plaintiffs have not specified the amount of their damages claim. The Company has filed an indemnity claim against A Sure Wing, LLC and has received a reciprocal indemnity claim from A Sure Wing, LLC. A Sure Wing, LLC and the Company have agreed to toll their respective indemnity claims pending resolution of the matter. This case is in the discovery phase and the plaintiffs have not specified the amount of damages, the Company is unable to reasonably estimate a possible loss or range of loss.
 
Additionally, 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 27, 2016 and March 29, 2015:
 
 
Three months ended
 
 
March 27, 2016
 
March 29, 2015
Income available to common stockholders
 
$
430,405

 
$
262,642

 
 
 
 
 
Weighted-average shares outstanding
 
26,298,034

 
26,149,184

Effect of dilutive securities
 

 
99,240

Weighted-average shares outstanding - assuming dilution
 
26,298,034

 
26,248,424

 
 
 
 
 
Earnings per share
 
$
0.02

 
$
0.01

Earnings per share - assuming dilution
 
$
0.02

 
$
0.01


Potentially dilutive securities whose effect would have been antidilutive are excluded from the computation of diluted earnings per share.


12.            SUPPLEMENTAL CASH FLOWS INFORMATION
 
Other Cash Flows Information
 
Cash paid for interest was $1.4 million and $419,674 during the three-month periods ended March 27, 2016 and March 29, 2015 respectively.
 
Cash paid for income taxes was $0 and $60,000 during the three-month periods ended March 27, 2016 and March 29, 2015, respectively.

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 27, 2016 and March 29, 2015, was $1.8 million and $0.4 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

15

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

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 27, 2016 and December 27, 2015, respectively, our financial instruments consisted of cash and cash equivalents; including money market funds, accounts receivable, 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.
 
As of March 27, 2016 and December 27, 2015, our total debt was approximately $122.1 million and $126.3 million, respectively, which approximated fair value because the applicable interest rates are adjusted frequently based on short-term market rates (Level 2).
 
There were no transfers between levels of the fair value hierarchy during the three months ended March 27, 2016 and the fiscal year ended December 27, 2015.

The following table presents the fair values for those assets and liabilities measured on a recurring basis as of March 27, 2016:
 
FAIR VALUE MEASUREMENTS
Description
 
Level 1
 
Level 2
 
Level 3
 
Asset/(Liability)
Total
Interest rate swaps
 
$

 
$
(3,114,361
)
 
$

 
$
(3,114,361
)
 
 
The following table presents the fair values for those assets and liabilities measured on a recurring basis as of December 27, 2015:
 
FAIR VALUE MEASUREMENTS
Description
 
Level 1
 
Level 2
 
Level 3
 
Asset/(Liability)
Total
Cash equivalents
 
$
2,000,000

 
$

 
$

 
$
2,000,000

Interest rate swaps
 

 
(1,525,255
)
 

 
(1,525,255
)
Total
 
$
2,000,000

 
$
(1,525,255
)
 
$

 
$
474,745

 


16


14. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
 
The following table summarizes each component of Accumulated Other Comprehensive Income (loss):
 
 
Three Months Ended March 27, 2016
 
 
Interest Rate Swap
 
Investments
 
Total
Beginning balance
 
$
(1,006,667
)
 
$

 
$
(1,006,667
)
 
 
 
 
 
 
 
Loss recorded to other comprehensive income
 
(1,589,106
)
 

 
(1,589,106
)
Tax benefit
 
540,296

 

 
540,296

Other comprehensive loss
 
(1,048,810
)
 

 
(1,048,810
)
 
 
 
 
 
 
 
Accumulated OCL
 
$
(2,055,477
)
 
$

 
$
(2,055,477
)

 
 
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 income (expense)
 
161,691

 
(1,959
)
 
159,732

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

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

 
$
(485,225
)

15. SEGMENT REPORTING

During the First Quarter 2016, the Company reorganized segment reporting from one reportable segment to two reportable segments, BWW and Bagger Dave's, due to differences that have developed in the economic characteristics between the two concepts. All prior period information was recast to reflect this change. The Company’s reportable segments are organized based on restaurant concept. Resources are allocated and performance is assessed for the concepts by the Company’s Chief Executive Officer, Chief Financial Officer and Chief Operating Officer whom the Company has determined to be its Chief Operating Decision Makers. See Note 1 for additional information.

Revenues for all segments include only transactions with customers and include no intersegment revenues. Excluded from net income from operations for BWW and Bagger Dave's are certain legal and corporate costs not directly related to the performance of the segments, interest and other expenses related to the Company’s credit agreements and derivative instruments, certain stock-based compensation expenses, certain bonus expense and certain insurance expenses managed centrally.

17


Segment activity is as follows:

 
Three months ended
 
March 27, 2016
 
March 29, 2015
Revenue from external customers:
 
 
 
BWW
$
43,143,252

 
$
31,852,089

Bagger Dave's
5,269,547

 
7,588,243

Total
$
48,412,799

 
$
39,440,332

 
 
 
 
Segment operating profit (loss):
 
 
 
BWW
$
5,285,645

 
$
4,606,331

Bagger Dave's
(612,260
)
 
(1,458,634
)
Total segment operating profit
$
4,673,385

 
$
3,147,697

Closure-related expenses
(345,011
)
 

Corporate expenses
(2,641,625
)
 
(2,539,193
)
Total consolidated operating profit
$
1,686,749

 
$
608,504

 
 
 
 
Interest expense
$
(1,444,940
)
 
$
(432,223
)
Other income
45,272

 
17,003

Net income before income taxes
$
287,081

 
$
193,284

 
 
 
 
 
March 27, 2016
 
December 27, 2015
Total assets
 
 
 
BWW
$
117,530,474

 
$
115,044,166

Bagger Dave's
22,262,803

 
21,886,470

Corporate
20,763,325

 
28,841,859

Total assets
$
160,556,602

 
$
165,772,495


18




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 27, 2015. 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 Buffalo Wild Wings® Grill & Bar (“BWW”) concept and consumer acceptance of the Bagger Dave’s Tavern® (“Bagger Dave’s”) 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 ("SEC"), 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 restaurant company operating two complementary concepts:   BWW and Bagger Dave’s.  As the largest franchisees of BWW and the creator, developer, and operator of Bagger Dave’s, 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 27, 2016, we had 80 locations in Florida, Illinois, Indiana, Michigan, Missouri and Ohio.
  
DRH is the largest BWW franchisee and currently operates 63 DRH-owned BWW restaurants (20 in Michigan, 16 in Florida, seven in Illinois, five in Indiana and 15 in Missouri), 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 77 DRH-owned BWW restaurants by the end of 2020, exclusive of potential additional BWW restaurant acquisitions. 

DRH originated the Bagger Dave’s concept with our first restaurant opening in January 2008 in Berkley, Michigan.  Currently, there are 19 Bagger Dave’s, 16 in Michigan and one in Indiana and two in Ohio.


19


RESTAURANT OPENINGS
 
The following table outlines the restaurant unit information for each fiscal year from 2012 through 2016.
 
 
2016 (estimate)
 
2015
 
2014
 
2013
 
2012
 
Summary of restaurants open at the beginning of year
 
 
 
 
 
 
 
 
 
 
 
DRH-owned BWW
 
62

 
42

 
36

 
33

 
22

 
Bagger Dave’s
 
18

 
24

 
18

 
11

 
6

 
Total
 
80

 
66

 
54

 
44

 
28

 
 
 
 
 
 
 
 
 
 
 
 
 
Openings:
 
 
 
 
 
 
 
 
 
 
 
DRH-owned BWW
 
2

 
3

 
3

 
3

 
3

 
Bagger Dave’s
 
1

 
5

 
6

 
7

 
5

 
BWW Acquisitions
 

 
18

 
3

 

 
8

 
Closures - DRH-owned BWW
 

 
(1
)
 

 

 

 
Closures - Bagger Dave's
 

 
(11
)
 

 

 

 
Total restaurants
 
83

 
80

 
66

 
54

 
44

 

RESULTS OF OPERATIONS
 
For the three-month period ended March 27, 2016 ("First Quarter 2016"), revenue was generated from the operations of 62 BWW restaurants and 18 Bagger Dave’s restaurants. 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. 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 67 and 50 restaurants at March 27, 2016 and March 29, 2015, respectively.
 

20


Results of Operations for the Three Months Ended March 27, 2016 and March 29, 2015
 
 
Three Months Ended
 
 
 
March 27, 2016
 
Percent of sales
 
March 29, 2015
 
Percent of sales
 
BWW
 
$
43,143,252

 
89.1
%
 
$
31,852,089

 
80.8
%
 
Bagger Dave's
 
5,269,547

 
10.9
%
 
7,588,243

 
19.2
%
 
Total revenue
 
48,412,799

 
100.0
%
 
39,440,332

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Food, beverage, and packaging costs
 
 
 
 
 
 
 
 
 
BWW
 
12,060,753

 
28.0
%
 
9,183,664

 
28.8
%
 
Bagger Dave's
 
1,634,790

 
31.0
%
 
2,264,239

 
29.8
%
 
Food, beverage, and packaging costs
 
13,695,543

 
28.3
%
 
11,447,903

 
29.0
%
 
 
 
 
 
 
 
 
 
 
 
Compensation costs
 
 
 
 
 
 
 
 
 
BWW
 
10,512,320

 
24.4
%
 
7,433,248

 
23.3
%
 
Bagger Dave's
 
1,999,621

 
37.9
%
 
2,721,544

 
35.9
%
 
Compensation costs
 
12,511,941

 
25.8
%
 
10,154,792

 
25.7
%
 
 
 
 
 
 
 
 
 
 
 
Occupancy costs
 
 
 
 
 
 
 
 
 
BWW
 
2,766,459

 
6.4
%
 
1,731,247

 
5.4
%
 
Bagger Dave's
 
404,296

 
7.7
%
 
641,220

 
8.5
%
 
Occupancy costs
 
3,170,755

 
6.5
%
 
2,372,467

 
6.0
%
 
 
 
 
 
 
 
 
 
 
 
Other operating costs
 
 
 
 
 
 
 
 
 
BWW
 
8,604,312

 
19.9
%
 
6,419,037

 
20.2
%
 
Bagger Dave's
 
1,064,321

 
20.2
%
 
1,541,512

 
20.3
%
 
Closure-related expenses
 
370,211

 
0.8
%
 

 
%
 
Other operating costs
 
10,038,844

 
20.7
%
 
7,960,549

 
20.2
%
 
 
 
 
 
 
 
 
 
 
 
General and administrative expenses
 
2,662,758

 
5.5
%
 
2,496,887

 
6.3
%
 
Pre-opening costs
 
272,364

 
0.6
%
 
1,093,500

 
2.8
%
 
Depreciation and amortization
 
4,307,717

 
8.9
%
 
3,157,322

 
8.0
%
 
Loss on disposal of property and equipment
 
66,128

 
0.1
%
 
148,408

 
0.4
%
 
 
 
 
 
 
 
 
 
 
 
Total operating expenses
 
46,726,050

 
96.5
%
 
38,831,828

 
98.5
%
 
 
 
 
 
 
 
 
 
 
 
Operating profit
 
$
1,686,749

 
3.5
%
 
$
608,504

 
1.5
%
 

Revenue for First Quarter 2016 was $48.4 million, an increase of $9.0 million, or 22.7%, over the $39.4 million of revenue generated during First Quarter 2015. The increase was attributable to the following: $10.9 million increase from the acquisition of 18 BWW locations; $3.5 million increase from six new restaurant openings consisting of three BWW restaurants and three Bagger Dave's restaurants; $3.0 million decrease from the closure of 11 Bagger Dave's restaurants and one BWW restaurant; $0.4 million decrease in DRH-Owned BWW same store sales; $0.5 million decrease from Easter calendar shift; $1.5 million decrease from impact of restaurants not falling into the sales comp-base because the restaurants have not been open for 18 months and lower Bagger Dave's average unit volumes.

With regard to the costs and expenses discussed below, results and trends that are unique and material within our individual reporting segments have been highlighted. Otherwise, the trends and results for the individual segments are consistent with our discussion of the composite trends and results.  
 

Food, beverage, and packaging costs increased by $2.2 million, or 19.6%, to $13.7 million in First Quarter 2016 from $11.4 million in First Quarter 2015.  The increase was primarily due to an increased number of restaurants operating in 2016. Food, beverage, and packaging costs as a percentage of revenue decreased to 28.3% in First Quarter 2016 from 29.0% in First Quarter 2015 primarily

21


due to some overall commodity price relief and menu price increases. Average cost per pound for bone-in chicken wings, our most significant input cost for our BWW concept, had a slight increase to $1.92 in First Quarter 2016 compared to $1.89 in First Quarter 2015. For Bagger Dave's, we experienced commodity cost relief for beef and bacon which was offset by an increase in potato costs and a price decrease resulting from our plattering initiative in the latter half of 2015.
 
Compensation costs increased by $2.4 million, or 23.2%, to $12.5 million in First Quarter 2016 from $10.2 million in First Quarter 2015.  The increase was primarily due to an increased number of restaurants operating in 2016.  Compensation costs as a percentage of sales increased to 25.8% in First Quarter 2016 from 25.7% in First Quarter 2015 due to higher average hourly wages and lower volumes partially offset by increased pricing.  
 
Occupancy costs increased by $0.8 million, or 33.6%, to $3.2 million in First Quarter 2016 from $2.4 million in First Quarter 2015.  This increase is primarily due to the increased number of restaurants operating in 2016. Occupancy as a percentage of sales increased to 6.5% in First Quarter 2016 from 6.0% in First Quarter 2015 primarily due to the impact of the 18 acquired BWW locations, which had higher average occupancy costs as a percentage of sales and lower comparable sales over the same period last year. This was partially offset by lower occupancy costs as a percentage of sales for Bagger Dave's due to the recent closure of underperforming locations.
 
Other operating costs increased by $2.1 million, or 26.1%, to $10.0 million in First Quarter 2016 from $8.0 million in First Quarter 2015.  The increase was primarily due to an increased number of restaurants operating in 2016. Other operating costs as a percentage of sales increased to 20.7% in First Quarter 2016 from 20.2% in First Quarter 2015 due to non-recurring expenses related to the closure of eleven Bagger Dave's locations at the end of 2015, which contributed to 0.8% of sales, and lower overall sales volume, partially offset by cost savings initiatives in both concepts.
 
General and administrative expenses increased by $0.2 million, or 6.6%, to $2.7 million in First Quarter 2016 from $2.5 million in First Quarter 2015.  This increase was primarily due to additional salaries and marketing expense directly related to the acquisition of 18 locations, partially offset by the decrease in salaries and marketing expenses directly related to closures. General and administrative expenses as a percentage of sales decreased to 5.5% in First Quarter 2016 from 6.3% in First Quarter 2015 due to the leverage of the acquired locations' sales on our overall general and administrative expenses.
 
Pre-opening costs decreased by $0.8 million, or 75.1%, to $0.3 million in First Quarter 2016 from $1.1 million in First Quarter 2015. DRH and its wholly-owned subsidiaries (collectively, the "Company") will open two new restaurants in April 2016 (one Bagger Dave's and one BWW) and opened one Bagger Dave's restaurant and one BWW relocation in First Quarter 2015. There were five openings in the previous year Fourth Quarter 2014, which contributed to carry-over costs in First Quarter 2015.  Pre-opening costs as a percentage of sales decreased to 0.6% in First Quarter 2016 from 2.8% in First Quarter 2015.
 
Depreciation and amortization increased by $1.2 million, or 36.4%, to $4.3 million in First Quarter 2016 from $3.2 million in First Quarter 2015.  This increase was primarily due to an increased number of restaurants operating in 2016 driven by the acquisition of 18 BWW locations.  Depreciation and amortization as a percentage of sales increased to 8.9% in First Quarter 2016 from 8.0% in First Quarter 2015 primarily due to the impact of the 18 acquired locations which had higher average depreciation and amortization expense as a percentage of sales and some acceleration of depreciation due to upcoming remodels. 
 
Loss on disposal of property and equipment decreased by $82,280, or 55.4%, to $66,128 in First Quarter 2016 from $148,408 in First Quarter 2015 due to the timing of remodels. Loss on disposal of property and equipment as a percentage of sales decreased to 0.1% in First Quarter 2016 from 0.4% in First Quarter 2015.

INTEREST AND TAXES
 
Interest expense was $1.4 million and $432,223 during First Quarter 2016 and First Quarter 2015, respectively. The increase was primarily due to the acquisition of 18 BWW locations occurring in the Second Quarter 2015 along with the building of new restaurants. 
 
For First Quarter 2016, DRH had an income tax benefit of $143,324 compared to First Quarter 2015 income tax benefit of $69,358.  The increase in the First Quarter 2016 income tax benefit primarily relates to the increase in tip credits for the period. 


22


LIQUIDITY AND CAPITAL RESOURCES; EXPANSION PLANS
 
On June 29, 2015, the Company, entered into a $155.0 million Senior Secured Credit Facility with Citizens Bank, N.A. ("Citizens") (the “June 2015 Senior Secured Credit Facility”). The June 2015 Senior Secured Credit Facility consists of a $120.0 million Term Loan (the "June 2015 Term Loan"), a $30.0 million development line of credit (the "June 2015 DLOC") and a $5.0 million revolving line of credit (the "June 2015 RLOC"). The Company immediately used approximately $65.5 million of the June 2015 Term Loan to refinance existing outstanding debt and $54.0 million of the June 2015 Term Loan to finance an acquisition occurring in the second quarter 2015. The remaining balance of the June 2015 Term Loan, approximately $0.5 million, was used to pay the fees, costs and expenses arising in connection with the closing of the loans constituting the June 2015 Senior Secured Credit Facility. The June 2015 Term Loan is for a term of five years. Payments of principal shall be based upon a 12-year straight-line amortization schedule, with monthly principal payments of $833,333 plus accrued interest. The interest rate for the Term Loan is LIBOR plus an applicable margin which ranges from 2.25% to 3.5%. The entire remaining outstanding principal and accrued interest on the Term Loan is due and payable on the Term Loan maturity date of June 29, 2020. The June 2015 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 12-year straight-line amortization schedule, plus interest, through maturity on June 29, 2020. The June 2015 RLOC is for a term of five years and bears interest at LIBOR plus an applicable margin, no amount was outstanding as of March 27, 2016.
 
We believe that along with our current cash balance, the cash flow from operations and availability of credit will be sufficient to meet our operational, development and debt 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 the cost and potential obligation to invest in 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.  We expect that a build-out of a new DRH-owned BWW restaurant will require an estimated cash investment of $1.7 million to $2.1 million (excluding potential tenant incentives). 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).  We expect to spend up to $0.3 million per restaurant for pre-opening expenses.  Depending on individual lease negotiations, we may receive cash tenant incentives of up to $0.4 million.  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 payback 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 2016 was $2.8 million compared with $3.1 million for First Quarter 2015. Net cash provided by operating activities consisted primarily of net earnings adjusted for non-cash expenses.

For 2016, capital expenditures are anticipated to be between $14.0 million and $16.0 million. We plan to use the capital as follows: 35.0% for new restaurant openings, 15.0% for construction of buildings associated with new restaurant openings; and the remaining 50.0% for restaurant remodels, upgrades and other general corporate purposes. Any excess cash from operations will be used to accelerate pay down of our debt. With planned capital expenditures significantly lower than historical and additional operating cash flows, both of which are due to the fact that we have just recently integrated 18 additional BWW locations and closed underperforming restaurants, we are targeting a net debt-to-adjusted EBITDA ratio of 3.0x by mid-2018.
 
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 $1.3 million (for a full extensive remodel of the restaurant), we target remodels of $0.6 million to upgrade a typical BWW restaurant to the new Stadia design. The strategy of the Company is to fully remodel existing BWW restaurants to the new Stadia design at time of scheduled refresh or remodel typically within seven years or less of opening.


23


Mandatory Upgrades
 
In fiscal year 2016, we will invest in eight mandatory remodels of existing DRH-owned BWW restaurants. These will primarily be funded through cash from operations, supplemented by drawing off our development line of credit.
 
Discretionary Upgrades and Relocations
 
In fiscal year 2016, the Company plans to invest additional capital to provide minor upgrades to a number of its existing locations, all of which we expect to be fund with cash from operations. These improvements will primarily consist of refreshing interior building finishes audio/visual equipment upgrades, and patio upgrades. In fiscal year 2016, we do not have any planned relocations. 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 27, 2016:
 
 
Total
 
Less than
one year
 
1 - 3 years
 
3 - 5 years
 
After 5 years
Long-term debt1
 
$
122,101,756

 
$
9,842,417

 
$
22,142,188

 
$
90,117,151

 
$

Operating lease obligations
 
94,087,125

 
10,940,611

 
21,090,556

 
18,730,716

 
43,325,242

Commitments for restaurants under development 2
 
7,780,630

 
2,699,499

 
680,000

 
1,054,317

 
3,346,814

 
 
$
223,969,511

 
$
23,482,527

 
$
43,912,744

 
$
109,902,184

 
$
46,672,056

 
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 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’s ADA requires DRH to open 42 restaurants within its designated "development territory” by April 1, 2021.   As of March 27, 2016 we have opened 27 of the 42 restaurants required by the ADA.  With the remaining 15 restaurants, we expect the Company will operate 77 BWW restaurants by 2020, exclusive of potential additional BWW restaurant acquisitions.  


24


Impact of New Accounting Standards

See Note 1, "Business and Summary of Significant Accounting Policies," included in Part 1, Item 1, "Notes to Interim Consolidated Financial Statements," of this Quarterly Report.

 
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 27, 2015.

25


Item 3. Quantitative and Qualitative Disclosure About Market Risks 

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 27, 2016, DRH had $122.1 million of variable-rate debt with a weighted average interest rate of 3.94%, 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 3.5%, 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 $1.2 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 27, 2016 and March 29, 2015 chicken wings accounted for approximately 33.2% and 31.4% of cost of sales, with an average price per pound of $1.98 and $1.89, respectively.

26



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 Securities and Exchange Commission 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 27, 2016, 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 27, 2016.
 
(b) Changes in internal control over financial reporting.
 
There were no changes in the Company’s internal control over financial reporting during the quarter ended March 27, 2016 that have materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting.
 
Our process for evaluating controls and procedures is continuous and encompasses constant improvement of the design and effectiveness of established controls and procedures and the remediation of any deficiencies that may be identified during this process.


27


PART II. OTHER INFORMATION
 
Item 1. Legal Proceedings 
 
The following information is incorporated by reference: the information set forth under the heading "Legal Proceedings" in Note 10 "Commitments and Contingencies" of the "Notes to the Interim Consolidated Financial Statements" of Part I, Item 1 to this Report on Form 10-Q.

In addition, we are occasionally 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 27, 2015.

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.

28


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

29


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 6, 2016
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)


30



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

31