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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