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EXCEL - IDEA: XBRL DOCUMENT - CEC ENTERTAINMENT INCFinancial_Report.xls
EX-32.1 - EXHIBIT 32.1 CEO CERTIFICATION - CEC ENTERTAINMENT INCcecex32-1_10q3rd2010.htm
EX-31.1 - EXHIBIT 31.1 CEO CERTIFICATION - CEC ENTERTAINMENT INCcecex31-1_10q3rd2010.htm
EX-32.2 - EXHIBIT 32.2 CFO CERTIFICATION - CEC ENTERTAINMENT INCcecex32-2_10q3rd2010.htm
EX-31.2 - EXHIBIT 31.2 CFO CERTIFICATION - CEC ENTERTAINMENT INCcecex31-2_10q3rd2010.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________________

FORM 10-Q
_______________________
 
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended October 3, 2010
 
OR

¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from  ________ to ________ 
 
Commission File Number: 001-13687
______________________

CEC ENTERTAINMENT, INC.
(Exact name of registrant as specified in its charter)
_______________________

Kansas
 
48-0905805
(State or other jurisdiction of incorporation or organization)
 
(IRS Employer Identification No.)
     
4441 West Airport Freeway
Irving, Texas
 
75062
(Address of principal executive offices)
 
(Zip Code)
     
(972) 258-8507
(Registrant’s telephone number, including area code)
     
Not applicable
 (Former name, former address and former fiscal year, if changed since last report)
_______________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x    No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x    No ¨

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

Large accelerated filer x   Accelerated filer ¨   Non-accelerated filer ¨   Smaller reporting company ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨   No x
 
As of October 25, 2010, an aggregate of 20,539,333 shares of the registrant’s common stock, par value $0.10 per share were outstanding.




 
 

 


CEC ENTERTAINMENT, INC.

 
       
 
Page
PART I
 
FINANCIAL INFORMATION
   
         
ITEM 1.
     
         
     
3
         
     
4
         
     
5
         
     
6
         
     
7
         
ITEM 2.
   
13
         
ITEM 3.
   
26
         
ITEM 4.
   
26
         
PART II
 
OTHER INFORMATION
   
         
ITEM 1.
   
27
         
ITEM 1A.
   
27
         
ITEM 2.
   
27
         
ITEM 6.
   
28
         
 
29
         
         
         
         
         
         

 
2

 

PART I - FINANCIAL INFORMATION

ITEM 1.  Financial Statements.

CEC ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands, except share information)

   
October 3,
   
January 3,
 
   
2010
   
2010
 
ASSETS
           
             
Current assets:
           
Cash and cash equivalents
  $ 18,733     $ 17,361  
Accounts receivable
    14,419       27,031  
Inventories
    17,368       18,016  
Prepaid expenses
    15,618       13,915  
Deferred tax asset
    3,392       3,392  
Total current assets
    69,530       79,715  
                 
Property and equipment, net
    669,856       662,747  
Other noncurrent assets
    6,673       1,804  
Total assets
  $ 746,059     $ 744,266  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
                 
Current liabilities:
               
Capital lease obligations, current portion
  $ 935     $ 881  
Accounts payable
    35,146       32,754  
Accrued expenses
    38,111       33,927  
Unearned revenues
    8,637       7,641  
Accrued interest
    1,869       1,077  
Derivative instrument liability
    3,181       4,459  
Total current liabilities
    87,879       80,739  
                 
Capital lease obligations, less current portion
    9,938       10,629  
Revolving credit facility borrowings
    356,500       354,300  
Deferred rent liability
    50,440       48,758  
Deferred landlord contributions
    27,511       28,220  
Deferred tax liability
    33,246       33,690  
Accrued insurance
    12,510       12,068  
Derivative instrument liability
    -       1,154  
Other noncurrent liabilities
    6,985       6,795  
Total liabilities
    585,009       576,353  
                 
Commitments and contingencies (Note 5)
               
                 
Stockholders’ equity:
               
Common stock, $0.10 par value; authorized 100,000,000 shares; 61,401,172 and 61,120,018 shares issued, respectively
    6,140       6,112  
Capital in excess of par value
    433,204       425,717  
Retained earnings
    753,635       702,414  
Accumulated other comprehensive income
    2,982       1,140  
Less treasury stock, at cost; 40,861,839 and 38,944,354 shares, respectively
    (1,034,911 )     (967,470 )
Total stockholders’ equity
    161,050       167,913  
Total liabilities and stockholders’ equity
  $ 746,059     $ 744,266  


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


CEC ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(Unaudited)
(in thousands, except per share amounts)

   
Three Months Ended
   
Nine Months Ended
 
   
October 3,
   
September 27,
   
October 3,
   
September 27,
 
   
2010
   
2009
   
2010
   
2009
 
REVENUES
                       
Food and beverage sales
  $ 99,452     $ 95,060     $ 309,532     $ 314,662  
Entertainment and merchandise sales
    106,747       101,860       321,996       313,117  
                                 
Company store sales
    206,199       196,920       631,528       627,779  
Franchise fees and royalties
    945       898       2,929       2,967  
                                 
Total revenues
    207,144       197,818       634,457       630,746  
                                 
OPERATING COSTS AND EXPENSES
                               
Company store operating costs:
                               
Cost of food and beverage (exclusive of items shown separately below)
    22,143       21,868       69,729       69,626  
Cost of entertainment and merchandise (exclusive of items shown separately below)
    8,906       8,947       26,692       28,071  
Cost of food, beverage, entertainment and merchandise
    31,049       30,815       96,421       97,697  
                                 
Labor expenses
    55,740       54,593       168,112       167,538  
Depreciation and amortization
    19,903       19,232       59,345       57,186  
Rent expense
    17,719       17,010       52,645       50,643  
Other store operating expenses
    36,025       32,226       96,757       92,635  
Total company store operating costs
    160,436       153,876       473,280       465,699  
                                 
Advertising expense
    9,870       9,179       27,292       27,860  
General and administrative expenses
    12,176       11,328       37,297       37,583  
Asset impairments
    936       -       936       -  
Total operating costs and expenses
    183,418       174,383       538,805       531,142  
Operating income
    23,726       23,435       95,652       99,604  
                                 
Interest expense
    2,951       2,769       9,063       8,938  
Income before income taxes
    20,775       20,666       86,589       90,666  
                                 
Income taxes
    8,194       7,955       35,368       34,909  
Net income
  $ 12,581     $ 12,711     $ 51,221     $ 55,757  
                                 
Earnings per share:
                               
Basic
  $ 0.60     $ 0.55     $ 2.38     $ 2.43  
Diluted
  $ 0.60     $ 0.55     $ 2.38     $ 2.42  
                                 
Weighted average common shares outstanding:
                               
Basic
    20,844       22,971       21,488       22,949  
Diluted
    20,877       23,021       21,525       23,080  


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


CEC ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
For the Nine Months Ended October 3, 2010
(Unaudited)
(in thousands, except share information)
   
Common Stock
   
Capital In Excess of
   
Retained
   
Accumulated Other Comprehensive
   
Treasury Stock
       
   
Shares
   
Amount
   
Par Value
   
Earnings
   
Income
   
Shares
   
Amount
   
Total
 
                                                 
Balance at January 4, 2010
    61,120,018     $ 6,112     $ 425,717     $ 702,414     $ 1,140       38,944,354     $ (967,470 )   $ 167,913  
Net income
    -       -       -       51,221       -       -       -       51,221  
Change in fair value of cash flow hedge, net of
income taxes of $(489)
     -        -        -       -       (802 )      -        -       (802 )
Hedging loss realized in earnings, net of
income taxes of $1,411
     -        -        -       -        2,312        -        -        2,312  
Foreign currency translation adjustments, net of
income taxes of $54
     -        -        -       -        332        -        -       332  
Comprehensive income
                                                            53,063  
                                                                 
Stock-based compensation costs
    -       -       5,654       -       -       -       -       5,654  
Stock options exercised
    147,957       15       4,722       -       -       -       -       4,737  
Restricted stock issued, net of forfeitures
    192,428       19       (19 )     -       -       -       -       -  
Tax shortfall from stock options and
restricted stock
     -        -       (722 )     -        -        -        -       (722 )
Restricted stock returned for taxes
    (78,123 )     (8 )     (2,749 )     -       -       -       -       (2,757 )
Common stock issued under 401(k) plan
    18,892       2       601       -       -       -       -       603  
Purchases of treasury stock
    -       -       -       -       -       1,917,485       (67,441 )     (67,441 )
Balance at October 3, 2010
    61,401,172     $ 6,140     $ 433,204     $ 753,635     $ 2,982       40,861,839     $ (1,034,911 )   $ 161,050  

 

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


 CEC ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

   
Nine Months Ended
 
   
October 3,
   
September 27,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 51,221     $ 55,757  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    60,013       57,859  
Deferred income taxes
    (2,220 )     8,628  
Stock-based compensation expense
    5,511       5,974  
Amortization of landlord contributions
    (1,532 )     (1,506 )
Amortization of deferred debt financing costs
    211       211  
Loss on asset disposals, net
    3,106       2,128  
Other adjustments
    15       (8 )
Changes in operating assets and liabilities:
               
Accounts receivable
    6,949       13,803  
Inventories
    694       (2,138 )
Prepaid expenses
    (1,677 )     (3,455 )
Accounts payable
    3,840       (5,910 )
Accrued expenses
    1,972       1,110  
Unearned revenues
    993       (1,029 )
Accrued interest
    724       (2,022 )
Income taxes payable
    5,547       (2,373 )
Deferred rent liability
    1,646       991  
Deferred landlord contributions
    777       (589 )
Net cash provided by operating activities
    137,790       127,431  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchases of property and equipment
    (70,685 )     (51,167 )
Other investing activities
    (2,451 )     119  
Net cash used in investing activities
    (73,136 )     (51,048 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Net proceeds from (repayments on) revolving credit facility
    2,200       (62,250 )
Payments on capital lease obligations
    (654 )     (602 )
Exercise of stock options
    4,737       18,282  
Excess tax benefit realized from stock-based compensation
    619       2,037  
Payment of taxes for returned restricted shares
    (2,757 )     (1,364 )
Treasury stock acquired
    (67,441 )     (33,571 )
Net cash used in financing activities
    (63,296 )     (77,468 )
                 
Effect of foreign exchange rate changes on cash
    14       (645 )
                 
Change in cash and cash equivalents
    1,372       (1,730 )
                 
Cash and cash equivalents at beginning of period
    17,361       17,769  
                 
Cash and cash equivalents at end of period
  $ 18,733     $ 16,039  
                 
SUPPLEMENTAL CASH FLOW INFORMATION:
               
Interest paid
  $ 8,128     $ 9,231  
Income taxes paid, net
  $ 31,851     $ 18,845  
                 
NON-CASH INVESTING AND FINANCING ACTIVITIES:
               
Accrued construction costs
  $ 6,339     $ 6,455  
Common stock issued under 401(k) plan
  $ 603     $ 577  
                 


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


CEC ENTERTAINMENT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.   Basis of Presentation and Recently Issued Accounting Guidance:

The use of the terms “CEC Entertainment,” “Company,” “we,” “us” and “our” throughout these Notes to Condensed Consolidated Financial Statements refer to CEC Entertainment, Inc. and its subsidiaries.

All of our stores utilize a consistent restaurant-entertainment format that features both family dining and entertainment areas where each store offers the same general mix of food, beverages, entertainment and merchandise. The economic characteristics, products and services, preparation processes, distribution methods and types of customers are substantially similar for each of our stores. Therefore, we aggregate each store’s operating performance into one reportable operating segment for financial reporting purposes.

Our consolidated financial statements include the accounts of the Company and the International Association of CEC Entertainment, Inc. (the “Association”), a variable interest entity in which we have a controlling financial interest. The Association primarily administers the collection and disbursement of funds (the “Association Funds”) used for advertising, entertainment and media programs that benefit both us and our franchisees. We and our franchisees are required to contribute a percentage of gross sales to these funds and could be required to make additional contributions to fund any deficits that may be incurred by the Association. We include the Association in our consolidated financial statements because we concluded that we are the primary beneficiary of its variable interests because we (a) have the power to direct the majority of its significant operating activities, (b) provide it unsecured lines of credit and (c) own the majority of the store locations that benefit from the Association’s advertising and media expenditures. The assets, liabilities and operating results of the Association are not material to our consolidated financial statements. We provide unsecured lines of credit to the Association which it uses to fund deficiencies in its media and advertising funds.

Because the Association Funds are required to be segregated and used for specified purposes, we do not reflect franchisee contributions as revenue, but rather as an offset to reported expenses. Our contributions to the Association Funds eliminate in consolidation. Contributions to the advertising and media funds from our franchisees reflected as offsets to reported advertising expenses were approximately $0.5 million each for the three months ended October 3, 2010 and September 27, 2009 and approximately $1.7 million each for the nine months ended October 3, 2010 and September 27, 2009.

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements as of October 3, 2010 and for the three and nine month periods ended October 3, 2010 and September 27, 2009 are presented in accordance with the requirements for quarterly reports on Form 10-Q and, consequently, do not include all of the information and footnote disclosures required by accounting principles generally accepted in the United States of America (“GAAP”). In the opinion of management, such financial statements include all adjustments (consisting solely of normal recurring adjustments) necessary for the fair statement of the financial information included herein in accordance with GAAP and the rules and regulations of the Securities and Exchange Commission (the “SEC”). The balance sheet at January 3, 2010 has been derived from the audited financial statements at that date, but does not include all of the information and footnote disclosures required by GAAP for complete financial statements. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ from those estimates. Results of operations for interim periods are not necessarily indicative of results for the full year. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K filed with the SEC for the fiscal year ended January 3, 2010.

Recently Issued Accounting Guidance

Newly Adopted Accounting Guidance: As of the beginning of our 2010 fiscal year, we adopted a new accounting standard amending the consolidation accounting requirements for a variable interest entity (“VIE”) which now prescribes a qualitative assessment for determining whether a variable interest gives an enterprise a controlling financial interest in a VIE. This new guidance also requires separate presentation of the assets and liabilities of a consolidated VIE on the face of the balance sheet if specific criteria are met. Our adoption of this new standard did not have a material impact on our consolidated financial statements.


CEC ENTERTAINMENT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

1.   Basis of Presentation and Recently Issued Accounting Guidance (continued):

Accounting Guidance Not Yet Adopted: In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2009-13 which amends the accounting and reporting guidance for arrangements comprised of multiple products or services (“deliverables”). The FASB’s revised guidance clarifies how an entity determines separate units of accounting in a multiple-deliverable arrangement and requires that revenue be allocated to all arrangement deliverables using the relative selling price method. The revised guidance is effective for the first annual reporting period beginning on or after June 15, 2010 and may be applied prospectively as of the adoption date or retrospectively for all periods presented. Early adoption is permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. We will apply this guidance prospectively as of the start of our 2011 fiscal year. We have evaluated this new accounting guidance and our adoption will not have a material effect on our consolidated financial statements.

2.   Inventories:

Inventories consisted of the following:
 
   
October 3,
   
January 3,
 
   
2010
   
2010
 
   
(in thousands)
 
             
Food and beverage
  $ 3,777     $ 4,934  
Entertainment and merchandise
    13,591       13,082  
    $ 17,368     $ 18,016  

Food and beverage inventories include food, beverage, paper products and other supplies needed for our food service operations. Entertainment and merchandise inventories consist primarily of novelty toy items used as redemption prizes for certain games that may also be sold to our customers and birthday party and other supplies needed for our entertainment operations.

3.   Revolving Credit Facility:

   
October 3,
   
January 3,
 
   
2010
   
2010
 
   
(in thousands)
 
             
Revolving credit facility borrowings
  $ 356,500     $ 354,300  

We have a revolving credit facility providing for total borrowings of up to $550.0 million. The credit facility, which matures in October 2012, also includes an accordion feature allowing us, subject to lender approval, to request an additional $50.0 million in borrowings at any time. As of October 3, 2010, there were $356.5 million of borrowings outstanding and $10.7 million of letters of credit issued but undrawn under the credit facility. Based on the type of borrowing, the credit facility bears interest at the London Interbank Offered Rate (“LIBOR”) plus an applicable margin of 0.625% to 1.25% determined based on our financial performance and debt levels, or alternatively, the higher of (a) the prime rate or (b) the Federal Funds rate plus 0.50%. As of October 3, 2010, borrowings under the credit facility incurred interest at LIBOR (ranging from 0.26% - 0.31%) plus 1.00% or prime (3.25%). A commitment fee of 0.1% to 0.3%, depending on our financial performance and debt levels, is payable on a quarterly basis on any unused credit line. All borrowings under the credit facility are unsecured, but we have agreed not to pledge any of our existing assets to secure future indebtedness.

Including the effect of our interest rate swap contract discussed in Note 4 “Derivative Instrument,” the weighted average effective interest rate incurred on borrowings under our revolving credit facility was 2.9% for the three months ended October 3, 2010 and September 27, 2009, and was 3.0% and 2.9% for the nine months ended October 3, 2010 and September 27, 2009, respectively.

The revolving credit facility agreement contains certain restrictions and conditions that, among other things, require us to comply with financial covenant ratios, including a minimum fixed charge coverage ratio of 1.5 to 1.0 and a maximum leverage ratio of 3.0 to 1.0, as defined in the revolving credit facility agreement. Additionally, the terms of the revolving credit facility agreement limit the amount of our repurchases of our common stock and cash dividends we may pay on our common stock based on certain financial covenants and criteria. As of October 3, 2010, we were in compliance with these covenants.


CEC ENTERTAINMENT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

4.   Derivative Instrument:

Interest Rate Risk Management

Our revolving credit facility bears interest at variable rates and therefore exposes us to the impact of interest rate changes. To manage this risk, we use an interest rate swap contract to mitigate the variability of the interest payment cash flows and to reduce our exposure to adverse interest rate changes.

Cash Flow Hedge

We have entered into a $150.0 million notional amount interest rate swap contract to effectively convert a portion of our variable rate revolving credit facility debt to a fixed interest rate. The contract, which matures in May 2011, requires us to pay a fixed rate of 3.62% while receiving variable payments from the counterparty at the three-month LIBOR rate. Including the 1.00 percentage point applicable margin incurred on our revolving credit facility, the effective interest rate of the swap contract was 4.62% at October 3, 2010. The differential amounts receivable or payable under the swap contract are recorded over the life of the contract as adjustments to interest expense.

We have designated the swap contract as a cash flow hedge. Accordingly, gains or losses from changes in its fair value that are determined to be effective in mitigating our exposure to changes in interest payments on the hedged amount of revolving credit facility debt are reported on the Consolidated Balance Sheets as a component of “Accumulated other comprehensive income.” Throughout the term of the swap contract, the unrealized gains or losses we have reported in accumulated other comprehensive income will be recognized in earnings when the variable interest rate of the debt affects earnings. The ineffective portion of any gains or losses would be recorded immediately in earnings.

The following table summarizes the location and fair value of the derivative instrument in our unaudited Condensed Consolidated Balance Sheets:
 
     
October 3,
   
January 3,
 
 
Balance Sheet Location
 
2010
   
2010
 
Derivative designated as hedging instrument:
   
(in thousands)
 
               
Interest rate swap contract
Derivative instrument liability(1) (2) 
  $ 3,181     $ 5,613  

   
 (1)    
As of October 3, 2010, the estimated fair value was recorded as a $3.2 million current liability.
 (2)    
As of January 3, 2010, the estimated fair value was comprised of a $4.5 million current liability and a $1.2 million noncurrent liability.

The following table summarizes the effect of the derivative instrument on other comprehensive income (“OCI”) and income:

   
Three Months Ended
   
Nine Months Ended
 
   
October 3,
   
September 27,
   
October 3,
   
September 27,
 
   
2010
   
2009
   
2010
   
2009
 
Derivative in cash flow hedging relationship:
 
(in thousands, excluding income tax effects)
 
                         
Loss recognized in accumulated OCI – effective portion:
                       
Interest rate swap contract
  $ (408 )   $ (1,116 )   $ (1,291 )   $ (2,274 )
                                 
Loss reclassified from accumulated OCI into income – effective portion:
                               
Interest expense
  $ (1,213 )   $ (1,159 )   $ (3,723 )   $ (2,814 )

There were no ineffective gains or losses recognized during the three and nine months ended October 3, 2010 and September 27, 2009. We expect that approximately $2.0 million, net of taxes, of the change in fair value of the swap contract included in “Accumulated other comprehensive income” as of October 3, 2010 will be realized in earnings as additional interest expense within the next 12 months.


CEC ENTERTAINMENT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

4.   Derivative Instrument (continued):

Fair Value Measurement

Our interest rate swap contract is not traded on a public exchange. Therefore, its fair value is determined using the present value of expected future cash flows arising from the contract which approximates an amount to be received from or paid to a market participant for this instrument. This valuation methodology utilizes forward interest rate yield curves obtained from an independent pricing service’s quotes of three-month forward LIBOR rates through the swap contract’s maturity. Accordingly, the inputs to our fair value measurement of the interest rate swap are classified within Level 2 of the fair value hierarchy. For more information regarding fair value measurements, refer to Note 1 “Fair Value Measurements” to our consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended January 3, 2010.

5.   Commitments and Contingencies:

Legal Proceedings

From time to time, we are involved in various inquiries, investigations, claims, lawsuits, and other legal proceedings that are incidental to the conduct of our business. These matters typically involve claims from customers, employees or other third parties involved in operational issues common to the retail, restaurant and entertainment industries. Such matters typically represent actions with respect to contracts, intellectual property, taxation, employment, employee benefits, personal injuries and other matters. A number of such claims may exist at any given time and there are currently a number of claims and legal proceedings pending against us.

In the opinion of our management, after consultation with legal counsel, the amount of ultimate liability with respect to claims or proceedings currently pending against us is not expected to have a material adverse effect on our financial condition, results of operations or cash flows.

6.   Income Taxes:

Our liability for uncertain tax positions increased from $5.1 million as of January 3, 2010 to $7.9 million as of October 3, 2010, primarily in connection with the current Internal Revenue Service examination of our 2006 and 2007 tax years. In addition, we have recognized additional estimated interest expense of approximately $0.8 million related to these matters. Also, during the third quarter of 2010, we paid $0.6 million in connection with the settlement of a state tax audit.

7.   Asset Impairments:

During the third quarter of 2010, we recognized asset impairment charges of $0.9 million related to three stores we continue to operate due to the adverse impact of various economic factors in the markets in which the properties are located and resulting decline in the stores’ financial performance. Based on these factors, we determined that the stores’ forecasted cash flows were insufficient to recover the carrying amount of their long-lived assets. Asset impairments represent adjustments we recorded to write down the carrying amount of the property and equipment at these stores to their estimated fair value.

Fair Value Measurement

We estimate the fair value of a store’s long-lived assets by discounting the expected future cash flows of the store using a weighted average cost of capital over its remaining lease term. Our estimate of cash flows used to determine fair value is developed from the highest and best use of the store from the perspective of market participants, which may differ from the basis of our own internal expectations of the store’s future cash flows. Accordingly, the inputs to our fair value measurement of the stores we have recognized impairment charges for are classified within Level 3 of the fair value hierarchy. For more information regarding fair value measurements, refer to Note 1 “Fair Value Measurements” to our consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended January 3, 2010.


CEC ENTERTAINMENT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
8.   Earnings Per Share:

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding during the period. Common shares outstanding consist of shares of our common stock and certain unvested shares of restricted stock containing nonforfeitable dividend rights. Diluted EPS is computed using the weighted average number of common shares and dilutive potential common shares outstanding during the period using the treasury stock method. Potential common shares consist of dilutive stock options and unvested shares of restricted stock that are not considered to be participating securities.

The following table sets forth the computation of EPS, basic and diluted:

   
Three Months Ended
   
Nine Months Ended
 
   
October 3,
   
September 27,
   
October 3,
   
September 27,
 
   
2010
   
2009
   
2010
   
2009
 
   
(in thousands, except per share amounts)
 
Numerator:
                       
Net income
  $ 12,581     $ 12,711     $ 51,221     $ 55,757  
                                 
Denominator:
                               
Basic weighted average common shares outstanding
    20,844       22,971       21,488       22,949  
Potential common shares for stock options and restricted stock
    33       50       37       131  
Diluted weighted average common shares outstanding
     20,877        23,021        21,525        23,080  
                                 
Earnings per share:
                               
Basic
  $ 0.60     $ 0.55     $ 2.38     $ 2.43  
Diluted
  $ 0.60     $ 0.55     $ 2.38     $ 2.42  

Stock options to purchase 54,270 shares and 685,400 shares of common stock for the three months ended October 3, 2010 and September 27, 2009, respectively, and 119,267 shares and 705,080 shares for the nine months ended October 3, 2010 and September 27, 2009, respectively, were not included in the diluted EPS computations because the exercise prices of these options were greater than the average market price of the common shares and, therefore, their effect would be antidilutive.

9.   Stock-Based Compensation:

We have stock-based compensation plans pursuant to which we may grant awards of restricted stock and, prior to fiscal 2006, stock options to our employees and non-employee directors. The fair value of all stock-based awards, less estimated forfeitures, is recognized as stock-based compensation expense in the financial statements over the vesting period of the award.

The following table summarizes total pre-tax stock-based compensation expense recognized in the unaudited condensed consolidated financial statements:
 
   
Three Months Ended
   
Nine Months Ended
 
   
October 3,
   
September 27,
   
October 3,
   
September 27,
 
   
2010
   
2009
   
2010
   
2009
 
   
(in thousands)
 
                         
Total stock-based compensation cost
  $ 1,906     $ 1,846     $ 5,654     $ 6,132  
Portion capitalized as property and equipment(1) 
    (48 )     (55 )     (143 )     (158 )
                                 
Pre-tax stock-based compensation expense recognized(2) 
  $  1,858     $  1,791     $  5,511     $  5,974  

   
(1)
We capitalize the portion of stock-based compensation costs related to our design, construction, facilities and legal departments that are directly attributable to our store development projects, such as the design and construction of a new store and the remodeling and expansion of our existing stores. Capitalized stock-based compensation is included in “Property and equipment, net” on the unaudited Condensed Consolidated Balance Sheets.
(2)
Included in “General and administrative expense” in the unaudited Condensed Consolidated Statements of Earnings.


CEC ENTERTAINMENT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

9.   Stock-Based Compensation (continued):

As of October 3, 2010, there was $14.7 million of unrecognized pre-tax stock-based compensation cost related to restricted stock that will be recognized over a weighted average remaining vesting period of 1.7 years. All previously granted and currently outstanding stock options are fully vested. As such there is no unrecognized stock-based compensation cost related to stock options.

10.   Stockholders’ Equity:

Stock Repurchase Program

Our Board of Directors (the “Board”) has approved a program for us to repurchase shares of our common stock. On July 25, 2005, the Board approved a stock repurchase program which authorized us to repurchase from time to time up to $400 million of our common stock and on October 22, 2007 and October 27, 2009 authorized $200 million increases each. During the nine months ended October 3, 2010, we repurchased 1,917,485 shares of our common stock at an aggregate purchase price of approximately $67.4 million under the repurchase program. As of October 3, 2010, approximately $151.3 million remained available for share repurchases under our repurchase authorization.

The share repurchase authorization approved by the Board does not have an expiration date and the pace of our repurchase activity will depend on factors such as our working capital needs, our debt repayment obligations, our stock price, and economic and market conditions. Our share repurchases may be effected from time to time through open market purchases, accelerated share repurchases or in privately negotiated transactions. Our share repurchase program may be accelerated, suspended, delayed or discontinued at any time.

Stock Options

During the nine months ended October 3, 2010, 147,957 shares of common stock were issued from the exercise of stock options for cash proceeds of $4.7 million.

Restricted Stock

The following table summarizes restricted stock activity during the nine months ended October 3, 2010 (not presented in thousands):

   
 
Restricted
Shares
   
Weighted Average
Grant Date
Fair Value
 
             
Unvested restricted stock awards, January 3, 2010
    712,227     $ 27.68  
Granted
    241,392     $ 35.72  
Vested
    (257,867 )   $ 29.23  
Forfeited
    (48,964 )   $ 30.27  
Unvested restricted stock awards, October 3, 2010
    646,788     $ 29.87  

During the nine months ended October 3, 2010, employees and non-employee directors tendered 78,123 shares of common stock to satisfy tax withholding requirements on the vesting of restricted stock at an average price per share of $35.20.

401(k) Plan Contribution

During the nine months ended October 3, 2010, we contributed 18,892 shares of our common stock at a cost of approximately $0.6 million to the CEC Entertainment 401(k) Plan in connection with our annual match of employee contributions for the 2009 plan year.


 ITEM 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

As used in this report, the terms “CEC Entertainment,” “we,” “Company,” “us” and “our” refer to CEC Entertainment, Inc. and its subsidiaries.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide the readers of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in Part I, Item 1 “Financial Statements” of this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended January 3, 2010. Our MD&A is presented in the following sections:
 
·
Executive Summary
 
·
Overview of Operations
 
·
Results of Operations
 
·
Financial Condition, Liquidity and Capital Resources
 
·
Off-Balance Sheet Arrangements and Contractual Obligations
 
·
Critical Accounting Policies and Estimates
 
·
Recently Issued Accounting Guidance

Executive Summary

 
·
Revenues increased 4.7% during the third quarter of 2010 compared to the same period in 2009.
 
-
Comparable store sales on a fiscal week basis increased 3.9%.
 
-
Comparable store sales on a same calendar week basis increased 3.8%.
 
-
Weighted average Company-owned store count increased by approximately four stores.
 
-
Menu prices increased on average 3.3%.

 
·
Company store operating costs as a percentage of Company store sales decreased 0.3 percentage points during the third quarter of 2010 primarily due to the effect of menu price increases, improved labor utilization and certain cost savings initiatives we implemented during the year. These factors were partially offset by an increase in the price of cheese, increases in our self-insurance costs and a charge incurred to transition to a new soft drink supplier.

 
·
During the third quarter of 2010, we recognized asset impairment charges of $0.9 million related to three of our stores.

 
·
Diluted earnings per share for the third quarter of 2010 increased 9.1% to $0.60 compared to $0.55 in the same period in 2009. Earnings per share benefited from our cumulative repurchase of 3,047,574 shares of our common stock since the beginning of the third quarter of 2009.

 
·
We repurchased approximately 1.0 million shares of our common stock during the third quarter of 2010 at an average price of $32.03 a share.

 
·
During the third quarter of 2010, we completed 44 capital initiatives, including three major remodels, nine expansions and 32 game enhancements.

 
·
We acquired two stores from a franchisee during the third quarter of 2010.


Overview of Operations

We develop, operate and franchise family dining and entertainment centers under the name “Chuck E. Cheese’s®” in 48 states and six foreign countries or territories. Chuck E. Cheese’s stores feature musical and comic entertainment by robotic and animated characters, arcade-style and skill oriented games, video games, rides and other activities intended to appeal to our primary customer
base of families with children between two and 12 years of age. All of our stores offer dining selections consisting of a variety of beverages, pizzas, sandwiches, appetizers, a salad bar, and desserts.

The following table summarizes information regarding the number of Company-owned and franchised stores for the periods presented:
 
   
Three Months Ended
   
Nine Months Ended
 
   
October 3,
   
September 27,
   
October 3,
   
September 27,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Number of Company-owned stores:
                       
Beginning of period
    498       496       497       495  
New
    1       -       1       1  
Acquired from franchisees
    2       -       3       -  
Closed
    (1 )     (1 )     (1 )     (1 )
End of period
    500       495       500       495  
                                 
Number of franchised stores:
                               
Beginning of period
    48       48       48       46  
New
    -       -       1       2  
Acquired by the Company
    (2 )     -       (3 )     -  
Closed
    -       -       -       -  
End of period
    46       48       46       48  

Comparable store sales. We define comparable store sales as the percentage change in sales for our domestic Company-owned stores that have been open for more than 18 months as of the beginning of each respective fiscal year or 12 months for acquired stores (our “comparable store base”). Relocated stores are excluded from the comparable store base until they are open for more than 18 months as of the beginning of a respective fiscal year. Comparable store sales is a key performance indicator used within our industry and is a critical factor when evaluating our performance as it is indicative of acceptance of our strategic initiatives and local economic and consumer trends.

As a result of the 53 week fiscal year in 2009 (see “Fiscal Year” below), our 2010 fiscal year began one week later than our 2009 fiscal year. In order to provide useful information to investors to better analyze our business, we have provided below comparable store sales presented on both a fiscal week basis and calendar week basis. Comparable store sales on a fiscal week basis compares the results of our fiscal periods ended October 3, 2010 and September 27, 2009. Comparable store sales for the three months ended October 3, 2010 on a calendar week basis compares the results for the period from July 5, 2010 through October 3, 2010 (weeks 27 through 39 of our 2010 fiscal year) to the results for the period from July 6, 2009 through October 4, 2009 (weeks 28 through 40 of our 2009 fiscal year). Comparable store sales for the nine months ended October 3, 2010 on a calendar week basis compares the results for the period from January 4, 2010 through October 3, 2010 (weeks 1 through 39 of our 2010 fiscal year) to the results for the period from January 5, 2009 through October 4, 2009 (weeks 2 through 40 of our 2009 fiscal year). We believe comparable store sales calculated on a same calendar week basis is more indicative of the health of our business.  However, we also recognize that comparable store sales growth calculated on a fiscal week basis is a useful measure when analyzing year-over-year changes in our financial statements.

Revenues. Our primary source of revenues is from sales at our Company-owned stores (“Company store sales”) and consists of the sale of food, beverages, game-play tokens and merchandise. A portion of Company store sales comes from sales of value-priced combination packages generally comprised of food, beverage and game tokens (“package deals”), which we promote through in-store menu pricing or coupon offerings. Food and beverage sales include all revenue recognized with respect to stand-alone food and beverage sales as well as the portion of revenue that is allocated from package deals. Entertainment and merchandise sales include all revenue recognized with respect to stand-alone game token sales as well as the portion of revenue that is allocated from package deals. This revenue caption also includes sales of merchandise at our stores. We allocate the revenue recognized from the sale of our package deals between “Food and beverage sales” and “Entertainment and merchandise sales” based upon the price charged for each component when it is sold separately, or in limited circumstances our best estimate of selling price if a component is not sold on a stand-alone basis, which we believe approximates each component’s fair value.

Franchise fees and royalties include area development and initial franchise fees received from franchisees to establish new stores and royalties charged to franchisees based on a percentage of a franchised store’s sales.


Company store operating costs. Certain costs and expenses relate only to the operation of our Company-owned stores and are as follows:

·
Cost of food and beverage includes all direct costs of food, beverages and costs of related paper and birthday supplies, less rebates from suppliers;

·
Cost of entertainment and merchandise includes all direct costs of prizes provided and merchandise sold to our customers, as well as the cost of tickets dispensed to customers and redeemed for prize items;

·
Labor expenses consist of salaries and wages, related payroll taxes and benefits for store personnel;

·
Depreciation and amortization expenses that pertain directly to our store assets primarily consisting of leasehold improvements, game and ride equipment, furniture, fixtures and other equipment;

·
Rent expense includes lease costs for Company-owned stores, excluding common occupancy costs (e.g. common area maintenance (“CAM”) charges, property taxes, etc.); and

·
Other store operating expenses which include utilities, repair costs, liability and property insurance, CAM charges, property taxes, preopening expenses, store asset disposal gains and losses, and all other costs directly related to the operation of a store.

Our “Cost of food and beverage” and “Cost of entertainment and merchandise” mentioned above do not include an allocation of (i) store employee payroll, related taxes and benefit costs and (ii) depreciation and amortization expense associated with Company-store assets. We believe that presenting store-level labor costs and depreciation and amortization expense in the aggregate provides the most informative financial reporting presentation.

Advertising expense. Advertising expense includes production costs for television commercials, newspaper inserts, Internet advertising, coupons and media expenses for national and local advertising, with offsetting contributions from our franchisees.

General and administrative expenses. General and administrative expenses represent all costs associated with our corporate office operations, including regional and district management and corporate personnel payroll and benefits, depreciation and amortization of corporate assets and other administrative costs not directly related to the operation of a store location.

Asset impairments. Asset impairments (if any) represent non-cash charges we record to write down the carrying amount of long-lived assets within stores that are not expected to generate sufficient projected cash flows in order to recover their net book value.

Seasonality

Our operating results fluctuate seasonally due to the timing of school vacations, holidays and changing weather conditions. As a result, we typically generate higher sales volumes during the first and third quarters of each fiscal year.  School operating schedules, holidays and weather conditions may affect sales volumes in some operating regions differently than others.  Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

Fiscal Year

We operate on a 52 or 53 week fiscal year that ends on the Sunday nearest to December 31. Each quarterly period has 13 weeks, except for a 53 week year when the fourth quarter has 14 weeks. Our 2010 fiscal year will consist of 52 weeks and our 2009 fiscal year consisted of 53 weeks.


Results of Operations

The following table summarizes our principal sources of Company store sales expressed in dollars and as a percentage of total Company store sales for the periods presented:

   
Three Months Ended
   
Nine Months Ended
 
   
October 3, 2010
   
September 27, 2009
   
October 3, 2010
   
September 27, 2009
 
   
(in thousands, except percentages)
 
                                                 
Food and beverage sales
  $ 99,452       48.2 %   $ 95,060       48.3 %   $ 309,532       49.0 %   $ 314,662       50.1 %
Entertainment and merchandise sales
    106,747       51.8 %     101,860       51.7 %     321,996       51.0 %     313,117       49.9 %
Company store sales
  $ 206,199       100.0 %   $ 196,920       100.0 %   $ 631,528       100.0 %   $ 627,779       100.0 %

The following table summarizes our revenues and expenses expressed in dollars and as a percentage of total revenues (except as otherwise noted) for the periods presented:

   
Three Months Ended
   
Nine Months Ended
 
   
October 3, 2010
   
September 27, 2009
   
October 3, 2010
   
September 27, 2009
 
   
(in thousands, except percentages)
 
                                                 
Company store sales
  $ 206,199       99.5 %   $ 196,920       99.5 %   $ 631,528       99.5 %   $ 627,779       99.5 %
Franchising activities
    945       0.5 %     898       0.5 %     2,929       0.5 %     2,967       0.5 %
Total revenues
    207,144       100.0 %     197,818       100.0 %     634,457       100.0 %     630,746       100.0 %
Company store operating costs:
                                                               
Cost of food and beverage (1) 
    22,143       22.3 %     21,868       23.0 %     69,729       22.5 %     69,626       22.1 %
Cost of entertainment and merchandise (2) 
     8,906       8.3 %      8,947       8.8 %      26,692       8.3 %      28,071       9.0 %
Cost of food, beverage, entertainment and merchandise (3) 
     31,049       15.1 %      30,815       15.6 %      96,421       15.3 %      97,697       15.6 %
                                                                 
Labor expenses (3) 
    55,740       27.0 %     54,593       27.7 %     168,112       26.6 %     167,538       26.7 %
Depreciation and amortization (3) 
    19,903       9.7 %     19,232       9.8 %     59,345       9.4 %     57,186       9.1 %
Rent expense (3) 
    17,719       8.6 %     17,010       8.6 %     52,645       8.3 %     50,643       8.1 %
Other store operating expenses (3) 
    36,025       17.5 %     32,226       16.4 %     96,757       15.3 %     92,635       14.8 %
Total Company store operating costs (3) 
     160,436       77.8 %      153,876       78.1 %      473,280       74.9 %      465,699       74.2 %
                                                                 
Advertising expense
    9,870       4.8 %     9,179       4.6 %     27,292       4.3 %     27,860       4.4 %
General and administrative expenses
    12,176       5.9 %     11,328       5.7 %     37,297       5.9 %     37,583       6.0 %
Asset impairments
    936       0.5 %     -       0.0 %     936       0.1 %     -       0.0 %
Total operating costs and expenses
     183,418       88.5 %      174,383       88.2 %      538,805       84.9 %      531,142       84.2 %
                                                                 
Operating income
    23,726       11.5 %     23,435       11.8 %     95,652       15.1 %     99,604       15.8 %
Interest expense
    2,951       1.4 %     2,769       1.4 %     9,063       1.4 %     8,938       1.4 %
Income before income taxes
  $ 20,775       10.0 %   $ 20,666       10.4 %   $ 86,589       13.6 %   $ 90,666       14.4 %

   
(1)
Percent amount expressed as a percentage of food and beverage sales.
(2)
Percent amount expressed as a percentage of entertainment and merchandise sales.
(3)
Percent amount expressed as a percentage of Company store sales.
Due to rounding, percentages presented in the table above may not add. The percentage amounts for the components of cost of food, beverage, entertainment and merchandise do not sum due to the fact that cost of food and beverage and cost of entertainment and merchandise are expressed as a percentage of related food and beverage and entertainment and merchandise sales, as opposed to total Company store sales.

Three Months Ended October 3, 2010 Compared to Three Months Ended September 27, 2009

Revenues

Company store sales increased 4.7% to $206.2 million during the third quarter of 2010 compared to $196.9 million in the third quarter of 2009 primarily due to a 3.9% increase in fiscal week comparable store sales and a weighted average net increase of approximately four Company-owned stores. On a same calendar week basis, which we believe to be more indicative of the health of our business, comparable store sales increased 3.8%. Menu prices increased approximately 3.3% during the third quarter of 2010 as compared to the third quarter of 2009. The current economic environment continues to be challenging, however in addition to menu price increases, we believe our implementation of various strategies including the ongoing capital initiatives at our existing stores, expanded television advertising promoting value to the consumer, and our improved birthday party packages, which have increased our birthday party sales compared to the same period last year, helped us achieve a 3.8% growth in comparable store sales on a same calendar week basis during the third quarter of 2010.


Company Store Operating Costs

Cost of food and beverage as a percentage of food and beverage sales decreased 0.7 percentage points to 22.3% during the third quarter of 2010 compared to 23.0% in the third quarter of 2009 primarily due to menu price increases and the implementation of certain cost savings initiatives which have resulted in reductions in paper supplies and beverage costs, partially offset by higher cheese prices. During the third quarter of 2010, the average price per pound of cheese increased approximately $0.38, or 31%, compared to prices paid in the third quarter of 2009.

Cost of entertainment and merchandise as a percentage of entertainment and merchandise sales decreased 0.5 percentage points to 8.3% during the third quarter of 2010 from 8.8% in the third quarter of 2009, primarily due to margin pressure in the third quarter of 2009 associated with incremental prize merchandise awarded to our guests from promotional in-store token distributions which did not occur in 2010, and higher costs incurred in the prior year associated with an attraction that dispensed novelty photo cards.

Labor expenses as a percentage of Company store sales decreased 0.7 percentage points to 27.0% during the third quarter of 2010 compared to 27.7% in the third quarter of 2009 primarily due to improved labor utilization of our hourly labor force during the third quarter of 2010 and leverage obtained from higher sales on the fixed component of our labor costs. Partially offsetting these factors were a 2.0% increase in average hourly wage rates at our stores and higher incentive compensation payable to our store employees primarily due to an increase in our store level financial performance during the third quarter of 2010.

Depreciation and amortization expense related to our stores increased $0.7 million to $19.9 million during the third quarter of 2010 compared to $19.2 million in the third quarter of 2009 primarily due to the ongoing capital investment initiatives occurring at our existing stores and new store development.

Store rent expense increased $0.7 million to $17.7 million during the third quarter of 2010 compared to $17.0 million in the third quarter of 2009 primarily due to an increase in our leased properties resulting from new store development and expansions of existing stores.
 
Other store operating expenses as a percentage of Company store sales increased 1.1 percentage points to 17.5% during the third quarter of 2010 compared to 16.4% in the third quarter of 2009 primarily due to higher insurance related costs and a charge incurred to transition soft drink suppliers. Insurance related costs were approximately $0.9 million, or approximately 0.4 percentage points, higher during the third quarter of 2010 compared to the same period in 2009 primarily due to an increase in our self-insurance reserves in the third quarter of 2010 due to the unfavorable development of certain general liability claims. Also during the third quarter of 2010, we incurred a charge of approximately $0.9 million to transition to a new soft drink supplier.

Advertising Expense

Advertising expense as a percentage of total revenues increased 0.2 percentage points to 4.8% during the third quarter of 2010 from 4.6% in the third quarter of 2009 primarily due to increased expenditures for local television advertising and online media associated with our expanded marketing activities during the third quarter of 2010. These increases were partially offset by the leveraging effect of higher sales during the third quarter of 2010.

General and Administrative Expenses

General and administrative expenses increased $0.8 million to $12.2 million during the third quarter of 2010 from $11.3 million in the third quarter of 2009 primarily due to a favorable $0.9 million adjustment to a tax penalty reserve recorded in the third quarter of 2009 resulting from the settlement of a federal income tax examination.

Asset Impairments

During the third quarter of 2010, we recognized asset impairment charges of $0.9 million for three of our stores based on the determination that they had been adversely impacted by various economic factors in the markets in which they are located. Due to a decline in the financial performance of these stores, management determined that the estimated fair value of the stores’ long-lived assets (determined from discounted expected operating cash flows of the store over its remaining lease term) had declined below their carrying amount. For additional information about these impairment charges, refer to Note 7 “Asset Impairments” of our unaudited condensed consolidated financial statements included in Part I, Item 1 “Financial Statements” of this Quarterly Report on Form 10-Q.

Interest Expense

Interest expense increased to $3.0 million during the third quarter of 2010 compared to $2.8 million in the third quarter of 2009 primarily due to interest charges incurred pursuant to additional tax reserves we had initially established during the second quarter of 2010 in connection with the current Internal Revenue Service (“IRS”) examination of prior tax years.


Income Taxes

Our effective income tax rate was 39.4% and 38.5% during the third quarter of 2010 and 2009, respectively. The increase in our effective tax rate was primarily due to various federal and state tax adjustments recorded during the third quarter of 2010, partially offset by the recognition of certain state enterprise zone tax credits.

Diluted Earnings Per Share

Diluted earnings per share increased to $0.60 per share for the third quarter of 2010 from $0.55 per share in the third quarter of 2009 primarily due to a 9.3% decrease in the number of weighted average diluted shares outstanding between the two periods, partially offset by a 1.0% decrease in our net income. The increase in diluted earnings per share between the two periods was impacted by our repurchase of approximately 3.0 million shares of our common stock since the beginning of the third quarter of 2009. We estimate that the decrease in the number of weighted average diluted shares outstanding during the third quarter of 2010 attributable solely to these repurchases benefited our earnings per share in the third quarter of 2010 by approximately $0.04. Our estimate is based on the weighted average number of shares repurchased since the beginning of the third quarter of 2009 and includes consideration of the estimated additional interest expense attributable to increased borrowings under our revolving credit facility to finance the repurchases. Our computation does not include the effect of share repurchases prior to the third quarter of 2009, or the effect of the issuance of restricted stock or exercise of stock options subsequent to the third quarter of 2009.

Nine Months Ended October 3, 2010 Compared to Nine Months Ended September 27, 2009

Revenues

Company store sales increased 0.6% to $631.5 million during the first nine months of 2010 compared to $627.8 million in the first nine months of 2009 primarily due to a weighted average net increase of approximately three Company-owned stores during the first nine months of 2010, partially offset by a comparable store sales decrease on a fiscal week basis of 0.4%. On a same calendar week basis, which we believe to be more indicative of the health of our business, comparable store sales grew 0.8%. The difference between fiscal week and calendar week comparable store sales is primarily attributable to the effect of an additional operating week in our 2009 fiscal year which caused the seasonally strong first week of the 2010 calendar year to shift into the fourth quarter of 2009. Menu prices increased approximately 2.4% during the first nine months of 2010 as compared to the first nine months of 2009.

While we increased our same calendar week comparable store sales during the first nine months of 2010 by 0.8%, we believe this moderate growth reflects the difficult economic environment in which we have operated throughout the year. In addition to menu price increases, we believe our implementation of various strategies including, the ongoing capital initiatives at our existing stores, expanded television advertising promoting value to the consumer and our improved birthday party packages, which have increased our birthday party sales compared to the same period last year, led to the positive growth in our same calendar week comparable store sales for the year.

Our sales for the first nine months of 2010 also includes a $0.6 million adjustment we recorded in food and beverage sales during the second quarter of 2010 for the initial recognition of breakage income related to unredeemed gift card balances. The recognition of initial breakage income during the first nine months of 2010 is not included in either the fiscal week or calendar week comparable store sales figures. Refer to “Critical Accounting Policies and Estimates” of our MD&A for more information regarding our initial recognition of gift card breakage income.

Our Company store sales mix was 49.0% food and beverage sales and 51.0% entertainment and merchandise sales during the first nine months of 2010 compared to 50.1% and 49.9%, respectively, in the first nine months of 2009. We believe the sales mix shift from food and beverage to entertainment and merchandise is primarily the result of increased birthday party packages that contained greater components of merchandise and game tokens as compared to the packages offered in the first nine months of 2009, as well as increased token sales in the current year.

Company Store Operating Costs

Cost of food and beverage as a percentage of food and beverage sales increased 0.4 percentage points to 22.5% during the first nine months of 2010 from 22.1% in the first nine months of 2009 primarily due to an increase in cheese prices. During the first nine months of 2010, the average price per pound of cheese increased approximately $0.29, or 24%, compared to prices paid in the first nine months of 2009. This increase was partially offset by menu price increases and the implementation of certain cost savings initiatives which have resulted in reductions in paper supplies and beverage costs during the first nine months of 2010.
 
 
Cost of entertainment and merchandise as a percentage of entertainment and merchandise sales decreased 0.7 percentage points to 8.3% during the first nine months of 2010 from 9.0% in the first nine months of 2009. This decrease is primarily due to margin


pressure associated with incremental prize merchandise awarded to our guests in the first nine months of 2009 from promotional in-store token distributions which did not occur in 2010, as well as, from the liquidation of certain prize inventory in the first quarter of 2009. Additionally, higher costs were incurred in the first nine months of 2009 associated with an attraction that dispensed novelty photo cards.

Labor expenses as a percentage of Company store sales decreased 0.1 percentage point to 26.6% during the first nine months of 2010 compared to 26.7% in the first nine months of 2009 primarily due to improved labor utilization of our hourly labor force during the first nine months of 2010 and leverage obtained from higher sales on the fixed component of our labor costs. Partially offsetting these factors were a 3.1% increase in average hourly wage rates at our stores, higher incentive compensation payable to our store employees primarily due to an increase in our store level financial performance during 2010 and increased unemployment taxes and other benefits.

Depreciation and amortization expense related to our stores increased $2.2 million to $59.3 million during the first nine months of 2010 compared to $57.2 million in the first nine months of 2009 primarily due to the ongoing capital investment initiatives occurring at our existing stores and new store development.

Store rent expense increased $2.0 million to $52.6 million during the first nine months of 2010 compared to $50.6 million in the first nine months of 2009 primarily due to an increase in our leased properties resulting from new store development and expansions of existing stores.
 
Other store operating expenses as a percentage of Company store sales increased 0.5 percentage points to 15.3% during the first nine months of 2010 compared to 14.8% in the first nine months of 2009 primarily due to higher insurance related costs and a charge incurred to transition soft drink suppliers. Insurance related costs were approximately $2.0 million, or 0.3 percentage points, higher during the first nine months of 2010 compared to the same period in 2009 primarily due to the unfavorable development of certain general liability claims. Additionally, during the third quarter of 2010, we incurred a charge of approximately $0.9 million to transition to a new soft drink supplier.

Advertising Expense

Advertising expense as a percentage of total revenues decreased 0.1 percentage points to 4.3% during the first nine months of 2010 from 4.4% in the first nine months of 2009 primarily due to lower television media costs compared to the same period last year and reductions in certain media expenditures during the first nine months of 2010. These decreases were partially offset by additional local television advertising during the first nine months of 2010.

General and Administrative Expenses

General and administrative expenses decreased $0.3 million to $37.3 million during the first nine months of 2010 from $37.6 million in the first nine months of 2009 primarily due to the effect of a net reduction in various corporate office overhead costs during the first nine months of 2010 as compared to the same period in 2009, partially offset by a favorable $0.9 million adjustment to a tax penalty reserve we recorded during the third quarter of 2009 resulting from the settlement of a federal income tax examination.

Asset Impairments

During the third quarter of 2010, we recognized asset impairment charges of $0.9 million for three of our stores based on the determination that they had been adversely impacted by various economic factors in the markets in which they are located. Due to a decline in the financial performance of these stores, management determined that the estimated fair value of the stores’ long-lived assets (determined from discounted expected operating cash flows of the store over its remaining lease term) had declined below their carrying amount. For additional information about these impairment charges, refer to Note 7 “Asset Impairments” of our unaudited condensed consolidated financial statements included in Part I, Item 1 “Financial Statements” of this Quarterly Report on Form 10-Q.

Interest Expense

Interest expense increased to $9.1 million during the first nine months of 2010 compared to $8.9 million in the first nine months of 2009 due to interest charges incurred pursuant to additional tax reserves established in connection with the current IRS examination of prior tax years in excess of amounts recognized in the first nine months of 2009. This increase was partially offset by a decrease in interest expense incurred on our revolving credit facility which was primarily attributable to a decrease in the average debt balance outstanding between the two periods. During the first nine months of 2010, the average debt balance outstanding under our revolving credit facility was $325.2 million compared to $347.5 million during the first nine months of 2009.

Income Taxes

Our effective income tax rate increased to 40.8% during the first nine months of 2010 compared to 38.5% for the first nine months of 2009, primarily due to unfavorable discrete adjustments of approximately $2.4 million we recorded
 

to income tax expense during the second quarter of 2010 in connection with the current IRS examination of our 2006 and 2007 tax years.

Diluted Earnings Per Share

Diluted earnings per share decreased to $2.38 per share for the first nine months of 2010 from $2.42 per share in the first nine months of 2009 primarily due to a 8.1% decrease in our net income, partially offset by a 6.7% decrease in the number of weighted average diluted shares outstanding between the two periods. The decrease in diluted earnings per share between the two periods was impacted by our repurchase of approximately 3.7 million shares of our common stock since the beginning of the first quarter of 2009. We estimate that the decrease in the number of weighted average diluted shares outstanding during the first nine months of 2010 attributable solely to these repurchases benefited our earnings per share in the first nine months of 2010 by approximately $0.16. Our estimate is based on the weighted average number of shares repurchased since the beginning of the first quarter of 2009 and includes consideration of the estimated additional interest expense attributable to increased borrowings under our revolving credit facility to finance the repurchases. Our computation does not include the effect of share repurchases prior to the 2009 fiscal year, or the effect of the issuance of restricted stock or exercise of stock options subsequent to the beginning of the first quarter of 2009.

Financial Condition, Liquidity and Capital Resources

Overview of Liquidity

Funds generated by our operating activities, available cash and cash equivalents, and our revolving credit facility continue to be our most significant sources of liquidity. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to finance our business development strategies and capital initiatives for the next year. Our revolving credit facility is also available for additional working capital needs and investment opportunities. However, in the event of a material decline in our sales trends, there can be no assurance that we will generate cash flows at or above our current levels.

Our primary requirements for cash provided by operating activities relate to planned capital expenditures and servicing our debt. We may also use cash from operations to make repurchases of our common stock.

Our customers pay for their purchases in cash or credit cards at the time of the sale. Rapid inventory turnover results in limited investment in inventories, and cash from sales is usually received before related accounts payable for food, supplies and payroll become due. As a result, we are able to frequently operate with a working capital deficit, and we can do so without incurring significant short-term or long-term borrowings.

We do not enter into any material development or contractual purchase obligations in connection with our business development strategy. As a result, with respect to our planned capital expenditures, including spending that pertains to our new store development and capital initiatives, we believe that we have the flexibility necessary to manage our liquidity by promptly deferring or curtailing our capital spending.

The following tables present summarized financial information that we believe is helpful in evaluating our liquidity and capital resources:
 
   
Nine Months Ended
 
   
October 3,
   
September 27,
 
   
2010
   
2009
 
   
(in thousands)
 
             
Net cash provided by operating activities
  $ 137,790     $ 127,431  
Net cash used for investing activities
    (73,136 )     (51,048 )
Net cash used for financing activities
    (63,296 )     (77,468 )
Effect of foreign exchange rate changes on cash
    14       (645 )
Change in cash and cash equivalents
  $ 1,372     $ (1,730 )
                 
Interest paid
  $ 8,128     $ 9,231  
Income taxes paid, net
  $ 31,851     $ 18,845  

   
October 3,
   
January 3,
 
   
2010
   
2010
 
   
(in thousands)
 
             
Cash and cash equivalents
  $ 18,733     $ 17,361  
Revolving credit facility borrowings
  $ 356,500     $ 354,300  
Available unused commitments under revolving credit facility
  $ 182,841     $ 185,743  


Cash Flows – Operating Activities

Net cash provided by operating activities increased $10.4 million to $137.8 million during the first nine months of 2010 from $127.4 million in the first nine months of 2009. The increase was primarily attributable to the increase in our Company store sales, the receipt of a $1.8 million franchise development fee during the first quarter of 2010 and a $1.1 million increase in the amount of vendor rebates received during the first nine months of 2010 compared to the same period in 2009.

Our cash interest payments decreased $1.1 million to $8.1 million during the first nine months of 2010 from $9.2 million in the first nine months of 2009 primarily due to a reduction in the average debt balance outstanding under our revolving credit facility between the two periods.

Our cash payments for income taxes, net of refunds received, increased $13.0 million to $31.9 million during the first nine months of 2010 from $18.8 million in the first nine months of 2009 primarily due to the non recurrence of a $5.5 million refund of excess federal income taxes we received in the first quarter of 2009, combined with increases in our current year federal estimated and state tax payments during the first nine months of 2010. Also, during the third quarter of 2010, we paid $0.6 million in connection with the settlement of a state tax audit.

Cash Flows – Investing Activities

Net cash used in investing activities increased $22.1 million to $73.1 million during the first nine months of 2010 from $51.0 million in the first nine months of 2009, primarily due to an increase in the number of capital spending initiatives for our existing stores which affected 157 stores during the first nine months of 2010 compared to 107 stores during the same period in 2009 and cash payments associated with our acquisition of former franchised store locations during the first nine months of 2010.

The following table summarizes information regarding the number of capital spending initiatives we completed during each of the periods presented:
   
Nine Months Ended
 
   
October 3,
   
September 27,
 
   
2010
   
2009
 
             
Existing Company-owned store initiatives:
           
Major remodels
    9       6  
Store expansions
    19       15  
Game enhancements
    129       86  
Total completed
    157       107  
                 
Company-owned stores added (1) 
    4       1  

   
(1)
Company-owned stores added during the nine months ended October 3, 2010 include three stores we acquired from franchisees.

Cash Flows – Financing Activities

Net cash used in financing activities decreased $14.2 million to $63.3 million during the first nine months of 2010 from $77.5 million in the first nine months of 2009 primarily due to a reduction in our net repayments on our revolving credit facility during the first nine months of 2010, partially offset by an increase in our share repurchase activity and a decrease in proceeds obtained through the exercise of employee stock options. During the first nine months of 2010, we increased the outstanding borrowings under our revolving credit facility by $2.2 million, compared to the same period in 2009 when we made repayments of $62.3 million. This increase in borrowings was primarily related to our share repurchases during 2010. During the first nine months of 2010, our repurchases of our common stock increased $33.9 million to $67.4 million compared to $33.6 million during the same period last year. Also, during the first nine months of 2010, cash proceeds received through the exercise of employee stock options decreased $13.5 million compared to the same period in 2009 due to a decline in the number of exercisable awards outstanding.

Sources of Liquidity

We currently finance our business activities through cash flows provided by our operations and, as necessary, from borrowings under our revolving credit facility.

Our requirement for working capital is not significant since our customers pay for their purchases in cash or credit cards at the time of the sale, enabling us to monetize many of our inventory items before we have to pay suppliers for such items. We attempt to maintain only sufficient inventory of supplies in our stores to satisfy current operational needs. Since our accounts payable are generally due in five to 30 days, we are able to operate with a net working capital deficit (current liabilities in excess of current assets). Our net working capital deficit increased to $18.3 million at October 3, 2010 from $1.0 million at January 3, 2010 primarily


due to variations in the timing and amount of payments for accounts payable, income taxes and vendor rebate collection, combined with an increase in our accrued expenses attributed to an unfavorable adjustment to our income tax liability during the second quarter of 2010.

Our ability to access our revolving credit facility is subject to our compliance with the terms and conditions of the credit facility agreement, including our maintenance of certain prescribed financial ratio covenants, as more fully described below.

Debt Financing

We have a revolving credit facility providing for total borrowings of up to $550.0 million. The credit facility, which matures in October 2012, also includes an accordion feature allowing us, subject to lender approval, to request an additional $50.0 million in borrowings at any time. As of October 3, 2010, there were $356.5 million of borrowings outstanding and $10.7 million of letters of credit issued but undrawn under the credit facility. Based on the type of borrowing, the credit facility bears interest the London Interbank Offered Rate (“LIBOR”) plus an applicable margin of 0.625% to 1.25% determined based on our financial performance and debt levels, or alternatively, the higher of (a) the prime rate or (b) the Federal Funds rate plus 0.50%. As of October 3, 2010, borrowings under the credit facility incurred interest at LIBOR (ranging from 0.26% - 0.31%) plus 1.00% or prime (3.25%). A commitment fee of 0.1% to 0.3%, depending on our financial performance and debt levels, is payable on a quarterly basis on any unused credit line. All borrowings under the credit facility are unsecured, but we have agreed not to pledge any of our existing assets to secure future indebtedness.

During the first nine months of 2010, we increased the outstanding debt balance under our revolving credit facility by $2.2 million to $356.5 million from $354.3 million as of January 3, 2010. Including the effect of our interest rate swap contract, the weighted average effective interest rate incurred on borrowings under our revolving credit facility was 2.9% for the three months ended October 3, 2010 and September 27, 2009, and was 3.0% and 2.9% for the nine months ended October 3, 2010 and September 27, 2009, respectively.

Our revolving credit facility agreement contains a number of covenants that, among other things, require us to comply with the following financial ratios as of the end of any fiscal quarter:

a consolidated fixed charge coverage ratio of not less than 1.5 to 1.0, based upon the ratio of (a) consolidated EBITR (as defined in the revolving credit facility agreement) for the last four fiscal quarters to (b) the sum of consolidated interest charges plus consolidated rent expense during such period.
   
a consolidated leverage ratio of not greater than 3.0 to 1.0, based upon the ratio of (a) the quarter-end consolidated funded indebtedness (as defined in the revolving credit facility agreement) to (b) consolidated EBITDA (as defined in the revolving credit facility agreement) for the last four fiscal quarters.

Our revolving credit facility is the primary source of committed funding from which we finance our planned capital expenditures, strategic initiatives, such as repurchases of our common stock, and certain working capital needs. Non-compliance with the financial covenant ratios could prevent us from being able to access further borrowings under our revolving credit facility, require us to immediately repay all amounts outstanding under the revolving credit facility, and increase our cost of borrowing. As of October 3, 2010, we were in compliance with these covenant ratios, with a consolidated fixed charge coverage ratio of 2.29 to 1 and a consolidated leverage ratio of 1.92 to 1.

Interest Rate Swap

We have entered into an interest rate swap contract to effectively convert $150.0 million of our variable rate revolving credit facility debt to a fixed interest rate. The contract, which matures in May 2011, requires us to pay a fixed rate of 3.62% while receiving variable payments from the counterparty at the three-month LIBOR rate. Including the 1.00 percentage point applicable margin incurred on our revolving credit facility, the effective interest rate of the swap contract was 4.62% as of October 3, 2010. The differential amounts receivable or payable under the swap contract are recorded over the life of the contract as adjustments to interest expense.

As of October 3, 2010, the estimated fair value of the swap contract was a liability of approximately $3.2 million. Refer to Note 4 “Derivative Instrument” of our condensed consolidated financial statements for a more complete discussion of our interest rate swap contract.

Capital Expenditures

Our future capital expenditures are expected to be primarily for reinvestment into our existing Company-owned store base through various capital initiatives and the development or acquisition of additional Company stores. We estimate capital expenditures in 2010 will total approximately $103.0 million to $105.0 million, including approximately $64.0 million related to


capital initiatives for our existing stores, approximately $23.0 million to $25.0 million related to new store development and the acquisition of franchise stores, and the remainder for other store initiatives, general store requirements and corporate capital expenditures. We plan to fund these capital expenditures through cash flow from operations and, if necessary, borrowings under our revolving credit facility.

The following tables summarize information regarding the expected number of and estimated average cost for our projected capital expenditures activities during each of the periods presented:

   
Completed Through
   
Projection for Remainder of
   
Projected Completions
   
Estimated
 
   
Third Quarter
   
Fiscal
Year
   
Fiscal
Year
   
Average
Cost
 
   
2010
   
2010
   
2010
   
Per Project
 
                     
(in millions)
 
Investment in existing Company-owned stores:
                       
Major remodels
    9       6       15     $ 0.6  
Store expansions
    19       10       29     $ 1.0  
Game enhancements
    129       67       196     $ 0.1 to $0.2  
Total
    157       83       240          
                                 
New Company store development and franchise store acquisitions
    4    
6 to 8
   
10 to 12
    $ 2.1 to $2.2  

   
Projected Completions
   
Actual Completions
   
Increase
 
   
Fiscal Year
   
Fiscal Year
   
Over Prior
 
   
2010
   
2009
   
Fiscal Year
 
                   
Investment in existing Company-owned stores:
                 
Major remodels
    15       9       6  
Store expansions
    29       26       3  
Game enhancements
    196       125       71  
Total
    240