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EX-32.2 - EXHIBIT 32.2 - Diversified Restaurant Holdings, Inc.copyofex32210q-9252016.htm
EX-32.1 - EXHIBIT 32.1 - Diversified Restaurant Holdings, Inc.copyofex32110q-9252016.htm
EX-31.2 - EXHIBIT 31.2 - Diversified Restaurant Holdings, Inc.copyofex31210q-9252016.htm
EX-31.1 - EXHIBIT 31.1 - Diversified Restaurant Holdings, Inc.copyofex31110q-9252016.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 26, 2017 
 
[_] 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 [  ]

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

Large accelerated filer
[   ]
Accelerated filer
[  ]
 
 
 
 
Non-accelerated filer
[   ]
(Do not check if a smaller reporting company)
 
 
 
Smaller reporting company
[ X ]
 
 
Emerging growth company
[  ]
        If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
[  ]

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 26,669,347 shares of $.0001 par value common stock outstanding as of May 4, 2017.



INDEX
 






PART I.FINANCIAL INFORMATION

Item 1.  Financial Statements

DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 
 
March 26, 2017
 
December 25, 2016
ASSETS
 
(unaudited)
 
Current assets
 
 
 
 
Cash and cash equivalents
 
$
5,382,263

 
$
4,021,126

Accounts receivable
 
88,456

 
276,238

Inventory
 
1,631,565

 
1,700,604

Prepaid and other assets
 
992,732

 
1,305,936

Total current assets
 
8,095,016

 
7,303,904

 
 
 
 
 
Deferred income taxes
 
16,410,956

 
16,250,928

Property and equipment, net
 
54,817,201

 
56,630,031

Intangible assets, net
 
2,586,563

 
2,666,364

Goodwill
 
50,097,081

 
50,097,081

Other long-term assets
 
231,455

 
233,539

Total assets
 
$
132,238,272

 
$
133,181,847

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' DEFICIT
 
 
 
 
Current liabilities
 
 
 
 
Accounts payable
 
$
4,121,332

 
$
3,995,846

Accrued compensation
 
1,980,366

 
2,803,549

Other accrued liabilities
 
2,893,239

 
2,642,269

Current portion of long-term debt
 
11,313,759

 
11,307,819

Current portion of deferred rent
 
194,206

 
194,206

Total current liabilities
 
20,502,902

 
20,943,689

 
 
 
 
 
Deferred rent, less current portion
 
2,043,552

 
2,020,199

Unfavorable operating leases
 
571,171

 
591,247

Other long-term liabilities
 
3,570,054

 
3,859,231

Long-term debt, less current portion
 
108,263,169

 
109,878,201

Total liabilities
 
134,950,848

 
137,292,567

 
 
 
 
 
Commitments and contingencies (Notes 3, 11 and 12)
 

 

 
 
 
 
 
Stockholders' deficit
 
 
 
 
Common stock - $0.0001 par value; 100,000,000 shares authorized; 26,636,346 and 26,632,222, respectively, issued and outstanding
 
2,611

 
2,610

Additional paid-in capital
 
21,489,849

 
21,355,270

Accumulated other comprehensive loss
 
(769,778
)
 
(934,222
)
Accumulated deficit
 
(23,435,258
)
 
(24,534,378
)
Total stockholders' deficit
 
(2,712,576
)
 
(4,110,720
)
 
 
 
 
 
Total liabilities and stockholders' deficit
 
$
132,238,272

 
$
133,181,847

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

2


DIVERSIFIED RESTAURANT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
 
 
 
Three Months Ended
 
 
March 26, 2017
 
March 27, 2016
Revenue
 
$
44,337,964

 
$
43,143,252

 
 
 
 
 
Operating expenses
 
 
 
 
Restaurant operating costs (exclusive of depreciation and amortization shown separately below):
 
 
 
 
Food, beverage, and packaging costs
 
13,038,426

 
12,059,759

Compensation costs
 
10,965,530

 
10,520,246

Occupancy costs
 
2,893,852

 
2,766,459

Other operating costs
 
9,029,876

 
8,573,747

General and administrative expenses
 
2,356,966

 
2,174,291

Pre-opening costs
 
31,370

 
123,443

Depreciation and amortization
 
3,633,254

 
3,762,102

Loss on asset disposal
 
22,059

 
47,224

Total operating expenses
 
41,971,333

 
40,027,271

 
 
 
 
 
Operating profit
 
2,366,631

 
3,115,981

 
 
 
 
 
Interest expense
 
(1,575,954
)
 
(1,444,940
)
Other income, net
 
27,167

 
39,742

 
 
 
 
 
Income from continuing operations before income taxes
 
817,844

 
1,710,783

Income tax expense
 
(22,264
)
 
(418,354
)
Income from continuing operations
 
795,580

 
1,292,429

 
 
 
 
 
Discontinued operations
 
 
 
 
Income (loss) from discontinued operations before income taxes
 
36,535

 
(1,423,704
)
Income tax (expense) benefit of discontinued operations
 
(995
)
 
561,679

Income (loss) from discontinued operations
 
35,540

 
(862,025
)
 
 
 
 
 
Net Income
 
$
831,120

 
$
430,404

 
 
 
 
 
Basic earnings (loss) per share from:
 
 
 
 
Continuing operations
 
$
0.03

 
$
0.05

Discontinued operations
 

 
(0.03
)
Basic net earnings per share
 
$
0.03

 
$
0.02

 
 
 
 
 
Diluted earnings (loss) per share from:
 
 
 
 
Continuing operations
 
$
0.03

 
$
0.05

Discontinued operations
 

 
(0.03
)
Diluted net earnings per share
 
$
0.03

 
$
0.02

 
 
 
 
 
Weighted average number of common shares outstanding
 
 
 
 
Basic
 
26,629,974

 
26,298,034

Diluted
 
26,629,974

 
26,298,034

 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 26, 2017
 
March 27, 2016
 
 
 
 
 
Net Income
 
$
831,120

 
$
430,404

 
 
 
 
 
Other comprehensive income (loss)
 
 
 
 
Unrealized changes in fair value of interest rate swaps, net of tax of ($84,714) and $540,296, respectively
 
164,444

 
(1,048,810
)
Total other comprehensive income (loss)
 
164,444

 
(1,048,810
)
 
 
 
 
 
Comprehensive income (loss)
 
$
995,564

 
$
(618,406
)
 
 







































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 (DEFICIT) (unaudited)

 
 
 
 
 
Additional
 
Accumulated
Other
 
 
 
Total
 
Common Stock
 
Paid-in
 
Comprehensive
 
Accumulated
 
Stockholders'
 
Shares
 
Amount
 
Capital
 
Loss
 
Deficit
 
Equity (Deficit)
 Balances - December 27, 2015
26,298,725

 
$
2,597

 
$
36,136,319

 
$
(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 from continuing operations

 

 

 

 
1,292,429

 
1,292,429

 
 
 
 
 
 
 
 
 
 
 
 
Net loss from discontinued operations

 

 

 

 
(862,025
)
 
(862,025
)
 
 
 
 
 
 
 
 
 
 
 
 
Balances - March 27, 2016
26,297,068

 
$
2,598

 
$
36,244,451

 
$
(2,055,477
)
 
$
(18,101,493
)
 
$
16,090,079

 
 
 
 
 
 
 
 
 
 
 
 
Balances - December 25, 2016
26,632,222

 
$
2,610

 
$
21,355,270

 
$
(934,222
)
 
$
(24,534,378
)
 
$
(4,110,720
)
 
 
 
 
 
 
 
 
 
 
 
 
Forfeitures of restricted shares
(1,000
)
 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
Employee stock purchase plan
5,124

 
1

 
11,497

 

 

 
11,498

 
 
 
 
 
 
 
 
 
 
 
 
Share-based compensation

 

 
123,082

 

 

 
123,082

 
 
 
 
 
 
 
 
 
 
 
 
Other comprehensive income

 

 

 
164,444

 

 
164,444

 
 
 
 
 
 
 
 
 
 
 
 
Adoption of ASU 2016-09 (Note 1)

 

 

 

 
268,000

 
268,000

 
 
 
 
 
 
 
 
 
 
 
 
Net income from continuing operations

 

 

 

 
795,580

 
795,580

 
 
 
 
 
 
 
 
 
 
 
 
Net income from discontinued operations

 

 

 

 
35,540

 
35,540

 
 
 
 
 
 
 
 
 
 
 
 
Balances - March 26, 2017
26,636,346

 
$
2,611

 
$
21,489,849

 
$
(769,778
)
 
$
(23,435,258
)
 
$
(2,712,576
)
 
 

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 26, 2017
 
March 27, 2016
Cash flows from operating activities
 
 
 
 
Net income
 
$
831,120

 
$
430,404

Net income (loss) from discontinued operations
 
35,540

 
(862,025
)
Net income from continuing operations
 
795,580

 
1,292,429

Adjustments to reconcile net income to net cash provided by operating activities
 
 
 
 
Depreciation and amortization
 
3,633,254

 
3,762,102

Amortization of debt discount and loan fees
 
52,443

 
50,880

Amortization of gain on sale-leaseback
 
(34,794
)
 
(39,301
)
Impairment and loss on asset disposals
 
22,059

 
47,224

Share-based compensation
 
123,082

 
97,426

Deferred income taxes
 
23,259

 
317,225

Changes in operating assets and liabilities that provided (used) cash
 
 
 
 
Accounts receivable
 
187,782

 
(309,327
)
Inventory
 
69,039

 
(13,670
)
Prepaid and other assets
 
313,204

 
240,947

Intangible assets
 
(18,915
)
 
46,107

Other long-term assets
 
2,084

 
(8,792
)
Accounts payable
 
(208,157
)
 
(289,041
)
Accrued liabilities
 
(577,438
)
 
(942,775
)
Deferred rent
 
23,353

 
24,124

Net cash provided by operating activities of continuing operations
 
4,405,835

 
4,275,558

Net cash provided by (used in) operating activities of discontinued operations
 
35,540

 
(1,163,832
)
Net cash provided by operating activities
 
4,441,375

 
3,111,726

 
 

 
 
Cash flows from investing activities
 
 
 
 
Purchases of property and equipment
 
(1,430,201
)
 
(6,405,269
)
Net cash used in investing activities of continuing operations
 
(1,430,201
)
 
(6,405,269
)
Net cash used in investing activities of discontinued operations
 

 
(1,101,142
)
Net cash used in investing activities
 
(1,430,201
)
 
(7,506,411
)
 
 

 
 
Cash flows from financing activities
 
 
 
 
Proceeds from issuance of long-term debt
 
1,217,621

 
3,311,231

Repayments of long-term debt
 
(2,879,156
)
 
(7,500,000
)
Proceeds from employee stock purchase plan
 
11,498

 
10,707

Net cash used in financing activities
 
(1,650,037
)
 
(4,178,062
)
 
 
 
 
 
Net increase (decrease) in cash and cash equivalents
 
1,361,137

 
(8,572,747
)
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
4,021,126

 
13,499,890

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
5,382,263

 
$
4,927,143

 
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 a single concept, Buffalo Wild Wings® Grill & Bar (“BWW”). As the largest franchisee of BWW, we provide a unique guest experience in a casual and inviting environment.

DRH currently operates 64 DRH-owned BWW restaurants (20 in Michigan, 17 in Florida, 15 in Missouri, 7 in Illinois and 5 in Indiana), including the nation’s largest BWW, based on square footage, in downtown Detroit, Michigan. We have an area development agreement (“ADA”) with Buffalo Wild Wings International, Inc. ("BWLD") under which we have opened 29 restaurants out of a total required of 42 by 2021. We have one additional restaurant in process and are in discussions with BWLD regarding the remaining 12 restaurants. We may continue to open new restaurants but at a potentially lower number over a longer period of time under an amended ADA.

On December 25, 2016, the Company completed a spin-off (the "Spin-Off") of 19 Bagger Dave's entities and certain real estate entities which house the respective Bagger Dave's entities previously owned by DRH into a new independent publicly traded company, Bagger Dave's Burger Tavern, Inc. ("Bagger Dave's"). See Note 2 for additional details.

Principles of Consolidation

The consolidated financial statements as of March 26, 2017 and December 25, 2016, and for the three-month periods ended March 26, 2017 and March 27, 2016, have been prepared by DRH 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 26, 2017 and for the three-month periods ended March 26, 2017 and March 27, 2016 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 statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated.

The consolidated financial information as of December 25, 2016 is derived from our audited consolidated financial statements and notes thereto for the fiscal year ended December 25, 2016, which is included in Item 8 in the Fiscal 2016 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 periods ended March 26, 2017 and March 27, 2016 are not necessarily indicative of the results of operations that may be achieved for the entire fiscal year ending December 31, 2017.

For Variable Interest Entities ("VIE(s)"), we assess whether we are the primary beneficiary as prescribed by the accounting guidance on the consolidation of VIEs. The primary beneficiary of a VIE is the party that has the power to direct the activities that most significantly impact the performance of the entity and the obligation to absorb losses or the right to receive benefits that could potentially be significant to the entity. See Note 3 to the accompanying notes to the consolidated financial statements for more details.
 
Segment Reporting
 
Since December 25, 2016, as a result of the Spin-Off of Bagger Dave’s as further described in Note 2 to the consolidated financial statements, the Company has one operating and reportable segment.

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 both March 26, 2017 and December 25, 2016, we had goodwill of $50.1 million. The goodwill is assigned to the Company's Buffalo Wild Wings reporting unit, which, due to the Spin-Off of Bagger Dave's on December 25, 2016, represents the Company's only reporting unit.

7

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


The Company assesses goodwill for impairment on an annual basis by reviewing relevant qualitative and quantitative factors. More frequent evaluations may be required if the Company experiences changes in its business climate or as a result of other triggering events that take place. If carrying value exceeds fair value, a possible impairment exists and further evaluation is performed.

ASC Topic 350-20, Intangibles - Goodwill and Other, gives companies the option to perform a one-step (Step zero) qualitative assessment to determine whether it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount. In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we assess relevant events and circumstances. If, after assessing the totality of events and circumstances, we determine that it is more likely than not that the fair value of the reporting unit is less than the carrying amount, the first and second steps of the goodwill impairment test would be necessary. Conversely, if we do not make this determination, further action would not be required.

As of December 25, 2016, as a result of step zero of the qualitative assessment, the Company has concluded that its goodwill is recoverable. At March 26, 2017, 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. During the three-month periods ended March 26, 2017 and March 27, 2016, no impairment was recognized.

We account for exit or disposal activities, including restaurant closures, in accordance with 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.

Intangible Assets

Amortizable intangible assets consist of franchise fees, trademarks, non-compete agreements, favorable and unfavorable operating leases, and loan fees and are stated at cost, less accumulated amortization. Intangible assets are amortized on a straight-line basis over the estimated useful life, as follows: Franchise fees- 1020 years, Trademarks- 15 years, Non-compete- 3 years, Favorable and unfavorable leases - over the term of the respective leases and Loan fees - over the term of the respective loan.

Liquor licenses, if transferable, are deemed to have an indefinite life and are carried at the lower of fair value or cost. 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 fair value of the asset is less than the carrying amount, an impairment charge is recorded. No impairments were recognized for the three months ended March 26, 2017 or fiscal year ended December 25, 2016.

Concentration Risks

Approximately 78% and 79% of the Company's continuing revenue for the three months ended March 26, 2017 and March 27, 2016, respectively, were generated from food and beverage sales from restaurants located in the Midwest region. The remaining 22% and 21% of the Company's continuing revenue for the three months ended March 26, 2017 and March 27, 2016, respectively, were generated from food and beverage sales from restaurants located in Florida.

8

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

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 Citizens Bank, N.A. (“Citizens”) and other banks to fix interest rates on a portion of the Company’s portfolio of variable rate debt, which reduces exposure to interest rate fluctuations. Our derivative financial instruments are recorded at fair value on the Consolidated Balance Sheets. The effective portion of changes in the fair value of derivatives which qualify for hedge accounting is recorded in other comprehensive income and is recognized in the Consolidated Statements of Operations when the hedged item affects earnings. The ineffective portion of the change in fair value of a hedge would be recognized in income immediately. 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 interest rate swap agreements associated with the Company’s current debt 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 Sheets in other long-term assets or other liabilities depending on the fair value of the swaps. See Note 8 and Note 15 for additional information on the interest rate swap agreements.

Recent Accounting Pronouncements

In January 2017, the FASB issued Accounting Standards Update ("ASU") 2017-04, Topic 350: Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). ASU 2017-04 simplified wording and removes step 2 of the goodwill impairment test. A goodwill impairment will now be the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. The FASB also eliminated the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform step 2 of the goodwill test. We do not expect the standard will have a significant impact.  ASU 2017-04 is effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2020, with early adoption permitted for interim or annual goodwill impairment tests on testing dates after January 1, 2017. DRH has not adopted this standard as of March 26, 2017.

In August 2016, the FASB issued ASU 2016-15, Topic 230: Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments ("ASU 2016-15"). ASU 2016-15 clarifies current GAAP that is either unclear or does not include specific guidance on a number of specific issues. The amendments set forth are an improvement to GAAP because they provide guidance for each issue and reduce the current and potential future diversity in practice. ASU 2016-15 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We are currently evaluating the pending adoption of ASU 2016-15 and the impact it will have on our consolidated financial statements.

In February 2016, FASB issued ASU 2016-02, Leases. 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 believe the adoption of ASU 2016-02 will materially impact our consolidated financial statements by significantly increasing our non-current assets and non-current liabilities on our consolidated balance sheets in order to record the right of use assets and related lease liabilities for our existing operating leases. We are currently unable to estimate the impact of the updated guidance on our consolidated financial statements.


9

DIVERSIFIED RESTAURANT HOLDINGS, INC.
NOTES TO INTERIM 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 revenue 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. Most recent updates to the standard delay the required adoption by one year, now effective for annual periods beginning after December 15, 2018, 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 Pronouncements

In March 2016, the FASB issued 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. Beginning in fiscal 2017, the tax effects of awards will be recognized in the statement of operations. In addition, the Company will account for forfeitures as they occur.

Effective December 26, 2016, the Company adopted the accounting guidance contained within ASU 2016-09. As a result, the Company recorded a deferred tax asset and retained earnings increase of $268,000 to recognize the Company's excess tax benefits that existed as of December 25, 2016, on the Consolidated Balance Sheet.

2.     DISCONTINUED OPERATIONS

Spin-Off of Bagger Dave's

On August 4, 2016, DRH announced that its Board of Directors unanimously approved a plan to pursue a tax-free spin-off of its Bagger Dave's business. Pursuant to this plan, DRH contributed its 100.0% owned entity, AMC Burgers, LLC and certain real estate entities, into Bagger Dave's Burger Tavern, Inc., a newly created Nevada company, which was then spun-off into a stand-alone company. AMC Burgers, Inc. owns and operates all of the Bagger Dave's Burger Tavern® restaurants and the real estate entities held certain real estate related to the restaurants before the real estate was sold in 2014 and 2015. In connection with the Spin-Off, DRH contributed certain assets, liabilities and employees currently related to its Bagger Dave's businesses. Intercompany balances due to/from DRH, which included amounts from sales, were contributed to equity of Bagger Dave's. The Spin-Off was effected on December 25, 2016 via a one-for-one distribution of common shares in Bagger Dave's to DRH holders of record on December 19, 2016.

As part of the Spin-Off transaction, DRH agreed to fund a one-time $2.0 million cash distribution to Bagger Dave's and agreed that, if deemed necessary within twelve months after the date of the Spin-Off, up to $1 million of additional cash funding may be considered upon approval by DRH and its lenders.

Prior to the Spin-Off, Bagger Dave’s was a co-obligor on a joint and several basis with the Company on its $155.0 million senior secured credit facility. The Company’s debt under this facility remained with the Company and Bagger Dave’s was released as a borrower. As a result, this debt was not assigned to discontinued operations. Additionally, DRH retained substantially all of the tax benefits (net operating loss and tax credit carryforwards) generated by Bagger Dave's prior to the date of the transaction representing an amount sufficient to offset pre-tax income totaling over $50 million at current estimated tax rates.


10

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

DRH decided to spin-off Bagger Dave's after considering all reasonable strategic and structural alternatives because of the disparity between the operating models of its two brands, BWW as franchisee, and Bagger Dave's as an owned concept. The management teams of Bagger Dave's and DRH agreed that the nature of the two concepts varied greatly, and that each will be more valuable and operate more effectively independently of one another. Bagger Dave's is a concept developed by the management team of DRH. In contrast to operating a franchised concept like BWW, it has no development restrictions and the flexibility to enhance brand attributes such as logos, trade dress and restaurant design, change its menu offering and improve its operational model in an effort to better align with guest expectations. To manage these functions effectively, specific resources are required that are not necessary for a franchisee. For example, menu development, purchasing and brand marketing are critical to the success of Bagger Dave's but not necessary for a BWW franchisee since these functions are managed by the franchisor. Additionally, as a start-up brand, Bagger Dave's has both higher risk and higher growth potential while BWW, being a mature brand and as a franchisee, has more limited organic growth potential due to the status of its existing market penetration and the need to obtain development rights from the franchisor.

In conjunction with the Spin-Off, DRH entered into a transition services agreement (the "TSA") with Bagger Dave's pursuant to which DRH will provide certain information technology and human resources support, limited accounting support, and other minor administrative functions at no charge. The TSA is intended to assist the discontinued component in efficiently and seamlessly transitioning to stand on its own. The agreement expires in December 2017 at which time the parties may negotiate which services will be required on an ongoing basis and the fees that will be charged for such services.

Information related to Bagger Dave's has been reflected in the accompanying consolidated financial statements as follows:

Consolidated Statements of Operations - Bagger Dave's results of operations for the three-month period ended March 27, 2016 have been presented as discontinued operations. Additionally, all activity related to the discontinued operation at the Company is presented as discontinued operations for the three-month period ended March 26, 2017.

Consolidated Statements of Cash Flows - The Bagger Dave's cash flows from operating and investing activities for the three-month periods ended March 26, 2017 and March 27, 2016 have been presented separately on the face of the cash flow statement. The Bagger Dave's cash flows from financing activities for these years have not been separately reported on the consolidated statements of cash flows since there was only one financing function for both entities.

The following are major classes of line items constituting pre-tax loss from discontinued operations:



Three Months Ended


March 26, 2017

March 27, 2016
Revenue

$


$
5,269,547

Restaurant operating and closure related costs (exclusive of depreciation and amortization)

66,693


(5,496,874
)
General and administrative expenses

(30,158
)

(488,467
)
Depreciation and amortization



(545,615
)
Pre-opening costs



(148,921
)
Other income



5,530

Impairment and loss on asset disposals



(18,904
)
Income (Loss) from discontinued operations before income taxes

36,535


(1,423,704
)
Income tax (expense) benefit

(995
)

561,679








Total income (loss) from discontinued operations

$
35,540


$
(862,025
)

The operating results of the discontinued operations include only direct expenses incurred by Bagger Dave’s. Interest expense was not allocated to discontinued operations because the Company’s debt under the $155 million secured credit facility remained with the Company.

Prior to the Spin-Off, Bagger Dave's was a reportable segment of the Company. Following the Spin-Off, there were no assets or liabilities remaining from the Bagger Dave's operations as of December 25, 2016. See Note 3 for a discussion of involvement the Company will continue to have with Bagger Dave's after the Spin-Off.

11

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

3.     UNCONSOLIDATED VARIABLE INTEREST ENTITIES

After the Spin-Off of Bagger Dave’s and the related discontinuation of its operations described in Note 2, the Company remains involved with certain activities that result in Bagger Dave’s being considered a VIE. This conclusion results primarily from the existence of guarantees by the Company of certain Bagger Dave’s leases as described below under "Lease Guarantees". While the Company holds a variable interest in Bagger Dave’s, it is not considered to be its primary beneficiary because it does not have the power to direct the activities of Bagger Dave’s. Specifically, we considered the fact that, although three of the Company’s executive officers are currently also on Bagger Dave’s board, there are no agreements in place that require these executive officers to vote in the interests of the Company. In other words, these executive officers do not represent the Company in their capacity as Bagger Dave’s directors. Furthermore, they remain on the board of Bagger Dave’s so long as the shareholders annually elect them. At any time, these board members can be replaced by a vote of the Bagger Dave’s shareholders. As a result, the Company does not consolidate the VIE.

Lease Guarantees

At March 26, 2017, the Company is a guarantor for 18 leases, two of which now relate to an unaffiliated party. In the event the respective lessees cannot make their lease payments, the Company may become responsible for the payments under its guarantee.

In accordance with ASC 460, Guarantees, the Company evaluated its liability from the Bagger Dave's lease guarantees first by estimating the non-contingent component representing the estimated fair market value of the guarantees at inception, and recorded a liability in the amount of $0.3 million as of December 25, 2016, which is included in other liabilities on the Consolidated Balance Sheet as of March 26, 2017 and December 25, 2016. No liability had previously been recorded as a result of the affiliate relationship between the Company and Bagger Dave’s.

Secondly, the Company considered the contingent component of the guarantees and concluded that, as of March 26, 2017 and December 25, 2016, no loss exposure under the guarantees was probable because, among other things, each of the Bagger Dave's restaurants subject to the leases is either currently operating or the lease has been assigned or sublet to another tenant who is responsible for, and making, the lease payments.

The Company has determined that its maximum exposure resulting from the lease guarantees includes approximately $9.5 million of future minimum lease payments plus potential additional payments to satisfy maintenance, property tax and insurance requirements under the leases as of March 26, 2017.  The terms and conditions of the guarantees vary, and each guarantee has an expiration date which may or may not correspond with the end of the underlying lease term.  These expiration dates range from less than 2 months to 13 years as of March 26, 2017.  In the event that the Company is required to perform under any of its lease guarantees, we do not believe a liability to the Company would be material because we would first seek to minimize its exposure by finding a suitable tenant to sub-lease the space.  In many cases, a replacement tenant can be found and the lessor could agree to release the Company from its future guarantee obligation. During 2015, 11 Bagger Dave’s locations were closed, 9 of which had DRH lease guarantees. Of the 9 guaranteed leases, new tenants were found to step into the Company’s obligations for 5 locations in 3 to 14 months from the date of closure, 3 guarantees expired or were terminated, and 1 remains an obligation of the Company. In reaching our conclusion, we also considered the following:

the financial condition of Bagger Dave’s, including its ability to service the lease payments on the locations it continues to operate;
its recent history of incurring operating losses, along with the more recent trends in its business after completing the closure of 11 underperforming locations and rationalizing the cost structure both of its remaining 18 restaurants and its general and administrative costs;
its liquidity position and the actions available to it should its liquidity deteriorate to such a degree that its ability to service required lease payments is threatened; and
the actions available to the Company to avoid or mitigate potential losses should Bagger Dave's become unable to service one or more of the leases that the Company guarantees.

12

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

The following is a detailed listing of all Bagger Dave's leases that include a guarantee by the Company as of March 26, 2017:
Location of lease
Status of location
Guarantee expiry date
 
Liability recognized on balance sheet
 
Future guaranteed lease payments
Grandville, MI
Closed
05/12/17
 
$
893

 
$
10,436

Holland, MI
Closed
10/09/17
 
2,101

 
45,000

Bloomfield, MI
Open
01/14/18
 
2,787

 
68,333

Shelby Township, MI
Open
01/31/18
 
2,622

 
64,823

West Chester Township, OH
Open
02/01/18
 
2,866

 
70,833

Woodhaven, MI
Open
11/30/18
 
4,426

 
123,667

Traverse City, MI
Open
01/31/19
 
5,887

 
166,667

Fort Wayne, IN
Open
01/31/19
 
5,424

 
153,485

Grand Blanc, MI
Open
01/31/20
 
6,759

 
199,667

Centerville, OH
Open
11/30/20
 
13,293

 
399,871

Chesterfield Township, MI
Open
12/31/20
 
8,092

 
243,750

E. Lansing, MI
Open
09/10/21
 
2,334

 
75,000

Birch Run, MI
Open
12/31/24
 
23,557

 
734,663

Berkley, MI
Open
06/08/29
 
32,532

 
1,026,720

Cascade Township, MI
Open
06/08/29
 
29,856

 
942,264

Avon, IN
Closed
06/30/29
 
48,658

 
1,535,664

Greenwood, IN
Closed
06/30/29
 
50,372

 
1,589,760

Canton, MI
Open
06/30/30
 
63,541

 
2,018,100

Totals
 
 
 
$
306,000

 
$
9,468,703



4.          PROPERTY AND EQUIPMENT

Property and equipment are comprised of the following assets:
 
 
March 26, 2017
 
December 25, 2016
Equipment
 
29,506,649

 
29,426,476

Furniture and fixtures
 
7,267,527

 
7,275,923

Leasehold improvements
 
63,501,105

 
63,449,082

Restaurant construction in progress
 
1,708,861

 
94,595

Total
 
101,984,142

 
100,246,076

Less accumulated depreciation
 
(47,166,941
)
 
(43,616,045
)
Property and equipment, net
 
$
54,817,201

 
$
56,630,031


13

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

5.        INTANGIBLE ASSETS

Intangible assets are comprised of the following:
 
 
March 26, 2017
 
December 25, 2016
Amortized intangible assets
 
 
 
 
Franchise fees
 
$
1,290,642

 
$
1,290,642

Trademark
 
2,500

 
2,500

Non-compete
 
76,560

 
76,560

Favorable operating leases
 
351,344

 
351,344

Loan fees
 
368,083

 
368,083

Total
 
2,089,129

 
2,089,129

Less accumulated amortization
 
(766,818
)
 
(718,517
)
Amortized intangible assets, net
 
1,322,311

 
1,370,612

 
 
 
 
 
Unamortized intangible assets
 
 
 
 
Liquor licenses
 
1,264,252

 
1,295,752

Total intangible assets, net
 
$
2,586,563

 
$
2,666,364


Amortization expense for the three-month periods ended March 26, 2017 and March 27, 2016 was $21,230 and $22,790, 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 8.3 years at March 26, 2017.

6.           RELATED PARTY TRANSACTIONS

Fees for accounting support services were 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 months ended March 26, 2017 and March 27, 2016 were $8,300 and $41,682, respectively. DRH has a liability to Bagger Dave's for expenses paid on behalf of DRH in the amount of $424,089 as of March 26, 2017, which is included in Other Accrued Liabilities on the Consolidated Balance Sheet.

7.    OTHER ACCRUED LIABILITES
 
March 26, 2017
 
December 25, 2016
Sales tax payable
$
881,052

 
$
816,215

Accrued interest
547,275

 
442,976

Accrued royalty fees
161,158

 
144,727

Accrued property taxes
594,105

 
490,809

Related party payable
424,089

 

Other
285,560

 
747,542

Total other accrued liabilities
$
2,893,239

 
$
2,642,269



14

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

8.           LONG-TERM DEBT

Long-term debt consists of the following obligations:
 
 
March 26, 2017
 
December 25, 2016
$120.0 million term loan - the rate at March 26, 2017 and December 25, 2016 was 4.29% and 4.12%, respectively.
 
$
97,198,617

 
$
99,698,616

 
 
 
 
 
$30.0 million development line of credit, converted to $18.2 million facility term loan in December 2016 - the rate at March 26, 2017 and December 25, 2016 was 4.29% and 4.21%, respectively.
 
17,820,320

 
18,199,476

 
 
 
 
 
$5.0 million revolving line of credit - the rate at March 26, 2017 and December 25, 2016 was 6.50% and 6.25%, respectively.
 
4,000,000

 
4,000,000

 
 
 
 
 
$5.0 million development line of credit - the rate at March 26, 2017 was 4.36%.
 
1,217,621

 

 
 
 
 
 
Unamortized discount and debt issuance costs
 
(659,630
)
 
(712,072
)
 
 
 
 
 
Total debt
 
119,576,928

 
121,186,020

 
 
 
 
 
Less current portion
 
(11,313,759
)
 
(11,307,819
)
 
 
 
 
 
Long-term debt, net of current portion
 
$
108,263,169

 
$
109,878,201


On June 29, 2015, the Company entered into a $155.0 million senior secured credit facility with a syndicate of lenders led by Citizens (the “June 2015 Senior Secured Credit Facility”) with a senior lien on all the Company’s personal property and fixtures. The June 2015 Senior Secured Credit Facility consists of a $120.0 million term loan (the “June 2015 Term Loan”), a $30.0 million, subsequently amended to $23.0 million (see amendment details immediately following this paragraph) development line of credit (the “June 2015 DLOC”) and a $5.0 million (see amendment details immediately following this paragraph) 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.

On December 23, 2016, the Company entered into an amendment agreement for purposes of, among other things, releasing the Bagger Dave’s entities as borrowers and releasing all related liens on the Bagger Dave’s assets. In addition, the amendment (a) converted the amounts then outstanding under the June 2015 DLOC to a development facility term loan (the “DF Term Loan”), (b) canceled $6.8 million previously available under the June 2015 DLOC, and (c) extended the maturity date on the remaining $5.0 million under the June 2015 DLOC to June 29, 2018.

Payments of principal are based upon a 12-year straight-line amortization schedule, with monthly principal payments of $833,333 on the June 2015 Term Loan and $126,385 on the DF Term Loan, plus accrued interest. The entire remaining outstanding principal and accrued interest on the June 2015 Term Loan and the DF 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 subject to certain limitations relative to actual development costs. Once the DLOC is fully drawn, outstanding balances convert 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. If the DLOC is not fully drawn by the end of the two years term, the outstanding principal balance becomes due based on the 12-year amortization period with final payment due June 29, 2020. The June 2015 RLOC, which is subject to certain usage restrictions during each annual period, is for a term of five years.

The interest rate for each of the loans, as selected by the borrower, is based upon either a LIBOR or base rate (generally Prime or Fed Funds) plus an applicable margin, which ranges from 2.25% to 3.5% for LIBOR loans and from 1.25% to 2.5% for base rate loans, depending on the lease adjusted leverage ratio as defined in the agreement.


15

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

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. As a result of the December 2016 Amendment, the Company incurred $197,889 of debt issuance costs recorded as a part of debt discount. Debt discount and debt issuance cost related to term debt, net of accumulated amortization totaled $659,630 and $712,072 at March 26, 2017 and December 25, 2016, respectively. The unamortized portion of capitalized debt issuance costs related to the DLOC and RLOC totaled $223,010 and $244,336 at March 26, 2017 and December 25, 2016, respectively. Debt discount and debt issuance cost are amortized over the life of the debt and are recorded in interest expense using the effective interest method.

For the three-month periods ended March 26, 2017 and March 27, 2016, interest expense was $1.6 million and $1.4 million, 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. As of March 26, 2017, the Company is in compliance with the loan covenants.

At March 26, 2017, 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 15 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 26, 2017
 
 
 
Notional amounts
 
Derivative assets
 
Derivative liabilities
Interest rate swaps
Rate
Expires
 
 
 
 
 
April 2012
1.4%
April 2019
$
4,761,905
 
 
$
 
 
$
7,619
 
October 2012
0.9%
October 2017
2,142,857
 
 
1,611
 
 
 
July 2013
1.4%
April 2018
3,904,762
 
 
 
 
8,019
 
May 2014
1.5%
April 2018
8,750,000
 
 
 
 
31,099
 
January 2015
1.8%
December 2019
21,261,905
 
 
 
 
181,790
 
August 2015
2.3%
June 2020
39,226,322
 
 
 
 
939,417
 
Total
 
 
$
80,047,751
 
 
$
1,611
 

$
1,167,944
 

 
 
 
December 25, 2016
 
 
 
Notional amounts
 
Derivative assets
 
Derivative liabilities
Interest rate swaps
Rate
Expires
 
 
 
 
April 2012
1.4%
April 2019
$
5,333,333
 
 
$
 
 
$
21,037
 
October 2012
0.9%
October 2017
2,357,143
 
 
 
 
723
 
July 2013
1.4%
April 2018
4,761,905
 
 
 
 
18,949
 
May 2014
1.5%
April 2018
9,285,714
 
 
 
 
58,359
 
January 2015
1.8%
December 2019
21,119,048
 
 
 
 
271,144
 
August 2015
2.3%
June 2020
49,696,875
 
 
 
 
1,045,279
 
Total
 
 
$
92,554,018
 
 
$
 
 
$
1,415,491
 


16

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

9.            SHARE-BASED COMPENSATION

Restricted share awards

For the three months ended March 26, 2017, no restricted shares were issued and for the three months ended March 27, 2016, restricted shares were issued to certain team members at a weighted-average grant date fair value of $2.66. Based on the Stock Award Agreement, shares typically vest ratably over either a one or three year period, or on the third anniversary of the grant date, as determined by the Compensation Committee. Unrecognized share-based compensation expense of $414,793 at March 26, 2017 will be recognized over the remaining weighted-average vesting period of 1.8 years. The total fair value of shares vested during the three-month periods ended March 26, 2017 and March 27, 2016, was $0 and $59,631, respectively.  Under the Stock Incentive Plan, there are 70,791 shares available for future awards at March 26, 2017.

The following table presents the restricted shares transactions during the three-month period ended March 26, 2017:
 
Number of
Restricted
Stock Shares
Unvested, December 25, 2016
473,391

Granted

Vested

Vested shares tax portion

Expired/Forfeited
(1,000
)
Unvested, March 26, 2017
472,391


The following table presents the restricted shares transactions during the three-month period 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


On July 30, 2010, prior to the Stock Incentive Plan, 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 originally expired six years from issuance. On July 28, 2016, the Stock Option Agreement of 2010 was amended to extend the expiration date of these options to July 31, 2019. The options can be exercised at a price of $2.50 per share. At March 26, 2017, 180,000 shares of authorized common stock are reserved for issuance to provide for the exercise of the remaining options. The intrinsic value of outstanding options was negligible as of both March 26, 2017 and March 27, 2016.

Employee stock purchase plan

The Company 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 coincide with the fiscal quarter and are awarded on the last day of the offering period. During the three months ended March 26, 2017 and March 27, 2016, the Company issued 5,124 and 5,609 shares, respectively. Under the ESPP, there are 179,201 shares available for future purchase at March 26, 2017.


17

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

Share-based Compensation

Share-based compensation of $0.1 million and $0.1 million was recognized during the three-month periods ended March 26, 2017 and March 27, 2016, respectively, as compensation cost in the Consolidated Statements of Operations and as additional paid-in capital on the Consolidated Statement of Stockholders' Equity (Deficit) to reflect the fair value of shares vested.

The Company has authorized 10,000,000 shares of preferred stock at a par value of $0.0001No preferred shares are issued or outstanding as of March 26, 2017. 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.

10.           INCOME TAXES

The effective income tax rate for continuing operations for the three-month periods ended March 26, 2017 and March 27, 2016 was 2.7% and 24.5%, respectively. The change in the effective income tax rate for March 26, 2017 compared with March 27, 2016 was primarily attributable to the decrease in income before income taxes.

11.           OPERATING LEASES

The Company's lease terms 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 $2.2 million for both three-month periods ended March 26, 2017 and March 27, 2016.

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 26, 2017 are summarized as follows:
Year
Amount
Remainder of 2017
$
6,672,071

2018
8,597,826

2019
7,876,606

2020
7,780,028

2021
6,970,160

Thereafter
30,609,163

Total
$
68,505,854


18

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

12.           COMMITMENTS AND CONTINGENCIES

The Company’s ADA with BWLD calls for it to open 42 restaurants by April 1, 2021. As of March 26, 2017 we have opened 29 restaurants under the ADA and have one additional restaurant under development. We are currently in discussions with BWLD with respect to both the timing and desirability of building the remaining 12 restaurants pursuant to the current ADA. If the ADA is not renegotiated, the Company may choose not to build some, or all of the remaining 12 locations in exchange for a fee of $50,000 for each unbuilt unit.

The Company is required to pay BWLD royalties (5.0% of net sales) and advertising fund contributions (between 3.00% and 3.15% of net sales). In addition, the Company is required to spend an additional 0.25% - 0.50% of regional net sales related to advertising cooperatives for certain metropolitan markets for the term of the individual franchise agreements. The Company incurred $2.2 million in royalty expense for both three-month periods ended March 26, 2017 and March 27, 2016. Advertising fund contribution and advertising cooperative expenses were $1.4 million for both three-month periods ended March 26, 2017 and March 27, 2016. Amounts are recorded in Other Operating Costs on the Consolidated Statement of Operations.

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 $450,000 to $850,000 depending on an individual restaurant's needs.

In connection with the Spin-Off of Bagger Dave’s, the Company’s board of directors approved a cash distribution of $2.0 million to $3.0 million to Bagger Dave’s within twelve months of the transaction date. On December 25, 2016, the Company contributed $2.0 million in cash to Bagger Dave’s as part of the Spin-Off. The additional $1.0 million of funding by the Company would only be considered if deemed necessary, and would only be made if approved by the Company’s lenders.

In October 2015, the Company settled two collective actions alleging violations of fair labor standards acts and minimum wage laws. The first action, Tammy Wolverton et al v. Diversified Restaurant Holdings, Inc. et al, was filed on March 31, 2014, in the United States District Court for the Eastern District of Michigan and made allegations regarding employees in Michigan. The second action, Lisa Murphy & Andre D. Jordan, Jr. v. Diversified Restaurants Holdings, Inc., et al, was filed on May 19, 2014, in United States District Court for the Northern District of Illinois, and made allegations involving employees in Illinois, Indiana and Florida.

The actions, in which the plaintiffs were represented by the same legal counsel, contained mirror allegations that tipped servers and bartenders in the Company’s restaurants were required to perform general preparation and maintenance duties, or “non-tipped work,” for which they should be compensated at the minimum wage.

In August 2016, the Company and A Sure Wing, LLC settled a third collective action that was filed on December 18, 2015 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 alleged 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 Company filed an indemnity claim against A Sure Wing, LLC and received a reciprocal indemnity claim from A Sure Wing, LLC.

We believe that the Company’s wage and hour policies comply with the law and that we had meritorious defenses to the substantive claims in each of these matters. A Sure Wing, LLC settled with the plaintiffs in the December 2015 matter and funded the settlement. As a result, the Company released its indemnity claim against A Sure Wing, LLC.

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. 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.

Refer to Note 3 for a discussion of lease guarantees provided by the Company.


19

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

13.         EARNINGS PER SHARE

The following is a reconciliation of basic and fully diluted earnings per common share for the three-month periods ended March 26, 2017 and March 27, 2016:
 
 
Three Months Ended
 
 
March 26, 2017
 
March 27, 2016
Income from continuing operations
 
$
795,580

 
$
1,292,429

Income (loss) from discontinued operations
 
35,540

 
(862,025
)
Net income
 
$
831,120

 
$
430,404

 
 
 
 
 
Weighted-average shares outstanding
 
26,629,974

 
26,298,034

Effect of dilutive securities
 

 

Weighted-average shares outstanding - assuming dilution
 
26,629,974

 
26,298,034

 
 
 
 
 
Earnings per common share from continuing operations
 
$
0.03

 
$
0.05

Earnings per common share from discontinued operations
 

 
(0.03
)
Earnings per common share
 
$
0.03

 
$
0.02

 
 
 
 
 
Earnings per common share - assuming dilution - from continuing operations
 
0.03

 
0.05

Earnings per common share - assuming dilution - from discontinued operations
 

 
(0.03
)
Earnings per common share - assuming dilution
 
$
0.03

 
$
0.02


During the three-month periods ended March 26, 2017 and March 27, 2016, 472,392 and 202,913 shares, respectively, of unvested restricted stock were excluded from the calculation of diluted earnings per share because such shares were anti-dilutive.


14.            SUPPLEMENTAL CASH FLOWS INFORMATION

Other Cash Flows Information

Cash paid for interest was $1.4 million during both three-month periods ended March 26, 2017 and March 27, 2016.

Cash paid for income taxes was $0 during both three-month periods ended March 26, 2017 and March 27, 2016.

Supplemental Schedule of Non-Cash Operating, Investing, and Financing Activities

Noncash investing activities for property and equipment not yet paid as of March 26, 2017 and March 27, 2016, was $0.4 million and $1.8 million, respectively.

15.           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.


20

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

As of March 26, 2017 and December 25, 2016, our financial instruments consisted of cash and cash equivalents, accounts receivable, accounts payable, interest rate swaps, lease guarantee liability, 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 observable market 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 8 for additional information pertaining to interest rates swaps.

The fair value of our lease guarantee liability is determined by calculating the present value of the difference between the estimated rate at which the Company and Bagger Dave’s could borrow money in a duration similar to the underlying lease guarantees. Our lease guarantees are classified as a Level 2 measurement as there is no actively traded market for such instruments.

As of March 26, 2017 and December 25, 2016, our total debt was approximately $119.6 million and $121.2 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 26, 2017 and March 27, 2016.

The following table presents the fair values for those liabilities measured on a recurring basis as of March 26, 2017:

FAIR VALUE MEASUREMENTS
Description
 
Level 1
 
Level 2
 
Level 3
 
Liability
Total
Interest rate swaps
 
$

 
$
(1,166,333
)
 
$

 
$
(1,166,333
)
Lease guarantee liability
 

 
(306,000
)
 

 
(306,000
)
Total
 
$

 
$
(1,472,333
)
 
$

 
$
(1,472,333
)

 
The following table presents the fair values for those assets and liabilities measured on a recurring basis as of December 25, 2016:

FAIR VALUE MEASUREMENTS
Description
 
Level 1
 
Level 2
 
Level 3
 
Liability
Total
Interest rate swaps
 
$

 
$
(1,415,491
)
 
$

 
$
(1,415,491
)
Lease guarantee liability
 

 
(306,000
)
 

 
(306,000
)
Total
 
$

 
$
(1,721,491
)
 
$

 
$
(1,721,491
)
 

21

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

16.    ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table summarizes each component of Accumulated Other Comprehensive Income (Loss):
 
 
Three Months Ended March 26, 2017
 
Three Months Ended March 27, 2016
 
 
Interest Rate Swaps
 
Interest Rate Swaps
Beginning balance
 
$
(934,222
)
 
$
(1,006,667
)
Gain (loss) recorded to other comprehensive income
 
249,158

 
(1,589,106
)
Tax benefit (expense)
 
(84,714
)
 
540,296

Other comprehensive income (loss)
 
164,444

 
(1,048,810
)
 
 
 
 
 
Accumulated OCL
 
$
(769,778
)
 
$
(2,055,477
)

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 25, 2016. Information included in this discussion and analysis includes commentary on company-owned restaurants, restaurant sales, and same store sales. Management believes such sales information is an important measure of our performance, and is useful in assessing the Buffalo Wild Wings® Grill & Bar (“BWW”) concept. 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 marketplaces; 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.


22


OVERVIEW

Diversified Restaurant Holdings, Inc. and its wholly-owned subsidiaries (“DRH” or the "Company") is a single-concept restaurant company operating 64 BWW franchised restaurants. As the largest franchisee of BWLD, we provide a unique guest experience in a casual and inviting environment. We are committed to providing value to our guests by offering generous portions of flavorful food in an upbeat and entertaining atmosphere. We believe BWW is a uniquely positioned restaurant brand, designed to maximize guest appeal, offering competitive price points and a family-friendly atmosphere, which we believe enables strong performance through economic cycles.We were incorporated in 2006 and are headquartered in the Detroit metropolitan area. As of March 26, 2017, we had 64 restaurants (20 in Michigan, 17 in Florida, 15 in Missouri, 7 in Illinois and 5 in Indiana), including the nation’s largest BWW, based on square footage, in downtown Detroit, Michigan. We will continue to grow our restaurant base under our current ADA, but likely will have fewer new restaurant openings than previously agreed. We believe our historical track record of acquiring and integrating restaurants provides us with additional future growth opportunities and we will seek to take advantage of strategic acquisitions that may be available in the marketplace.

RESTAURANT OPENINGS

The following table outlines the restaurant unit information for each fiscal year from 2013 through 2016.
 
 
2017 (estimate)
 
2016
 
2015
 
2014
 
2013
 
 
 
 
 
 
 
 
 
 
 
Restaurants open at the beginning of year
 
64

 
62

 
42

 
36

 
33

 
 
 
 
 
 
 
 
 
 
 
Openings/closures:
 
 
 
 
 
 
 
 
 
 
New restaurant openings
 
1

 
2

 
3

 
3

 
3

Restaurant acquisitions
 

 

 
18

 
3

 

Restaurant closures
 

 

 
(1
)
 

 

Total restaurants open at the end of the year
 
65

 
64

 
62

 
42

 
36


RESULTS OF OPERATIONS

For the three-month period ended March 26, 2017 ("First Quarter 2017"), revenue was generated from the operations of 64 restaurants. For the three-month period ended March 27, 2016 ("First Quarter 2016"), revenue was generated from the operations of 62 restaurants. Quarterly 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 restaurant's comparable sales in the first full month after 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 61 and 56 restaurants at March 26, 2017 and March 27, 2016, respectively.
 

23


Results of Operations for the Three Months Ended March 26, 2017 and March 27, 2016
 
 
Three Months Ended
 
 
March 26, 2017
 
March 27, 2016
Total revenue
 
100.0
 %
 
100.0
 %
 
 
 
 
 
Operating expenses
 
 
 
 
Food, beverage, and packaging costs
 
29.4
 %
 
28.0
 %
Compensation costs
 
24.7
 %
 
24.4
 %
Occupancy costs
 
6.5
 %
 
6.4
 %
Other operating costs
 
20.4
 %
 
19.9
 %
General and administrative expenses
 
5.3
 %
 
5.0
 %
Pre-opening costs
 
0.1
 %
 
0.3
 %
Depreciation and amortization
 
8.2
 %
 
8.7
 %
Loss on asset disposal
 
 %
 
0.1
 %
Total operating expenses
 
94.6
 %
 
92.8
 %
 
 
 
 
 
Operating profit
 
5.4
 %
 
7.2
 %
 
 
 
 
 
Interest expense
 
(3.6
)%
 
(3.3
)%
Other income, net
 
0.1
 %
 
0.1
 %
 
 
 
 
 
Income from continuing operations before income taxes
 
1.9
 %
 
4.0
 %
 
 
 
 
 
Income tax expense
 
(0.1
)%
 
(1.0
)%
 
 
 
 
 
Income from continuing operations
 
1.8
 %
 
3.0
 %
 
 
 
 
 
Income (loss) from discontinued operations before income taxes
 
0.1
 %
 
(3.3
)%
Income tax (expense) benefit of discontinued operations
 
 %
 
1.3
 %
Income (loss) from discontinued operations
 
0.1
 %
 
(2.0
)%
 
 
 
 
 
Net Income
 
1.9
 %
 
1.0
 %


Revenue for First Quarter 2017 was $44.3 million, an increase of $1.2 million, or 2.8%, over $43.1 million of revenue generated during First Quarter 2016. The increase was driven by two new restaurants opening in the Second Quarter of 2016, offset by a decrease in same-store sales of 0.3%.

Food, beverage, and packaging costs increased by $0.9 million, or 8.1%, to $13.0 million in First Quarter 2017 from $12.1 million in First Quarter 2016 due to the increase in the number of restaurants operating in 2017. Food, beverage, and packaging costs as a percentage of revenue increased to 29.4% in First Quarter 2017 from 28.0% in First Quarter 2016 primarily due to commodity cost inflation and an increase in promotional activity. Average cost per pound for bone-in chicken wings, our most significant input cost, increased to $2.02 in First Quarter 2017 compared with $1.92 in First Quarter 2016.

Compensation costs increased by $0.5 million, or 4.2%, to $11.0 million in First Quarter 2017 from $10.5 million in First Quarter 2016. The increase was primarily due to the increased number of restaurants operating in 2017. Compensation costs as a percentage of sales increased to 24.7% in First Quarter 2017 from 24.4% in First Quarter 2016 due to higher average hourly wages and labor overhead expense.

Occupancy costs increased $0.1 million, or 4.6%, to $2.9 million in First Quarter 2017 from $2.8 million in First Quarter 2016 due to the increased number of restaurants operating in 2017. Occupancy as a percentage of sales remained relatively flat at 6.5% in First Quarter 2017 compared with 6.4% First Quarter 2016.


24


Other operating costs increased $0.4 million, or 5.3%, to $9.0 million in First Quarter 2017 from $8.6 million in First Quarter 2016 due to the increased number of restaurants operating in 2017. Other operating costs as a percentage of sales increased to 20.4% in First Quarter 2017 from 19.9% in First Quarter 2016, primarily due to an increase in technology expenses.

General and administrative expenses increased $0.2 million, or 8.4%, to $2.4 million in First Quarter 2017 from $2.2 million in First Quarter 2016.  This increase was primarily due an increase in corporate wage and marketing expenses. General and administrative expenses as a percentage of sales increased to 5.3% in First Quarter 2017 from 5.0% in First Quarter 2016.

Pre-opening costs decreased $0.1 million, or 74.6%, to $31,370 in First Quarter 2017 from $0.1 million in First Quarter 2016. We are not opening a new restaurant until the Third Quarter 2017 and opened two new restaurants in the Second Quarter 2016. Pre-opening costs as a percentage of sales decreased to 0.1% in First Quarter 2017 from 0.3% in First Quarter 2016.

Depreciation and amortization decreased by $0.2 million, or 3.4%, to $3.6 million in First Quarter 2017 from $3.8 million in First Quarter 2016. This decrease was primarily due to fixed asset disposals partially offset by the addition of two new restaurants opened in the Second Quarter of 2016.  Depreciation and amortization as a percentage of sales decreased to 8.2% in First Quarter 2017 from 8.7% in First Quarter 2016.

INTEREST AND TAXES

Interest expense was $1.6 million and $1.4 million during First Quarter 2017 and First Quarter 2016, respectively. The increase was primarily due to increased debt resulting from building new restaurants in fiscal 2016.

For First Quarter 2017, DRH had an income tax expense of $22,264 compared to First Quarter 2016 income tax expense of $0.4 million. The decrease in the income tax expense was primarily related to the decrease in income before income taxes.

LIQUIDITY AND CAPITAL RESOURCES; EXPANSION PLANS

On June 29, 2015, the Company entered into a $155.0 million senior secured credit facility with a syndicate of lenders led by Citizens (the “June 2015 Senior Secured Credit Facility”) with a senior lien on all the Company’s personal property and fixtures. The June 2015 Senior Secured Credit Facility consists of a $120.0 million term loan (the “June 2015 Term Loan”), a $30.0 million, subsequently amended to $23.0 million (see amendment details immediately following this paragraph) development line of credit (the “June 2015 DLOC”) and a $5.0 million (see amendment details immediately following this paragraph) 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 finance an acquisition. 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.

On December 23, 2016, the Company entered into an amendment agreement for purposes of, among other things, releasing the Bagger Dave’s entities as borrowers and releasing all related liens on the Bagger Dave’s assets. In addition, the amendment (a) converted the amounts then outstanding under the June 2015 DLOC to a development facility term loan (the “DF Term Loan”), (b) canceled $6.8 million previously available under the June 2015 DLOC, and (c) extended the maturity date on the remaining $5.0 million under the June 2015 DLOC to June 29, 2018.

Payments of principal are based upon a 12-year straight-line amortization schedule, with monthly principal payments totaling $833,333 on the June 2015 Term Loan and $126,385 on the DF Term Loan, plus accrued interest. The entire remaining outstanding principal and accrued interest on the June 2015 Term Loan and the DF Term Loan is due and payable on the maturity date of June 29, 2020. Availability under the June 2015 DLOC is subject to certain limitations relative to actual development costs, and outstanding balances convert into an additional DF Term Loan 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. There were no balances outstanding under the June 2015 DLOC at December 25, 2016. If the DLOC is not fully drawn by the end of the two years term, the outstanding principal balance becomes due based on the 12 amortization period with final payment due June 29, 2020. The June 2015 RLOC is for a term of five years.

The interest rate for each of the loans, as selected by the borrower, is based upon either a LIBOR or base rate (generally Prime or Fed Funds) plus an applicable margin, which ranges from 2.25% to 3.5% for LIBOR loans and from 1.25% to 2.5% for base rate loans, depending on the lease adjusted leverage ratio as defined in the agreement.


25


The current debt agreement contains various customary financial covenants generally based on the performance of the Company. The financial covenants consist of a minimum required debt service coverage ratio and a maximum permitted lease adjusted leverage ratio. As of March 26, 2017, the Company was in compliance with the loan covenants.

We believe that our current cash balance, in addition to our cash flow from operations and availability of credit, will be sufficient to fund our present operations and meet our commitments on our existing debt. If suitable acquisition opportunities or working capital needs arise that require additional financing, we believe that our financial position and earnings history provide a sufficient base for obtaining additional financing resources at reasonable rates and terms. We may also issue additional shares or common or preferred stock to raise funds.

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). 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, which have historically been 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 continuing operations for First Quarter 2017 was $4.4 million compared with $4.3 million for First Quarter 2016. Net cash provided by operating activities consisted primarily of net earnings adjusted for non-cash expenses.

For 2017, capital expenditures are anticipated to be between $5.0 million and $6.0 million. We plan to use the capital as follows: approximately 50.0% for 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.

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 have ranged from approximately $50,000 (for minor interior refreshes) to approximately $1.3 million (for a full remodel of the restaurant). We target remodels of $0.6 million to $0.7 million to upgrade a typical BWW restaurant to the new Stadia design. The Company's strategy is to fully remodel existing BWW restaurants to the Stadia design at time of scheduled refresh or remodel typically within seven years or less of opening.

Mandatory Upgrades
 
In fiscal year 2017, we will invest in two mandatory remodels of existing 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 2017, the Company plans to invest additional capital to provide minor upgrades to a number of its existing locations, all of which we expect to 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 2017, 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.


26


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 at higher rates 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 BWW restaurants within its designated development territory by April 1, 2021. As of March 26, 2017, 29 of the required 42 restaurants under the ADA had been opened for business. We have one additional restaurant in process and are in discussions with BWLD regarding the remaining 12 restaurants required by 2021. The Company may continue to open new locations, but at a lower number over a longer period of time, under an amended ADA.

After the Spin-Off, the Company remains liable for guarantees of certain Bagger Dave’s leases. These guarantees cover 18 separate leases, several of which relate to restaurants previously closed and being operated by a new tenant under either a sub-lease or a new lease.

The Company has determined that its maximum exposure resulting from the lease guarantees includes approximately $9.5 million of future minimum lease payments plus potential additional payments to satisfy maintenance, property tax and insurance requirements under the leases. The terms and conditions of the guarantees vary, and each guarantee has an expiration date which may or may not correspond with the end of the underlying lease term. These expiration dates range from less than 2 months to 13 years as of March 26, 2017. In the event that the Company is required to perform under any of its lease guarantees, we do not believe a liability to the Company would be material because it would first seek to minimize its exposure by finding a suitable tenant to sub-lease the space. In many cases, a replacement tenant can be found and the lessor could agree to release the Company from its future guarantee obligation. During 2015, 11 Bagger Dave’s locations were closed, 9 of which had DRH lease guarantees. Of the 9 guaranteed leases, new tenants were found to step into the Company’s obligations for 5 locations in 3 to 14 months from the date of closure, 3 guarantees expired or were terminated, and 1 remains an obligation of the Company.

Further, in conjunction with the Spin-Off, DRH entered into a transition services agreement (the "TSA") with Bagger Dave's pursuant to which DRH will provide certain information technology and human resources support, limited accounting support, and other minor administrative functions at no charge. The TSA is intended to assist the discontinued component in efficiently and seamlessly transitioning to stand on its own. The current terms of the TSA expire in December 2017 at which time the parties may negotiate which services will be required on an ongoing basis and the fees that will be charged for such services, and at any time thereafter the TSA can be terminated by the Company with 10 days written notice.

Impact of New Accounting Standards

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


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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 25, 2016.

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Item 3. Quantitative and Qualitative Disclosure About Market Risks 

Not applicable for smaller reporting companies.


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 26, 2017, 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 26, 2017.
 
(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 26, 2017 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.


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PART II. OTHER INFORMATION
 
Item 1. Legal Proceedings 
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
 
Not applicable for smaller reporting companies.

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.

Item 6. Exhibits

The Exhibit Index following the signature page hereto is incorporated by reference under this item.

 


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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 5, 2017
By:
/s/ David G. Burke
 
 
David G. Burke
 
 
President and Chief Executive
 
 
Officer (Principal Executive Officer)
 
 
 
 
 
 
 
 
By:
/s/ Phyllis A. Knight
 
 
Phyllis A. Knight
 
 
Chief Financial Officer and Treasurer
 
 
(Principal Financial and Accounting Officer)


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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).
 
 
 3.4
Second 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 July 29, 2016, and incorporated herein by this reference).
 
 
10.1
Transition Services Agreement, dated as of December 23, 2016 (filed as an exhibit to the Company's Form 8-K filed with the Securities and Exchange Commission on December 29, 2016, and incorporated herein by this reference).
10.2
Amendment No. 4 to Credit Agreement and Limited Consent, dated as of December 23, 2016 (filed as an exhibit to the Company's Form 8-K filed with the Securities and Exchange Commission on December 29, 2016, 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

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