Nature of Business
Diversified Restaurant Holdings, Inc. (“DRH,” the "Company," "us," "our" or "we") is a restaurant company operating a single concept, Buffalo Wild Wings® (“BWW”). As one of the largest franchisees of BWW, we provide a unique guest experience in a casual and inviting environment.
DRH currently operates 64 BWW restaurants (20 in Michigan, 17 in Florida, 15 in Missouri, 7 in Illinois and 5 in Indiana).
Basis of Presentation
The consolidated financial statements as of June 30, 2019 and December 30, 2018, and for the three and six-month periods ended June 30, 2019 and July 1, 2018, have been prepared in accordance with 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 June 30, 2019 and for the six-month periods ended June 30, 2019 and July 1, 2018 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 30, 2018 is derived from our audited consolidated financial statements and notes thereto for the fiscal year ended December 30, 2018, which is included in Part II Item 8 in the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 2018, and should be read in conjunction with such consolidated financial statements.
The results of operations for the six-month periods ended June 30, 2019 and July 1, 2018 are not necessarily indicative of the results of operations that may be achieved for the entire fiscal year ending December 29, 2019.
Certain prior year amounts have been reclassified for consistency with the current year presentation.
Our significant accounting policies are disclosed in Part II, Item 8, of our Annual Report on Form 10-K for the fiscal year ended December 30, 2018.
Since December 30, 2018, there has been one significant change in our accounting policies related to the implementation of ASU No. 2016-02, Leases, which is presented below and in Note 9.
As further discussed in Note 6, the Company has approximately $96.6 million of debt outstanding under its $155.0 million senior secured credit facility with a syndicate of lenders led by Citizens (the “Credit Facility”) with a maturity date of June 29, 2020. The debt agreement contains various customary financial covenants generally based on the earnings of the Company relative to its debt. The financial covenants consist of a quarterly minimum required debt service coverage ratio and a maximum permitted lease adjusted leverage ratio which were reset pursuant an amendment dated February 28, 2018. This amendment also changed the definition of "consolidated EBITDA" used in the calculation of these financial covenants to permit the inclusion of a maximum of $5 million of equity proceeds over the remaining term of the agreement.
On July 24, 2018 the Company completed an underwritten registered public offering of 6 million shares of common stock at a public offering price of $1.00 per share, which included 700,000 shares offered by a certain selling stockholder, for total Company gross proceeds of $5.3 million. The net proceeds from the offering were approximately $4.6 million after deducting the underwriting discounts and commissions and offering expenses payable by us, and were included in "consolidated EBITDA" for purposes of computing financial covenants beginning in the third quarter of 2018.
As of June 30, 2019, the Company was in compliance with its loan covenants. However, beginning in the third quarter of 2019, the net proceeds from the registered public offering will no longer be included in "consolidated EBITDA" and, as a result, the Company is currently forecasting that it may not be in compliance with these financial covenants in the third quarter.
While the Company has successfully negotiated financial covenant amendments in the past and would seek to do so again should it be in default or near a default, there can be no assurance that it will be successful in obtaining a satisfactory amendment.
As a result of this uncertainty coupled with the June 2020 maturity of the Credit Facility, the Company has been in discussions with its current lenders and other sources of capital regarding a possible refinancing and/or replacement of the Credit Facility. The Company is also exploring various other alternatives. There can be no assurance, however, that any such efforts will be successful.
Until such time as the Company has executed an agreement to amend, refinance or replace the Credit Facility, the Company cannot conclude that it is probable that it will do so and, accordingly, this raises substantial doubt about the Company’s ability to continue as a going concern.
However, the accompanying financial statements have been prepared assuming the Company will continue to operate as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The accompanying financial statements do not include adjustments that might result from the outcome of this uncertainty, including any adjustments to reflect the possible future effects of the recoverability and classification of recorded asset amounts or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.
Revenue Recognition Policy
Revenue is measured based on consideration specified in implied contracts with our customers and excludes amounts collected on behalf of third parties. The Company recognizes revenue when it satisfies a performance obligation (at the time of sale) by transferring control over a product to a customer. Payment is due at the time the food or merchandise is transferred to the customer. The portion of any sale that results in loyalty rewards being issued is deferred, net of estimated breakage, until redemption.
Nature of Goods Sold
DRH earns revenue through sales of food, beverages and merchandise, and redemptions of gift cards by our customers. These sales occur through multiple channels, such as in-restaurant, call-in, online (web-based) and via third party delivery services.
BWW offers a system-wide loyalty program (Blazin’ Rewards®) whereby enrolled customers earn points for each qualifying purchase. As a franchisee, DRH is required to participate in the program. DRH estimates the value of loyalty points earned (the value per point) by dividing the menu price of redeemable items by the loyalty reward points required to redeem that menu item. Points issued as part of the loyalty program expire after 6 months of member inactivity. DRH commissioned a study to determine a reasonable estimate of the breakage rate, which was approximately 32%.
DRH has two types of sales transactions, transactions without loyalty attachment and transactions with loyalty attachment. Transactions without loyalty attachment require no allocation of the transaction price, because the price is observable and fixed based on the menu. Transactions with loyalty attachment have two performance obligations: 1) providing the purchased food, beverages and/or merchandise to the customer and, 2) redeeming awarded loyalty points for food, beverages or merchandise in the future. In loyalty related transactions the price is allocated to the products sold and the points issued. Revenue related to loyalty points that may be redeemed in the future is deferred, net of estimated breakage, until such loyalty points are redeemed. The accrued loyalty liability balance is reflected in Note 5.
The Company offers gift cards for purchase through a BWW system-wide program. Gift cards sold are recorded as a liability to BWW. When redeemed, the gift card liability is offset by recording the transaction as revenue. Net gift card activity is settled with BWW weekly. At times, gift card redemptions may exceed amounts due to BWW for gift card purchases, resulting in an asset balance. Because this is a system-wide program operated by BWW, the Company is not impacted by and does not record breakage.
Disaggregation of Revenue
In the following table, revenue is disaggregated by product mix.
Three Months Ended June 30, 2019
Three Months Ended July 1, 2018
Six Months Ended June 30, 2019
Six Months Ended July 1, 2018
Recent Accounting Pronouncements
We reviewed all 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 February 2016, FASB issued ASU No. 2016-02, Leases ("ASU 2016-02"). ASU 2016-02 requires the lessee to recognize a lease asset and liability for lease arrangements longer than 12 months. Leases are 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. The Company adopted the new standard as of December 31, 2018 using the modified retrospective approach. The Company has adjusted comparative periods and has elected the package of practical expedients which allows it to not reassess whether a contract is or contains a lease, lease classification, and initial direct costs. The adoption of ASU 2016-02 materially impacted our consolidated financial statements by significantly increasing our non-current assets and liabilities on our consolidated balance sheets in order to record the right-of-use ("ROU") assets and related lease liabilities for our operating leases. We lease all of our restaurant properties under operating leases. The adoption of the standard does not have a material impact on our Consolidated Statements of Comprehensive Income (Loss) or Consolidated Statements of Cash Flows.
In conjunction with our adoption of the new lease accounting standard, certain line items have been adjusted on our opening balance sheets as of January 1, 2018 and December 31, 2018 to conform to the current period presentation. As of January 1, 2018, the line items impacted and adjustments consist of: the addition of $50.0 million in ROU assets, $6.3 million in current operating lease liabilities, $46.9 million in non-current operating lease liabilities, and $1.4 million in retained earnings; and the removal of $0.1 million of intangible assets, $2.6 million in deferred rent, $0.5 million of unfavorable operating lease liabilities, and $1.5 million in deferred gains associated with prior sale leaseback transactions. As of December 31, 2018, the line items impacted and adjustments consist of: the addition of $52.3 million in ROU assets, $6.7 million in current operating lease liabilities, $49.0 million in non-current operating lease liabilities, and $1.3 million in retained earnings; and the removal of $0.1 million of intangible assets, $2.8 million in deferred rent, $0.4 million of unfavorable operating lease liabilities, and $1.4 million in deferred gains associated with prior sale leaseback transactions. Additionally, the Consolidated Statement of Operations for the three and six months ended July 1, 2018, reflects an increase in general and administrative expense of approximately $32,000 and $64,000, respectively. Refer to Note 9 for further details.
In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income ("ASU 2018-02"). ASU 2018-02 provided financial statement preparers with an option to reclassify stranded tax effects within accumulated other comprehensive income to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act of 2017 (or portion thereof) was recorded. ASU 2018-02 is effective for fiscal years beginning after December 15, 2018. The Company adopted ASU 2018-02 effective December 31, 2018, and elected to reclassify the income tax effects of the 2017 Tax Cuts and Jobs Act from Accumulated Other Comprehensive Income (Loss) to retained earnings. Adoption did not have a material impact on the Company's consolidated financial statements.
In May 2014, the FASB issued ASU No. 2014-09, Revenue with Contracts from Customers (Topic 606) ("ASU 2014-09"). ASU 2014-09 supersedes the current revenue recognition guidance, including industry-specific guidance. This ASU and subsequently issued amendments, introduce a five-step model to achieve its core principal of the entity recognizing revenue to depict the transfer of goods or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which delayed the effective date of ASU 2014-09 for public companies to January 1, 2018. The FASB also agreed to allow entities to choose to adopt the standard as of the original effective date.
The requirements for these standards relating to Topic 606 were effective for interim and annual periods beginning after December 15, 2017. The Company adopted ASU 2014-09 effective as of January 1, 2018, using the modified retrospective transition method to all existing contracts that were not substantially completed at the adoption date. We finalized our analysis and the adoption of ASU 2014-09 which did not have a material impact on the timing or amount of revenue recognized as compared to the Company's previous revenue recognition practices.