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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended May 28, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 333-42137
KINDERCARE LEARNING CENTERS, INC.
(Exact name of registrant as specified in its charter)
Delaware 63-0941966
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
650 NE Holladay Street, Suite 1400
Portland, OR 97232
(Address of principal executive offices)
(503) 872-1300
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per share
(Title of Class)
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The aggregate market value of the voting common stock held by
non-affiliates of the registrant (assuming for purposes of this calculation, but
without conceding, that all executive officers and directors are "affiliates")
at December 12, 2003 (the last business day of the most recently completed
second fiscal quarter) was $9,640,519 based on the market price at the close of
business on December 12, 2003, as quoted on the OTC Bulletin Board.
The number of shares of the registrant's common stock, $.01 par value per
share, outstanding at August 6, 2004 was 19,721,646.
Selected portions of the registrant's 2004 proxy statement for its 2004
Annual Meeting of Shareholders, to be filed within 120 days of May 28, 2004, are
incorporated by reference into Part III of this Form 10-K, to the extent
identified herein.
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KinderCare Learning Centers, Inc. and Subsidiaries
Index
Part I.........................................................................1
Item 1. Business.....................................................1
Item 2. Properties..................................................16
Item 3. Legal Proceedings...........................................17
Item 4. Submission of Matters to a Vote of Security Holders.........17
Item 4(a) Executive Officers of the Registrant........................17
Part II.......................................................................19
Item 5. Market for the Registrant's Common Equity and
Related Stockholder Matters.................................19
Item 6. Selected Historical Consolidated Financial and Other Data...22
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.........................25
Item 7A. Quantitative and Qualitative Disclosures About Market Risk..41
Item 8. Financial Statements and Supplementary Data.................43
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.........................67
Item 9A. Disclosure Controls and Procedures..........................67
Part III......................................................................68
Item 10. Directors and Executive Officers of the Registrant..........68
Item 11. Executive Compensation......................................68
Item 12. Security Ownership of Certain Beneficial Owners and
Related Stockholder Matters.................................68
Item 13. Certain Relationships and Related Transactions..............68
Item 14. Principal Accounting Fees and Services......................68
Part IV.......................................................................70
Item 15. Exhibits and Financial Statement Schedules and
Reports on Form 8-K.........................................70
Signatures....................................................................74
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PART I
ITEM 1. BUSINESS
Forward-Looking Statements
Some of the statements under "Business," "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and elsewhere in this
report may include forward-looking statements which reflect our current views
with respect to future events and financial performance. The forward-looking
statements are subject to various known and unknown risks, uncertainties and
other factors. When we use words such as "believes," "expects," "anticipates,"
"plans," "estimates," "projects," "may," "intends," "seeks" or similar
expressions, we are making forward-looking statements.
All forward-looking statements address matters that involve risks and
uncertainties. Accordingly, there are or will be important factors that could
cause actual results to differ materially from those indicated in these
statements. We believe that these factors include the following:
o the effects of general economic conditions, including changes in the
rate of inflation, tuition price sensitivity and interest rates;
o competitive conditions in the early childhood education and care
services industry;
o various factors affecting occupancy levels, including, but not limited
to, the reduction in or changes to the general labor force that would
reduce the need for child care services;
o the availability of a qualified labor pool, the impact of labor
organization efforts and the impact of government regulations
concerning labor and employment issues;
o federal and state regulations regarding changes in child care
assistance programs, welfare reform, transportation safety, tax rates,
minimum wage increases and licensing standards;
o the loss or reduction of government funding for child care assistance
programs or the federal food program or the establishment of a
governmentally mandated universal child care benefit;
o our inability to successfully execute our growth strategy or plans
designed to improve the operating results, cash flow or our financial
position;
o our ability to adequately maintain our disclosure controls and
procedures;
o the availability of financing, additional capital or access to the
sale-leaseback market;
o our difficulty in meeting or the inability to meet our obligations to
repay our indebtedness;
o the availability of sites and/or licensing or zoning requirements that
may hinder our ability to open new centers;
o our inability to integrate acquisitions;
o our inability to successfully defend against or counter negative
publicity associated with claims involving alleged incidents at our
centers;
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o our inability to obtain insurance at the same levels, or at costs
comparable to those incurred historically;
o the effects of potential environmental contamination existing on any
real property owned or leased by us;
o the effects of audits by tax authorities, which if determined
adversely, could have a material adverse effect on our cash flow and
result of operations;
o the loss of any of our key management employees; and
o other risk factors that are discussed in this report and, from time to
time, in our other Securities and Exchange Commission reports and
filings.
We caution you that these risks may not be exhaustive. We operate in a
continually changing business environment and new risks emerge from time to
time.
You should not rely upon forward-looking statements except as statements of
our present intentions and of our present expectations that may or may not
occur. You should read these cautionary statements as being applicable to all
forward-looking statements wherever they appear. We assume no obligation to
publicly update or revise any forward-looking statement or to update the reasons
why actual results could differ from those projected in the forward-looking
statement, whether as a result of new information, future developments or
otherwise.
Overview
KinderCare Learning Centers, Inc, referred to as KinderCare, is the
nation's leading for-profit provider of early childhood education and care
services based on number of centers and licensed capacity. We provide services
to infants and children up to 12 years of age, with a majority of the children
from the ages of six weeks to five years old. At August 6, 2004, licensed
capacity at our centers was approximately 165,000, and we served approximately
114,000 children and their families at 1,230 child care centers. We distinguish
ourselves by providing high quality educational programs, a professional and
well-trained staff and clean, safe and attractive facilities. We focus on the
development of the whole child: physically, socially, emotionally, cognitively
and linguistically. In addition to our primary business of center-based child
care, we also own and operate a distance learning company serving teenagers and
young adults through our subsidiary, KC Distance Learning, Inc.
Education is core to our mission. We have developed a series of educational
programs, including five separate proprietary age-specific curricula, tailored
for (1) infants and toddlers, (2) two-year olds, (3) preschool, (4) kindergarten
and (5) school-age children between six and 12. We also offer tutorial programs
in the areas of literacy, reading, foreign languages and mathematics. Our
educational programs recognize the importance of using high quality,
research-based curriculum materials designed to create a rich and nurturing
learning environment for children. Our programs are revised on a rotating basis
to take advantage of the latest research in child development. In furtherance of
our focus on quality educational programming, we pursue accreditation by various
accrediting bodies that have been approved by states as meeting quality
improvement initiatives.
At August 6, 2004, we operated 1,230 centers across 39 states, 1,160 of
which were branded with the KinderCare name and 70 of which were branded with
the Mulberry name. We operate two types of centers: community centers and
employer-sponsored centers. The vast majority of our centers are community
centers, which are designed to meet the general needs of families within a given
area. Our employer-sponsored centers partner with institutions to provide
on-site or near-site education and child care for their employees. All of our
centers are open year round. Tuition is generally collected on a weekly basis,
in advance, and tuition rates vary for children of different ages and by
location.
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We hold a minority investment in Voyager Expanded Learning, Inc., a
developer of educational curricula for elementary and middle schools and a
provider of a public school teacher retraining program.
Our Corporate Information
We are a Delaware corporation organized on November 14, 1986. Our principal
executive offices are located at 650 N.E. Holladay Street, Suite 1400, Portland,
Oregon 97232. Our telephone number is (503) 872-1300. Our website addresses
include kindercare.com, kindercareatwork.com, mulberrychildcare.com,
kcdistancelearning.com, keystonehighschool.com, creditmakeup.com,
iqacademies.com and go2iq.com. The information on our websites is not
incorporated by reference in this report.
Our Business Strengths
Our objective is to continue to build on our position as the nation's
leading for-profit provider of quality early childhood education and care
services by further enhancing our competitive operating strengths, which include
the following:
Leading Market Position. We are the nation's leading for-profit provider of
early childhood education and care services in the highly fragmented child care
industry. Our current licensed capacity represented more than 25% of the
aggregate licensed capacity of the top 40 for-profit child care service
providers at January 1, 2004. Our position as the industry leader with a large,
nationwide customer base gives us both the ability to spread the costs of
programs and services, such as curriculum development, training programs and
other management processes, over a large number of centers and a valuable
distribution network for new products and services. Our national presence, with
centers located throughout 39 states, allows us to continue to serve customers
who relocate to other communities where we have centers, enhances brand
awareness and mitigates any potential negative impact of changing local or
regional economic trends, demographic trends or regulatory factors.
Strong Brand Identity and Reputation. With more than 35 years of experience
in the industry, we believe that we enjoy strong brand recognition and a
reputation for quality. Established in 1969, we believe our KinderCare brand
provides a valuable asset in an industry where personal trust and parent
referrals play an important role in retaining existing customers and attracting
new customers. We strive to reinforce our positive image through our many
quality initiatives and our targeted marketing to current and potential
customers.
High Quality Educational Programs. Early childhood education is a crucial
part of child development, and we believe that educational content is becoming
increasingly important as a distinguishing factor in our industry. We have
developed high quality proprietary curricula targeted to children in each of the
various age and development levels we serve. Our programs are updated and
enhanced as new research becomes available. We also pursue accreditation of our
centers by various accrediting bodies, including the National Association for
the Education of Young Children ("NAEYC"). Accreditation strengthens the quality
of our centers by motivating the teaching staff and enhancing their
understanding of developmentally appropriate early childhood practices. In
certain states, these quality initiatives are tied to financial incentives such
as higher child care assistance reimbursement rates and property tax incentives.
At August 6, 2004, we had 483 centers accredited by NAEYC and approximately 430
centers actively pursuing accreditation through various organizations, including
NAEYC. We believe that our high quality educational programs allow us to attract
new students, retain our existing students and distinguish ourselves from our
competitors.
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Ability to Attract and Retain a Qualified Workforce. We believe our ability
to provide attractive employee benefits and recognition programs gives us a
competitive advantage in attracting and retaining a high quality workforce,
which is an important factor in the successful operation of our centers. The
center directors at our KinderCare centers have an average of approximately
eight years with us, and those at our Mulberry centers have an average of
approximately seven years with us. As part of our focus on investing in our
people, we have implemented attractive benefit and incentive programs, employee
recognition programs and training programs.
Growth Opportunities
We are pursuing the following growth opportunities:
Increase Existing Center Revenue. We have ongoing initiatives to increase
center revenue by:
o Sharing best practices--Center directors are encouraged to share best
practices. For example, we recently completed an incentive campaign
that was designed to get center directors to think creatively about
ways to increase enrollment. Each week during the campaign, center
directors were asked to submit their ideas to our corporate
headquarters and received recognition by having their winning ideas
posted on our intranet;
o Providing incentives for center directors--Bonus programs reward
center directors for enrollment growth and overall operating profit
performance;
o Using targeted marketing--Targeted marketing programs include a
referral program under which parents receive tuition credits for every
new customer enrollment referral and a variety of direct mail
solicitation, telephone directory and internet yellow pages listings
and local advertising vehicles. We also periodically hold open house
events and have established parent forums to involve parents in center
activities and events;
o Maintaining competitive tuition pricing--In coordination with center
directors, we carefully manage occupancy and tuition rates at the
classroom level to maximize net revenue yield from each of our
centers;
o Increasing the number and availability of supplemental fee
programs--We offer tutorial programs in the areas of literacy,
reading, foreign languages and mathematics in the majority of our
centers for a supplemental fee and are exploring additional
supplemental fee programs; and
o Continuing to operate clean, safe and attractive facilities--We
continue to maintain and upgrade our facilities on a regularly
scheduled basis to enhance their curb appeal. In the past five years,
we have improved the signage at our centers to ensure a uniform
standard designed to enhance customer recognition of our brands.
Continue to Open Centers. Many attractive markets across the United States
offer opportunities to locate new community and employer-sponsored centers. We
plan to expand by opening 15 to 30 new, higher capacity centers per year in
locations where we believe the market for center-based child care will support
tuition rates higher than our current average rates. We opened 16 and 28 new
centers during fiscal years 2004 and 2003, respectively. We believe we have
multiple sources of funding available to fund new center openings, including our
sale-leaseback program, our revolving credit facility and cash flows from
operations. Our new centers typically produce positive EBITDA in their first
full year of operation and positive net income by the end of their second full
year of operation.
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Pursue Strategic Acquisitions. We plan to continue making selective
acquisitions of existing high quality centers. Our strong market position
enhances the opportunities to capitalize on consolidation of the highly
fragmented early childhood education and care services industry. For example,
our acquisition of Mulberry Child Care Centers, Inc. in 2001 allowed us to
increase our presence in certain attractive markets in the northeast. In
addition to making center acquisitions, we plan to continue evaluating
investment and acquisition opportunities for companies in the education industry
that offer educational content and services to children, teenagers and adults.
We believe these opportunities would complement our center based education and
distance learning services.
Increase Profitability Through Operational Efficiencies. We have developed
a culture dedicated to operational efficiencies. We focus on center-level
economics, which hold each center director accountable for profitability. Labor
costs are the most significant component of a center's cost structure. We
developed and utilize a proprietary labor management system to assist center
directors in managing staff hours relative to attendance levels at their
centers. We also require most supply purchases to be executed through our
automated procurement system, which tracks expenses against benchmarks and
requires field management oversight at the order point. Strong controls have
helped us contain costs and leverage our overhead over our large, nationwide
center base. We believe we are well positioned to benefit from future
utilization of our available capacity with our proven ability to manage our cost
structure.
Expand Our Distance Learning Operations. Our subsidiary, KC Distance
Learning, Inc., is based in Bloomsburg, Pennsylvania and operates three business
units: Keystone National High School, Learning and Evaluation Center and IQ
Academies. Keystone National High School is an accredited high school distance
learning program, which provides courses delivered in either online or
correspondence formats. Learning and Evaluation Center provides subject
extension or make-up and extra credit courses to fifth through twelfth grade
students. IQ Academies is a virtual charter high school operator, which has
enrolled students in Wisconsin for the 2004-2005 academic year. KC Distance
Learning sells and delivers its high school curriculum over the
kcdistancelearning.com, keystonehighschool.com, creditmakeup.com,
iqacademies.com and go2iq.com websites. The information on our websites is not
incorporated by reference in this report. We plan to expand our distance
learning operations by expanding our services in additional states and
increasing sales of these services.
Establish Strategic Relationships. Through our strategic partnerships, we
offer our customers proprietary conveniences and discounts, including access to
various educational products and toys. We recently announced an exclusive
arrangement with Discover(R) Card to accept payments via credit card online or
at our centers. Our market position and large, nationwide base of centers with
its associated customer base make us an attractive strategic partner for
companies with comparable products and services and give our strategic partners
access to a valuable distribution network for such products and services. Since
fiscal year 2000, we have been successfully offering literacy and reading
tutorial programs in our centers, which we have licensed from companies that
sell these same products in the retail market. We believe that strategic
partnerships strengthen our reputation as an early childhood education and care
service provider and enrich the experience for children enrolled at our centers.
Center Operations
We operate the largest system of for-profit centers providing early
childhood education and care in the United States. At August 6, 2004, we managed
1,230 centers in 39 states primarily under the KinderCare name with a licensed
capacity of 165,000 students. We managed 70 of these centers under the Mulberry
name. At August 6, 2004, we owned 722 centers, leased 501 centers and operated
seven centers under management contracts. Our centers are open year round. The
hours vary by location, although Monday through Friday from 6:30 a.m. to 6:00
p.m. is typical. Children are usually enrolled on a weekly basis for either
full- or half-day sessions.
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Centers. We operate two types of centers: community centers and
employer-sponsored centers. Community centers are designed to meet the needs of
the general community in which they are located. Employer-sponsored centers
partner with institutions to provide on-site or near-site education and child
care for the families of their employees. The vast majority of our centers are
community centers, which are designed to meet the general needs of families
within a given area.
Our typical community and employer-sponsored center is a one-story,
air-conditioned building constructed based on our design and located on
approximately one acre of land. Larger capacity centers are situated on parcels
ranging from one to four acres of land. The centers contain classrooms, play
areas and complete kitchen and bathroom facilities. Each center is equipped with
a variety of audio and visual aids, educational supplies, games, puzzles, toys
and outdoor play equipment. Centers also lease vehicles used for field trips and
transporting children enrolled in our before- and after-school programs. All
centers are equipped with computers for children's educational programs. Most of
our centers are able to accommodate from 95 to 190 children, with our older
centers having an average capacity of 134 children. Since 1997, we have been
developing and opening centers based on prototypes with average capacities
ranging from 140 to 185 children. The employer-sponsored centers are
individualized for each sponsor and range in capacity from 75 to 230 children.
Tuition. We determine tuition rates based upon a number of factors,
including the age of the child, full- or part-time attendance, enrollment
levels, location and competition. Tuition rates are typically adjusted
company-wide each year to coincide with the back-to-school period. However, we
may adjust individual classroom rates within a specific center at any time based
on competitive position, occupancy levels and demand. In order to maximize
enrollment, center directors may also adjust the rates at their center or offer
discounts at their discretion, within limits. These rate discounts and
adjustments are closely monitored by our field and corporate management. Our
focus on pricing at the classroom level within our centers has enabled us to
improve comparable center net revenue growth throughout the year without losing
occupancy in centers where the quality of our services, demand and other market
conditions support such increases.
Center Oversight. Each of our centers is linked to our corporate
headquarters through a fully automated information, communication and financial
reporting system. This system is designed to provide timely information on items
such as net revenues, enrollments, expenses, payroll and staff hours and
provides center directors with the ability to receive reports and update
centrally maintained information on a daily basis. We regularly seek new uses
for our intranet as a tool to communicate with our centers. For example, in
fiscal year 2004, we used our intranet to collect and publish creative marketing
ideas of our center directors. Our intranet provides an automated way to
communicate information to our corporate headquarters where management can use
it to assess quality and identify best practices.
Field and Center Personnel. Our centers are organized into six geographic
regions, each headed by a region vice president. The region vice presidents are
supported by 81 area manager positions for KinderCare and nine region director
positions for Mulberry.
Individual centers are managed by a center director and, in most cases, an
assistant director. All center directors participate in periodic training
programs or meetings and must be familiar with applicable state and local
licensing regulations. The corporate human resources department monitors
salaries and benefits for competitiveness. During fiscal year 2002, we conducted
a center director retention survey. We believe the results of the survey reflect
overall center director satisfaction. As a result of the survey, we revised the
center director bonus plan in fiscal year 2003 to increase the focus on customer
retention and new enrollments.
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Due to high employee turnover rates in the early childhood education and
care services industry in general, we emphasize recruiting and retaining
qualified personnel. The turnover of personnel experienced by us and other
providers in our industry results in part from the fact that a significant
portion of our employees earn entry-level wages and are part-time employees.
All center teachers and other non-management staff are required to attend
an initial half-day training session prior to being assigned full duties and to
complete a six week on-the-job basic training program. Our basic orientation and
staff training program is delivered via a video series. Additionally, we have
developed and implemented training programs to certify personnel as teachers of
various age groups in accordance with our internal standards and in connection
with our age-specific educational programs. We offer ongoing sales and service
training to center directors, area managers and region directors that focuses on
enrollment and retention of families, training on delivery of our educational
programs and health and safety related training. Center staff also participate
in ongoing in-service training as required by state licensing authorities, most
of which is focused on education and child health and safety related issues.
Marketing, Advertising and Promotions. We conduct our marketing efforts
through direct response programs supported by the use of the internet and grass
roots efforts at the center level in conjunction with our corporate sponsored
initiatives. We combine traditional direct mail, email, yellow pages listings,
internet directory placements and search optimization for visibility that makes
local efforts successful. We believe that our referral, drive-by and yellow
pages marketing strategies are the most effective in helping customers find us.
In addition to contacting a local center, customers can gain information by
calling an advertised toll free number or visiting either of our websites,
kindercare.com or mulberrychildcare.com. The information on our websites is not
incorporated by reference in this report.
Our local marketing programs use a wide variety of approaches from extended
hours to center events for existing and prospective families, to a parent
referral program in order to acquire new families and retain those currently
enrolled. The referral program provides tuition credits for every referral that
becomes an enrollment to both the new and current family. We also periodically
hold open house events and have established parent forums to involve parents in
center activities and events, in an effort to retain customers.
Each of our center directors receives training and support designed to
facilitate their marketing success. These materials are developed using the most
recent customer research and are designed specifically for the center director
and staff. The end goal is to better prepare center level staff to convert each
inquiry into an enrollment.
From a corporate perspective, we have focused on center-specific marketing
opportunities such as (1) choosing sites that are convenient for customers to
encourage drive-by identification, (2) refurbishing our existing centers to
enhance their curb appeal and (3) upgrading the signage at our centers to
enhance customer recognition.
Our new center pre-opening marketing effort includes direct mail and
newspaper support, as well as local public relations support. Every new center
hosts a grand opening and an open house and provides individualized center tours
where parents and children can talk with staff, visit classrooms and play with
educational toys and computers.
Employer-Sponsored Child Care Services
Through KinderCare At Work(R), we offer a more customized format for our
services by individually evaluating the needs of each sponsoring company to find
the appropriate format to fit its needs for on-site or near-site employee child
care. Our employer-sponsored centers utilize an operating model that is very
similar to our community centers, including collecting tuition fees directly
from the employee parent, however they support businesses, government, hospitals
and universities with large, single site employee populations. Most
employer-sponsored centers also allow community children to attend as a second
priority to the children of the sponsoring company's employees, which helps to
maximize the revenue and profit opportunity at each employer-sponsored center.
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Employer-sponsored centers are typically located on the business owner's
property and the business owner sponsors and usually supports the center with
free or reduced rent, utilities and custodial maintenance. Employer-sponsored
centers may be operated on a profit and loss basis, on a management fee basis or
a variation of the two. The management contracts generally provide for a three-
to five-year initial period with renewal options ranging from two to five years.
Our compensation under existing agreements is generally based on a fixed fee
with annual escalations.
KinderCare At Work(R) can also assist organizations in one or more aspects
of implementing a child care related benefit, including needs assessments,
financial analysis, architectural design and development plans. KinderCare At
Work's(R) website address is kindercareatwork.com. The information on our
websites is not incorporated by reference into this report.
At August 6, 2004, we operated 44 on-site/near-site employer-sponsored
early childhood education and care centers for 40 different employers, including
Universal Orlando Resort, Saturn Corporation, LEGO Systems, Inc., Oregon State
University, University of Utah and several hospitals and other businesses and
universities. Of the 44 employer-sponsored centers, 35 were leased by us, two
were owned and seven were operated under management contracts.
We also offer back-up child care, a program that utilizes our existing
centers to provide back-up child care services to the employees of subscribed
employers. Current clients include Universal Orlando Resort, Prudential
Financial, US Cellular and KPMG.
Educational Programs
We have developed a series of educational programs, including five separate
proprietary age-specific curricula. Our educational programs recognize the
importance of using high quality, research-based curriculum materials designed
to create a rich and nurturing learning environment for children. The programs
are revised on a rotating basis to take advantage of the latest research in
child development.
Our educational programs and materials are designed to respond to the needs
of the children, parents and families we serve and to prepare children for
success in school and in life. Specifically, we focus on the development of the
whole child: physically, socially, emotionally, cognitively and linguistically.
Infant and Toddler Curricula. Our infant and toddler program, Welcome to
Learning(R), is designed for children ages six weeks to two years. The infant
component, for children from six weeks to 15 months, is based on building
relationships with the child and the family and focuses on providing a safe and
nurturing environment. The toddler component lets children from 12 to 24 months
feel free to explore and discover the world around them.
Two-Year-Old Curriculum. Our Early Learning Curriculum focuses on using the
latest research in brain development to provide learning experiences for
children during one of their most critical developmental stages. This curriculum
provides children with opportunities to explore and discover the world around
them with both daily and long-term extended activities and projects. The Early
Learning Curriculum is offered for children from 24 to 36 months.
Preschool Curricula. We have two preschool programs designed for children
three to five years of age. Both programs use research-based goals and
objectives as their framework to provide a high quality learning experience for
children. We also offer tutorial programs in the areas of literacy, reading,
foreign languages and mathematics for a supplemental fee in the majority of our
centers.
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The Preschool Readiness Curriculum focuses on three-year-olds. Monthly
themes are divided into two-week units to allow children extended time for
in-depth exploration and discovery. Curriculum activities emphasize emerging
readiness skills in reading and language development. Specially designed
LetterBooks are used to introduce children to phonics and letter and word
recognition. Discovery areas support children's learning of basic math and
science concepts, computer awareness, creative arts, cooking and homeliving.
The Preschool at KinderCare curriculum focuses on four-year-olds. It
teaches children to enjoy learning through hands-on involvement and stimulating
activities. Monthly themes are divided into one-week units providing a
comprehensive array of activities relevant to the lives of older preschoolers.
Curriculum materials build pre-reading, writing and language skills. Discovery
areas provide opportunities for exploration and choice based on children's
interests.
We are investigating the demand for a new pre-kindergarten concept that
represents a more academic approach to learning. This program is being pilot
tested in a select group of centers. The curriculum focuses on teaching basic
skills in literacy, math, science and social studies in learning stations set up
to provide challenging daily lessons. We use experienced degreed teachers who
work from a scope and sequence based on standards recognized by state
departments of education to define what children should know and be able to do.
We will provide on-going assessments to parents that support children's
language, cognitive, social, emotional and physical development.
Kindergarten Curriculum. For five-year-olds, we offer the Kindergarten at
KinderCare...Journey to Discovery(R) program. Children learn through play,
hands-on exploration, activities and experiences that are real world and sensory
in nature. This curriculum emphasizes reading development, beginning math
concepts and those skills necessary to give children the confidence to succeed
in school. Our kindergarten is offered in approximately two-thirds of our child
care centers and meets state requirements for instructional curriculum prior to
first grade.
School-Age Curriculum. Our KC Imagination Highway(R) program is a
project-based curriculum designed for children ages six to 12. The program
includes a number of challenging activities and projects designed to stimulate
the imagination of elementary school-age children through researching,
designing, building, decorating and presenting. This program meets the needs of
parents looking for content rich after-school experiences that keep school-age
children interested and involved.
Summer Curriculum. We offer a summer program called Summer AdventuresSM to
elementary school-agers. This program is a fun-filled, academic-based curriculum
of 20 weekly themes, including themes that help children learn new vocabulary,
try healthy recipes, make volcanoes that erupt, construct robots out of junk and
learn about patriotism.
Distance Learning. Although center-based child-care is our primary
business, we also own and operate a distance learning company serving teenagers
and young adults. Our subsidiary, KC Distance Learning, Inc., operates Keystone
National High School, an accredited distance-learning program which is licensed
as a private high school. Keystone National High School is accredited by several
national and regional bodies, including Northwest Association of Colleges and
Schools; Distance Education and Training Council and the National Collegiate
Athletic Association. Keystone's curriculum has been developed to reflect the
curriculum being taught in high schools across the country. Our course catalog
consists of over 60 courses, covering all the subjects required to obtain a
diploma. We deliver courses in both online and correspondence formats. We
provide each student with current textbooks from major publishers, which have
been selected by subject matter specialists. Accompanying each textbook, our
learning guides are written by veteran classroom teachers and provide the
appropriate level of direction. Our certified teachers provide guidance,
tutoring and grading services for our students.
9
Center Accreditation. We continue to stress the importance of offering high
quality programs and services to children and families. We also pursue
accreditation of our centers by various accrediting bodies recognized by states
as meeting quality improvement initiatives and believe that the accreditation
process improves the quality of our centers by motivating the teaching staff and
enhancing their understanding of developmentally appropriate childhood
practices. In certain states, these quality initiatives are tied to financial
incentives such as higher child care assistance reimbursement rates and property
tax incentives. At August 6, 2004, we had 483 centers accredited by NAEYC, which
is the most widely recognized accrediting body by states that have implemented
these quality initiatives. Other agencies that have been recognized by a number
of states include the National Early Childhood Program Accreditation and the
National Accreditation Commission of the National Association of Child Care
Professionals.
Training. We provide curriculum-specific training for teachers and
caregivers to assist them in effectively delivering our programs. Each
curriculum is designed to provide teachers with the necessary materials and
enhancements to enable effective delivery based on the resources and needs of
the local community. We emphasize selection of staff who are caring adults
responsive to the needs of children. We strive to give each teacher the
opportunity, training and resources to effectively implement the best in
developmentally and age appropriate practice. Opportunities for professional
growth are available through company-wide training such as the Certificate of
Excellence Program. We also make available more advanced training opportunities,
including tuition reimbursement for employment-related college courses or course
work in obtaining a Child Development Associate credential.
Asset Management
We have developed processes designed to effectively manage our real estate
assets at all stages beginning with site selection and development and including
center maintenance, refurbishment and, where appropriate, center closure.
Site Selection and Development of New Centers. We seek to identify
attractive new sites for our centers in large, metropolitan markets and smaller,
growth markets that offer convenience for our customers, provide opportunities
for drive-by interest and that meet our operating and financial goals. We look
for sites where we believe the market for our services will support tuition
rates higher than our current average rates. Our real estate department performs
comprehensive studies of geographic markets to determine potential areas for new
center development as well as comprehensive financial modeling. These studies
include analysis of land prices, development costs, competitors, tuition pricing
and demographic data such as population, age, household income and employment
levels. In addition, we review state and local laws, including zoning
requirements, development regulations and child care licensing regulations to
determine the timing and probability of receiving the necessary approvals to
construct and operate a new center. Within a prospective area, we often analyze
several alternative sites. Each potential site is evaluated against our
standards for location, convenience, visibility, traffic patterns, size, layout,
affordability and functionality, as well as potential competition. This
information is reviewed by our Development Committee, which includes our Chief
Executive Officer, our Executive Vice President and Chief Financial Officer, our
Senior Vice President and Chief Development Officer and our Senior Vice
President of Operations, among others. The Development Committee meets every two
weeks and evaluates new center development opportunities as well as center
acquisition opportunities, lease renewals and center closures.
Our new center development is supported by a team of individuals from our
operations, purchasing, human resources, marketing and legal departments to
streamline the new center opening process. We believe this results in a more
efficient transition of new centers from the construction phase to field
operation.
10
We opened 16 new centers and acquired one center during fiscal year 2004
and opened two more through August 6, 2004. These new centers have an average
licensed capacity of 161. When mature, these larger centers are designed to
generate higher revenues, operating income and margins than the older centers.
These new centers also have higher average costs of construction and typically
take three to four years to reach maturity. On average, our new centers have
historically begun to produce positive EBITDA during the first year of operation
and have begun to produce positive net income by the end of the second year of
operation. Accordingly, as more new centers are developed and opened,
profitability is expected to be negatively impacted in the short-term, but
enhanced in the long-term once these new, more profitable centers achieve
anticipated levels.
The following is a summary of our center opening activity over the past
five years:
Fiscal Year Ended
--------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
--------- --------- --------- --------- ------------
Number of centers, beginning of period.... 1,264 1,264 1,242 1,169 1,160
--------- --------- --------- --------- ------------
Openings.................................. 16 28 35 44 35
Acquisitions.............................. 1 -- -- 75 13
Centers closed or sold.................... (41) (28) (13) (46) (39)
--------- --------- --------- --------- ------------
Net centers additions (closures)....... (24) -- 22 73 9
--------- --------- --------- --------- ------------
Number of centers, end of period.... 1,240 1,264 1,264 1,242 1,169
========= ========= ========= ========= ============
Center Maintenance. We strive to maintain a fresh, clean, pleasant and safe
environment for the children and families we serve as well as our employees. The
appearance of our facilities affects tuition rates, occupancy and the long term
success of our centers. We use a centralized maintenance program to ensure
consistent high quality maintenance of our facilities located across the
country. Each of our approximately 100 maintenance technicians has a van stocked
with spare parts and handles emergency, routine and preventative maintenance
functions through an automated work order system. Technicians are notified and
track all work orders via palm top computers. At August 6, 2004, specific
geographic areas were supervised by two regional directors and 12 facility
managers, each of whom manages between six and 10 technicians.
Our facilities management department has developed a center assessment
system that allows our facilities technicians to assess the condition of the
major building components of our centers, such as roofing, parking lots,
exteriors, playgrounds, mechanical systems, appliances and building finishes.
The assessment data is recorded in a central database, which is accessible over
the intranet. The system includes replacement benchmarks for building
components, which will be used to assist in determining replacement schedules
and capital priorities. Center condition assessments have been completed on
approximately 1,000 of our centers, and we expect to complete assessments on the
remaining centers in the first half of fiscal year 2005. We believe this system
will enable us to make better capital deployment decisions on more significant
center enhancements.
Asset Evaluation and Center Closings. We routinely analyze the
profitability of our existing centers through a detailed evaluation that
considers leased versus owned status, lease options, operating history, premises
expense, capital requirements, area demographics, competition and site
assessment. Through this evaluation process, our asset management staff
formulates a plan for the property reflecting our strategic direction and
marketing objectives.
11
Our asset management department also manages the disposition of all surplus
real estate owned or leased by us. These real estate assets include undeveloped
sites, unoccupied buildings and closed centers. We disposed of five surplus
properties in fiscal year 2004. From the end of fiscal year 2004 to August 6,
2004, we sold five surplus properties. We were in the process of marketing an
additional 17 surplus properties at August 6, 2004.
The profitability of our centers is closely monitored by our asset
management program. If a center continues to underperform, exit strategies are
employed in an attempt to minimize our financial liability. Typical reasons for
a center closure include changing demographics that have adversely affected
financial performance and inability to renew a lease on economically favorable
terms. We make an effort to time center closures to minimize the negative impact
on affected families. During fiscal year 2004, we closed 41 centers. From the
end of fiscal year 2004 through August 6, 2004, we closed 12 additional centers.
Sale-leaseback program. At August 6, 2004, we owned 722, or 58.7%, of our
1,230 centers. Those centers have an approximate net book value of $538.0
million, which includes land, building and equipment costs. Our current
sale-leaseback program began during the fourth quarter of fiscal year 2002.
Under this initiative, we began selling centers to individual real estate
investors and concurrently signing long term leases to continue operating the
centers. Most leases have an average lease term of 15 years, with three to four
five-year renewal options. We continue to manage the operations of any centers
that are sold in such transactions. During fiscal year 2004, we completed sales
totaling $89.0 million, which represented 41 centers. From the end of fiscal
year 2004 through August 6, 2004, we completed another $10.5 million of sales,
which represented four centers. We are currently in the process of negotiating
another $37.6 million of sales related to 16 centers. It is possible that we
will be unable to complete these transactions. We expect this effort to
continue, assuming the market for such transactions remains favorable.
Industry Competition
The early childhood education and care services industry is competitive and
highly fragmented, with the most important competitive factors generally based
upon reputation, location and price. Competition consists principally of the
following: o other for-profit, center-based child care providers;
o preschool, kindergarten and before- and after-school programs provided
by public and private schools;
o child care franchising organizations;
o local nursery schools and child care centers, including
church-affiliated and other non-profit centers;
o providers of child care services that operate out of homes; and
o substitutes for organized child care, such as relatives, nannies and
one parent caring full-time for a child.
Competition includes other large, national, for-profit companies providing
child education and care services, many of which offer these services at a lower
price than we do. These other for-profit providers continue to expand in many of
the same markets where we currently operate or plan to operate. We compete by
offering (1) high quality education and recreational programs, (2) contemporary,
well-equipped facilities, (3) trained teachers and supervisory personnel and (4)
a range of services, including infant and toddler care, food service at a
majority of our centers, drop-in service and the transportation of older
children enrolled in our before- and after-school program between the centers
and schools.
12
In some markets, we also face competition with respect to preschool
services and before- and after-school programs from public schools that offer
such services at little or no cost to parents. In many instances, public schools
hire third-party operators to manage these programs, and we are currently
evaluating opportunities in this area. The number of school districts offering
these services is growing, and we expect that this form of competition will
increase in the future.
Local nursery schools and certain child care centers, including
church-affiliated and other non-profit centers, and in-home providers generally
charge less for their services than we do. Many church-affiliated and other
non-profit child care centers have lower operating expenses than we do and may
receive donations and/or other funding to subsidize operating expenses.
Consequently, operators of such centers often charge tuition rates that are less
than our rates. In addition, fees for home-based care are normally substantially
lower than fees for center-based care because providers of home care are not
always required to satisfy the same health, safety, insurance or operational
regulations as our centers.
Our employer-sponsored centers compete with center-based child care chains,
some of which have divisions that compete for employer-sponsorship
opportunities, and with other organizations that focus exclusively on the
work-site segment of the child care market.
Insurance
Our insurance program currently includes the following types of policies:
workers' compensation, comprehensive general liability, automobile liability,
property, excess "umbrella" liability, directors' and officers' liability and
employment practices liability. These policies provide for a variety of
coverages, which are subject to various limits, and include substantial
deductibles or self-insured retentions. Special insurance is sometimes obtained
with respect to specific hazards, if deemed appropriate and available at a
reasonable cost. Claims in excess of, or not included within, our coverage may
be asserted or coverage may not be available due to insurance company failures
or other reasons. The effects of these claims could have an adverse effect on
us. At August 6, 2004, approximately $37.3 million of letters of credit were
outstanding to secure obligations under retrospective and self-insurance
programs.
Governmental Laws and Regulations Affecting Us
Center Licensing Requirements. Our centers are subject to numerous state
and local regulations and licensing requirements. We have policies and
procedures in place to assist in complying with such regulations and
requirements. Although these regulations vary from jurisdiction to jurisdiction,
government agencies generally review the fitness and adequacy of buildings and
equipment, the ratio of staff personnel to enrolled children, staff training,
record keeping, children's dietary program, the daily curriculum and compliance
with health and safety standards. In most jurisdictions, these agencies conduct
scheduled and unscheduled inspections of the centers and licenses must be
renewed periodically. Most jurisdictions establish requirements for background
checks or other clearance procedures for new employees of child care centers.
Repeated failures of a center to comply with applicable regulations can subject
it to sanctions, which might include probation or, in more serious cases,
suspension or revocation of the center's license to operate and could also lead
to sanctions against our other centers located in the same jurisdiction. In
addition, this type of action could lead to negative publicity extending beyond
that jurisdiction.
We believe that our operations are in substantial compliance with all
material regulations applicable to our business. However, a licensing authority
may determine that a particular center is in violation of applicable regulations
and may take action against that center and possibly other centers in the same
jurisdiction. In addition, there may be unforeseen changes in regulations and
licensing requirements, such as changes in the required ratio of child center
staff personnel to enrolled children, that could have a material adverse effect
on our operations. States in which we operate routinely review the adequacy of
regulatory and licensing requirements and implement changes which may
significantly increase our costs to operate in those states.
13
Child Care Assistance Programs. During fiscal years 2004 and 2003,
approximately 20.0% and 21.6%, respectively, of our net revenues were generated
from federal and state child care assistance programs, primarily the Child Care
and Development Block Grant and At-Risk Programs. These programs are designed to
assist low-income families with child care expenses and are administered through
various state agencies. Although additional funding for child care may be
available for low income families as part of welfare reform and the
reauthorization of the Block Grant, we may not benefit from any such additional
funding.
At August 6, 2004, approximately 500 of our centers were also eligible to
participate in the Child and Adult Care Food Program, or CACFP, which provides
reimbursement for meals and snacks that meet certain USDA approved nutritional
guidelines. Centers can qualify to participate in the CACFP by meeting one of
two tests: 25% or more of the enrolled students receive child care assistance
funding or 25% or more of the center's customers have household incomes that are
at or below state specified income levels. Reimbursement is calculated based on
the percentage of the center's customers that fall into a "free" or "reduced"
income category established by the state. During fiscal years 2004 and 2003, our
CACFP reimbursements were $8.7 million and $7.8 million, respectively, which
were recorded as a reduction of operating expense.
Federal or state child care assistance programs may not continue to be
funded at current levels. Many states have recently experienced fiscal problems
and have reduced or may in the future reduce spending on social services. A
termination or reduction of child care assistance programs could have a material
adverse effect on our business.
Child Care Tax Incentives. Tax incentives for child care programs can
potentially benefit us. Section 21 of the Internal Revenue Code of 1986,
referred to as the Code, provides a federal income tax credit ranging from 20%
to 35% of specified child care expenses with maximum eligible expenses of $3,000
for one child and $6,000 for two or more children. The fees paid to us by
eligible taxpayers for child care services qualify for these tax credits,
subject to the limitations of Section 21 of the Code. However, these tax
incentives are subject to change.
Code Section 45F provides incentives to employers to offset costs related
to employer-provided child care facilities. Costs related to (a) acquiring or
constructing property used as a qualified child care center, (b) operating an
existing child care center, or (c) contracting with an independent child care
operator to care for the children of the taxpayer's employees will qualify for
the credit. The credit amount is 25% of the qualified costs. An additional
credit of 10% of qualified expenses for child care resource and referral
services has also been enacted. The maximum credit available for any taxpayer is
$150,000 per tax year.
Many states offer tax credits in addition to the federal credits discussed
above. Credit programs vary by state and may apply to both the individual
taxpayer and the employer.
Americans with Disabilities Act. The federal Americans with Disabilities
Act, referred to as the ADA, and similar state laws prohibit discrimination on
the basis of disability in public accommodations and employment. Compliance with
the ADA requires that public accommodations reasonably accommodate individuals
with disabilities and that new construction or alterations made to commercial
facilities conform to accessibility guidelines unless structurally impracticable
for new construction or technically infeasible for alterations. Non-compliance
with the ADA could result in the imposition of injunctive relief, fines, an
award of damages to private litigants and additional capital expenditures to
remedy such noncompliance. We have not experienced any material adverse impact
as a result of these laws.
14
Federal Transportation Regulations. In 1998, the National Highway Traffic
Safety Administration, or NHTSA, issued interpretive letters stating that
automobile dealers may no longer sell 12 to 15-passenger vans intended to be
used for the transportation of children to and from school by child care
providers and that any vehicle designed to transport 11 persons or more must
meet federal school bus standards if it is likely to be used significantly to
transport children to and from school or school-related events. These
interpretations and related changes in state and federal transportation
regulations have affected the type of vehicle that we may purchase for use in
transporting children between schools and our centers and, in effect, require us
to replace our remaining fleet of vans with school buses over time. These
changes have increased our costs to transport children because school buses are
more expensive to purchase and maintain and, in some jurisdictions, require
drivers with commercial licenses. At August 6, 2004, we had 1,309 school buses
out of a total of 2,262 vehicles used to transport children.
Trademarks and Service Marks
We believe that our name and logo are important to our operations. We own
and use various registered and unregistered trademarks and service marks
covering the name KinderCare, our schoolhouse logo and a number of other names,
slogans and designs. A federal registration in the United States is effective
for 10 years and may be renewed for 10-year periods perpetually, subject only to
required filings based on continued use of the mark by the registrant.
Employees
At August 6, 2004, we had approximately 24,000 employees. Of these
employees, over 23,000 were employed in our centers. Center employees include
the following:
o center directors,
o assistant directors,
o regular full- and part-time teachers,
o temporary and substitute teachers,
o teachers' aides, and
o non-teaching staff, including cooks and van drivers.
There were approximately 330 employees in the corporate headquarters and
290 field management and support personnel. Approximately 7.2% of our 24,000
employees, including all management and supervisory personnel, are salaried. All
other employees are paid on an hourly basis. We do not have an agreement with
any labor union, and we believe that we have good relations with our employees.
Recent Developments
In April 2004, we filed registration statements with the Securities and
Exchange Commission for a proposed initial public offering of Income Deposit
Securities ("IDSs"), a separate proposed offering of senior subordinated notes
and a proposed recapitalization pursuant to which our existing stockholders
would receive in exchange for their common stock, cash and either IDSs or shares
of new class B common stock. The proposed offerings and recapitalization are
referred to in this report as "the IDS Transactions." An IDS is a unit
containing one share of new class A common stock of KinderCare and a fixed
principal amount of senior subordinated notes of KinderCare. The senior
subordinated notes to be sold in the separate offering will be identical to
those senior subordinated notes included in the IDSs. The completion of the
proposed offerings and recapitalization is subject to a number of conditions,
including the approval of the recapitalization by the holders of a majority of
KinderCare's outstanding existing common stock. We plan to use the net proceeds
of the proposed offerings, together with available cash, to refinance certain
outstanding indebtedness and to finance the cash portion of the cash to be paid
to holders of our existing common stock in the proposed recapitalization. The
registration statements are currently under review by the Securities and
Exchange Commission. There is no guarantee that the IDS Transactions will be
consummated in whole or in part, and we may elect at any time and for any reason
not to proceed with the IDS Transactions or to change any of the proposed terms
of the IDS Transactions.
15
ITEM 2. PROPERTIES
Early Childhood Education and Care Centers. Of our child care centers in
operation at August 6, 2004, we owned 722, leased 501 and operated seven under
management contracts. We own or lease other centers that have not yet been
opened or are being held for disposition. In addition, we own real property held
for the future development of centers.
The community and employer-sponsored centers we operated at August 6, 2004
were located as follows:
Number of Number of Number of
Location Centers Location Centers Location Centers
------------- --------- ------------- --------- -------------- ---------
Alabama 8 Kentucky 14 New York 10
Arizona 24 Louisiana 11 North Carolina 32
Arkansas 2 Maryland 26 Ohio 78
California 141 Massachusetts 51 Oklahoma 6
Colorado 35 Michigan 31 Oregon 20
Connecticut 19 Minnesota 40 Pennsylvania 65
Delaware 5 Mississippi 3 Rhode Island 1
Florida 69 Missouri 32 Tennessee 23
Georgia 30 Nebraska 10 Texas 91
Illinois 92 Nevada 8 Utah 8
Indiana 25 New Hampshire 4 Virginia 54
Iowa 10 New Jersey 52 Washington 58
Kansas 12 New Mexico 6 Wisconsin 24
------------
Total 1,230
============
Environmental Compliance. We are not aware of any existing environmental
conditions that currently or in the future could reasonably be expected to have
a material adverse effect on our financial position, operating results or cash
flows. We have not incurred material expenditures to address environmental
conditions at any owned or leased property. Approximately 10 years ago, we
established a process of obtaining environmental assessment reports to reduce
the likelihood of incurring liabilities under applicable federal, state and
local environmental laws upon acquisition or lease of prospective new centers or
sites. These assessment reports have not revealed any environmental liability
that we believe would have a material adverse effect on us. Nevertheless, it is
possible that these assessment reports do not or will not reveal all
environmental liabilities and it is also possible that sites acquired prior to
the establishment of our current process have environmental liabilities. In
connection with the origination of the CMBS loan in July 2003, see "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Liquidity and Capital Resources," a third party performed Phase I
environmental assessments for approximately half of the centers secured by the
mortgage loan. Although there were no material adverse findings, operations and
maintenance plans relating to lead paint and asbestos were recommended and have
been implemented. Additionally, from time to time, we have conducted additional
limited environmental investigations and remedial activities at some of our
former and current centers. However, we have not undertaken an in-depth
environmental review of all of our owned and leased centers. Consequently, there
may be material environmental liabilities of which we are unaware.
16
In addition, future laws, ordinances or regulations may impose material
environmental liability, the current environmental condition of our owned or
leased centers may be adversely affected by conditions at locations in the
vicinity of our centers (such as the presence of leaking underground storage
tanks) or by third parties unrelated to us and, on sites we lease to others,
tenants may violate their leases by introducing hazardous or toxic substances
into our owned or leased centers that could expose us to liability under
federal, state, or local environmental laws.
Corporate Headquarters. Our corporate office is located in Portland,
Oregon. We lease approximately 80,000 square feet of office space for annual
rental payments of $26.50 per square foot. The initial term of the lease expires
in November 2007 with one five-year extension option at market rent.
ITEM 3. LEGAL PROCEEDINGS
We do not believe that there are any pending or threatened legal
proceedings that, if adversely determined, would have a material adverse effect
on our business or operations. However, we are subject to claims and litigation
arising in the ordinary course of business, including claims and litigation
involving allegations of physical or sexual abuse of children. We have notice of
such allegations that have not yet resulted in claims or litigation. Although we
cannot be assured of the ultimate outcome of the allegations, claims or lawsuits
of which we are aware, we believe that none of these allegations, claims or
lawsuits, either individually or in the aggregate, will have a material adverse
effect on our financial position, operating results or cash flows. In addition,
we cannot predict the negative impact of publicity that may be associated with
any such allegation, claim or lawsuit.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4(a). Executive Officers of the Registrant
Set forth below is information regarding our executive officers:
Name Age Position
-------------------- ----- ----------------------------------------------------
David J. Johnson 58 Chief Executive Officer and Chairman of the Board
Dan R. Jackson 50 Executive Vice President, Chief Financial Officer
Edward L. Brewington 61 Senior Vice President, Human Resources and Education
S. Wray Hutchinson 44 Senior Vice President, Operations
Eva M. Kripalani 45 Senior Vice President, General Counsel and Secretary
Bruce A. Walters 47 Senior Vice President, Chief Development Officer
David J. Johnson joined us as Chief Executive Officer and Chairman of the
Board in February 1997. Between September 1991 and November 1996, Mr. Johnson
served as President, Chief Executive Officer and Chairman of the Board of Red
Lion Hotels, Inc., which was formerly an affiliate of Kohlberg Kravis Roberts &
Co. L.P., or its predecessor. From 1989 to September 1991, Mr. Johnson was a
general partner of Hellman & Friedman, a private equity investment firm based in
San Francisco. From 1986 to 1988, he served as President, Chief Operating
Officer and director of Dillingham Holdings, a diversified company headquartered
in San Francisco. From 1984 to 1987, Mr. Johnson was President and Chief
Executive Officer of Cal Gas Corporation, a principal subsidiary of Dillingham
Holdings.
17
Dan R. Jackson was promoted to Executive Vice President, Chief Financial
Officer in November 2002. He had served as Senior Vice President, Finance since
October 1999. He joined us in February 1997 as Vice President of Financial
Control and Planning. Prior to that time, Mr. Jackson held various financial
positions with Red Lion Hotels, Inc., or its predecessor, from September 1985 to
January 1997, the last of which was Vice President, Controller. From 1978 to
1985, Mr. Jackson held several financial management positions with Harsch
Investment Corporation, a real estate holding company based in Portland, Oregon.
Edward L. Brewington was promoted in July 2001 to Senior Vice President,
Human Resources and Education. He had served as Vice President, Human Resources
since April 1997. From June 1993 to April 1997, Mr. Brewington was with Times
Mirror where his last position held was Vice President, Human Resources for the
Times Mirror Training Group. Prior to that time, Mr. Brewington spent 25 years
with IBM in various human resource, sales and marketing positions.
S. Wray Hutchinson was promoted to Senior Vice President, Operations in
October 2000. He had served as Vice President, Operations since April 1996. He
joined us in 1992 as District Manager in New Jersey and was later promoted to
Region Manager for the Chicago, Illinois market. Prior to that time, Mr.
Hutchinson was a restaurant consultant and also spent 12 years with McDonald's
Corporation in various operations positions.
Eva M. Kripalani was promoted in July 2001 to Senior Vice President,
General Counsel and Secretary. She had served as Vice President, General Counsel
and Secretary since July 1997. Prior to joining us, Ms. Kripalani was a partner
in the law firm of Stoel Rives LLP in Portland, Oregon, where she had worked
since 1987.
Bruce A. Walters has served as Senior Vice President, Chief Development
Officer since July 1997. From June 1995 to February 1997, Mr. Walters served as
the Executive Vice President of Store Development for Hollywood Entertainment
Corporation in Portland, Oregon. Prior to that time, Mr. Walters spent 14 years
with McDonald's Corporation in various domestic and international development
positions.
18
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND
RELATED STOCK HOLDER MATTERS
Stock Split
On July 15, 2002, the Board of Directors authorized a 2-for-1 stock split
of our common stock and an increase of the authorized common shares to 10.0
million shares. The 2-for-1 stock split was effective August 19, 2002 for
stockholders of record on August 9, 2002. All of the information in this report,
including all references to the number or price of shares of common stock, gives
effect to the stock split. The information in this report also gives effect to
adjustments in the number of shares available, the number of shares subject to
options granted and the exercise price of those options under our stock option
plan, in each case, to reflect the stock split.
Market Information
In February 1997, affiliates of KKR became owners of 15.7 million shares of
our common stock in a recapitalization transaction. Since then, our common stock
has been traded in the over-the-counter ("OTC") market in the "pink sheets"
published by the National Quotation Bureau. It is listed on the OTC Bulletin
Board under the symbol "KDCR."
The market for our common stock must be characterized as very limited due
to the extremely low trading volume, the small number of brokerage firms acting
as market makers and the sporadic nature of the trading activity. The average
weekly trading volume during fiscal year 2004 and 2003 was less than 1,300 and
100 shares, respectively. The following table sets forth, for the periods
indicated, information with respect to the high and low bid quotations for our
common stock as reported by a market maker for our common stock, as reported on
the OTC Bulletin Board. The quotations represent inter-dealer quotations without
retail markups, markdowns or commissions and may not represent actual
transactions.
Common Stock
------------------------
High Bid Low Bid
---------- ----------
Fiscal year ended May 28, 2004:
First quarter $ 16.00 $ 13.25
Second quarter 13.00 10.00
Third quarter 11.50 9.00
Fourth quarter 14.00 8.00
Fiscal year ended May 30, 2003:
First quarter $ 11.50 $ 11.25
Second quarter 11.25 11.01
Third quarter 11.01 11.01
Fourth quarter 15.00 11.01
In April 2004, we filed registration statements with the Securities and
Exchange Commission for a proposed initial public offering of IDSs, a separate
proposed offering of senior subordinated notes and a proposed recapitalization
pursuant to which our existing stockholders would receive in exchange for their
common stock, cash and either IDSs or shares of new class B common stock. See
"Item 1. Business Recent Developments."
See "Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters."
19
Approximate Number of Security Holders, Outstanding Options and Warrants
At August 6, 2004, there were 134 holders of record of our common stock and
outstanding options to purchase 2,767,712 shares of our common stock.
Dividend Policy
During the past two fiscal years, we have not declared or paid any cash
dividends or distributions on our capital stock. We do not intend to pay any
cash dividends for the foreseeable future. We intend to retain earnings, if any,
for the future operation and expansion of our business. Any determination to pay
dividends in the future will be at the discretion of our Board of Directors and
will be dependent upon our results of operations, financial condition,
contractual restrictions, restrictions imposed by applicable law and other
factors deemed relevant by our Board of Directors. Further, the indenture
governing our senior subordinated notes and our credit facility currently
contain limitations on our ability to declare or pay cash dividends on our
common stock, see "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations, Liquidity and Capital Resources. Our credit
facility allows us to pay dividends provided that the aggregate amount paid does
not exceed $30.0 million plus 50.0% of the cumulative consolidated net income
available to stockholders at such time, and that, at the time of payment, the
consolidated debt to consolidated EBITDA ratio, as defined in the credit
agreement, is less than 3.0 to 1.0. We are currently prohibited from paying
dividends, as our consolidated debt to consolidated EBITDA ratio is greater than
3.0 to 1.0. Future indebtedness or loan arrangements incurred by us may also
prohibit or restrict our ability to pay dividends and make distributions to our
stockholders.
If the IDS Transactions are consummated, we intend to adopt changes to our
dividend policy as described in the registration statement related to such
transactions. See "Item 1. Business - Recent Developments."
Compensations Plans Involving Equity Securities
The following table provides information about compensation plans
(including individual compensation arrangements) under which our equity
securities are authorized for issuance to employees or non-employees (such as
directors and consultants), at May 28, 2004:
Number of
Number of securities
securities to be remaining available
issued upon Weighted-average for future issuance
exercise of exercise price under equity
outstanding of outstanding compensation plans
Plan Category options (a) options (b)
- --------------------------- ---------------- ---------------- ------------------
Equity compensation plans
approved by security
holders:
1997 Stock Purchase and
Option Plan (referred
to as the 1997
Plan) 2,775,212 $ 12.05 1,664,356
2002 Stock Purchase and
Option Plan for
California Employees
(referred to as the
California Plan) 7,000 13.87 93,000
Equity compensation plans
not approved by
security holders N/A N/A N/A
---------------- ---------------- ------------------
Total 2,782,212 $ 12.06 1,757,356
================ ================ ==================
20
(a) Represents the number of shares of common stock issuable upon exercise of
outstanding options under the 1997 Plan and the California Plan, which were
approved during fiscal 1998 and 2003, respectively. See "Item 8. Financial
statements and supplementary data, Note 11. Benefit Plans."
(b) Represents the shares remaining available for issuance under the 1997 Plan
and the California Plan. Future grants or awards under either plan may take
the form of purchased stock, restricted stock, incentive or nonqualified
stock options or other types of rights specified in each plan.
21
ITEM 6. SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA
The following table sets forth selected historical consolidated financial
and other data, with dollars in thousands, except per share amounts and child
care centers data. Our fiscal year ends on the Friday closet to May 31. The
fiscal years are typically comprised of 52 weeks. However, fiscal year 2000
included 53 weeks. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Item 8. Financial Statements
and Supplementary Data" included elsewhere in this report.
Fiscal Year Ended
---------------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
---------- ---------- ---------- ---------- ---------------
Statement of Operations Data:
Revenues, net................................... $ 855,933 $ 834,655 $ 802,754 $ 716,880 $ 670,205
Operating expenses.............................. 783,943 761,769 728,343 642,448 596,359
Operating income................................ 71,990 72,886 74,411 74,432 73,846
Interest expense, net (a)....................... (45,249) (40,612) (43,511) (48,232) (44,979)
Loss on minority investment (b)................. -- (6,700) (2,265) -- --
Income from continuing operations............... 27,237 25,574 28,635 26,200 28,867
Income tax expense.............................. (11,167) (10,128) (11,297) (10,067) (10,871)
Net income...................................... 14,700 13,415 16,543 15,671 19,963
Per Share Data (c):
Basic net income per share...................... $ 0.75 $ 0.68 $ 0.83 $ 0.82 $ 1.05
Diluted net income per share.................... 0.74 0.67 0.82 0.81 1.04
Balance Sheet Data (at end of period):
Property and equipment, net..................... $ 692,981 $ 660,834 $ 696,264 $ 660,009 $ 607,032
Total assets.................................... 904,494 811,093 845,451 805,367 695,570
Total long-term obligations, including
current portion............................... 503,944 470,976 549,240 540,602 475,175
Stockholders' equity............................ 149,862 135,159 123,269 106,731 76,673
Other Financial Data:
Net cash provided by operating activities....... $ 93,651 $ 77,513 $ 84,791 $ 69,671 $ 61,197
EBITDA (d)...................................... 134,423 123,386 130,155 120,807 117,132
EBITDA margin (d)............................... 15.7% 14.8% 16.2% 16.9% 17.5%
Rent expense (e) ............................... 55,427 53,327 49,120 39,240 29,949
Comparable center net revenue growth (f)........ 0.5% 1.4% 1.1% 3.1% 8.4%
Capital expenditures (g)........................ 58,436 83,114 95,843 104,766 87,502
Child Care Center Data:
Number of centers at end of fiscal year......... 1,240 1,264 1,264 1,242 1,169
Center licensed capacity at end of fiscal year.. 166,000 167,000 166,000 162,000 150,000
Average weekly tuition rate (h)................. $ 152.64 $ 144.45 $ 137.72 $ 129.34 $ 120.75
Occupancy (i)................................... 60.4% 63.3% 65.6% 68.3% 69.8%
See accompanying notes to selected historical consolidated financial and other data.
22
Notes to Selected Historical Consolidated Financial and Other Data
(a) Interest expense, net, was comprised of the following:
Fiscal Year Ended
---------------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
---------- ---------- ---------- ---------- ---------------
Investment income..................... $ 265 $ 420 $ 560 $ 582 $ 386
Interest expense...................... (39,753) (41,032) (44,071) (48,814) (45,365)
Loss on the early extinguishment
of debt............................ (5,761) -- -- -- --
---------- ---------- ---------- ---------- ---------------
$ (45,249) $ (40,612) $ (43,511) $ (48,232) $ (44,979)
========== ========== ========== ========== ===============
(b) Investments, wherein we do not exert significant influence or own over 20%
of the investee's stock, are accounted for under the cost method. During
fiscal years 2003 and 2002, we wrote down a minority investment by $6.7
million and $2.3 million, respectively.
(c) The per share amounts have been adjusted to reflect the 2-for-1 stock
split, which was effective August 19, 2002.
(d) EBITDA was calculated as follows, with dollars in thousands:
Fiscal Year Ended
---------------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
---------- ---------- ---------- ---------- ---------------
Net income........................... $ 14,700 $ 13,415 $ 16,543 $ 15,671 $ 19,963
Interest expense, net................ 45,249 40,612 43,511 48,232 44,979
Income tax expense................... 11,167 10,128 11,297 10,067 10,871
Depreciation and amortization........ 61,665 56,832 57,293 45,082 38,953
Discontinued operations:
Interest expense................... -- 1 7 6 10
Income tax (benefit) expense....... (952) (1,333) (496) 199 1,267
Depreciation....................... 2,594 3,731 2,000 1,550 1,089
---------- ---------- ---------- ---------- ---------------
EBITDA.......................... $ 134,423 $ 123,386 $ 130,155 $ 120,807 $ 117,132
========== ========== ========== ========== ===============
EBITDA as a percentage of net
revenues (EBITDA margin)......... 15.7% 14.8% 16.2% 16.9% 17.5%
EBITDA is a non-GAAP financial measure of our liquidity. We believe EBITDA
is a useful tool for certain investors and creditors for measuring our
ability to meet debt service requirements. Additionally, management uses
EBITDA for purposes of reviewing our results of operations on a more
comparable basis. EBITDA was restated from amounts reported in previous
filings in order to comply with SEC Regulation G, Conditions for Use of
Non-GAAP Financial Measures. EBITDA does not represent cash flow from
operations as defined by accounting principles generally accepted in the
United States of America ("GAAP"), is not necessarily indicative of cash
available to fund all cash flow needs and should not be considered an
alternative to net income under GAAP for purposes of evaluating our results
of operations. A reconciliation of EBITDA to net cash provided by operating
activities was as follows, with dollars in thousands:
23
Fiscal Year Ended
---------------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
---------- ---------- ---------- ---------- ---------------
Net cash provided by operating
activities......................... $ 93,651 $ 77,513 $ 84,791 $ 69,671 $ 61,197
Income tax expense................... 11,167 10,128 11,297 10,067 10,871
Deferred income taxes................ 16,535 10,968 (6,431) 116 (4,271)
Interest expense, net................ 45,249 40,612 43,511 48,232 44,979
Effect of discontinued operations
on interest and taxes.............. (952) (1,332) (489) 205 1,277
Change in operating assets and
liabilities........................ (32,830) (14,000) (2,094) (6,997) 3,585
Other non-cash items................. 1,603 (503) (430) (487) (506)
---------- ---------- ---------- ---------- ---------------
EBITDA.......................... $ 134,423 $ 123,386 $ 130,155 $ 120,807 $ 117,132
========== ========== ========== ========== ===============
(e) Rent expense was as follows, in thousands:
Fiscal Year Ended
---------------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
---------- ---------- ---------- ---------- ---------------
Rent from continuing operations...... $ 54,784 $ 51,379 $ 46,499 $ 36,908 $ 27,886
Rent from discontinued operations.... 643 1,948 2,621 2,332 2,063
---------- ---------- ---------- ---------- ---------------
$ 55,427 $ 53,327 $ 49,120 $ 39,240 $ 29,949
========== ========== ========== ========== ===============
(f) Comparable center net revenues include those centers that have been open
and operated by us at least one year. Therefore, a center is considered
comparable during the first four-week period it has prior year net
revenues. Non-comparable net revenues include those generated from centers
that have been closed and our revenues from distance learning services. The
fiscal year ended June 2, 2000 included 53 weeks of operations. If fiscal
year 2000 were adjusted to a 52 week basis, the comparable center net
revenue growth would have been 5.2% in fiscal year 2001 and 6.3% in
fiscal year 2000.
(g) Capital expenditures included the following, in thousands:
Fiscal Year Ended
---------------------------------------------------------------
May 28, May 30, May 31, June 1, June 2, 2000
2004 2003 2002 2001 (53 weeks)
---------- ---------- ---------- ---------- ---------------
New center development and
acquisitions....................... $ 26,428 $ 50,651 $ 63,990 $ 54,751 $ 41,660
Maintenance capital expenditures..... 32,008 32,463 31,853 50,015 45,842
---------- ---------- ---------- ---------- ---------------
$ 58,436 $ 83,114 $ 95,843 $ 104,766 $ 87,502
========== ========== ========== ========== ===============
Capital expenditures do not include the purchase of centers previously
included in the synthetic lease facility in fiscal year 2004.
(h) We calculate the average weekly tuition rate as the actual tuition charged,
net of discounts, for a specified time period, divided by "full-time
equivalent", or FTE, attendance for the related time period. FTE attendance
is not a strict head count. Rather, the methodology determines an
approximate number of full-time children based on weighted averages. For
example, an enrolled full-time child equates to one FTE, while a part-time
child enrolled for five half-days equates to 0.5 FTE. The FTE measurement
of center capacity utilization does not necessarily reflect the actual
number of full- and part-time children enrolled.
(i) Occupancy is a measure of the utilization of center capacity. We calculate
occupancy as the FTE attendance divided by the sum of the centers' licensed
capacity during the related time period.
24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Introduction
You should read the following discussion in conjunction with "Selected
Historical Consolidated Financial and Other Data" and the consolidated financial
statements and the related notes. We utilize a financial reporting schedule
comprised of 13 four-week periods and our fiscal year ends on the Friday closest
to May 31. The information presented refers to the 52 weeks ended May 28, 2004
as "fiscal year 2004," the 52 weeks ended May 30, 2003 as "fiscal year 2003" and
the 52 weeks ended May 31, 2002 as "fiscal year 2002." Our first fiscal quarter
is comprised of 16 weeks, while the remaining quarters are each comprised of 12
weeks.
Overview
We are the nation's leading for-profit provider of early childhood
education and care services based on number of centers and licensed capacity. We
provide services to infants and children up to 12 years of age, with a majority
of the children from the ages of six weeks to five years old. At May 28, 2004,
licensed capacity at our centers was approximately 166,000, and we served
approximately 125,000 children and their families at 1,240 child care centers.
We distinguish ourselves by providing high quality educational programs, a
professional and well-trained staff and clean, safe and attractive facilities.
We focus on the development of the whole child: physically, socially,
emotionally, cognitively and linguistically. In addition to our primary business
of center-based child care, we also own and operate a distance learning company
serving teenagers and young adults through our subsidiary, KC Distance Learning,
Inc.
Net Revenues
We derive our net revenues primarily from the tuition we charge for
attendance by children at our centers. Our tuition rates and net revenues can be
significantly impacted by enrollment levels and factors affecting the enrollment
mix at our centers. These factors include (i) enrollment levels by geographic
location because we can command higher tuition rates in certain geographic
areas; (ii) the age mix of children enrolled because our tuition rates depend on
the age of the child and are generally higher for younger children; (iii) the
mix between full- and part-time attendance because we charge a premium rate for
part-time enrollment and (iv) the level of participation in discount programs.
Recently, net revenue growth has primarily resulted from the addition of new
centers through internal development and acquisitions, and to a lesser extent
due to increased tuition charges and expanded programs at existing centers.
Tuition charges from our child care centers represent the majority of our
net revenues. We collect tuition on a weekly basis in advance. The majority of
our tuition is paid by individual families. Approximately 20% of our net revenue
is paid at varying levels of subsidy by government agencies. In our
employer-sponsored centers, tuition may be partly subsidized by the employers.
We provide certain discounts to families, government agencies and employees.
These include discounts with respect to government agency reimbursed rates,
staff discounts, family discounts for multiple enrollments, marketing discounts
for referrals or trial periods and employer-based discounts.
Over the past several years, we have pursued a strategy of increasing our
net revenues through enhanced center yield management. We have done so by
balancing an increase in tuition rates and a gradual decline in occupancy at our
centers. In addition, we have expanded our fee-based service offerings, which
include tutorial programs in the areas of literacy, reading, foreign languages
and mathematics. Revenues from our fee-based offerings were $7.9 million, $5.1
million and $4.1 million in fiscal years 2004, 2003 and 2002, respectively. Our
comparable center net revenues have grown moderately from fiscal year 2001 to
fiscal year 2003 and were relatively flat during fiscal year 2004. A center is
included in comparable center net revenues when it has been open and operated by
us for at least one year. Therefore, a center is considered comparable during
the first four-week period it has prior year net revenues. Non-comparable net
revenues include those generated from centers that have been closed and from our
distance learning services.
25
We determine tuition rates based upon a number of factors, including the
age of the child, full- or part-time attendance, enrollment levels, location and
competition. Tuition rates are typically adjusted company-wide each year to
coincide with the back-to-school period. However, we may adjust individual
classroom rates within a specific center at any time based on competitive
position, occupancy levels and demand. In order to maximize enrollment, center
directors may also adjust the rates at their center or offer discounts at their
discretion, within limits. These rate discounts and adjustments are closely
monitored by our field and corporate management. Our focus on pricing at the
classroom level within our centers has enabled us to improve comparable center
net revenue growth throughout the year without losing occupancy in centers where
the quality of our services, demand and other market conditions support such
increases. We believe that our reputation, brand awareness, educational
offerings and focus on developing centers in growing and comparatively more
affluent regions of the United States are some of the primary reasons we have
been able to charge premium tuition rates.
We calculate an average weekly tuition rate as the actual tuition charged,
net of discounts, for a specified time period, divided by "full-time
equivalent," or FTE, attendance for the related time period. FTE attendance is
not a strict head count. Rather, the methodology determines an approximate
number of full-time children based on weighted averages. For example, an
enrolled full-time child equates to one FTE, while a part-time child enrolled
for five half-days equates to 0.5 FTE. The FTE measurement of center capacity
utilization does not necessarily reflect the actual number of full- and
part-time children enrolled.
The average weekly tuition rate has risen primarily due to the annual
tuition rate increases we have instituted as well as the classroom specific
tiered rates we have implemented. Although we have increased rates, in most
cases our families experience lower tuition charges over time. This is due to
the fact that within a specific center, the highest pricing levels exist in the
infant program, as a result of the higher care requirements of younger children,
and the lowest pricing is charged in our school-age offerings. The average
weekly tuition rate is also impacted by shifts in enrollment within various
geographic markets, enrollment mix between age segments, enrollment mix between
full- and part-time attendance, participation levels within discount programs
and the opening of new centers in markets that support rates at levels higher
than our company average. Average tuition is also affected by regional
concentrations, which may represent markets with significantly different tuition
levels.
Occupancy is a measure of the utilization of center capacity. We calculate
occupancy as the FTE attendance divided by the sum of the centers' licensed
capacity during the related time period. We have experienced declines in our
occupancy levels in recent years. We believe the factors contributing to these
declines include reduced or flat government funding for child care assistance
programs, increased unemployment rates and job losses and the general economic
downturn. Our licensed capacity has remained relatively flat for the past three
fiscal years. Typically, our new centers open with lower occupancy than our
pre-existing center base.
In addition to our tuition charges, we record revenues from fees and other
income. We charge a reservation fee, typically at half of the normal tuition
charge, for any full week that an enrolled child is absent from our centers. We
also collect registration fees and fees to cover educational supplies at the
time of enrollment and annually thereafter. We offer tutorial programs on a
supplemental fee basis in the majority of our centers in the areas of literacy
and reading, foreign language and mathematics. We also offer field trips,
predominantly during the summer months, for an additional charge. Our child care
centers earn other miscellaneous income from various sources, including
management fees related to certain employer-sponsored contracts. In addition to
our child care operations, our subsidiary, KC Distance Learning, Inc., sells
high school level courses via online and correspondence formats and provides
related instructional services directly to private students, as well as to
schools and school districts.
26
Seasonality
New enrollments are generally highest during the traditional fall "back to
school" period and after the calendar year-end holidays. Therefore, we attempt
to focus our marketing efforts to support these periods of high re-enrollments.
Enrollment generally decreases 5% to 10% during the summer months and calendar
year-end holidays.
New Center Openings, Acquisitions and Center Closures
We intend to continue to open 15 to 30 new centers each year. In addition,
we will make selective acquisitions of existing high quality centers. We also
continually evaluate our centers and close those, typically older, centers that
are not generating positive cash flow. During the periods indicated, we opened,
acquired and closed centers as follows:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Number of centers at the beginning of the year............ 1,264 1,264 1,242
Openings.................................................. 16 28 35
Acquisitions.............................................. 1 -- --
Closures.................................................. (41) (28) (13)
------------ ------------ ------------
Number of centers at the end of the period............. 1,240 1,264 1,264
============ ============ ============
Total center licensed capacity at the end of the period... 166,000 167,000 166,000
Operating Expenses
Our operating expenses include the direct costs related to the operations
of our centers, as well as the costs associated with the field and corporate
oversight of such centers. Our large, nationwide center base gives us the
ability to leverage the costs of programs and services, such as curriculum
development, training programs and other management processes.
Labor related costs are the largest component of operating expenses. We
have been successful in managing our labor productivity without impacting the
quality of services within our centers. Other costs incurred at the center level
include insurance, janitorial, maintenance, utilities, transportation, provision
for doubtful accounts, food and marketing. While we generally have seen gradual
rises in our expenses, our largest increase has been in insurance expense. This
is due to the higher premiums that resulted from the terrorist attacks on
September 11, 2001, the subsequent expiration of a set of three-year fixed
premium policies and higher claims costs, particularly with respect to workers
compensation. Our May 2004 policy renewals resulted in a slight decrease in
premium costs. However, we anticipate that premium and claims costs will
continue to reflect market forces, which are beyond our control.
Other significant components of our cost structure include depreciation and
rent. We have experienced increases in our rent expense primarily due to an
active sale-leaseback program in which we sell our centers to unaffiliated third
parties and lease them back. We then redeploy the proceeds to buy and develop
additional sites for our child care centers, or to reduce debt levels. We have
an active inventory of our properties available for sale and plan to continue
our sale-leaseback program for as long as there is investor interest.
27
Application of Critical Accounting Policies
Critical Accounting Estimates. The preparation of financial statements in
conformity with accounting principles generally accepted in the United States of
America requires that management make estimates and assumptions that affect the
amounts reported in the financial statements and accompanying notes. Predicting
future events is inherently an imprecise activity and as such requires the use
of judgment. Actual results may vary from estimates in amounts that may be
material to the financial statements.
For a description of our significant accounting policies, see note 2 to the
audited consolidated financial statements included in this report. The following
accounting estimates and related policies are considered critical to the
preparation of our financial statements due to the business judgment and
estimation processes involved in their application. Management has reviewed the
development and selection of these estimates and their related disclosure with
the Audit Committee of the Board of Directors.
Revenue recognition. The recognition of our net revenues meets the
following criteria: the existence of an arrangement through an enrollment
agreement, the rendering of child care services, an age specific tuition rate
and/or fee and probable collection. Tuition revenues, net of discounts, and
other revenues are recognized as services are performed. Payments may be
received in advance of services being rendered, in which case the revenue is
deferred and recognized during the appropriate time period, typically a week.
Our non-refundable registration and education fees are amortized over the
average enrollment period, not to exceed one year.
Accounts receivable. Our accounts receivable are comprised primarily of
tuition due from governmental agencies, parents and employers. Accounts
receivable are presented at estimated net realizable value. We use estimates in
determining the collectibility of our accounts receivable and must rely on our
evaluation of historical experience, governmental funding levels, specific
customer issues and current economic trends to arrive at an appropriate
allowance. At May 28, 2004 and May 30, 2003 our allowance for doubtful accounts,
as a percentage of accounts receivable, was 13.0% and 11.9%, respectively.
Material differences may result in the amount and timing of bad debt expense if
actual experience differs significantly from management estimates.
Long-lived and intangible assets. We assess the potential impairment of
property and equipment and finite-lived intangibles whenever events or changes
in circumstances indicate that the carrying value may not be recoverable. An
asset's value is typically impaired if our estimate of the aggregate future cash
flows, undiscounted and without interest charges, to be generated by the asset
is less than the carrying value of the asset. Such cash flows consider factors
such as expected future operating income and historical trends, as well as the
effects of demand and competition. Impairment may not be appropriate under
certain circumstances, such as: (1) a new or maturing center, (2) recent center
director turnover or (3) an unusual, non-recurring expense impacting the cash
flow projection. Conversely, we will impair a center, regardless of mitigating
factors, when the center is placed on an exit list after a review conducted by
our Development Committee, assuming that the center's undiscounted cash flows
are less than the net book value for leased centers or the projected proceeds
for the sale of owned centers are less than the net book value.
To the extent impairment has occurred, the loss will be measured as the
excess of the estimated carrying amount of the asset over its fair value. Such
estimates require the use of judgment and numerous subjective assumptions,
which, if actual experience varies, could result in material differences in the
requirements for impairment charges. Impairment charges, which were included as
a component of depreciation expense, were as follows, in thousands:
28
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Impairment charges included in
depreciation expense................. $ 2,589 $ 1,216 $ 2,968
Impairment charges included in
discontinued operations.............. 1,024 2,130 597
------------ ------------ ------------
Total impairment charges.......... $ 3,613 $ 3,346 $ 3,565
============ ============ ============
Investments. Investments, wherein we do not exert significant influence or
own over 20% of the investee's stock, are accounted for under the cost method.
We measure the fair values of these investments annually, or more frequently if
there is an indication of impairment, using multiples of comparable companies
and discounted cash flow analysis. During fiscal years 2003 and 2002, we wrote
down a minority investment by $6.7 million and $2.3 million, respectively, due
to a reduced valuation on the subject company and dilution of our minority
interest. Subsequent to May 28, 2004, we sold our investment in the subject
company, which resulted a gain of $2.1 million in the first quarter of fiscal
year 2005. During fiscal year 2004, we received a $0.7 million dividend payment
from a minority investment accounted for under the cost method. We recognized
dividend income of $0.5 million for our proportionate share of accumulated
earnings since the date of the initial investment and $0.2 million was recorded
as a return of investment in the subject company.
Self-insurance obligations. We self-insure a portion of our general
liability, workers' compensation, auto, property and employee medical insurance
programs. We purchase stop loss coverage at varying levels in order to mitigate
our potential future losses. The nature of these liabilities, which may not
fully manifest themselves for several years, requires significant judgment. We
estimate the obligations for liabilities incurred but not yet reported or paid
based on available claims data and historical trends and experience, as well as
future projections of ultimate losses, expenses, premiums and administrative
costs. The accrued obligations for these self-insurance programs were $54.1
million and $46.2 million at May 28, 2004 and May 30, 2003, respectively. Our
internal estimates are reviewed periodically by a third party actuary. While we
believe that the amounts accrued for these obligations are sufficient, any
significant increase in the number of claims and/or costs associated with claims
made under these programs could have a material adverse effect on our
consolidated financial statements.
Income taxes. Accounting for income taxes requires us to estimate our
future tax liabilities. Due to timing differences in the recognition of items
included in income for accounting and tax purposes, deferred tax assets or
liabilities are recorded to reflect the impact arising from these differences on
future tax payments. With respect to recorded tax assets, we assess the
likelihood that the asset will be realized. If realization is in doubt because
of uncertainty regarding future profitability or enacted tax rates, we provide a
valuation allowance related to the asset. Should any significant changes in the
tax law or our estimate of the necessary valuation allowance occur, we would be
required to record the impact of the change. This could have a material effect
on our financial position or results of operations. See "Note 8. Income Taxes."
In fiscal year 2004, our effective tax rate increased to 41.0% compared to 39.6%
in fiscal year 2003 due, in part, to the expiration of the Work Opportunity Tax
Credit as of December 31, 2003.
Income taxes payable with respect to any fiscal year are subject to
adjustment at any time until the tax returns are audited or the statute of
limitations for the fiscal year closes. We maintain contingency accruals for
potential adjustments that may arise after our tax returns have been filed. We
believe that an appropriate liability has been established for potential tax
exposure; however, actual results may differ materially from these potential
contingency accruals. At May 28, 2004, we were subject to income tax audits for
fiscal years 2000, 1999 and 1998. To the extent the adjustments arising from
this audit, or other potential events, result in a material adjustment to the
accrued estimates, the effect would be recognized in income tax expense
(benefit) in the consolidated statement of operations in the period of the
event.
29
Initial Adoption of Accounting Policies
Statement of Financial Accounting Standards ("SFAS") No. 149, Amendments of
Statement 133 on Derivative Instruments and Hedging Activities, amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities under SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No.
149 is effective for contracts entered into or modified and for hedging
relationships designated after June 30, 2003. SFAS No. 149 was effective in our
first quarter of our fiscal year 2004. We have determined that our interest rate
cap agreement purchased in connection with the CMBS Loan, see "Note 7. Long-Term
Debt," is a cash flow hedge, which is a derivative that is based on future cash
flows attributed to a particular risk, such as interest rate changes on variable
rate debt. A mark-to-market adjustment of $0.2 million was recorded as
comprehensive loss in the fourth quarter of fiscal 2004, which reduced the value
of the interest rate cap agreement.
SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, establishes standards for how an
issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. The statement requires that an
issuer classify a financial instrument that is within its scope as a liability,
or an asset in some circumstances. SFAS No. 150 was effective for financial
instruments entered into or modified after May 31, 2003, and otherwise was
effective in the second quarter of our fiscal year 2004. This statement did not
have a material impact on our consolidated financial statements. While SFAS No.
150 did not have a material impact on our existing financial instruments, it is
reasonably possible that certain equity instruments issued in future periods
will include features that require those instruments, or portions of those
instruments, to be treated as debt in our consolidated financial statements.
Financial Accounting Standards Board Interpretation, or FIN, 46,
Consolidation of Variable Interest Entities, as amended by FIN 46R, requires
consolidation where there is a controlling financial interest in a variable
interest entity, previously referred to as a special-purpose entity, and certain
other entities. The implementation of FIN 46R was adopted during the fourth
quarter of our fiscal year 2004. This adoption did not have a material impact on
our consolidated financial statements.
30
Fiscal 2004 compared to Fiscal 2003
The following table shows the comparative operating results of KinderCare,
in thousands, except the average weekly tuition rate:
Fiscal Fiscal Change
Year Ended Percent Year Ended Percent Amount
May 28, of May 30, of Increase/
2004 Revenues 2003 Revenues (Decrease)
---------- -------- ---------- -------- ----------
Revenues, net......................... $ 855,933 100.0% $ 834,655 100.0% $ 21,278
---------- -------- ---------- -------- ----------
Operating expenses:
Salaries, wages and benefits:
Center expense.................... 430,865 50.3 425,252 50.9 5,613
Field and corporate expense....... 39,449 4.6 34,761 4.2 4,688
---------- -------- ---------- -------- ----------
Total salaries, wages and
benefits...................... 470,314 54.9 460,013 55.1 10,301
Depreciation and amortization....... 61,665 7.2 56,832 6.8 4,833
Rent................................ 54,784 6.4 51,379 6.2 3,405
Other............................... 197,180 23.1 193,545 23.2 3,635
---------- -------- ---------- -------- ----------
Total operating expenses.......... 783,943 91.6 761,769 91.3 22,174
---------- -------- ---------- -------- ----------
Operating income................ $ 71,990 8.4% $ 72,886 8.7% $ (896)
========== ======== ========== ======== ==========
Average weekly tuition rate........... $ 152.64 $ 144.45 $ 8.19
Occupancy............................. 60.4% 63.3% (2.9)
Comparable center net revenue growth.. 0.5% 1.4%
Revenues, net. Net revenues increased $21.3 million, or 2.5%, from the same
period last year to $855.9 million in fiscal year 2004. The increase was due to
higher average weekly tuition rates, offset by reduced occupancy, as well as
additional net revenues generated by the newly opened centers. Newly opened
centers represents those centers opened within the most recent two fiscal years.
Comparable center net revenues increased $4.2 million, or 0.5%.
The average weekly tuition rate increased $8.19, or 5.7%, to $152.64 in
fiscal year 2004 due primarily to tuition increases. Occupancy declined to 60.4%
from 63.3% for the same period last year due primarily to reduced full-time
equivalent attendance within the population of older centers. We believe the
factors contributing to this decline include reduced or flat government funding
for child care assistance programs, increased unemployment rates and job losses
and the general economic downturn.
During the periods indicated, we opened, acquired and closed centers as
follows:
Fiscal Year Ended
---------------------------
May 28, 2004 May 30, 2003
------------ ------------
Number of centers at the beginning
of the fiscal year......................... $ 1,264 $ 1,264
Openings..................................... 16 28
Acquisitions................................. 1 --
Closures..................................... (41) (28)
------------ ------------
Number of centers at the end of
the fiscal year......................... 1,240 1,264
============ ============
Total center licensed capacity at
the end of the fiscal year................ 166,000 167,000
31
Salaries, wages and benefits. Expenses for salaries, wages and benefits
increased $10.3 million, or 2.2%, in fiscal year 2004 from the same period last
year to $470.3 million. Total salaries, wages and benefits expense as a
percentage of net revenues was 54.9% and 55.1% for fiscal years 2004 and 2003,
respectively.
Expenses for salaries, wages and benefits directly associated with the
centers were $430.9 million, an increase of $5.6 million from the same period
last year. The increase was primarily due to costs from newly opened centers and
overall higher wage rates, offset by control over labor hours and a reduction in
medical insurance costs. Labor hours are controlled by our center directors
managing staff hours relative to attendance levels at the centers. At the center
level, salaries, wages and benefits expense as a percentage of net revenues
declined to 50.3% from 50.9% for the same period last year due primarily to
control over labor hours and a reduction in medical insurance costs.
Depreciation and amortization. Depreciation and amortization expense
increased $4.8 million from the same period last year to $61.7 million.
Significant changes in depreciation expense included the impact of purchasing
centers previously included in our synthetic lease facility, the impact of newly
opened centers, our sale-leaseback program, whereby centers are classified as
operating leases when they are sold and leased back, and impairment charges.
These changes were as follows, in thousands:
Depreciation for centers previously included
in the synthetic lease facility...................... $ 3,622
Impact of newly opened centers......................... 2,342
Impairment charges..................................... 1,373
Impact of centers sold in the sale-leaseback program... (1,605)
Other.................................................. (899)
-----------
Increase in depreciation and amortization expense... $ 4,833
===========
Impairment charges of $2.6 million and $1.2 million in fiscal years 2004
and 2003, respectively, related to under-performing centers and certain
undeveloped properties.
Rent. Rent expense increased $3.4 million from the same period last year to
$54.8 million. The most significant changes in rent expense included the impact
of our sale-leaseback program and the impact of centers previously included in
our synthetic lease facility. In addition, the rental rates experienced on new
and renewed center leases are higher than those experienced in previous fiscal
periods. The changes were as follows, in thousands:
Impact of centers leased under the
sale-leaseback program............................... $ 6,518
Amortization of deferred gains on
sale-leaseback transactions.......................... (2,179)
Impact of newly opened centers......................... 1,606
Rent expense for centers previously included in the
synthetic lease facility............................. (3,162)
Other.................................................. 622
-----------
Increase in rent expense............................... $ 3,405
===========
Other operating expenses. Other operating expenses include costs directly
associated with the centers, such as food, insurance, transportation,
janitorial, maintenance, utilities, property taxes and licenses and marketing
costs, and expenses related to field management and corporate administration.
Other operating expenses increased $3.6 million, or 1.9%, from the same period
last year to $197.2 million. The increase was due primarily to newly opened
centers. As a percentage of net revenues, other operating expenses decreased to
23.1% from 23.2% for the same period last year primarily as a result of cost
controls.
32
Interest expense. Interest expense was $39.8 million in fiscal year 2004, a
decrease of $1.3 million from the same period last year. The decrease in
interest expense was due primarily to a reduction in the outstanding balance of
our 9.5% senior subordinated notes. The changes were as follows, in thousands:
Mortgage loan financed in July 2003.................... $ 9,292
Repurchase and redemption of 9.5% senior
subordinated notes................................... (5,103)
Debt refinancing of the credit facility in July 2003... (6,624)
Other.................................................. 1,156
-----------
Decrease in interest expense............................. $ (1,279)
===========
Our weighted average interest rate on our long-term debt, including
amortization of deferred financing costs, but excluding the write-off discussed
below, was 7.0% and 8.0% for fiscal years 2004 and 2003, respectively. The
decrease in the weighted average interest rate in fiscal year 2004 was due to
the change in the composition of our indebtedness. See "Note 7. Long-Term Debt."
Loss on the early extinguishment of debt. As a result of our debt
refinancing in July 2003 and the acquisition and redemption of a portion of our
9.5% senior subordinated notes, we recognized a loss on the early extinguishment
of debt of $5.8 million in fiscal year 2004. These costs included the write-off
of deferred financing costs of $4.0 million associated with the debt that was
repaid and the incurrence of premium costs of $1.8 million in connection with
the acquisition and redemption of a portion of our 9.5% senior subordinated
notes. In fiscal year 2004, we purchased $55.6 million and redeemed $55.0
million aggregate principal amount of our 9.5% senior subordinated notes.
Dividend income. During the third quarter of fiscal 2004 we received a
dividend payment of $0.7 million from a minority investment accounted for under
the cost method. Dividend income of $0.5 million was recognized to the extent of
our proportionate share of accumulated earnings since the date of the initial
investment. The remaining $0.2 million was recorded as a return of investment in
the subject company.
Income tax expense. Income tax expense was $11.2 million, or 41.0% of
pretax income, and $10.1 million, or 39.6% of pretax income, in fiscal years
2004 and 2003, respectively. Income tax expense was computed by applying
estimated effective income tax rates to the income or loss before income taxes.
Income tax expense varies from the statutory federal income tax rate due
primarily to state income taxes and non-tax deductible expenses, offset by tax
credits. The increase in the effective tax rate for fiscal 2004 was due, in
part, to the expiration of the Work Opportunity Tax Credit as of December 31,
2003.
Discontinued operations. We recognized losses of $1.4 million and $2.0
million on discontinued operations in fiscal years 2004 and 2003, respectively,
which represents the operating results, net of tax, for all periods presented of
the 69 centers closed since fiscal year 2002. Discontinued operations included
the following, in thousands:
33
Fiscal Year Ended
---------------------------
May 28, 2004 May 30, 2003
------------ ------------
Revenues, net................................. $ 7,483 $ 19,893
------------ ------------
Operating expenses:
Salaries, wages and benefits............... 5,217 12,662
Depreciation............................... 2,594 3,731
Rent....................................... 643 1,948
Provision for doubtful accounts............ 219 349
Other...................................... 1,132 4,566
------------ ------------
Total operating expenses................. 9,805 23,256
Operating loss............................. (2,322) (3,363)
Interest expense.............................. -- (1)
Income tax benefit............................ 952 1,333
------------ ------------
Discontinued operations, net of tax........ $ (1,370) $ (2,031)
============ ============
Depreciation expense for the fiscal year ended May 28, 2004 and May 30,
2003 included $1.0 million and $2.1 million of impairment charges, respectively.
Other operating expenses included gains on closed center sales of $1.8 million
and $1.2 million in fiscal years, 2004 and 2003, respectively.
Fiscal 2003 compared to Fiscal 2002
The following table shows the comparative operating results of KinderCare,
with dollars in thousands, except the average weekly tuition rate:
Fiscal Year Fiscal Year Change
Ended Percent Ended Percent Amount
May 30, of May 31, of Increase/
2003 Revenues 2002 Revenues (Decrease)
----------- -------- ----------- -------- ----------
Revenues, net.................... $ 834,655 100.0% $ 802,754 100.0% $ 31,901
----------- -------- ----------- -------- ----------
Operating expenses:
Salaries, wages and benefits:
Center expense............... 425,252 50.9 412,212 51.3 13,040
Field and corporate expense.. 34,761 4.2 31,943 4.0 2,818
----------- -------- ----------- -------- ----------
Total salaries, wages and
benefits................. 460,013 55.1 444,155 55.3 15,858
Depreciation and amortization.. 56,832 6.8 57,293 7.1 (461)
Rent........................... 51,379 6.2 46,499 5.8 4,880
Other.......................... 193,545 23.2 180,396 22.5 13,149
----------- -------- ----------- -------- ----------
Total operating expenses..... 761,769 91.3 728,343 90.7 33,426
----------- -------- ----------- -------- ----------
Operating income........... $ 72,886 8.7% $ 74,411 9.3% $ (1,525)
=========== ======== =========== ======== ==========
Average weekly tuition rate...... $ 144.45 $ 137.72 $ 6.73
Occupancy........................ 63.3% 65.6% (2.3)
Comparable center net revenue
growth........................ 1.4% 1.1%
Revenues, net. Net revenues increased $31.9 million, or 4.0%, in fiscal
year 2003 compared to fiscal year 2002 to $834.7 million. The increase was due
to higher average weekly tuition rates as well as additional net revenues
generated by newly opened centers. Comparable center net revenues increased
$11.0 million, or 1.4%.
34
The average weekly tuition rate increased $6.73, or 4.9%, to $144.45 in
fiscal year 2003, due primarily to tuition increases. Occupancy declined to
63.3% from 65.6% in fiscal year 2002 primarily due to reduced full-time
equivalent attendance within the population of older centers.
During fiscal years 2003 and 2002, we opened and closed centers as follows:
Fiscal Year Ended
----------------------------
May 30, 2003 May 31, 2002
------------ ------------
Number of centers at the beginning of
the fiscal year............................. 1,264 1,242
Openings...................................... 28 35
Closures...................................... (28) (13)
------------ ------------
Number of centers at the end of the
fiscal year................................ 1,264 1,264
============ ============
Total center licensed capacity at the
end of the fiscal year...................... 167,000 166,000
Salaries, wages and benefits. Expenses for salaries, wages and benefits
increased $15.9 million, or 3.6%, in fiscal year 2003 compared to fiscal year
2002 to $460.0 million. Total salaries, wages and benefits expense as a
percentage of net revenues was 55.1% and 55.3% for fiscal years 2003 and 2002,
respectively.
Expenses for salaries, wages and benefits directly associated with the
centers were $425.3 million, an increase of $13.0 million in fiscal year 2003
compared to fiscal year 2002. The increase was primarily due to overall higher
wage rates and higher medical insurance costs. At the center level, salaries,
wages and benefits expense as a percentage of net revenues improved to 50.9% for
fiscal year 2003 from 51.3% for fiscal year 2002. This improvement was due
primarily to strong controls over the management of labor hours relative to
attendance levels.
Depreciation and amortization. Depreciation and amortization expense
decreased $0.5 million in fiscal year 2003 compared to fiscal year 2002 to $56.8
million. Significant changes in depreciation included the impact of the
cessation of goodwill amortization for all of fiscal year 2003, our
sale-leaseback program, whereby centers are classified as operating leases when
they are sold and leased back, and impairment charges, offset by the impact of
newly opened centers. These changes were as follows, in thousands:
Cessation of goodwill amortization.................. $ (2,934)
Change in impairment charges........................ (1,753)
Impact of the centers sold in the sale-leaseback
program........................................... (1,239)
Impact of newly opened centers...................... 4,002
Other............................................... 1,463
------------
Decrease in depreciation and amortization expense. $ (461)
============
Impairment charges of $1.2 million and $3.0 million in fiscal year 2003 and
fiscal year 2002, respectively, related to underperforming centers and certain
undeveloped properties.
Rent. Rent expense increased $4.9 million in fiscal year 2003 compared to
fiscal year 2002 to $51.4 million. The most significant change in the rent
expense was the impact of our sale-leaseback program and newly opened centers.
In addition, the rental rates experienced on new and renewed center leases are
higher than those experienced in previous fiscal years. The changes were as
follows, in thousands:
35
Impact of centers leased under the
sale-leaseback program.......................... $ 4,415
Amortization of deferred gains on
sale-leaseback transactions..................... (1,116)
Impact of newly opened centers.................... 1,945
Other............................................. (364)
-----------
Increase in rent expense....................... $ 4,880
===========
Other operating expenses. Other operating expenses include costs directly
associated with the centers, such as insurance, janitorial, maintenance,
utilities, transportation, provision for doubtful accounts, food and marketing
costs, and expenses relating to field management and corporate administration.
Other operating expenses increased $13.1 million, or 7.3%, from fiscal year 2002
to $193.5 million in fiscal year 2003. Other operating expenses as a percentage
of net revenues were 23.2% and 22.5% for fiscal years 2003 and 2002,
respectively. The increase was due primarily to insurance costs that were $12.7
million higher in fiscal year 2003 compared to fiscal year 2002. The provision
for doubtful accounts declined $2.3 million in fiscal year 2003 compared to
fiscal year 2002. The reduction in our provision for doubtful accounts was due
to the implementation of automated programming that allows us to have stronger
controls over our receivables.
Interest expense. Interest expense was $41.0 million in fiscal year 2003
compared to $44.1 million in fiscal year 2002. The decrease was substantially
attributable to lower interest rates and a decrease in the principal balance on
our revolving credit facility. The decrease was as follows, in thousands:
Decrease in interest rates for borrowings
outstanding under our previous credit facility.... $ (2,001)
Decrease in principal outstanding under our
previous credit facility.......................... (1,126)
Other............................................... 88
------------
Decrease in interest expense..................... $ (3,039)
============
The weighted average interest rate on our long-term debt, including
amortization of deferred financing costs, was 8.0% and 7.8% for fiscal year 2003
and 2002, respectively. A larger portion of our debt was comprised of 9.5%
senior subordinated notes during fiscal year 2003, which resulted in an increase
in the weighted average interest rate from fiscal year 2003 compared to fiscal
year 2002.
Loss on minority investment. During fiscal year 2003, we recorded a write
down of $6.7 million to the net book value of a minority investment due to a
reduced valuation of the subject company and the dilution of our minority
interest in that investment. During fiscal year 2002, we wrote down the net book
value of the same investment by $2.3 million. The minority investment was
accounted for under the cost method. See "Note 2. Summary of Significant
Accounting Policies."
Income tax expense. Income tax expense was $10.1 million, or 39.6% of
pretax income, in fiscal year 2003 and $11.3 million, or 39.5% of pretax income,
in fiscal year 2002. The slight increase in the effective tax rate was due to
the relative impact of tax credits at different levels of taxable income, the
impact of the cessation of goodwill amortization and an increase in expenses
that were disallowed for income tax purposes. Income tax expense was computed by
applying estimated effective income tax rates to income before income taxes.
Income tax expense varies from the statutory federal income tax rate due
primarily to state and foreign income taxes, offset by tax credits.
36
Discontinued operations. Discontinued operations resulted in losses of $2.0
million and $0.8 million in fiscal years 2003 and 2002, respectively.
Discontinued operations represents the operating results for all periods
presented of the 69 centers closed since fiscal year 2002. Discontinued
operations included the following, in thousands:
Fiscal Year Ended
---------------------------
May 30, 2003 May 31, 2002
------------ ------------
Revenues, net................................ $ 19,893 $ 26,680
------------ ------------
Operating expenses:
Salaries, wages and benefits............... 12,662 16,636
Depreciation............................... 3,731 2,000
Rent....................................... 1,948 2,621
Provision for doubtful accounts............ 349 335
Other...................................... 4,566 6,372
------------ ------------
Total operating expenses............... 23,256 27,964
------------ ------------
Operating loss..................... (3,363) (1,284)
Interest expense............................. (1) (7)
Income tax benefit........................... 1,333 496
------------ ------------
Discontinued operations, net of tax........ $ (2,031) $ (795)
============ ============
Depreciation expense related to discontinued operations included impairment
charges of $2.1 million and $0.6 million for fiscal years 2003 and 2002,
respectively. Other operating expenses related to discontinued operations
included gains on closed center sales of $1.2 million in fiscal year 2003.
Liquidity and Capital Resources
Financing Activities
In July 2003 we refinanced $279.9 million of our debt. We obtained a $125.0
million revolving credit facility, and, as described below in greater detail,
one of our subsidiaries obtained a $300.0 million mortgage loan. Proceeds from
the mortgage loan were used to pay off the $98.0 million balance of the then
existing revolving credit facility, $47.0 million of the term loan facility and
$97.9 million under the synthetic lease facility. We also used a portion of the
remaining proceeds to purchase $37.0 million aggregate principal amount of our
9.5% senior subordinated notes.
The $300.0 million mortgage loan is secured by first mortgages or deeds of
trust on 475 of our owned centers located in 33 states. We refer to the mortgage
loan as the CMBS loan and the 475 mortgaged centers as the CMBS centers. In
connection with the CMBS loan, the CMBS centers were transferred to a newly
formed wholly owned subsidiary of ours, which is the borrower under the CMBS
loan and is referred to as the CMBS borrower. Because the CMBS centers are owned
by the CMBS borrower and subject to the CMBS loan, recourse to the CMBS centers
by our creditors will be effectively subordinated to recourse by holders of the
CMBS loan.
The CMBS loan is nonrecourse to the CMBS borrower and us, subject to
customary recourse provisions, and has a maturity date of July 9, 2008, which
may be extended to July 9, 2009, subject to certain conditions. The CMBS loan
bears interest at a per annum rate equal to LIBOR plus 2.25% and requires
monthly payments of principal and interest.
37
Our $125.0 million revolving credit facility is secured by first mortgages
or deeds of trusts on 119 of our owned centers and certain other collateral and
has a maturity date of July 9, 2008. The revolving credit facility includes
borrowing capacity of up to $75.0 million for letters of credit and up to $10.0
million for selected short-term borrowings.
During fiscal year 2004, we repurchased and redeemed our 9.5% senior
subordinated notes as follows, in thousands:
Write-off of
Aggregate Premium Deferred
Principal Price Costs Financing Costs Total Loss
---------- ---------- ---------- --------------- ----------
Notes repurchased.............. $ 55,577 $ 58,689 $ 914 $ 935 $ 1,849
Notes redeemed................. 55,000 56,076 871 1,034 1,905
---------- ---------- ---------- --------------- ----------
Total........................ $ 110,577 $ 114,765 $ 1,785 $ 1,969 $ 3,754
========== ========== ========== =============== ==========
We completed the repurchase of $11.0 million aggregate principal amount of
our 9.5% senior subordinated notes at an aggregate price of $11.4 million in the
first quarter of fiscal year 2004, which is included above. The premium costs
and associated write-off of deferred financing costs related to this repurchase
were recognized in the fourth quarter of fiscal year 2003 and were excluded from
the costs above.
In fiscal year 2000, we entered into a $100.0 million synthetic lease
facility under which a syndicate of lenders financed the construction of new
centers for lease to us for a three to five year period. A total of 44 centers
were constructed at a cost of $97.9 million. The synthetic lease facility was
terminated in July 2003 as part of our refinancing. The 44 centers are now owned
by us and the assets are reflected in our fiscal year 2004 consolidated
financial statements.
Cash Flows and Liquidity Sources
We expect to fund our liquidity needs primarily from cash flow generated
from operations, with proceeds received from our sale-leaseback program and, to
the extent necessary, through borrowings under our revolving credit facility. At
May 28, 2004, there were no borrowings outstanding under our revolving credit
facility and we had outstanding letters of credit totaling $55.1 million. Our
availability under our revolving credit facility was $69.9 million.
Our consolidated net cash provided by operating activities for fiscal years
2004, 2003 and 2002 was $93.7 million, $77.5 million and $84.8 million,
respectively. The $16.2 million increase in fiscal year 2004 compared to fiscal
year 2003 was due primarily to increased cash received from our customers as a
result of higher net revenues, as well as a reduction in cash paid for operating
expenses as a result of cost controls. In fiscal year 2003, cash provided by
operating activities decreased $7.3 million from fiscal year 2002 due primarily
to higher insurance claim and premium payments and operating expenses, offset by
increased cash received from our customers as a result of higher net revenues.
Cash and cash equivalents totaled $58.9 million at May 28, 2004, compared
to $18.1 million at May 30, 2003. The increase in our cash balance is due to
proceeds received from our sale-leaseback transactions and increased cash flow
from operations. Due to the pending IDS transaction, we have elected not to use
excess cash to repurchase or redeem our 9.5% senior subordinated notes.
Our current sale-leaseback program began during the fourth quarter of
fiscal year 2002. Under this initiative, we began selling centers to individual
real estate investors and concurrently signing long term leases to continue
operating the centers. The resulting leases have been classified as operating
leases with an average lease term of 15 years, with three to four five-year
renewal options. The sales were summarized as follows, in thousands:
38
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Number of centers......................... 41 41 5
Net proceeds from completed sales......... $ 89,034 $ 89,558 $ 9,259
Deferred gains............................ 28,348 32,507 2,599
Our sale-leaseback program has the effect of increasing rent expense while
typically reducing the depreciation and interest expense incurred to support the
previously owned centers. In addition, deferred gains have generally been
recognized on our sale-leaseback transactions. The deferred gains are amortized
on a straight-line basis, typically over a period of 15 years, and are offset
against the related rent expense. At May 28, 2004 and May 30, 2003, other
noncurrent liabilities on the consolidated balance sheet included deferred gains
on sale-leaseback transactions of $64.8 million and $38.6 million, respectively.
Subsequent to May 28, 2004, we closed $10.5 million in sales, which included
four centers, and we are currently in the process of negotiating another $37.6
million of sales related to 16 centers. It is possible that we will be unable to
complete some or all of these transactions currently in process. We expect our
sale-leaseback efforts to continue, assuming the market for such transactions
remains favorable.
We believe that cash flow generated from operations, proceeds from our
sale-leaseback program and borrowings under our revolving credit facility will
be sufficient to fund our interest and principal payment obligations, expected
capital expenditures, working capital requirements and anticipated dividend
payments for the foreseeable future.
Any future acquisitions, joint ventures or similar transactions may require
additional capital, which may be financed through borrowings under our revolving
credit facility, net cash provided by operating activities, other third party
financing or a combination of these alternatives, and such capital may not be
available to us on acceptable terms or at all. Although we cannot assure you
that such sources of capital will be sufficient, the capital expenditure program
has substantial flexibility and is subject to revision based on various factors,
including but not limited to, business conditions, cash flow requirements, debt
covenants, competitive factors and seasonality of openings. If we experience a
lack of working capital, it may reduce our future capital expenditures. If these
expenditures were substantially reduced, our operations and cash flow would be
adversely impacted.
Capital Expenditures
During fiscal years 2004 and 2003, we opened 16 and 28 new centers,
respectively. In addition, we completed the acquisition of one center in fiscal
year 2004. We expect to continue our practice of closing centers that are
identified as not meeting performance expectations. In addition, we may acquire
existing centers from local or regional early childhood education and care
providers. We may not be able to successfully negotiate and acquire sites and/or
previously constructed centers, meet our targets for new center additions or
meet targeted deadlines for the development of new centers.
New centers are located based upon detailed site analyses that include
feasibility and demographic studies and financial modeling. The length of time
from site selection to construction and, finally, the opening of a community
center ranges from 16 to 24 months. Frequently, new site negotiations are
delayed or canceled or construction is delayed for a variety of reasons, many of
which are outside our control. The average total cost for land, building and
equipment per owned community center typically ranges from $1.9 million to $2.9
million depending on the size and location of the center. However, the actual
costs of a particular center may vary from such range.
39
Our new centers typically have a licensed capacity ranging from 145 to 180,
while the centers constructed during fiscal 1997 and earlier have an average
licensed capacity of 125. When mature, these new, larger centers are designed to
generate higher revenues, operating income and margins than our older centers.
These new centers also have higher average costs of construction and typically
take three to four years to reach maturity. On average, our new centers should
begin to produce positive EBITDA during the first year of operation and begin to
produce positive net income by the end of the second year of operation.
Accordingly, as more new centers are developed and opened, profitability will be
negatively impacted in the short-term but is expected to be enhanced in the
long-term once these new centers achieve anticipated levels of occupancy.
Capital expenditures included the following, in thousands:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
New center development.................... $ 25,475 $ 50,651 $ 63,990
Refurbishment of existing facilities...... 19,551 18,945 18,979
Equipment purchases....................... 10,310 11,731 9,508
Information systems purchases............. 2,147 1,787 3,366
------------ ------------ ------------
57,483 83,114 95,843
Acquisition of previously constructed
center................................. 953 -- --
------------ ------------ ------------
$ 58,436 $ 83,114 $ 95,843
============ ============ ============
We refer to the costs associated with the refurbishment of existing
facilities and equipment and information systems purchases as maintenance
capital expenditures. Capital expenditures for fiscal year 2004 do not include
$97.9 million spent to purchase the 44 centers previously included in the
synthetic lease facility.
Capital expenditure limits under our credit facility for fiscal year 2004
are $110.0 million. We have some ability to incur additional indebtedness,
including through mortgages or sale-leaseback transactions, subject to the
limitations imposed by the indenture under which our notes are issued and our
revolving credit facility.
Contractual Commitments
We have certain contractual obligations and commercial commitments.
Contractual obligations are those that will require cash payments in accordance
with the terms of a contract, such as a loan or lease agreement. Commercial
commitments represent potential obligations for performance in the event of
demands by third parties or other contingent events, such as lines of credit.
Our contractual obligations and commercial commitments at May 28, 2004 were as
follows, in thousands:
40
Fiscal Year
------------------------------------------------------------------------------------
Total 2005 2006 2007 2008 2009 Thereafter
----------- ---------- --------- --------- --------- --------- ----------
Long-term debt...................... $ 488,779 $ 7,191 $ 3,799 $ 4,051 $ 4,322 $ 469,416 $ --
Fixed rate interest obligations..... 85,295 17,114 17,046 17,045 17,045 17,045 --
Variable rate interest obligations.. 50,262 10,008 9,884 9,752 9,613 9,462 1,543
Capital lease obligations........... 27,569 2,258 2,279 2,396 2,415 2,481 15,740
Operating leases.................... 487,180 51,071 47,787 43,861 40,295 36,121 268,045
Standby letters of credit........... 58,439 58,439 -- -- -- -- --
Other commitments................... 8,648 8,648 -- -- -- -- --
----------- ---------- --------- --------- --------- --------- ----------
$ 1,206,172 $ 154,729 $ 80,795 $ 77,105 $ 73,690 $ 534,525 $ 285,328
=========== ========== ========= ========= ========= ========= ==========
Fixed rate interest obligations related primarily to our 9.5% senior
subordinated notes. Variable rate interest obligations related to our interest
obligations under our CMBS Loan at a rate of 3.35% and our Series B Industrial
Revenue Bonds at a rate of 1.35%. These rates were those rates in effect at May
28, 2004. See "Note 7. Long-Term Debt." Other commitments include those related
to center development, purchase orders and vehicle leases.
Seasonality
See "Item 1. Business, Seasonality."
Governmental Laws and Regulations Affecting Us
See "Item 1. Business, Governmental Laws and Regulations Affecting Us."
Wage Increases
Expenses for salaries, wages and benefits represented approximately 54.9%
and 55.1% of net revenues for fiscal years 2004 and 2003, respectively. We
believe that, through increases in our tuition rates, we can mitigate any future
increase in expenses caused by adjustments to the federal or state minimum wage
rates or other market adjustments. However, we may not be able to increase our
rates sufficiently to offset such increased costs. We continually evaluate our
wage structure and may implement changes at targeted local levels.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative And Qualitative Disclosures About Market Risk
Market risk represents the risk of loss that may impact our consolidated
financial position, results of operations or cash flows. We are exposed to
market risk in the areas of interest rates and foreign currency exchange rates.
Interest Rates
Our exposure to market risk for changes in interest rates relates primarily
to debt obligations. We have no cash flow exposure due to rate changes on our
9.5% senior subordinated notes aggregating $179.4 million at May 28, 2004. We
also have no cash flow exposure on certain industrial revenue bonds, mortgages
and notes payable aggregating $3.6 million at May 28, 2004. However, we have
cash flow exposure on our revolving credit facility and certain industrial
revenue bonds subject to variable LIBOR or adjusted base rate pricing. We had no
borrowings outstanding under our credit facility at May 28, 2004. A 1% (100
basis points) change in the variable LIBOR or adjusted base rate pricing on our
industrial revenue bonds, aggregating $8.5 million at May 28, 2004, would have
resulted in interest expense changing by $0.1 million in both fiscal years 2004
and 2003.
41
We have cash flow exposure on the CMBS loan entered into in July 2003,
which bears interest at a rate equal to LIBOR plus 2.25%. A 1% (100 basis
points) change in the LIBOR rate would have resulted in interest expense
changing by approximately $2.8 million in fiscal year 2004. We have purchased an
interest rate cap agreement to protect us from significant movements in LIBOR
during the initial three years of the CMBS loan. The LIBOR strike price is 6.50%
under the interest rate cap agreement, which terminates July 9, 2006, at which
time we are required to purchase an additional interest rate cap agreement for
the duration of the loan term.
We also have cash flow exposure on our vehicle leases with variable
interest rates. A 1% (100 basis points) change in the interest rate defined in
our vehicle lease agreement would have resulted in rent expense changing by
approximately $0.4 million and $0.5 million in fiscal years 2004 and 2003,
respectively.
42
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
KinderCare Learning Centers, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except per share amounts)
May 28, 2004 May 30, 2003
------------ ------------
Assets
Current assets:
Cash and cash equivalents.............................. $ 58,898 $ 18,066
Receivables, net....................................... 28,727 31,493
Prepaid expenses and supplies.......................... 7,357 9,423
Deferred income taxes.................................. 14,132 14,500
Assets held for sale................................... 5,007 5,665
------------ ------------
Total current assets................................ 114,121 79,147
Property and equipment, net............................... 692,981 660,834
Deferred income taxes..................................... 15,075 1,868
Goodwill.................................................. 42,565 42,565
Deferred financing costs.................................. 18,673 9,445
Other assets.............................................. 21,079 17,234
------------ ------------
$ 904,494 $ 811,093
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Bank overdrafts........................................ $ 6,042 $ 9,304
Accounts payable....................................... 8,840 8,888
Current portion of long-term debt...................... 7,169 13,744
Accrued expenses and other liabilities................. 124,261 109,671
------------ ------------
Total current liabilities........................... 146,312 141,607
Long-term debt............................................ 481,610 441,336
Long-term self-insurance liabilities...................... 33,046 22,771
Deferred income taxes..................................... -- 3,696
Other noncurrent liabilities.............................. 93,664 66,524
------------ ------------
Total liabilities................................... 754,632 675,934
------------ ------------
Commitments and contingencies (Notes 7 and 11)
Stockholders' equity:
Preferred stock, $.01 par value; authorized 10,000
shares; none outstanding............................ -- --
Common stock, $.01 par value; authorized 100,000
shares; issued and outstanding 19,722 and 19,661
shares, respectively 197 197
Additional paid-in capital............................. 26,800 25,909
Notes receivable from stockholders..................... (1,933) (1,085)
Retained earnings...................................... 124,997 110,297
Accumulated other comprehensive loss................... (199) (159)
------------ ------------
Total stockholders' equity.......................... 149,862 135,159
------------ ------------
$ 904,494 $ 811,093
============ ============
See accompanying notes to consolidated financial statements.
43
KinderCare Learning Centers, Inc. and Subsidiaries
Consolidated Statements of Operations
(Dollars in thousands, except per share amounts)
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Revenues, net............................. $ 855,933 $ 834,655 $ 802,754
------------ ------------ ------------
Operating expenses:
Salaries, wages and benefits........... 470,314 460,013 444,155
Depreciation and amortization.......... 61,665 56,832 57,293
Rent................................... 54,784 51,379 46,499
Provision for doubtful accounts........ 6,559 4,907 7,164
Other.................................. 190,621 188,638 173,232
------------ ------------ ------------
Total operating expenses........... 783,943 761,769 728,343
------------ ------------ ------------
Operating income..................... 71,990 72,886 74,411
Investment income......................... 265 420 560
Interest expense.......................... (39,753) (41,032) (44,071)
Loss on early extinguishment of debt...... (5,761) -- --
Loss on minority investment............... -- (6,700) (2,265)
Dividend income........................... 496 -- --
------------ ------------ ------------
Income before income taxes and
discontinued operations.............. 27,237 25,574 28,635
Income tax expense........................ (11,167) (10,128) (11,297)
------------ ------------ ------------
Income before discontinued operations.. 16,070 15,446 17,338
Discontinued operations net of income tax
benefit of $952, $1,333 and $496,
respectively........................... (1,370) (2,031) (795)
------------ ------------ ------------
Net income........................... $ 14,700 $ 13,415 $ 16,543
============ ============ ============
Basic net income per share:
Income before discontinued operations..... $ 0.82 $ 0.78 $ 0.87
Discontinued operations, net of taxes..... (0.07) (0.10) (0.04)
------------ ------------ ------------
Net income........................... $ 0.75 $ 0.68 $ 0.83
============ ============ ============
Diluted net income per share:
Income before discontinued operations..... $ 0.81 $ 0.77 $ 0.86
Discontinued operations, net of taxes..... (0.07) (0.10) (0.04)
------------ ------------ ------------
Net income........................... $ 0.74 $ 0.67 $ 0.82
============ ============ ============
Weighted average common shares outstanding:
Basic................................... 19,701 19,701 19,819
Diluted................................. 19,966 19,908 20,111
See accompanying notes to consolidated financial statements.
44
KinderCare Learning Centers, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity and Comprehensive Income
(Dollars in thousands)
Notes Accumulated
Common Stock Additional Receivable Other
------------------ Paid-in from Retained Comprehensive
Shares Amount Capital Stockholders Earnings Loss Total
--------- ------- ---------- ------------ -------- ------------- ---------
Balance at June 1, 2001.................. 19,819 $ 198 $ 28,107 $ (1,355) $ 80,339 $ (558) $ 106,731
Comprehensive income:
Net income............................. -- -- -- -- 16,543 -- 16,543
Cumulative translation adjustment...... -- -- -- -- -- 66 66
---------
Total comprehensive income......... 16,609
Proceeds from collection of stockholders'
notes receivable...................... -- -- -- 35 -- -- 35
Issuances of stockholders' notes
receivable............................ -- -- -- (106) -- -- (106)
--------- ------- ---------- ------------ -------- ------------- ---------
Balance at May 31, 2002............ 19,819 198 28,107 (1,426) 96,882 (492) 123,269
Comprehensive income:
Net income............................. -- -- -- -- 13,415 -- 13,415
Cumulative translation adjustment...... -- -- -- -- -- 333 333
---------
Total comprehensive income........... 13,748
Retirement of common stock............... (120) (1) (1,645) -- -- -- (1,646)
Repurchase of common stock............... (38) -- (553) -- -- -- (553)
Proceeds from collection of stockholders'
notes receivable....................... -- -- -- 341 -- -- 341
--------- ------- ---------- ------------ -------- ------------- ---------
Balance at May 30, 2003............. 19,661 $ 197 $ 25,909 $ (1,085) $110,297 $ (159) $ 135,159
Comprehensive income:
Net income........................... -- -- -- -- 14,700 -- 14,700
Cumulative translation adjustment.... -- -- -- -- -- 159 159
Mark-to-market adjustment on interest
rate cap agreement................. -- -- -- -- -- (199) (199)
---------
Total comprehensive income....... 14,660
Issuance of common stock................. 74 -- 1,089 -- -- -- 1,089
Repurchase of common stock............... (13) -- (198) -- -- -- (198)
Issuance of stockholders' notes
receivable............................. -- -- -- (1,004) -- -- (1,004)
Proceeds from collection of stockholders'
notes receivable....................... -- -- -- 156 -- -- 156
--------- ------- ---------- ------------ -------- ------------- ---------
Balance at May 28, 2004............. 19,722 $ 197 $ 26,800 $ (1,933) $124,997 $ (199) $ 149,862
========= ======= ========== ============ ======== ============= =========
See accompanying notes to consolidated financial statements.
45
KinderCare Learning Centers, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(In thousands)
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Cash flows from operations:
Net income.................................... $ 14,700 $ 13,415 $ 16,543
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation.............................. 64,254 60,172 55,968
Amortization of deferred financing costs,
goodwill, other intangible assets and
deferred gain on sale-leasebacks........ 4,376 2,102 5,941
Provision for doubtful accounts........... 6,778 5,256 7,499
Loss on minority investment............... -- 6,700 2,265
Gain on sales and disposals of property
and equipment........................... (2,014) (2,202) (529)
Deferred tax expense (benefit)............ (16,535) (10,968) 6,431
Changes in operating assets and
liabilities:
Increase in receivables................. (4,011) (6,740) (10,387)
Decrease (increase) in prepaid expenses
and supplies.......................... 2,066 526 (2,113)
Increase in other assets................ (2,474) (287) (1,485)
Increase in accounts payable, accrued
expenses and other liabilities........ 26,551 9,206 4,592
Other, net................................ (40) 333 66
------------ ------------ ------------
Net cash provided by operating activities... 93,651 77,513 84,791
------------ ------------ ------------
Cash flows from investing activities:
Purchases of property and equipment........... (57,483) (83,114) (95,843)
Purchases of property and equipment
previously included in the synthetic
lease facility.............................. (97,851) -- --
Acquisitions of previously constructed centers (953) -- --
Issuance of notes receivable.................. (164) (114) --
Proceeds from sales of property and equipment. 92,359 95,172 11,537
Increase in restricted cash................... (1,438) -- --
Return of investment accounted for under the
cost method................................. 171 -- --
Proceeds from collection of notes receivable.. -- -- 26
------------ ------------ ------------
Net cash provided by (used in) investing
activities................................ (65,359) 11,944 (84,280)
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from long-term borrowings............ 343,300 56,000 57,128
Payments on long-term borrowings.............. (309,601) (133,237) (51,769)
Deferred financing costs...................... (17,210) (1,242) --
Payments on capital leases.................... (731) (844) (1,288)
Proceeds from issuance of common stock........ 86 -- (106)
Proceeds from collection of stockholders'
notes receivable............................ 156 341 35
Repurchases of common stock................... (198) (553) --
Bank overdrafts............................... (3,262) (475) 451
------------ ------------ ------------
Net cash provided by (used in) financing
activities................................ 12,540 (80,010) 4,451
------------ ------------ ------------
Increase in cash and cash equivalents..... 40,832 9,447 4,962
Cash and cash equivalents at the beginning of
the fiscal year............................. 18,066 8,619 3,657
------------ ------------ ------------
Cash and cash equivalents at the end of the
fiscal year................................. $ 58,898 $ 18,066 $ 8,619
============ ============ ============
Supplemental cash flow information:
Interest paid............................. $ 37,530 $ 36,608 $ 41,360
Income taxes paid, net.................... 15,968 18,985 11,614
Non-cash financial activities:
Issuance of notes receivable to
stockholders............................ $ 1,004 $ -- $ 106
Retirement of common stock................ -- 1,646 --
Property and equipment under capital leases -- -- 4,390
Conversion of stock on a minority
investment.............................. -- -- 2,225
See accompanying notes to consolidated financial statements.
46
KinderCare Learning Centers, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
1. Nature of Business
KinderCare Learning Centers, Inc., referred to as KinderCare, is the
leading for-profit provider of early childhood education and care services in
the United States. At May 28, 2004, we served approximately 125,000 children and
their families at 1,240 child care centers. At our child care centers, education
and care services are provided to infants and children up to twelve years of
age. However, the majority of the children we serve are from six weeks to five
years old. The total licensed capacity at our centers was approximately 166,000
at May 28, 2004.
We operate child care centers under two brands as follows:
o KinderCare - At May 28, 2004, we operated 1,171 KinderCare centers.
The brand was established in 1969 and includes centers in 39 states.
o Mulberry - We operated 69 Mulberry centers at May 28, 2004, which are
located primarily in the northeast region of the United States and
southern California. In addition, we had eight service contracts to
operate before- and after-school programs.
We also partner with companies to provide on- or near-site care to help
employers attract and retain employees. Included in the 1,240 centers, at May
28, 2004, are 44 employer-sponsored centers. In addition to our center-based
child care operations, we own and operate a distance learning company serving
teenagers and young adults. Our subsidiary, KC Distance Learning, Inc., offers
an accredited high school program delivered in either online or correspondence
format. We have made a minority investment in Voyager Expanded Learning, Inc., a
developer of educational curricula for elementary and middle schools and a
provider of a public school teacher retraining program.
2. Summary of Significant Accounting Policies
Basis of Presentation. The consolidated financial statements include the
financial statements of KinderCare and our subsidiaries, all of which are wholly
owned. All significant intercompany balances and transactions have been
eliminated in consolidation.
Reporting for Segments. We operate in one reportable segment.
Revenue Recognition. The recognition of our net revenues meets the
following criteria: the existence of an arrangement through an enrollment
agreement, the rendering of child care services, an age specific tuition rate
and/or fee and probable collection. Net revenues include tuition, fees and other
income, reduced by discounts. We receive fees for reservation, registration,
education and other services. Other income is primarily comprised of
supplemental fees from tutorial programs and field trips. Tuition, fees and
other income are recognized as the related services are provided. Payments for
these types of services may be received in advance of services being rendered,
in which case the revenue is deferred and recognized during the appropriate time
period, typically a week. Our non-refundable registration and education fees are
amortized over the estimated average enrollment period, not to exceed twelve
months.
Advertising. Costs incurred to produce media advertising for seasonal
campaigns are expensed during the quarter in which the advertising first takes
place. Costs related to website development are capitalized or expensed in
accordance with Statement of Position ("SOP") No. 98-1, Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use, and Emerging Issues
Task Force ("EITF") Issue No. 00-2, Accounting for Web Site Development Costs.
SOP 98-1 and EITF 00-2 identify the characteristics of internal use software and
related costs, and provides guidance on whether the costs should be expensed as
incurred or capitalized. Other advertising costs are expensed as incurred.
Advertising costs were $10.2 million, $10.8 million and $12.1 million during
fiscal 2004, 2003 and 2002, respectively.
47
Income Taxes. Income tax expense is based on pre-tax financial accounting
income. Deferred income taxes result primarily from the expected tax
consequences of temporary differences between financial and tax reporting. If it
is more likely than not that some portion or all of a deferred tax asset will
not be realized, a valuation allowance is established.
Comprehensive Income. Comprehensive income included the following, in
thousands:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Net income........ ............................. $ 14,700 $ 13,415 $ 16,543
Cumulative translation adjustment............... 159 333 66
Mark-to-market adjustment for interest rate
cap agreement................................. (199) -- --
------------ ------------ ------------
Total comprehensive income................ $ 14,660 $ 13,748 $ 16,609
============ ============ ============
The cumulative translation adjustment included in comprehensive income, for
all fiscal years presented, related to our previously owned subsidiaries in the
United Kingdom. During fiscal year 2004, a mark-to-market adjustment was
recorded for our interest rate cap agreement, which was purchased in connection
with our CMBS Loan. See "Note 7. Long-Term Debt."
Stock-Based Compensation. We measure compensation expense for our
stock-based employee compensation plans using the method prescribed by
Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued
to Employees, and provide pro forma disclosures of net income and earnings per
share as if the method prescribed by Statement of Financial Accounting Standards
("SFAS") No. 123, Accounting for Stock-Based Compensation, had been applied in
measuring compensation expense.
In accordance with SFAS No. 148, Accounting for Stock-Based
Compensation--Transition and Disclosure, we have provided the required
disclosures below. Had compensation expense for our stock option plans been
determined based on the estimated weighted average fair value of the options at
the date of grant in accordance with SFAS No. 123, our net income and basic and
diluted net income per share would have been as follows, in thousands, except
per share data:
48
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Reported net income............................. $ 14,700 $ 13,415 $ 16,543
Compensation cost for stock option plans,
net of tax.................................... (1,055) (573) (841)
------------ ------------ ------------
Pro forma net income...................... $ 13,645 $ 12,842 $ 15,702
============ ============ ============
Pro forma net income per share:
Reported basic income per share................. $ 0.75 $ 0.68 $ 0.83
Compensation cost for stock option plans,
net of tax................................... (0.05) (0.03) (0.04)
------------ ------------ ------------
Pro forma net income per share.......... $ 0.70 $ 0.65 $ 0.79
============ ============ ============
Reported diluted income per share............... $ 0.74 $ 0.67 $ 0.82
Compensation cost for stock option plans,
net of tax.................................. (0.05) (0.03) (0.04)
------------ ------------ ------------
Pro forma net income, pershare......... $ 0.69 $ 0.64 $ 0.78
============ ============ ============
A summary of the weighted average fair values was as follows:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Weighted average fair value of options
granted during the period, using the
Black-Scholes option pricing
model...................................... $ 7.73 $ 4.27 $ 5.55
Assumptions used to estimate the present
value of options at the grant date:
Volatility.............................. 50.7% 36.2% 36.5%
Risk-free rate of return................ 3.3% 3.9% 4.7%
Dividend yield.......................... 0.0% 0.0% 0.0%
Number of years to exercise options..... 7 7 7
49
Discontinued Operations. The operating results for the 69 centers closed
since fiscal 2002 have been classified as discontinued operations, net of tax,
in the consolidated statements of operations for all periods presented. A
summary of discontinued operations follows, in thousands:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Revenues, net........................... $ 7,483 $ 19,893 $ 26,680
Operating expenses...................... 9,805 23,256 27,964
------------ ------------ ------------
Operating loss........................ (2,322) (3,363) (1,284)
Interest expense........................ -- (1) (7)
------------ ------------ ------------
Discontinued operations before
income taxes....................... (2,322) (3,364) (1,291)
Income tax benefit...................... 952 1,333 496
------------ ------------ ------------
Discontinued operations, net of tax... $ (1,370) $ (2,031) $ (795)
============ ============ ============
Operating expenses included impairment charges of $1.0 million, $2.1
million and $0.6 million for fiscal 2004, 2003 and 2002, respectively, and gains
on closed center sales in the amount of $1.8 million and $1.2 million for fiscal
2004 and 2003, respectively. The owned centers that met the criteria of held for
sale have been classified as current in the consolidated balance sheets for all
periods presented. As a result, property and equipment of $5.0 million and $5.7
million was classified as current assets held for sale at May 28, 2004 and May
30, 2003, respectively.
Net Income per Share. The difference between basic and diluted net income
per share was a result of the dilutive effect of options, which are considered
potential common shares. A summary of the weighted average common shares was as
follows, in thousands:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Basic weighted average common shares
outstanding............................ 19,701 19,701 19,819
Dilutive effect of options............... 265 207 292
------------ ------------ ------------
Diluted weighted average common
shares outstanding..................... 19,966 19,908 20,111
============ ============ ============
Options excluded from potential
shares due to their
anti-dilutive effect................... 1,378 981 299
============ ============ ============
Stock split. On July 15, 2002, the Board of Directors authorized a 2-for-1
stock split of our $0.01 par value common stock effective August 19, 2002 for
stockholders of record on August 9, 2002. All references to the number of common
shares and per share amounts within these consolidated financial statements and
notes thereto for the fiscal years ended June 1, 2001, May 31, 2002 and May 30,
2003 have been restated to reflect the stock split. Concurrent with the stock
split, the number of authorized common shares was increased from 20.0 million to
100.0 million shares.
Cash and Cash Equivalents. Cash and cash equivalents consist of cash held
in banks and liquid investments with maturities, at the date of acquisition, not
exceeding 90 days.
Restricted Cash. Restricted cash includes cash held in connection with our
$300.0 million mortgage loan, see "Note 8. Long-Term Debt." At May 28, 2004,
restricted cash of $1.4 million was included in other assets in our audited
consolidated balance sheet. The restricted cash related primarily to capital
expenditure requirements under the mortgage loan.
50
Accounts receivable. Our accounts receivable are comprised primarily of
tuition due from governmental agencies, parents and employers. Accounts
receivable are presented at estimated net realizable value. We use estimates in
determining the collectibility of our accounts receivable and must rely on our
evaluation of historical experience, specific customer issues, governmental
funding levels and current economic trends to arrive at appropriate reserves.
Material differences may result in the amount and timing of bad debt expense if
actual experience differs significantly from our estimates.
Property and Equipment. Property and equipment are stated at cost. Interest
and overhead costs incurred in the construction of buildings and leasehold
improvements are capitalized. Depreciation on buildings and equipment is
provided on the straight-line basis over the estimated useful lives of the
assets. Leasehold improvements are amortized over the shorter of the estimated
useful life of the improvements or the lease term, including expected lease
renewal options where we have the unqualified right to exercise the option and
expect to exercise such option.
Our property and equipment is depreciated using the following estimated
useful lives:
Life
--------------
Buildings................................... 10 to 40 years
Building renovations........................ 2 to 15 years
Leasehold improvements...................... 2 to 15 years
Computer equipment.......................... 3 to 5 years
All other equipment......................... 1 to 10 years
Asset Impairments. Long-lived assets and certain identifiable intangibles
to be held and used are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be
recoverable. We regularly evaluate long-lived assets for impairment by comparing
projected undiscounted cash flows for each asset to the carrying value of such
asset. If the projected undiscounted cash flows are less than the asset's
carrying value, we record an impairment charge, if necessary, to reduce the
carrying value to estimated fair value. Impairment may not be appropriate under
certain circumstances, such as: (1) a new or maturing center, (2) recent center
director turnover or (3) an unusual, non-recurring expense impacting the cash
flow projection. Conversely, we will impair a center, regardless of mitigating
factors, when the center is placed on an exit list after a review conducted by
our Development Committee, assuming that the center's undiscounted cash flows
are less than the net book value, for leased centers or the projected proceeds
for the sale of owned centers are less than the net book value.
During fiscal years 2004, 2003 and 2002, impairment charges of $3.6
million, $3.3 million and $3.6 million, respectively, were recorded with respect
to certain underperforming and undeveloped centers. The impairment charges are
included as a component of depreciation expense from continuing and discontinued
operations in the statement of operations.
Goodwill and Other Intangible Assets. We ceased amortization of goodwill at
June 1, 2002. Amortization of goodwill for fiscal year 2002 was $2.4 million,
pre-tax. These assets must now be tested at least annually for impairment and
written down to their fair market values, if necessary. At June 1, 2002, we had
$42.6 million of goodwill recorded on our consolidated balance sheet. We
performed a transitional impairment test in the second quarter of fiscal year
2003. In addition, we performed our annual impairment test in the fourth
quarters of fiscal years 2004 and 2003. Although quoted market prices are the
best evidence in determining fair value, we used the value of our stock as
determined by the Board of Directors, due to low trading volume and closely held
nature of our stock, to perform the transitional impairment test. The fair value
of the reporting unit related to the recorded goodwill, as of May 28, 2004,
exceeded the carrying value at the same date, hence there was no evidence of
impairment.
51
If SFAS No. 142, Goodwill and Other Intangible Assets, had been adopted at
the beginning of fiscal year 2002, our pro forma net income and net income per
share would have been as follows, in thousands, except per share amounts:
Fiscal Year Ended
May 31, 2002
-----------------------------------
Net income per share
----------------------
Net Income Basic Diluted
---------- --------- ----------
Reported........................ $ 16,543 $ 0.83 $ 0.82
Goodwill amortization, net of
applicable taxes.............. 2,042 0.10 0.10
---------- --------- ----------
Adjusted................... $ 18,585 $ 0.93 $ 0.92
========== ========= ==========
Certain amounts of goodwill amortization were not tax deductible in fiscal
year 2002 and, therefore, are not shown net of tax above. Non-deductible
goodwill amortization was $1.4 million in fiscal year 2002.
Deferred Financing Costs. Deferred financing costs are amortized on a
straight-line basis over the lives of related debt facilities, such method
approximates the effective yield method. At May 28, 2004 and May 30, 2003,
deferred financing costs were $18.7 million and $9.4 million, respectively. The
increase in deferred financing costs was due to our debt refinancing in July
2003, see "Note 8. Long-Term Debt." A summary of the changes were as follows, in
thousands:
Balance at May 30, 2003.............................. $ 9,445
Additions............................................ 17,210
Costs written-off in connection with the
refinancing and the repurchase and
redemption of 9.5% senior subordinated notes....... (3,977)
Amortization for fiscal 2004......................... (4,005)
------------
Balance at May 28, 2004........................ $ 18,673
============
Investments. Investments, wherein we do not exert significant influence or
own over 20% of the investee's stock, are accounted for under the cost method.
We measure the fair value of these investments using multiples of comparable
companies and discounted cash flow analyses. During the fourth quarters of
fiscal year 2003 and 2002, we wrote down a minority investment by $6.7 million
and $2.3 million, respectively, due to a reduced valuation on the subject
company and dilution of our minority investment. During the third quarter of
fiscal 2004 we received a dividend payment of $0.7 million from a minority
investment accounted for under the cost method. Dividend income of $0.5 million
was recognized to the extent of our proportionate share of accumulated earnings
since the date of the initial investment. In accordance with APB No. 18, The
Equity Method of Accounting for Investments in Common Stock, the remaining $0.2
million was recorded as a return of investment in the subject company.
Subsequent to May 28, 2004, we sold our interest in a minority investment, which
resulted in a gain of $2.1 million in the first quarter of fiscal year 2005.
Self-Insurance Programs. We are self-insured for certain levels of general
liability, workers' compensation, auto, property and employee medical insurance
coverage. Estimated costs of these self-insurance programs are accrued at the
undiscounted value of projected settlements for known and anticipated claims
incurred. A summary of self-insurance liabilities was as follows, in thousands:
52
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Balance at the beginning of
the fiscal year............... $ 46,181 $ 36,523 $ 32,533
Expense.......................... 43,406 46,753 32,634
Claims paid...................... (35,496) (37,095) (28,644)
------------ ------------ ------------
Balance at the end of the
fiscal year................. 54,091 46,181 36,523
Less current portion of self-
insurance liabilities......... 21,045 23,410 20,800
------------ ------------ ------------
Long-term portion of self-
insurance liabilities......... $ 33,046 $ 22,771 $ 15,723
============ ============ ============
Recently Issued Accounting Pronouncements. FIN 46, Consolidation of
Variable Interest Entities, as amended by FIN 46R, requires consolidation where
there is a controlling financial interest in a variable interest entity,
previously referred to as a special-purpose entity and certain other entities.
The implementation of FIN 46R was effective during the fourth quarter of fiscal
year 2004. There was not an impact on our consolidated financial statements.
SFAS No. 149, Amendments of Statement 133 on Derivative Instruments and
Hedging Activities, amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives) and for hedging
activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities. SFAS No. 149 is effective for contracts entered into or modified and
for hedging relationships designated after June 30, 2003. SFAS No. 149 was
effective in our first quarter of our fiscal year 2004. We have determined that
our interest rate cap agreement purchased in connection with the CMBS Loan, see
"Note 7. Long-Term Debt," is a cash flow hedge, which is a derivative that is
based on future cash flows attributed to a particular risk, such as interest
rate changes on variable rate debt. A mark-to-market adjustment of $0.2 million
was recorded as comprehensive loss in the fourth quarter of fiscal 2004, which
reduced the value of the interest rate cap agreement.
SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, establishes standards for how an
issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. The statement requires that an
issuer classify a financial instrument that is within its scope as a liability,
or an asset in some circumstances. SFAS No. 150 was effective for financial
instruments entered into or modified after May 31, 2003. While SFAS No. 150 did
not have a material impact on our existing financial instruments, it is
reasonably possible that certain equity instruments issued in future periods
will include features that require those instruments, or portions of those
instruments, to be treated as debt in our consolidated financial statements.
Use of Estimates. The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
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 financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates under different conditions or if our assumptions change.
The most significant estimates underlying the accompanying consolidated
financial statements include the timing of revenue recognition, the allowance
for doubtful accounts, long-lived and intangible asset valuations and any
resulting impairment, the valuation of our investments, the adequacy of our
self-insurance obligations and future tax liabilities.
Reclassifications. As a result of the 69 centers closed since fiscal 2002,
we have restated amounts previously reported in our consolidated statements of
operations for fiscal years 2003 and 2002 to reflect the results of discontinued
operations separate from continuing operations. We have also restated each of
the four quarters of 2003 for similar reasons. See "Note 12. Quarterly Results
(Unaudited)." In addition, certain other prior period amounts have been
reclassified to conform to the current year's presentation.
53
3. Receivables
Receivables consisted of the following, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Tuition............................... $ 29,440 $ 32,248
Allowance for doubtful accounts....... (4,303) (4,255)
------------ ------------
25,137 27,993
Other................................. 3,590 3,500
------------ ------------
$ 28,727 $ 31,493
============ ============
4. Property and Equipment
Property and equipment consisted of the following, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Land.................................. $ 161,707 $ 155,855
Buildings and leasehold improvements.. 636,964 582,412
Equipment............................. 196,528 182,337
Construction in progress.............. 13,173 22,708
------------ ------------
1,008,372 943,312
Accumulated depreciation and
amortization........................ (315,391) (282,478)
------------ ------------
$ 692,981 $ 660,834
============ ============
5. Other Assets
Other assets consisted of the following, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Minority investments, cost method..... $ 9,877 $ 10,047
Non-qualified deferred compensation... 4,736 3,279
Notes receivable...................... 1,633 1,423
Restricted cash....................... 1,437 --
Other................................. 3,396 2,485
------------ ------------
$ 21,079 $ 17,234
============ ============
6. Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities consisted of the following, in
thousands:
May 28, 2004 May 30, 2003
------------ ------------
Accrued compensation, benefits and
related taxes....................... $ 37,809 $ 32,655
Current portion of self-insurance
liabilities......................... 21,045 23,410
Deferred revenue...................... 18,653 19,165
Accrued property taxes................ 17,414 9,161
Accrued interest...................... 8,840 8,060
Accrued income taxes.................. 5,296 6,632
Current portion of capital lease
obligations......................... 528 769
Other................................. 14,676 9,819
------------ ------------
$ 124,261 $ 109,671
============ ============
54
7. Long-Term Debt
Long-term debt consisted of the following, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Secured:
Mortgage loan payable in monthly installments
through July 2008, interest rate of 3.35% at
May 28, 2004................................ $ 297,221 $ --
Borrowings under revolving credit facility:
At May 30, 2003 2.57% and ABR of 4.25%......... -- 104,000
Term loan facility, interest rate, of 3.82% at
May 30, 2003................................... -- 47,000
Industrial refunding revenue bonds at variable
rates of interest of 1.35% and 1.70%
respectively, supported by letters of credit,
maturing calendar 2009......................... 8,500 8,500
Industrial revenue bonds secured by real property
with maturities to calendar 2005 at interest
rates of 2.80% to 4.55% and 2.98% to 4.55%,
respectively................................... 3,635 3,739
Real and personal property mortgages payable in
monthly installments through calendar 2005,
interest rates of 7.00%........................ -- 34
Unsecured:
Senior subordinated notes due calendar 2009,
interest at 9.5%, payable semi-annually........ 179,423 290,000
Notes payable in monthly installments through
calendar 2008, interest rate at 8.00%.......... -- 1,807
------------ ------------
488,779 455,080
Less current portion of long-term debt............. 7,169 13,744
------------ ------------
$ 481,610 $ 441,336
============ ============
Refinancing. In July 2003, we refinanced a portion of our debt. We obtained
a $125.0 million revolving credit facility, and, as described below in greater
detail, one of our subsidiaries obtained a $300.0 million mortgage loan.
Proceeds from the mortgage loan were used to pay off the balance on the then
existing revolving credit facility, the term loan facility and the synthetic
lease facility. We also used a portion of the remaining proceeds to purchase
$37.0 million aggregate principal amount of our 9.5% senior subordinated notes.
In accordance with SFAS No. 6, Classification of Short-Term Obligations Expected
to Be Refinanced, an Amendment of ARB No. 43, Chapter 3A, the $104.0 million
balance on our previous revolving credit facility and our annual $0.5 million
installment on our term loan were classified as long-term debt at May 30, 2003,
since they were refinanced on a long-term basis during our first quarter of
fiscal 2004.
Mortgage Loan. The $300.0 million mortgage loan is secured by first
mortgages or deeds of trust on 475 of our owned centers located in 33 states. We
refer to the mortgage loan as the CMBS Loan and the 475 mortgaged centers as the
CMBS Centers. In connection with the CMBS Loan, the CMBS Centers were
transferred to a newly formed wholly owned subsidiary of ours, which is the
borrower under the CMBS Loan and is referred to as the CMBS Borrower. Because
the CMBS Centers are owned by the CMBS Borrower and subject to the CMBS Loan,
recourse to the CMBS Centers by our creditors will be effectively subordinated
to recourse by holders of the CMBS Loan.
The CMBS Loan is nonrecourse to the CMBS Borrower and us, subject to
customary recourse provisions, and has a maturity date of July 9, 2008, which
may be extended to July 9, 2009, subject to certain conditions. The CMBS Loan
bears interest at a per annum rate equal to LIBOR plus 2.25% and requires
monthly payments of principal and interest. Principal payments are based on a
thirty-year amortization (based on an assumed rate of 6.50%). We have purchased
an interest rate cap agreement to protect us from significant changes in LIBOR
during the initial three years of the CMBS Loan. Under the cap agreement, which
terminates July 9, 2006, LIBOR is capped at 6.50%. We are required to purchase
additional interest rate cap agreements capping LIBOR at a rate no higher than
7.00% for the period from July 9, 2006 to the maturity date of the CMBS Loan.
55
Each of the centers included in the CMBS Centers is being ground leased by
the CMBS Borrower to another wholly owned subsidiary formed in connection with
the CMBS Loan, which is referred to as the CMBS Operator, and is being managed
by us pursuant to a management agreement with the CMBS Operator. Transactions
between the CMBS Borrower and the CMBS Operator are eliminated in consolidation
since both the CMBS Borrower and the CMBS Operator are wholly owned
subsidiaries. If the CMBS Loan is accelerated for any reason, the terms of such
loan will prevent us from allowing our centers that are not mortgaged under the
CMBS Loan to compete with CMBS Centers for a period of time after such
acceleration, as specified in the CMBS Loan agreement.
Prepayment of the CMBS Loan is prohibited through July 8, 2005, after which
prepayment is permitted in whole, subject to a prepayment premium of 3.0% from
July 8, 2005 through July 8, 2006, 2.0% from July 9, 2006 through July 8, 2007
and 1.0% from July 9, 2007 through January 8, 2008, with no prepayment penalty
thereafter. In addition, after July 8, 2005, the loan may be partially prepaid
as follows:
o up to $15.0 million each loan year in connection with releases of
mortgaged centers with no prepayment premium, and
o up to $5.0 million each loan year subject to payment of the applicable
prepayment premium.
The CMBS Loan contains a provision that requires the loan servicer to
escrow 50% of excess cash flow generated from the CMBS Centers (determined after
payment of debt service on the CMBS Loan, certain fees and required reserve
amounts) if the net operating income, as defined in the CMBS Loan agreement, of
the CMBS Centers declines to $60.0 million, as adjusted to account for released
properties. The amount of excess cash flow to be escrowed increases to 100% if
the net operating income of the CMBS Centers, declines to $50.0 million, as
adjusted. The net operating income of the CMBS Centers for the trailing 52 weeks
ended May 28, 2004 was approximately $79.3 million. The maximum amount of excess
cash flow that can be escrowed is limited to one year of debt service on the
CMBS Loan and one year of rent due under the ground lease with the CMBS Operator
during the term of the CMBS Loan. The escrowed amounts are released if the CMBS
Centers generate the necessary minimum net operating income for two consecutive
fiscal quarters. The annual debt service on the CMBS Loan is approximately $22.8
million (assuming a 6.50% interest rate). The annual rent under the ground lease
is $34.0 million for the term of the CMBS Loan. These excess cash flow
provisions could limit the amount of cash made available to us. Our restricted
cash balance in connection with the CMBS Loan was $1.4 million at May 28, 2004.
The restricted cash balance will fluctuate periodically due primarily to the
timing of debt service payments compared to our period end date.
Revolving Credit Facility. Our $125.0 million revolving credit facility is
secured by first mortgages or deeds of trusts on 119 of our owned centers and
certain other collateral and has a maturity date of July 9, 2008. The revolving
credit facility includes borrowing capacity of up to $75.0 million for letters
of credit and up to $10.0 million for selected short-term borrowings. At May 28,
2004, there were no borrowings outstanding under our credit facility.
The credit facility bears interest, at our option, at either of the
following rates, which are adjusted in quarterly increments based on our ratio
of total consolidated debt to total consolidated EBITDA (EBITDA is defined in
the credit facility as net income before interest expense, income taxes,
depreciation, amortization, non-recurring charges, non-cash charges, gains and
losses on asset sales, restructuring charges or reserves and non-cash gains):
56
o An adjusted LIBOR rate plus 2.00% to 3.25%. There were no borrowings
outstanding at this rate at May 28, 2004. o
o An alternative base rate (ABR) plus 0.75% to 2.00%. At May 28, 2004,
this rate would have been ABR plus 2.00%, or an all-in rate of 6.00%.
There were no borrowings outstanding at this rate at May 28, 2004.
The credit facility contains customary covenants and provisions that
restrict our ability to:
o make certain fundamental changes to our business,
o consummate asset sales,
o declare dividends,
o grant liens,
o incur additional indebtedness, amend the terms of or repay certain
indebtedness, and
o make capital expenditures.
In addition, the credit facility requires us to meet or exceed certain
leverage and interest and lease expense coverage ratios. We were in compliance
with our covenants at May 28, 2004. Our most restrictive covenant is the
limitation on dividend payments. We are currently prohibited from paying
dividends, as our consolidated debt to consolidated EBITDA ratio, as defined in
the credit agreement, is greater than 3.0 to 1.0 at 4.1 to 1.0.
Under the credit facility, we are required to pay a commitment fee at a
rate ranging from 0.40% to 0.50% on the available commitment. The fee is payable
quarterly in arrears. In addition, we are required to pay a letter of credit fee
at a rate ranging from 2.00% to 3.25%, minus 0.125%, plus a fronting fee of
0.125%, in each case on the average daily stated amount of each letter of
credit. These fees are also payable quarterly in arrears. At May 28, 2004 the
rates for our commitment and letter of credit fees were 0.50% and 3.125%,
respectively.
Series B Industrial Revenue Bonds. We are obligated to various issuers of
industrial revenue bonds, which is referred to as a refunded IRB. Such bonds
mature in calendar 2009. The refunded IRBs were issued to provide funds for
refunding an equal principal amount of industrial revenue bonds that were used
to finance the cost of acquiring, constructing and equipping specific centers.
At May 28, 2004, the refunded IRB bore interest at a variable rate of 1.35%, and
was secured by a letter of credit under the revolving credit facility.
Other Industrial Revenue Bonds. We are also obligated to various issuers of
other industrial revenue bonds that mature to calendar 2005. The principal
amount of such IRBs was used to finance the cost of acquiring, constructing and
equipping specific child care centers. The IRBs are secured by these centers. At
May 28, 2004, the IRBs bore interest at rates of 2.80% to 4.55%.
Senior Subordinated Notes. In fiscal 1997, we issued $300.0 million
aggregate principal amount of 9.5% unsecured senior subordinated notes under an
indenture between Marine Midland Bank, as trustee, and us. During fiscal 2000 we
acquired $10.0 million aggregate principal amount of our 9.5% senior
subordinated debt at an aggregate price of $9.6 million. This transaction
resulted in a write-off of deferred financing costs of $0.3 million and a gain
of approximately $0.1 million.
57
During fiscal year 2004, we repurchased and redeemed our 9.5% senior
subordinated notes as follows, in thousands:
Write-off of
Aggregate Premium Deferred
Principal Price Costs Financing Costs Total Loss
--------- --------- --------- --------------- ----------
Notes repurchased......... $ 55,577 $ 58,689 $ 914 $ 935 $ 1,849
Notes redeemed............ 55,000 56,076 871 1,034 1,905
--------- --------- --------- --------------- ----------
Total................... $ 110,577 $ 114,765 $ 1,785 $ 1,969 $ 3,754
========= ========= ========= =============== ==========
We used $37.0 million of proceeds from our debt refinancing and $73.6
million from sale-leaseback proceeds and cash flow from operations to fund the
repurchase and redemption transactions.
The 9.5% notes are due February 15, 2009 and are general unsecured
obligations, ranked behind all existing and future indebtedness that is not
expressly ranked behind, or made equal with, the notes. The 9.5% notes bear
interest at a rate of 9.5% per year, payable semi-annually on February 15 and
August 15 of each year. The 9.5% notes may be redeemed at any time, in whole or
in part, on or after February 15, 2002 at a redemption price equal to 104.75% of
the principal amount of the notes in the first year and declining yearly to par
at February 15, 2005, plus accrued and unpaid interest, if any, to the date of
redemption.
Upon the occurrence of a change of control, we will be required to make an
offer to repurchase all notes properly tendered at a price equal to 101% of the
principal amount plus accrued and unpaid interest to the date of repurchase.
The indenture governing the notes contains covenants that limit our ability
to:
o incur additional indebtedness or liens,
o incur or repay other indebtedness,
o pay dividends or make other distributions,
o repurchase equity interests,
o consummate asset sales,
o enter into transactions with affiliates,
o merge or consolidate with any other person or sell, assign, transfer,
lease, convey or otherwise dispose of all or substantially all of our
assets, and
o enter into guarantees of indebtedness.
Principal Payments. At May 28, 2004, the aggregate minimum annual
maturities of long-term debt for the five fiscal years subsequent to May 28,
2004 were as follows, in thousands:
Fiscal Year:
2005........................................ $ 7,169
2006........................................ 3,802
2007........................................ 4,051
2008........................................ 4,322
2009........................................ 13,122
Thereafter.................................. 456,313
----------
$ 488,779
==========
58
8. Income Taxes
The provision for income taxes attributable to income before income taxes
and cumulative effect of a change in accounting principle consisted of the
following, in thousands:
Fiscal Year Ended
-------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Current:
Federal................ $ 21,020 $ 14,683 $ 3,042
State.................. 5,704 4,975 1,388
Foreign................ 26 105 (60)
------------ ------------ ------------
26,750 19,763 4,370
Deferred:
Federal................ (15,587) (8,003) 5,868
State.................. (2,032) (1,048) 753
Foreign................ 1,084 (1,917) (190)
------------ ------------ ------------
(16,535) (10,968) 6,431
------------ ------------ ------------
Income tax expense, net
of discontinued
operations............ 10,215 8,795 10,801
Income tax benefit
related to
discontinued
operations............ 952 1,333 496
------------ ------------ ------------
Income tax expense....... $ 11,167 $ 10,128 $ 11,297
============ ============ ============
A reconciliation between the statutory federal income tax rate and the
effective income tax rates on income before income taxes and cumulative effect
of a change in accounting principle was as follows, in thousands:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Expected tax provision at the federal
rate of 35%.......................... $ 8,720 $ 7,781 $ 9,565
State income taxes, net of federal tax
benefit.............................. 1,204 1,080 1,330
Goodwill and other non-deductible
expenses............................. 551 401 678
Tax credits, net of valuation
adjustment............................ (328) (780) (780)
Other, net.............................. 68 313 8
------------ ------------ ------------
$ 10,215 $ 8,795 $ 10,801
=========== ============ ============
59
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities were summarized
as follows, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Deferred tax assets:
Deferred gains and deferred revenue.......... $ 25,261 $ 14,618
Self-insurance reserves...................... 19,076 14,118
Compensation payments........................ 5,766 5,132
Tax credits.................................. -- 3,317
Net operating loss carryforwards............. 2,408 2,282
Property and equipment, basis differences.... 3,780 1,118
Other........................................ 7,635 7,663
------------ ------------
Total gross deferred tax assets............ 63,926 48,248
Less valuation allowance................. (2,408) (5,336)
------------ ------------
Net deferred tax assets.................... 61,518 42,912
------------ ------------
Deferred tax liabilities:
Property and equipment, basis differences.... (25,617) (20,031)
Property and equipment, basis differences of
foreign subsidiaries....................... (4,449) (5,059)
Stock basis of foreign subsidiary............ -- (3,621)
Goodwill..................................... (2,142) (1,500)
Other........................................ (103) (29)
------------ ------------
Total gross deferred tax liabilities....... (32,311) (30,240)
------------ ------------
Financial statement net deferred tax assets $ 29,207 $ 12,672
============ ============
The valuation allowance decreased by $2.9 million due to the utilization of
net operating loss carryforwards, for which utilization had previously been
uncertain, and due to the sale or our subsidiaries in the United Kingdom.
Deferred tax assets, net of valuation allowances, have been recognized to the
extent that their realization is more likely than not. However, the amount of
the deferred tax assets considered realizable could be adjusted in the future as
estimates of taxable income or the timing thereof are revised. If we are unable
to generate sufficient taxable income in the future through operating results,
increases in the valuation allowance may be required through an increase to tax
expense in future periods. Conversely, if we recognize taxable income of a
suitable nature and in the appropriate periods, the valuation allowance will be
reduced through a decrease in tax expense in future periods.
At May 28, 2004, we had $2.1 million of net operating losses available for
carryforward that expire over various dates through fiscal year 2010.
Utilization of the net operating losses is subject to an annual limitation. In
addition, we have $9.5 million of contingency accruals available for reversal in
future periods. These contingency accruals are the result of fresh-start
reporting related to our emergence from bankruptcy in March 1993. Such
contingency accruals represent reserves equal to the tax benefit of
pre-bankruptcy income tax net operating loss carryforwards. The tax benefit was
reserved due to uncertainty associated with the their future realization. As
realization of these benefits becomes more likely than not, the reserve is
reversed from other liabilities and credited to additional paid-in capital.
These reserve reversals would be included in comprehensive income.
9. Benefit Plans
Stock Purchase and Option Plans. During fiscal year 1997, the Board of
Directors adopted and, during fiscal year 1998, the stockholders approved the
1997 Stock Purchase and Option Plan for Key Employees of KinderCare Learning
Centers, Inc. and Subsidiaries, referred to as the 1997 Plan. The 1997 Plan
authorizes grants of stock or stock options covering 5,000,000 shares of our
common stock. Grants or awards under the 1997 Plan may take the form of
purchased stock, restricted stock, incentive or nonqualified stock options or
other types of rights specified in the 1997 Plan.
60
During fiscal year 2003, the Board of Directors adopted the 2002 Stock
Purchase and Option Plan for Key California Employees of KinderCare Learning
Centers, Inc. and Subsidiaries, referred to as the California Stock Plan. The
California Stock Plan authorizes 100,000 shares of our common stock as available
for grants. The California Stock Plan is substantially similar to the 1997 plan,
except for modifications required by California law.
During fiscal years 2003 and 2002, there were no shares of restricted
common stock purchased under the terms of the 1997 Plan. During fiscal year
2004, 73,588 shares were purchased. All of the officers, with the exception of
the CEO, have executed term notes in order to purchase restricted stock. The
term notes mature from calendar 2005 to 2014 and bear interest at rates ranging
from 2.69% to 4.88% per annum, payable semi-annually on June 30 and December 31.
At May 28, 2004, the term notes totaled $1.9 million and are reflected as a
component of stockholders' equity.
Grants or awards under the 1997 Plan and the California Plan are made at
fair market value as determined by the Board of Directors. Options granted
during fiscal years 2004, 2003 and 2002 have exercise prices ranging from $13.53
to $15.44 per share. At May 28, 2004, options outstanding had exercise prices
ranging from $9.50 to $15.44. A summary of outstanding options for the 1997 Plan
and the California Plan was as follows:
Weighted
Number Average
of Exercise
Shares Price
------------ ------------
Outstanding at June 1, 2001..... 1,772,378 $ 10.12
Granted............................ 125,000 13.66
Canceled........................... (35,000) 12.14
------------ ------------
Outstanding at May 31, 2002..... 1,862,378 10.32
Granted............................ 583,000 14.52
Canceled........................... (151,742) 11.77
------------ ------------
Outstanding at May 30, 2003.... 2,293,636 11.29
Granted............................ 583,470 14.99
Cancelled.......................... (94,894) 11.75
------------ ------------
Outstanding at May 28, 2004... 2,782,212 $ 12.06
============ ============
The stock options granted were non-qualified options that vest 20% per year
over a five-year period. Options outstanding at May 28, 2004, May 30, 2003 and
May 31, 2002 had the following characteristics:
May 28, 2004 May 30, 2003 May 31, 2002
------------------------- ------------------------- -------------------------
California California California
1997 Plan Plan 1997 Plan Plan 1997 Plan Plan
----------- ----------- ----------- ----------- ----------- -----------
Exercisable options................ 1,657,701 2,400 1,460,860 1,000 1,410,464 N/A
Weighted average exercise price.... $ 10.39 $ 13.76 $ 9.89 $ 13.61 $ 9.75 N/A
Remaining average contractual life,
in years......................... 5.7 7.4 5.8 8.4 5.8 N/A
61
Additional information regarding options outstanding at May 28, 2004 was as
follows:
Options Outstanding Options Exercisable
----------------------------- -----------------------------
Weighted
Average Weighted Weighted
Outstanding Remaining Average Exercisable Average
Range of at May 28, Contractual Exercise at May 28, Exercise
Exercise Prices 2004 Life in Years Price 2004 Price
- ---------------- -------------- ------------- ------------- ------------- -------------
$ 9.50 to $ 9.97 1,218,832 2.8 $ 9.51 1,218,832 $ 9.51
$10.17 to $11.92 185,850 5.6 11.42 150,680 11.41
$12.21 to $13.61 257,060 6.6 12.75 148,236 12.61
$14.15 to $14.99 725,052 8.3 14.59 133,769 14.55
$15.06 to $15.44 395,418 9.2 15.09 8,584 15.16
-------------- ------------- ------------- ------------- -------------
2,782,212 5.7 $ 12.06 1,660,101 $ 10.40
============== ============= ============= ============= =============
There were 1,664,356 shares and 93,000 shares available for issuance under
the 1997 Plan and the California Plan at May 28, 2004, respectively.
We have adopted the disclosure only provisions of SFAS No. 123.
Accordingly, no compensation cost has been recognized for stock options granted
with an exercise price equal to or less than the fair value of the underlying
stock on the date of grant. Please see "Note 2. Summary of Significant
Accounting Policies, Stock-Based Compensation" for our pro forma disclosures of
net income and earnings per share had compensation cost been recognized for our
stock options.
Savings and Investment Plan. The Board of Directors adopted the KinderCare
Learning Centers, Inc. Savings and Investment Plan, referred to as the Savings
Plan, effective January 1, 1990 and approved the restatement of the Savings Plan
effective July 1, 1998. Effective June 10, 2003, the Board approved the adoption
of a new plan document. All employees, other than highly compensated employees,
over the age of 21 are eligible to participate in the Savings Plan on entry
dates of April 1 and October 1, whichever most closely follows the employee's
date of hire. Participants may contribute, in increments of 1%, up to 100% of
their pay or dollar amount fixed by law. We match participants' contributions up
to 1% of pay for some employees and up to 4% of pay for others. During fiscal
years 2004, 2003 and 2002, we contributed $0.4 million, $0.4 million and $0.3
million, respectively, in matching to the Savings Plan.
Nonqualified Deferred Compensation Plan. The Board of Directors adopted the
KinderCare Learning Centers, Inc. Nonqualified Deferred Compensation Plan,
effective August 1, 1996 and approved a restatement of the plan effective
January 1, 1999. Under the Nonqualified Deferred Compensation Plan, certain
highly compensated or key management employees are provided the opportunity to
defer receipt and income taxation of such employees' compensation. We have
matched participants' contributions up to 1% of compensation on a discretionary
basis. During each of fiscal years 2004, 2003 and 2002 we contributed $0.1
million to the Nonqualified Deferred Compensation Plan.
Directors' Deferred Compensation Plan. On May 27, 1998, the Board of
Directors adopted the KinderCare Learning Centers, Inc. Directors' Deferred
Compensation Plan. Under this plan, non-employee members of the Board of
Directors may elect to defer receipt and income taxation of all or a portion of
their annual retainer. Any amounts deferred under the Directors' Deferred
Compensation Plan are credited to a phantom stock account. The number of shares
of phantom stock credited to the director's account will be determined based on
the amount of deferred compensation divided by the then fair value per share, as
defined in the Directors' Deferred Compensation Plan, of our common stock.
62
Distributions from the Directors' Deferred Compensation Plan are made in
cash and reflect the value per share of the common stock at the time of
distribution multiplied by the number of phantom shares credited to the
director's account. Distributions from the Directors' Deferred Compensation Plan
occur upon the earlier of (1) the first day of the year following the director's
retirement or separation from the Board or (2) termination of the Directors'
Deferred Compensation Plan.
10. Disclosures About Fair Value of Financial Instruments
Fair value estimates, methods and assumptions are set forth below for our
financial instruments at May 28, 2004 and May 30, 2003.
Cash and cash equivalents, receivables, investments and current
liabilities. Fair value approximates the carrying value of cash and cash
equivalents, receivables and current liabilities as reflected in the
consolidated balance sheets at May 28, 2004 and May 30, 2003 because of the
short-term maturity of these instruments. Our minority investments, accounted
for under the cost method, are recorded at cost or net realizable value, which
approximate fair value.
Long-term debt. The estimated fair value of our 9.5% senior subordinated
notes was $182.1 million and $293.1 million at May 28, 2004 and May 30, 2003,
respectively. The carrying values for our remaining long-term debt of $309.4 and
$165.1 million at May 28, 2004 and May 30, 2003, respectively, approximated
market value based on current rates.
11. Commitments and Contingencies
We conduct a portion of our operations from leased or subleased day care
centers. At May 28, 2004, we leased 508 operating centers under various lease
agreements that average twenty year terms. Most leases contain standard renewal
clauses. A majority of the leases contain standard covenants and restrictions,
all of which we were substantially in compliance with at May 28, 2004. A
majority of the leases are classified as operating leases for financial
reporting purposes. We have 15 center leases that were classified as capital
leases, as well as certain equipment capital leases.
During the fourth quarter of fiscal year 2002, we began selling centers to
individual real estate investors and then leasing them back. The resulting
leases have been classified as operating leases. We will continue to manage the
operations of any centers that are sold in such transactions. The sales are
summarized as follows, with dollars in thousands:
Fiscal Year Ended
------------------------------------------
May 28, 2004 May 30, 2003 May 31, 2002
------------ ------------ ------------
Number of centers................. 41 41 5
Net proceeds from completed
sales........................... $ 89,034 $ 89,558 $ 9,259
Deferred gains.................... 28,348 32,507 2,599
The deferred gains are amortized on a straight-line basis typically over a
period of 15 years.
Each vehicle in our fleet is leased pursuant to the terms of a 12-month
non-cancelable master lease which may be renewed on a month-to-month basis after
the initial 12-month lease period. Payments under the vehicle leases vary with
the number, type, model and age of the vehicles leased. The vehicle leases
require that we guarantee specified residual values upon cancellation. At May
28, 2004, our residual guarantee was $8.3 million. In most cases, we expect that
substantially all of the leases will be renewed or replaced by other leases as
part of the normal course of business. All such leases are classified as
operating leases. Expenses incurred in connection with the fleet vehicle leases
were $8.8 million, $9.2 million and $9.8 million for fiscal 2004, 2003 and 2002,
respectively.
63
Following is a schedule of future minimum lease payments under capital and
operating leases, that have initial or remaining non-cancelable lease terms in
excess of one year at May 28, 2004, in thousands:
Capitalized Operating
Leases Leases
----------- ---------
Fiscal Year:
2005.................................. $ 2,258 $ 51,071
2006.................................. 2,279 47,787
2007.................................. 2,396 43,861
2008.................................. 2,415 40,295
2009.................................. 2,481 36,121
Subsequent years...................... 15,740 268,045
----------- ---------
27,569 487,180
=========
Less amounts representing interest.... 12,404
-----------
Present value of minimum
capitalized lease payments at
May 28, 2004................... $ 15,165
===========
In July 2003 we completed a refinancing of a portion of our debt, which
included terminating the $97.9 million synthetic lease facility. See "Note 7.
Long-Term Debt."
The present value of the future minimum lease payments for leases
classified as capital leases were as follows, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Present value of minimum capitalized lease
payments................................... $ 15,165 $ 15,896
Less current portion of capitalized lease
obligations................................ 528 769
------------ ------------
Long-term capitalized lease obligations.. $ 14,637 $ 15,127
============ ============
The net book value of property and equipment recorded under capital leases
was as follows, in thousands:
May 28, 2004 May 30, 2003
------------ ------------
Buildings under capital leases................ $ 16,595 $ 16,595
Equipment under capital leases................ 4,945 5,203
------------ ------------
21,540 21,798
Accumulated depreciation...................... (10,425) (8,801)
------------ ------------
Net book value of property and equipment
under capital leases................... $ 11,115 $ 12,997
============ ============
In fiscal year 2000, we entered into a $100.0 million synthetic lease
facility under which a syndicate of lenders financed the construction of new
centers for lease to us for a three to five year period. A total of 44 centers
were constructed for $97.9 million. As noted above, the synthetic lease facility
was terminated in July 2003 as part of our refinancing. The 44 centers are now
owned by us and the assets will be reflected in our fiscal year 2004
consolidated financial statements.
64
We are presently, and are from time to time, subject to claims and
litigation arising in the ordinary course of business. We believe that none of
the claims or litigation of which we are aware will materially affect our
financial position, operating results or cash flows, although assurance cannot
be given with respect to the ultimate outcome of any such actions.
12. Quarterly Results (Unaudited)
A summary of results of operations for fiscal 2004 and fiscal 2003 was as
follows, in thousands, except per share data. The first quarter of each fiscal
year included 16 weeks and the second, third and fourth quarters each included
12 weeks. The quarterly results for the first three quarters of fiscal 2004 and
each of the four quarters of fiscal 2003 were restated to exclude the operating
results of 69 centers closed since fiscal 2002. The operating results for these
centers were classified as discontinued operations.
First Second Third Fourth
Quarter Quarter Quarter Quarter (a)
------------ ------------ ------------ ------------
Fiscal Year ended May 28, 2004
Revenues, net................... $ 257,624 $ 194,878 $ 193,469 $ 209,962
Operating income................ 12,500 18,260 19,604 21,626
Net income (loss)............... (3,013) 4,338 5,065 8,310
Net income (loss) per share:
Basic net income (loss) per
share....................... $ (0.15) $ 0.22 $ 0.26 $ 0.42
Diluted net income (loss) per
share....................... (0.15) 0.22 0.26 0.42
Fiscal Year ended May 30, 2003
Revenues, net................... $ 250,202 $ 192,624 $ 189,300 $ 202,529
Operating income................ 14,283 16,158 19,338 23,107
Net income...................... 457 4,300 5,298 3,360
Net income per share:
Basic net income per share..... $ 0.02 $ 0.22 $ 0.27 $ 0.17
Diluted net income per share... 0.02 0.22 0.27 0.17
(a) Net income during the fourth quarter of fiscal 2003 included a loss on
minority investment of $4.0 million, net of taxes.
65
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
KinderCare Learning Centers, Inc.
We have audited the accompanying consolidated balance sheets of KinderCare
Learning Centers, Inc. and subsidiaries as of May 28, 2004 and May 30, 2003,
and the related consolidated statements of operations, stockholders' equity and
comprehensive income, and cash flows for each of the years ended May 28, 2004,
May 30, 2003 and May 31, 2002. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of KinderCare Learning Centers, Inc.
and subsidiaries as of May 28, 2004 and May 30, 2003, and the results of their
operations and their cash flows for each of the years ended May 28, 2004, May
30, 2003 and May 31, 2002, in conformity with accounting principles generally
accepted in the United States of America.
The Company adopted Statement of Financial Accounting Standards ("SFAS") No.
142, Goodwill and Other Intangible Assets, and SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, effective June 1, 2002.
DELOITTE & TOUCHE LLP
Portland, Oregon
August 11, 2004
66
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. DISCLOSURE CONTROLS AND PROCEDURES
Disclosure Controls and Procedures. Our management has evaluated, under the
supervision and with the participation of our Chief Executive Officer ("CEO")
and Chief Financial Officer ("CFO"), the effectiveness of our disclosure
controls and procedures at the end of the period covered by this report,
pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the
"Exchange Act"). Based on that evaluation, our CEO and CFO have concluded that,
at the end of the period covered by this report, our disclosure controls and
procedures were effective in ensuring that information required to be disclosed
in our Exchange Act reports was:
o recorded, processed, summarized and reported in a timely manner, and
o accumulated and communicated to our management, including our CEO and
CFO, as appropriate to allow timely decisions regarding required
disclosure.
Internal Control Over Financial Reporting. There has been no change in our
internal controls over financial reporting that occurred during our fiscal year
ended May 28, 2004 that has materially affected, or is reasonably likely to
materially affect, our internal controls over financial reporting.
67
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
In 1999 we adopted a Code of Business Conduct, referred to as the Code,
designed to assure the ethical conduct of our officers and employees. We
recently adopted minor amendments to our Code to conform to Securities and
Exchange Commission ("SEC") requirements. Our Code applies to our officers and
employees companywide, including our senior financial officers. There have been
no waivers of our Code granted to our principal executive officer, principal
financial officer, principal accounting officer or controller, or similar
persons. A copy of our Code is filed as exhibit 14(a) to this report.
Information regarding directors appearing under the caption "Election of
Directors" and "Board of Directors Meetings, Committees and Compensation" in our
Proxy Statement for the 2004 Annual Meeting of Shareholders is hereby
incorporated by reference.
Information regarding executive officers is included in Part I of this
report, see "Item 4(a), Executive Officers of the Registrant."
Information required by Item 405 of Regulation S-K appearing under the
caption "Section 16(a) Beneficial Ownership Reporting Compliance" in our 2004
Proxy Statement is hereby incorporated by reference.
ITEM 11. EXECUTIVE COMPENSATION
Information appearing under the captions "Board of Directors Meetings,
Committees and Compensation" and under "Executive Compensation" in our 2004
Proxy Statement is hereby incorporated by reference. See "Item 5. Market for the
Registrant's Common Equity and Related Stockholder Matters," for information
concerning our equity compensation plans.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information appearing under the captions "Security Ownership of Certain
Beneficial Owners and Management" and "Equity Compensation Plans" in our 2004
Proxy Statement is hereby incorporated by reference. See "Item 5. Market for the
Registrant's Common Equity and Related Stockholder Matters," for information
concerning our equity compensation plans.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information appearing under the caption "Certain Relationships and Related
Transactions," in our 2004 Proxy Statement is hereby incorporated by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Deloitte & Touche LLP, an independent registerd public accounting firm,
audited our financial statements for the fiscal years ended May 28, 2004 and May
30, 2003. The chart below sets forth the total amount billed to us by Deloitte &
Touche for services performed in fiscal years 2004 and 2003 and breaks down
these amounts by the category of service:
68
May 28, 2004 May 30, 2003
------------- -------------
Audit fees..................................... $ 1,076,090 $ 320,920
Audit-related fees............................. 60,610 84,750
Tax fees....................................... 410,378 71,640
All other fees................................. 26,273 266,375
------------- -------------
Total..................................... $ 1,573,351 $ 743,685
============= =============
Audit fees are fees billed for the audit of our fiscal year 2004 and 2003
annual financial statements and review of our quarterly financial statements. In
fiscal year 2004, audit fees also included services rendered in connection with
the pending IDS Transactions.
For fiscal year 2004, audit-related fees included employee benefit plan
audits and Sarbanes-Oxley Section 404 advisory services. For fiscal year 2003,
audit related fees were primarily for employee benefit plan audits and
consultation concerning financial accounting and reporting standards.
Tax fees in fiscal years 2004 and 2003 related to services for tax
compliance and tax planning and advice.
Other fees paid in fiscal years 2004 and 2003 consisted of permitted
non-audit services, which in fiscal years 2004 and 2003 consisted primarily of
consulting services for real estate projects.
The audit committee approves all audit, audit-related services, tax
services and other services provided by Deloitte & Touche LLP. Any services
provided by Deloitte & Touche LLP that are not specifically included within the
scope of the audit must be pre-approved by the audit committee in advance of any
engagement. The audit committee has determined that the services Deloitte &
Touche LLP provided do not impair its independence from us.
69
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The following is an index of the financial statements, schedules and
exhibits included in this report or incorporated herein by reference:
(a)(1) Financial Statements:
Page
Consolidated balance sheets at May 28, 2004 and May 30, 2003.... 43
Consolidated statements of operations for the fiscal years
ended May 28, 2004, May 30, 2003 and May 31, 2002............. 44
Consolidated statements of stockholders' equity and
comprehensive income for the fiscal years ended
May 28, 2004, May 30, 2003 and May 31, 2002................... 45
Consolidated statements of cash flows for the fiscal year ended
May 28, 2004, May 30, 2003 and May 31, 2002................... 46
Notes to consolidated financial statements......................47-65
Report of independent registered public accounting firm......... 66
(a)(2) Schedules to Financial Statements: None.
(a)(3) Exhibits: The following exhibits are filed with this report or
incorporated herein by reference:
Exhibit Description of
Number Exhibits
- -------- -----------------------
2(a) Stockholders' Agreement between KinderCare and the stockholders
parties thereto (incorporated by reference from Exhibit 2.3 of our
Registration Statement on Form S-4, filed March 11, 1997, File No.
333-23127).
3(a) Amended and Restated Certificate of Incorporation of KinderCare
(incorporated by reference from Exhibit 3(a) to our Annual Report on
Form 10-K for the fiscal year ended May 30, 2003).
3(b) Restated Bylaws of KinderCare effective September 1, 2001
(incorporated by reference from Exhibit 3(a) to our Quarterly Report
on Form 10-Q for the quarterly period ended September 21, 2001).
4(a) Indenture dated February 13, 1997 between KinderCare and Marine
Midland Bank, as Trustee (incorporated by reference from Exhibit 4.1
of our Registration Statement on Form S-4, filed March 11, 1997,
File No. 333-23127).
4(b) First Supplemental Indenture dated September 1, 1999 to the
Indenture dated as of February 13, 1997 between KinderCare and HSBC
Bank USA (formerly known as Marine Midland Bank), as Trustee
(incorporated by reference from Exhibit 4(a) to our Quarterly Report
on Form 10-Q for the quarterly period ended September 17, 1999).
4(c) Form of 9.5% Series B Senior Subordinated Note due 2009
(incorporated by reference from Exhibit 4.3 of our Registration
Statement on Form S-4, filed March 11, 1997, File No. 333-23127).
10(a) Revolving Credit Agreement dated July 1, 2003 among KinderCare, the
several lenders from time to time parties thereto (referred to as
Lenders), and Citicorp North America, Inc. as Administrative Agent
for the lenders (incorporated by reference from Exhibit 10(a) of our
Annual Report on Form 10-K for the fiscal year ended May 30, 2003).
10(b) Guarantee dated July 1, 2003 among certain subsidiaries of
KinderCare and Citicorp North America, Inc. (incorporated by
reference from Exhibit 10(b) of our Annual Report on Form 10-K for
the fiscal year ended May 30, 2003).
10(c) Pledge Agreement dated July 1, 2003 among KinderCare, certain
subsidiaries of KinderCare and Citicorp North America, Inc.
(incorporated by reference from Exhibit 10(c) of our Annual Report
on Form 10-K for the fiscal year ended May 30, 2003).
10(d) Security Agreement dated July 1, 2003 among KinderCare, certain
subsidiaries of KinderCare and Citicorp North America, Inc.
(incorporated by reference from Exhibit 10(d) of our Annual Report
on Form 10-K for the fiscal year ended May 30, 2003).
10(e) Form of Mortgage, Assignment of Leases and Rents, Security Agreement
and Financing Statement dated July 1, 2003 from KinderCare and
certain subsidiaries of KinderCare to Citicorp North America, Inc.
(incorporated by reference from Exhibit 10(e) of our Annual Report
on Form 10-K for the fiscal year ended May 30, 2003).
10(f) Registration Rights Agreement dated February 13, 1997 among KCLC
Acquisition, KLC Associates L.P. and KKR Partners II, L.P.
(incorporated by reference from Exhibit 10.2 of our Registration
Statement on Form S-4, filed March 11, 1997, File No. 333-23127).
10(g) Lease between 600 Holladay Limited Partnership and KinderCare dated
June 2, 1997 (incorporated by reference from Exhibit 10(f) of our
Annual Report on Form 10-K for the fiscal year ended May 30, 1997).
10(h) Addendum dated June 28, 2000 to Lease dated June 2, 1997 between 600
Holladay Limited Partnership and KinderCare (incorporated by
reference from Exhibit 10(a) to our Quarterly Report on Form 10-Q
for the quarterly period ended September 22, 2000).
10(i)* 1997 Stock Purchase and Option Plan for Key Employees of KinderCare
Learning Centers, Inc. and Subsidiaries (incorporated by reference
from Exhibit 10(c) to our Quarterly Report on Form 10-Q for the
quarterly period ended September 19, 1997).
70
Exhibit Description of
Number Exhibits
- -------- -----------------------
10(j)* 2002 Stock Purchase and Option Plan for Key California Employees
(incorporated by reference from Exhibit 10(j) of our Annual Report
on Form 10-K for the fiscal year ended May 30, 2003).
10(k)* Form of Restated Management Stockholder's Agreement (incorporated by
reference from Exhibit 10(f) to our Annual Report on Form 10-K for
the fiscal year ended June 1, 2001).
10(l)* Form of Non-Qualified Stock Option Agreement (incorporated by
reference from Exhibit 10(g) to our Annual Report on Form 10-K for
the fiscal year ended June 1, 2001).
10(m)* Form of Restated Sale Participation Agreement (incorporated by
reference from Exhibit 10(h) to our Annual Report on Form 10-K for
the fiscal year ended June 1, 2001).
10(n)* Form of Term Note (incorporated by reference from Exhibit 10(n) of
our Annual Report on Form 10-K for the fiscal year ended May 30,
2003).
10(o)* Form of Pledge Agreement (incorporated by reference from Exhibit
10(h) to our Quarterly Report on Form 10-Q for the quarterly period
ended September 19, 1997).
10(p)* Stockholders' Agreement dated as of February 14, 1997 between
KinderCare and David J. Johnson (incorporated by reference from
Exhibit 10(l) to our Quarterly Report on Form 10-Q for the quarterly
period ended September 19, 1997).
10(q)* Nonqualified Stock Option Agreement dated February 14, 1997 between
KinderCare and David J. Johnson (incorporated by reference from
Exhibit 10(j) to our Quarterly Report on Form 10-Q for the quarterly
period ended September 19, 1997).
10(r)* Sale Participation Agreement dated February 14, 1997 among KKR
Partners II, L.P., KLC Associates, L.P. and David J. Johnson
(incorporated by reference from Exhibit 10(k) to our Quarterly
Report on Form 10-Q for the quarterly period ended September 19,
1997).
10(s)* Directors' Deferred Compensation Plan (incorporated by reference
from Exhibit 10(q) to our Annual Report on Form 10-K for the fiscal
year ended May 29, 1998).
10(t) Form of Indemnification Agreement for Directors and Officers of
KinderCare (incorporated by reference from Exhibit 10(r) to our
Annual Report on Form 10-K for the fiscal year ended May 29, 1998).
10(u)* Restated Nonqualified Deferred Compensation Plan effective January
1, 1999 (incorporated by reference from Exhibit 10(a) to our
Quarterly Report on Form 10-Q for the quarterly period ended March
5, 1999).
10(v)* Amendment No. 1 to Nonqualified Deferred Compensation Plan
(incorporated by reference from Exhibit 4.4 of our Registration
Statement on For S-8, filed February 21, 2003, File No. 333-103383).
10(w)* Amendment No. 2 to Nonqualified Deferred Compensation Plan
(incorporated by reference from Exhibit 10(a) of our Quarterly
Report on Form 10-Q for the quarterly period ended December 12,
2003).
10(x)* Amendment No. 3 to Nonqualified Deferred Compensation Plan.
10(y) Loan Agreement dated July 1, 2003 between KC Propco, LLC and Morgan
Stanley Mortgage Capital, Inc. (incorporated by reference from
Exhibit 10(w) of our Annual Report on Form 10-K for the fiscal year
ended May 30, 2003).
10(z) First Amendment to Loan Agreement dated August 1, 2003 between KC
Propco, LLC and Morgan Stanley Capital, Inc. (incorporated by
reference from Exhibit 10(x) of our Annual Report on Form 10-K for
the fiscal year ended May 30, 2003).
10(aa) Management Agreement dated July 1, 2003 between KC Opco, LLC and
KinderCare (incorporated by reference from Exhibit 10(y) of our
Annual Report on Form 10-K for the fiscal year ended May 30, 2003).
10(bb) Lease Agreement dated July 1, 2003 between KC Propco, LLC and KC
Opco, LLC (incorporated by reference from Exhibit 10(aa) of our
Annual Report on Form 10-K for the fiscal year ended May 30, 2003).
71
Exhibit Description of
Number Exhibits
- -------- -----------------------
10(cc)* Form of letter regarding the Fiscal Year 2005 Management Bonus Plan.
14(a) Code of Business Conduct.
21 Subsidiaries of KinderCare.
23 Consent of Independent Registered Public Accounting Firm -
Deloitte & Touche LLP.
31(a) Rule 13(a)-14(a) Certification of Chief Executive Officer.
31(b) Rule 13(a)-14(a) Certification of Chief Financial Officer.
32(a) Section 1350 Certification of Chief Executive Officer.
32(b) Section 1350 Certification of Chief Financial Officer.
* Management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K: Filed April 15, 2004 for third quarter earnings
released April 14, 2004.
(c) Exhibits Required by Item 601 of Regulation S-K: The exhibits to this
report are listed under Item 15(a)(3) above.
72
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on August 12, 2004.
KINDERCARE LEARNING CENTERS, INC.
By: /s/ DAVID J. JOHNSON
-------------------------------------
David J. Johnson
Chief Executive Officer and
Chairman of the Board of Directors
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on August 12, 2004:
By: /s/ DAVID J. JOHNSON
-------------------------------------
David J. Johnson
Chief Executive Officer and
Chairman of the Board of Directors
(Principal Executive Officer)
By: /s/ DAN R. JACKSON
-------------------------------------
Dan R. Jackson
Executive Vice President,
Chief Financial Officer
(Principal Financial and Accounting
Officer)
By: /s/ MICHAEL W. MICHELSON
-------------------------------------
Michael W. Michelson
Director
By: /s/ SCOTT C. NUTTALL
-------------------------------------
Scott C. Nuttall
Director
By: /s/ RICHARD J. GOLDSTEIN
-------------------------------------
Richard J. Goldstein
Director
73