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EXCEL - IDEA: XBRL DOCUMENT - NPC Restaurant Holdings, LLCFinancial_Report.xls
EX-32.2 - EXHIBIT - NPC Restaurant Holdings, LLCexhibit322201471.htm
EX-31.1 - EXHIBIT - NPC Restaurant Holdings, LLCexhibit311-201471.htm
EX-10.26 - EXHIBIT - NPC Restaurant Holdings, LLCemploymentagreement-hedric.htm
EX-32.1 - EXHIBIT - NPC Restaurant Holdings, LLCexhibit321-201471.htm
EX-2.05 - EXHIBIT - NPC Restaurant Holdings, LLCedgarapa-carlisle_npc.htm
EX-31.2 - EXHIBIT - NPC Restaurant Holdings, LLCexhibit312-201471.htm
EX-10.27 - EXHIBIT - NPC Restaurant Holdings, LLCincrementalamendment-npcfi.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 ____________________________________________________________
Form 10-Q
 ____________________________________________________________
(Mark one)
ý 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 1, 2014
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 333-180524-04
 ____________________________________________________________
NPC RESTAURANT HOLDINGS, LLC
(Exact name of registrant as specified in its charter)
 ____________________________________________________________
 
DELAWARE
 
20-4509045
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. employer
identification number)
 
 
 
7300 W. 129th Street
Overland Park, KS
 
66213
(Address of principal executive offices)
 
(Zip Code)
Telephone: (913) 327-5555
(Registrant’s telephone number, including area code)
 ____________________________________________________________
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  ¨   No  ý
(Note: As a voluntary filer, not subject to the filing requirements, the registrant filed all reports required under Section 13 or 15(d) of the Exchange Act during the preceding 12 months.)
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    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. (Check one):
 
Large Accelerated filer
 
¨
 
Accelerated filer
 
¨
Non-accelerated filer
 
ý
 
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  ý
There is no market for the Registrant’s equity. As of August 15, 2014, there were 1,000 units of membership interests outstanding.





INDEX
 

2


PART I
PART 1. FINANCIAL INFORMATION

Item 1.
Consolidated Financial Statements (unaudited)

NPC RESTAURANT HOLDINGS, LLC
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands, except share data)
 
 
July 1,
2014
 
December 31,
2013
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
48,293

 
$
20,035

Accounts and other receivables
8,587

 
10,580

Inventories
9,187

 
8,255

Prepaid expenses and other current assets
9,141

 
7,339

Deferred income taxes
9,066

 
10,895

Total current assets
84,274

 
57,104

Facilities and equipment, less accumulated depreciation of $95,795 and $75,895, respectively
180,617

 
169,950

Franchise rights, less accumulated amortization of $40,509 and $31,629, respectively
631,401

 
640,151

Goodwill
292,638

 
292,623

Other assets, net
44,393

 
45,284

Total assets
$
1,233,323

 
$
1,205,112

Liabilities and member’s equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
36,554

 
$
30,335

Accrued liabilities
41,907

 
51,056

Accrued interest
10,322

 
9,641

Current portion of insurance reserves
11,275

 
10,598

       Current portion of debt
4,158

 
3,438

Total current liabilities
104,216

 
105,068

Long-term debt
592,302

 
561,687

Other deferred items
41,709

 
42,681

Insurance reserves
17,016

 
16,008

Deferred income taxes
211,345

 
214,455

Total long-term liabilities
862,372

 
834,831

Commitments and contingencies


 


Member’s equity:
 
 
 
Membership interests (1,000 units authorized, issued and outstanding as of July 1, 2014 and December 31, 2013)

 

Member’s capital
266,735

 
265,213

Total member’s equity
266,735

 
265,213

Total liabilities and member’s equity
$
1,233,323

 
$
1,205,112

See accompanying notes to the unaudited consolidated financial statements.

3


NPC RESTAURANT HOLDINGS, LLC
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands) 
 
13 Weeks Ended
 
26 Weeks Ended
 
July 1,
2014
 
June 25,
2013
 
July 1,
2014
 
June 25,
2013
Sales:
 
 
 
 
 
 
 
Net product sales
$
273,232

 
$
249,403

 
$
555,535

 
$
514,074

Fees and other income
12,674

 
12,555

 
26,624

 
26,853

Total sales
285,906

 
261,958

 
582,159

 
540,927

Costs and expenses:
 
 
 
 
 
 
 
Cost of sales
86,605

 
71,793

 
174,692

 
148,641

Direct labor
80,957

 
70,449

 
164,426

 
146,039

Other restaurant operating expenses
91,305

 
78,809

 
180,744

 
160,539

General and administrative expenses
15,684

 
15,097

 
31,143

 
29,521

Corporate depreciation and amortization of intangibles
5,097

 
4,480

 
10,194

 
8,873

Other
(45
)
 
416

 
260

 
549

Total costs and expenses
279,603

 
241,044

 
561,459

 
494,162

Operating income
6,303

 
20,914

 
20,700

 
46,765

Interest expense
10,042

 
10,237

 
20,204

 
20,477

(Loss) income before income taxes
(3,739
)
 
10,677

 
496

 
26,288

Income tax (benefit) expense
(2,365
)
 
2,589

 
(1,086
)
 
4,956

Net (loss) income
$
(1,374
)
 
$
8,088

 
$
1,582

 
$
21,332

 

See accompanying notes to the unaudited consolidated financial statements.

4


NPC RESTAURANT HOLDINGS, LLC
CONSOLIDATED STATEMENT OF EQUITY
(Unaudited)
(in thousands)
 
 
Member’s
equity
Balance December 31, 2013
$
265,213

Net income
1,582

Purchase of Company stock
(60
)
Balance at July 1, 2014
$
266,735

See accompanying notes to the unaudited consolidated financial statements.

5


NPC RESTAURANT HOLDINGS, LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands) 

 
26 Weeks Ended
 
July 1,
2014
 
June 25,
2013
Operating activities
 
 
 
Net income
$
1,582

 
$
21,332

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Depreciation and amortization
30,935

 
26,201

Amortization of debt issuance costs
1,928

 
1,663

Deferred income taxes
(1,281
)
 
1,870

Other
(16
)
 
384

Changes in assets and liabilities, excluding the effect of acquisitions:
 
 
 
Accounts receivable
1,993

 
5,910

Inventories
(932
)
 
(480
)
Prepaid expenses and other current assets
(1,194
)
 
(1,432
)
Accounts payable
6,219

 
5,285

Income taxes
(1,395
)
 
3,033

Accrued interest
681

 
1,425

Accrued liabilities
2,702

 
2,218

Insurance reserves
1,685

 
269

Other deferred items
(1,366
)
 
(851
)
Other assets
(258
)
 
(35
)
Net cash provided by operating activities
41,283

 
66,792

Investing activities
 
 
 
Capital expenditures
(35,105
)
 
(22,102
)
Proceeds from sale or disposition of assets
2,373

 
540

Net cash used in investing activities
(32,732
)
 
(21,562
)
Financing activities
 
 
 
Borrowings under revolving credit facility
60,800

 

Payments under revolving credit facility
(67,800
)
 

Issuance of debt
40,000

 

Payments on term bank facilities
(1,665
)
 

Debt issue costs
(693
)
 
(91
)
Purchase of Company stock
(60
)
 

Payment of accrued purchase price to sellers
(10,875
)
 
(2,847
)
Net cash provided by (used in) financing activities
19,707

 
(2,938
)
Net change in cash and cash equivalents
28,258

 
42,292

Beginning cash and cash equivalents
20,035

 
25,493

Ending cash and cash equivalents
$
48,293

 
$
67,785

Supplemental disclosures of cash flow information:
 
 
 
Net cash paid for interest
$
17,519

 
$
17,309

Net cash paid for income taxes
$
3,342

 
$
650


See accompanying notes to the unaudited consolidated financial statements.

6


NPC RESTAURANT HOLDINGS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – Basis of Presentation, Interim Financial Statements and Accounting Policies
NPC Restaurant Holdings, LLC is referred to herein as “Holdings.” Holdings and its subsidiaries are referred to herein as the “Company.” Holdings’ wholly-owned subsidiary, NPC International, Inc., is referred to herein as “NPC.” NPC’s wholly-owned subsidiary, NPC Quality Burgers, Inc., is referred to herein as “NPCQB.” On December 28, 2011, all of the outstanding membership interests of Holdings were acquired (the “Acquisition”) by NPC International Holdings, Inc. (“NPC Holdings” or “Parent”), an entity controlled by Olympus Growth Fund V, L.P. and certain of its affiliates (“Olympus” or “Sponsor”).
The accompanying unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for reporting on Form 10-Q. Accordingly, certain information and disclosures required by accounting principles generally accepted in the United States for complete consolidated financial statements are not included herein.
The unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s latest Annual Report on Form 10-K.
The results of operations of any interim period are not necessarily indicative of the results of operations for the full year. The Company believes the accompanying unaudited interim consolidated financial statements include all adjustments (consisting of normal recurring adjustments and accruals) necessary to fairly present the Company’s consolidated results of operations, financial position and cash flows as of the dates and for the periods presented.
Effective January 1, 2014, the Company adopted, on a prospective basis, Accounting Standards Update (“ASU”) No. 2013-11, Income Taxes, issued by the Financial Accounting Standards Board (“FASB”), related to the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The guidance requires, unless certain conditions exist, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, similar tax loss, or a tax credit carryforward. If a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. Generally Accepted Accounting Principles when it becomes effective. The new standard is effective for the Company on January 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.
Note 2 – Goodwill and Other Intangible Assets
Changes in goodwill are summarized below (in thousands):

Balance at December 31, 2013
$
292,623

     Purchase accounting adjustment
15

Balance at July 1, 2014
$
292,638


The carrying value of the Company’s goodwill is included in the Pizza Hut and Wendy’s reporting units. The Company assesses goodwill, which is not subject to amortization, for impairment annually in its second quarter, and also at any other date when events or changes in circumstances indicate that the carrying value of these assets may exceed their fair value. The Company based its goodwill impairment testing for the Wendy’s reporting unit on a qualitative assessment. As a result of negative comparable store sales in the Company’s Pizza Hut operations, the Company performed a quantitative assessment and estimated the fair value of the Pizza Hut reporting unit using the discounted expected future cash flows. As a result of the Company’s annual impairment testing, the Company determined that goodwill was not impaired.

7


Amortizable other intangible assets consist of franchise rights and leasehold interests. These intangible assets are amortized on a straight-line basis over the lesser of their economic lives or the remaining life of the applicable agreement. Intangible assets subject to amortization are summarized below (in thousands):
 
 
July 1, 2014
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Book
Value
Amortizable intangible assets:
 
 
 
 
 
Franchise rights
$
671,910

 
$
(40,509
)
 
$
631,401

Favorable leasehold interests
13,635

 
(2,907
)
 
10,728

Unfavorable leasehold interests
(17,416
)
 
5,403

 
(12,013
)
 
$
668,129

 
$
(38,013
)
 
$
630,116


 
December 31, 2013
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Book
Value
Amortizable intangible assets:
 
 
 
 
 
Franchise rights
$
671,780

 
$
(31,629
)
 
$
640,151

Favorable leasehold interests
13,937

 
(2,616
)
 
11,321

Unfavorable leasehold interests
(18,107
)
 
5,026

 
(13,081
)
 
$
667,610

 
$
(29,219
)
 
$
638,391

Amortization expense on intangible assets was $4.2 million and $3.6 million for the 13-week periods ended July 1, 2014 and June 25, 2013, respectively, and $8.4 million and $7.2 million for the 26-week periods ended July 1, 2014 and June 25, 2013, respectively.
Note 3 – Debt
The Company’s debt consisted of the following (in thousands):
 
 
July 1,
2014
 
December 31,
2013
Term Loan
$
406,460

 
$
368,125

Senior Notes
190,000

 
190,000

Revolving Facility ($110 million) (1)

 
7,000

 
596,460

 
565,125

Less current portion
4,158

 
3,438

 
$
592,302

 
$
561,687

 
(1) 
The Company had $91.8 million of borrowing capacity available under its revolving credit facility (“Revolving Facility”), net of $18.2 million of outstanding letters of credit at July 1, 2014. At December 31, 2013, the Company had $84.7 million of borrowing capacity available under its Revolving Facility, net of $18.3 million of outstanding letters of credit and borrowings of $7.0 million.

The Company's Senior Secured Credit Facilities are comprised of the Revolving Facility and the term loan. On June 19, 2014, the Company incurred $40.0 million of term loan debt under the existing credit facility’s $125.0 million term loan accordion feature, on the same terms as the Company’s existing term loan. This borrowing reduced the Company’s remaining available term loan accordion capacity to $85.0 million. The Company paid $0.7 million for transaction costs which were capitalized to debt issuance costs and will be amortized over the term of the related debt. The proceeds were used to fund the July 2014 acquisition of 56 Wendy’s units. (See Note 11 to the consolidated financial statements for a discussion regarding the Company’s subsequent events.)

The Company’s debt facilities contain restrictions on additional borrowings, certain asset sales, capital expenditures, dividend payments, certain investments and related-party transactions, as well as requirements to maintain various financial ratios. At July 1, 2014, the Company was in compliance with all of its debt covenants.


8


Based upon the amount of excess cash flow generated during the fiscal year and the Company’s leverage at fiscal year end, each of which is defined in the credit agreement governing the term loan, the Company may be required to make an excess cash flow mandatory prepayment. The excess cash flow mandatory prepayment is an annual requirement under the credit agreement and is due 95 days after the end of each fiscal year. The Company currently expects that it will not be required to make a payment in 2015. Because this is a preliminary estimate, it is possible that an excess cash flow mandatory prepayment could ultimately be required.
Note 4 – Fair Value Measurements
Fair value measurements enable the reader of the financial statements to assess the inputs used to develop those measurements by establishing a hierarchy for ranking the quality and reliability of the information used to determine fair values. The Company classifies and discloses assets and liabilities carried at fair value in one of the following three categories:
Level 1: Unadjusted quoted prices available in active markets for identical assets or liabilities.
Level 2: Pricing inputs, other than Level 1 quoted prices, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data. These inputs are frequently utilized in pricing models, discounted cash flow techniques and other widely accepted valuation methodologies.
Level 3: Unobservable inputs that are not corroborated by market data, which requires the Company to develop its own assumptions.
The following tables summarize the carrying amounts and fair values of certain assets at July 1, 2014 and December 31, 2013, (in thousands):
 
July 1, 2014
 
 
 
Fair Value Estimated Using
 
Carrying Amount
 
Total
 
Level 1 Inputs
 
Level 2 Inputs
 
Level 3 Inputs
Equities(1)
$
9,934

 
$
9,934

 
$
6,677

 
$
3,257

 
$

Fixed income(1)
5,320

 
5,320

 
1,512

 
3,808

 

Money market fund(2)
44,182

 
44,182

 

 
44,182

 

 
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 
 
 
Fair Value Estimated Using
 
Carrying Amount
 
Total
 
Level 1 Inputs
 
Level 2 Inputs
 
Level 3 Inputs
Equities(1)
$
9,015

 
$
9,015

 
$
5,778

 
$
3,237

 
$

Fixed income(1)
4,909

 
4,909

 
1,409

 
3,500

 

Money market fund(2)
13,948

 
13,948

 

 
13,948

 

 
 
 
 
 
 
 
 
 
 
`
(1) 
These investments relate to the Deferred Compensation Plan and the POWR Plan and are located in the other assets line item on the Consolidated Balance Sheets. The investments categorized as Level 2 in the fair value hierarchy are valued by using available market information which includes quoted market prices for identical or similar assets in non-active markets.
(2) 
At July 1, 2014 and December 31, 2013, $0.4 million and $0.6 million, respectively, related to the Deferred Compensation and POWR Plans, were located in the other assets line item on the Consolidated Balance Sheets. At July 1, 2014 and December 31, 2013 the remaining $43.8 million and $13.3 million, respectively, were short-term in nature and were classified in cash and cash equivalents on the Consolidated Balance Sheets. Money market funds are valued at amortized cost which reflects the market-based fair value.
The estimated fair value of the Company’s outstanding borrowings was as follows (in thousands):
 
 
July 1, 2014
 
December 31, 2013
Term Loan
$
404,428

 
$
372,285

Senior Notes
217,075

 
220,400

Revolving Facility

 
7,000

 
$
621,503

 
$
599,685

Carrying value
$
596,460

 
$
565,125


9


The Company measures the fair value of its debt facilities under a Level 2 observable input which consists of quotes from non-active markets. However, the fair value estimates presented herein are not necessarily indicative of the amount that the Company’s debtholders could realize in a current market exchange. Cash and cash equivalents (excluding the money market fund), accounts and other receivables and accounts payable are carried at cost which approximates fair value because of the short-term nature of these instruments.  
Note 5 – Income Taxes
For the 26 weeks ended July 1, 2014, the Company recorded an income tax benefit of $1.1 million compared to income tax expense of $5.0 million for the prior year period. Under Accounting Standards Codification 740 (“ASC 740”), companies are required to apply their estimated annual tax rate on a year-to-date basis in each interim period. Under ASC 740, companies should not apply the estimated annual tax rate to interim financial results if the estimated annual tax rate is not reliably predictable. In this situation, the interim tax rate should be based on the actual year-to-date results. Based on fluctuations in the Company’s current and projected results, a reliable projection of the Company’s annual effective rate has been difficult to determine, producing significant variations in the customary relationship between income tax expense and pre-tax book income in interim periods. As such, and in contrast with our previous methods of recording income tax expense, the Company recorded a tax benefit of $2.3 million for the 26 weeks ended July 1, 2014 based on actual year-to-date results. This benefit was primarily related to federal employment-related tax credits. This benefit was partially offset by income tax expense of $1.2 million for an adjustment to deferred taxes for a change in the applicable state income tax rate. For the 26 weeks ended June 25, 2013, the lower than statutory rate was primarily due to tax credits and a $1.6 million favorable tax adjustment related to previously unrecognized prior year federal employment-related credits that were recognized upon extension of the credits on January 2, 2013.
The Company files a consolidated US federal tax return with its parent company, NPC Holdings. The Company allocates taxes between it and the Parent utilizing the separate return method.
The liability for uncertain tax positions was $4.0 million as of July 1, 2014 and December 31, 2013, was considered long term and was included in other deferred items and as a reduction to deferred tax assets in the Consolidated Balance Sheets.
Note 6 – Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
 
July 1,
2014
 
December 31,
2013
Payroll and vacation
$
16,247

 
$
16,634

Accrued payroll taxes
2,688

 
2,453

Accrued purchase price due to sellers

 
10,895

Sales tax payable
4,235

 
6,379

Other
18,737

 
14,695

 
$
41,907

 
$
51,056

Note 7 - Stock-based Compensation Plan
In connection with the Acquisition, the Parent established the NPC International Holdings, Inc. Stock Option Plan (the “Plan”), which governs, among other things, the grant of options with respect to the common stock of the Parent. The purposes of this Plan are to: (i) attract and retain highly qualified employees for the Company; (ii) motivate the participants to exercise their best efforts on behalf of the Company and the Parent; (iii) allow participants in the Plan to participate in equity value creation; and (iv) align the incentives between the participants and the Parent as well as the Company.
The following table summarized stock option activity under the Plan during the 26 weeks ended July 1, 2014:

10



 
Number of
Options
Weighted
Average
Exercise
Price
Weighted
Average
Remaining
Contractual
Term
(in years)
Outstanding at December 31, 2013
249,019

 
$
146

 
 
Granted
22,765

 
143

 
 
Exercised

 

 
 
Forfeited or expired
(9,936
)
 
145

 
 
Outstanding at July 1, 2014
261,848

 
103

 
7.7
Exercisable at July 1, 2014
95,012

 
$
119

 
7.5
Under the Plan, options may be granted with respect to a maximum of 271,784 shares of common stock of the Parent, which represents 10% of the outstanding shares of common stock of the Parent as of the date of the Acquisition on a fully diluted basis and was recently adjusted to incorporate options to be available for performance of the Company’s Wendy’s operations. Each grant of options under the Plan will specify the applicable option exercise period, option exercise price, vesting conditions and such other terms and conditions as deemed appropriate by the Board of Directors of the Parent. Currently 79% of the options granted under the Plan will vest ratably over four years subject to the achievement of certain performance targets (“Series 1”); 20% of the options issued under the Plan will vest only upon a change of control of the Company (“Series 2”); and 1% of the options issued under the Plan have no vesting period and are fully exercisable at the date of grant (“Series 3”). In each case for options subject to vesting, vesting will be subject to the option holders’ continued employment through the vesting date. All options granted under the Plan will expire ten years from the date of grant, subject to earlier expiration in the event the option holder ceases to be employed. At July 1, 2014, there were 9,936 shares of common stock available for future grant under the Plan.
Under their respective employment agreements, the following options have been granted to certain members of management:

 
As of
July 1, 2014
Series 1 Options
207,266

 
Series 2 Options
51,817

 
Series 3 Options
2,765

 
Total options granted
261,848

 
Total options exercisable
95,012

 
The exercise price of the Series 1 options was established based on the per share price of the common stock investment in the Parent at the time of closing of the Acquisition, or $100 per share. For the Series 1 options, the exercise price accretes at a rate equal to 9% per annum, compounded annually. The exercise price of the Series 2 options was established as $250.00 per share. The exercise price of all options granted following the Acquisition was determined at the discretion of the Compensation Committee. The exercise price for all options granted was equal to or greater than the fair market value of the shares subject to the option on the date of grant.
Option grants will be made at the discretion and through approval of the Board of Directors to ensure that compensation to the Company’s executive officers remains competitive and in-line with its peer companies.
The Company considers these options to be liability awards. The compensation cost for the portion of awards that are outstanding for which the requisite service has not been rendered, or the performance condition has not been achieved, will be recognized as the requisite service is rendered (subject to the occurrence of a triggering event becoming probable as described below) and/or performance condition achieved. Further, under the award agreements under the Plan, any portion of the Series 1 and Series 2 options that were vested on the date of the termination of the option holder’s employment or engagement with the Company for any reason is forfeited without payment of any kind 30 days after the date of such separation; provided that in the event the separation is a result of a termination by the Company for cause or the resignation of the option holder (other than for good reason in certain situations), any portion of the option that was vested shall also expire and be forfeited without payment of any kind on the separation date. Under the Stockholders Agreement among the stockholders of Parent, upon the termination of an employee stockholder’s employment or engagement with the Company for any reason, the Parent is required to purchase and the employee is required to sell all of the shares held at a price per share equal to the greater of (i) the original cost of such repurchased shares or (ii) the fair market value of such repurchased shares; provided that, if the separation is the result of a termination by the

11


Company with cause or the resignation of the employee stockholder (other than for good reason in certain situations), then the purchase price for such repurchase shares equals the lesser of (i) the original cost or (ii) fair market value.
The Series 3 options are not subject to vesting and may be exercised at any time prior to expiration. Based on the term of the agreement under the Plan, any option not exercised by the tenth anniversary date of the option grant or in the event the separation is a result of a termination by the Company for cause or the resignation of the option holder (other than for good reason in certain situations), the option shall expire and is forfeited without payment. In the event of a Change of Control, the employee is entitled to receive the greater of (i) the fair market value of such repurchased shares or (ii) an amount by which the fair market value of such repurchased shares exceeds the exercise price of all repurchased shares.
The Company does not have a contractual obligation to fund the repurchase of these shares; however, the Company may be called upon to provide a distribution to the Parent upon such time a triggering event should occur that would require a repurchase of outstanding shares.
As of July 1, 2014, no options had been exercised by management. Based on the provisions of the Plan and the award agreements thereunder, all options granted have clearly defined and limited scenarios in which the option has value to the option holder. Specifically, the Stockholders Agreement prohibits the transfer or sale of shares to third parties without consent, which is at the sole discretion of the Parent and its majority owners. Further, there are no provisions in place under which an employee may require the Company to repurchase shares absent the occurrence of a triggering event (termination of employment or a Parent sale transaction). Therefore, the holder of either options or shares acquired upon exercise of those options can generally only monetize the options and/or sell the underlying shares upon occurrence of such an event, and upon the occurrence of such an event the options granted have the potential to yield value to each option holder only if the holder’s employment is terminated by the Company without cause or by the holder with good reason in certain situations (“Good Leaver Scenario”) or upon a Parent sale transaction. A Good Leaver Scenario is achieved when an event in the Company’s control, such as a base salary reduction or a forced relocation, occurs; all such events have been deemed improbable of occurrence for all option holders and are expected to continue to be deemed improbable until the time one such qualifying event occurs. Absent a Good Leaver Scenario, the Company can repurchase the underlying shares at the lower of original purchase price or the fair market value at the repurchase date if the option holders terminate employment at any time prior to a change in control. Due to the fact that an option holder would have no value for termination of employment for any other reason, and currently the Good Leaver Scenario and Parent sale transaction are not deemed probable, the Company has concluded a 100% forfeiture rate is appropriate, as the restriction on transferability and sale of underlying shares creates an in-substance service period and there is no assurance that the underlying stock related to the options will achieve any value above its original cost under these conditions prior to forfeiture or expiration. As no triggering events have been deemed probable as of July 1, 2014, the Company has recorded no compensation expense for all options granted.
Note 8 – Commitments and Contingencies

From time to time, the Company is involved in litigation, most of which is incidental to the business. In the Company’s opinion, no litigation to which the Company is party is likely to have a material adverse effect on the Company’s consolidated financial condition, results of operations or cash flows.
Note 9 – Transactions with Sponsor
Olympus Advisory Agreement. On December 28, 2011, the Company entered into a management advisory agreement with the Sponsor pursuant to which the Sponsor or its affiliates provide financial, investment banking, management advisory and other services on the Company’s behalf for an annual fee of $1.0 million, paid in quarterly installments in arrears on the last day of each calendar quarter. The Company accrues the fee ratably to general and administrative expenses. The Sponsor also receives reimbursement for out-of-pocket expenses incurred in connection with services provided pursuant to the agreement.

Note 10 – Condensed Consolidating Financial Statements
NPC’s obligations under the 10 1/2% Senior Notes due 2020 and Senior Secured Credit Facilities are fully guaranteed by Holdings. As of the date hereof, Holdings’ only material asset is 100% of the stock of NPC. The remaining co-issuers with NPC, NPCQB and NPC Operating Company B, Inc. (“NPC Op Co B”) are 100% owned by NPC. NPCQB did not have any assets, operations or cash flows prior to completing acquisitions of Wendy’s restaurants during the third and fourth quarters of fiscal 2013. NPC Op Co B does not have any assets, operations or cash flows as of July 1, 2014. Holdings and subsidiary guarantees are joint and several, full and unconditional. The following summarizes the Company’s condensed consolidating information as of July 1, 2014 and December 31, 2013, and for each of the 13-week and 26-week periods ended July 1, 2014 and June 25, 2013 (in thousands):


12


Condensed Consolidating Statements of Operations
 
 
 
 
 
 
 
 
 
 
 
 
 
13 Weeks Ended July 1, 2014
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
252,847

 
$
33,059

 
$

 
$

 
$
285,906

Total costs and expenses

 
247,780

 
31,823

 

 

 
279,603

Operating income

 
5,067

 
1,236

 

 

 
6,303

Interest expense

 
10,042

 

 

 

 
10,042

Equity in net (loss) income of subsidiary
(1,374
)
 
797

 

 

 
577

 

(Loss) income before income taxes
(1,374
)
 
(4,178
)
 
1,236

 

 
577

 
(3,739
)
Income tax (benefit) expense

 
(2,804
)
 
439

 

 

 
(2,365
)
Net (loss) income
$
(1,374
)
 
$
(1,374
)
 
$
797

 
$

 
$
577

 
$
(1,374
)


 
 
 
 
 
 
 
 
 
 
 
 
 
13 Weeks Ended June 25, 2013
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
261,958

 
$

 
$

 
$

 
$
261,958

Total costs and expenses

 
241,044

 

 

 

 
241,044

Operating income

 
20,914

 

 

 

 
20,914

Interest expense

 
10,237

 

 

 

 
10,237

Equity in net income of subsidiary
8,088

 

 

 

 
(8,088
)
 

Income before income taxes
8,088

 
10,677

 

 

 
(8,088
)
 
10,677

Income tax expense

 
2,589

 

 

 

 
2,589

Net income
$
8,088

 
$
8,088

 
$

 
$

 
$
(8,088
)
 
$
8,088


 
26 Weeks Ended July 1, 2014
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
519,215

 
$
62,944

 
$

 
$

 
$
582,159

Total costs and expenses

 
499,750

 
61,709

 

 

 
561,459

Operating income

 
19,465

 
1,235

 

 

 
20,700

Interest expense

 
20,204

 

 

 

 
20,204

Equity in net income of subsidiary
1,582

 
788

 

 

 
(2,370
)
 

Income before income taxes
1,582

 
49

 
1,235

 

 
(2,370
)
 
496

Income tax (benefit) expense

 
(1,533
)
 
447

 

 

 
(1,086
)
Net income
$
1,582

 
$
1,582

 
$
788

 
$

 
$
(2,370
)
 
$
1,582



13


 
26 Weeks Ended June 25, 2013
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
540,927

 
$

 
$

 
$

 
$
540,927

Total costs and expenses

 
494,162

 

 

 

 
494,162

Operating income

 
46,765

 

 

 

 
46,765

Interest expense

 
20,477

 

 

 

 
20,477

Equity in net income of subsidiary
21,332

 

 

 

 
(21,332
)
 

Income before income taxes
21,332

 
26,288

 

 

 
(21,332
)
 
26,288

Income tax expense

 
4,956

 

 

 

 
4,956

Net income
$
21,332

 
$
21,332

 
$

 
$

 
$
(21,332
)
 
$
21,332

 

14



Condensed Consolidating Balance Sheet
 
 
July 1, 2014
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Assets:
 
 
 
 
 
 
 
 
 
 
 
Current assets
$

 
$
79,865

 
$
4,409

 
$

 
$

 
$
84,274

Facilities and equipment, net

 
163,188

 
17,429

 

 

 
180,617

Franchise rights, net

 
600,215

 
31,186

 

 

 
631,401

Goodwill

 
290,502

 
2,136

 

 

 
292,638

Investment in subsidiary
266,735

 
44,144

 

 

 
(310,879
)
 

Other assets, net

 
43,390

 
1,003

 

 

 
44,393

Total assets
$
266,735

 
$
1,221,304

 
$
56,163

 
$

 
$
(310,879
)
 
$
1,233,323

Liabilities and member’s equity:
 
 
 
 
 
 
 
 
 
 
 
Current liabilities
$

 
$
94,851

 
$
9,365

 
$

 
$

 
$
104,216

Long-term debt

 
592,302

 

 

 

 
592,302

Other liabilities and deferred items

 
56,436

 
2,289

 

 

 
58,725

Deferred income taxes

 
210,980

 
365

 

 

 
211,345

Member’s equity
266,735

 
266,735

 
44,144

 

 
(310,879
)
 
266,735

Total liabilities and member’s equity
$
266,735

 
$
1,221,304

 
$
56,163

 
$

 
$
(310,879
)
 
$
1,233,323

 
 
December 31, 2013
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Assets:
 
 
 
 
 
 
 
 
 
 
 
Current assets
$

 
$
53,364

 
$
3,740

 
$

 
$

 
$
57,104

Facilities and equipment, net

 
152,810

 
17,140

 

 

 
169,950

Franchise rights, net

 
607,880

 
32,271

 

 

 
640,151

Goodwill

 
290,502

 
2,121

 

 

 
292,623

Investment in subsidiary
265,326

 
50,978

 

 

 
(316,304
)
 

Other assets, net

 
44,273

 
1,011

 

 

 
45,284

Total assets
$
265,326

 
$
1,199,807

 
$
56,283

 
$

 
$
(316,304
)
 
$
1,205,112

Liabilities and member’s equity:
 
 
 
 
 
 
 
 
 
 
 
Current liabilities
$

 
$
100,766

 
$
4,302

 
$

 
$

 
$
105,068

Long-term debt

 
561,687

 

 

 

 
561,687

Other liabilities and deferred items

 
58,060

 
629

 

 

 
58,689

Deferred income taxes

 
214,081

 
374

 

 

 
214,455

Member’s equity
265,326

 
265,213

 
50,978

 

 
(316,304
)
 
265,213

Total liabilities and member’s equity
$
265,326

 
$
1,199,807

 
$
56,283

 
$

 
$
(316,304
)
 
$
1,205,112



15



Condensed Consolidating Statements of Cash Flows
 
 
26 Weeks Ended July 1, 2014
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Operating activities:
 
 
 
 
 
 
 
 
 
 
 
Net cash flows provided by operating activities
$

 
$
31,824

 
$
9,459

 
$

 
$

 
$
41,283

Investing activities:
 
 
 
 
 
 
 
 
 
 
 
Capital expenditures

 
(32,895
)
 
(2,210
)
 

 

 
(35,105
)
Return of investment in NPCQB

 
7,622

 

 

 
(7,622
)
 

Proceeds from sale or disposition of assets

 
2,351

 
22

 

 

 
2,373

Net cash flows used in investing activities

 
(22,922
)
 
(2,188
)
 

 
(7,622
)
 
(32,732
)
Financing activities:
 
 
 
 
 
 
 
 
 
 
 
Payment of accrued purchase price to sellers

 
(10,875
)
 

 

 

 
(10,875
)
Net payments on debt

 
(8,665
)
 

 

 

 
(8,665
)
Issuance of debt

 
40,000

 

 

 

 
40,000

Distribution to parent

 

 
(7,622
)
 

 
7,622

 

Other

 
(753
)
 

 

 

 
(753
)
Net cash flows provided by (used in) financing activities

 
19,707

 
(7,622
)
 

 
7,622

 
19,707

Net change in cash and cash equivalents

 
28,609

 
(351
)
 

 

 
28,258

Beginning cash and cash equivalents

 
19,170

 
865

 

 

 
20,035

Ending cash and cash equivalents
$

 
$
47,779

 
$
514

 
$

 
$

 
$
48,293



16


 
26 Weeks Ended June 25, 2013
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer: NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Operating activities:
 
 
 
 
 
 
 
 
 
 
 
Net cash flows provided by operating activities
$

 
$
66,792

 
$

 
$

 
$

 
$
66,792

Investing activities:
 
 
 
 
 
 
 
 
 
 
 
Capital expenditures

 
(22,102
)
 

 

 

 
(22,102
)
Proceeds from sale or disposition of assets

 
540

 

 

 

 
540

Net cash flows used in investing activities

 
(21,562
)
 

 

 

 
(21,562
)
Financing activities:
 
 
 
 
 
 
 
 
 
 
 
Net cash flows used in financing activities

 
(2,938
)
 

 

 

 
(2,938
)
Net change in cash and cash equivalents

 
42,292

 

 

 

 
42,292

Beginning cash and cash equivalents

 
25,493

 

 

 

 
25,493

Ending cash and cash equivalents
$

 
$
67,785

 
$

 
$

 
$

 
$
67,785



17


Note 11 – Subsequent Events
Wendy’s Acquisition. Effective July 14, 2014, NPC’s wholly-owned subsidiary, NPCQB, completed the acquisition of 56 Wendy’s restaurants from a Wendy’s franchisee, Carlisle Corporation, for $57.1 million, plus amounts for working capital.The acquisition was funded with $40.0 million of incremental term loan borrowings, borrowings from the Revolving Facility and cash on hand. All of the acquired Wendy’s restaurants are owned and operated by NPCQB and are located in North Carolina and Virginia with a heavy concentration in the Greensboro-Winston Salem, North Carolina area. Included in the transaction are 20 fee-owned properties.

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
As used in this report, NPC Restaurant Holdings, LLC is referred to herein as “Holdings.” Holdings and its subsidiaries are referred to as the “Company,” “we” “us,” and “our.” Holdings’ wholly-owned subsidiary, NPC International, Inc. is referred to as “NPC.” NPC’s wholly-owned subsidiary, NPC Quality Burgers, Inc., is referred to herein as “NPCQB.”
Trademarks and Trade Names
The trade name “Pizza Hut” and all other trade names, trademarks, service marks, symbols, slogans, emblems, logos and designs used in the Pizza Hut system and appearing in this Form 10-Q are owned by Pizza Hut, Inc. (“PHI”) and are licensed to us for use with respect to the operation and promotion of our Pizza Hut restaurants. The “WingStreet” name is a trademark of WingStreet, LLC, an entity controlled by Yum! Brands, Inc. (“Yum!”). The trade name “Wendy’s” and all other trade names, trademarks, service marks, symbols, slogans, emblems, logos and designs used in the Wendy’s system and appearing in this Form 10-Q are owned by affiliates of Wendy’s and are licensed to us for use with respect to the operation and promotion of our Wendy’s restaurants. All other trademarks or trade names appearing in this Form 10-Q are the property of their respective owners. Solely for convenience, trademarks and trade names referred to in this Form 10-Q may appear without the ® or ™ symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the right of the applicable licensor to these trademarks and trade names.
Market and Industry Data
In this Form 10-Q, we refer to information regarding the U.S. restaurant industry and the quick service restaurant sector from publicly available market research reports and other publicly available information. Unless otherwise indicated, corporate information regarding PHI in this Form 10-Q has been made publicly available by Yum! and corporate information regarding Wendy's has been made publicly available by Wendy’s International, LLC. We have not independently verified such data and we make no representations as to the accuracy of such information. None of the reports referred to in the Form 10-Q were prepared for use in, or in connection with, this Form 10-Q.
Cautionary Statement Regarding Forward Looking Information
This report includes forward-looking statements regarding, among other things, our plans, strategies, and prospects, both business and financial. All statements contained in this document other than historical information are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs concerning future operations, strategies, financial results or other developments, and may contain words and phrases such as “may,” “expect,” “should,” “anticipate,” “intend,” or similar expressions. Because these forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, there can be no assurance we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Important factors that could cause actual results to differ materially from our forward-looking statements, expectations and historical trends include, but are not limited to, the following:
competitive conditions;
general economic and market conditions;
effectiveness of franchisor advertising programs and the overall success of our franchisors;
increases in commodity, labor, fuel and other costs;
effectiveness of the hedging program for cheese prices directed by the Restaurant Supply Chain Solutions, LLC (“RSCS”) for the Pizza Hut system;
significant disruptions in service or supply by any of our suppliers or distributors;
changes in consumer tastes, geographic concentration and demographic patterns;
consumer concerns about health and nutrition;
our ability to manage our growth and successfully implement our business strategy;

18


the risks associated with the expansion of our business, including risks relating to the integration of the Wendy’s restaurants recently acquired by us;
the effect of disruptions to our computer and information systems or cyber attacks;
the effect of local conditions, events and natural disasters;
general risks associated with the restaurant industry;
the outcome of pending or yet-to-be instituted legal proceedings;
regulatory factors, including changing laws related to healthcare coverage and menu labeling, which may adversely affect our business operations;
the loss of our executive officers and certain key personnel;
our ability to service our substantial indebtedness;
restrictions contained in our debt agreements;
availability, terms and deployment of capital;
our ability to obtain debt or equity financing on reasonable terms or at costs similar to that of our current credit facilities; and
various other factors beyond our control.
Any forward-looking statements made in this report speak only as of the date of this report. Consequently, such forward-looking statements should be regarded solely as our current plans, estimates and beliefs. We do not intend, and do not undertake, any obligation to update any forward-looking statements to reflect future events or circumstances after the date of such statements. For a more detailed discussion of the principal factors that could cause actual results to be materially different, you should read our risk factors in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 (“2013 Form 10-K”) as well as our unaudited consolidated financial statements, related notes, and other financial information appearing elsewhere in this report and our other filings with the Securities and Exchange Commission (“SEC”), which are available on the SEC’s website at www.sec.gov.
Overview
Who We Are. We are the largest Pizza Hut franchisee and the largest franchisee of any restaurant concept in the United States, based on unit count, according to the 2014 “Top 200 Restaurant Franchisees” by Franchise Times. We are also the ninth largest restaurant unit operator, based on unit count, in the U.S. according to the 2013 “Chain Restaurant Industry Review” by GE Capital Franchise Finance. NPC was founded in 1962 and, as of July 1, 2014 we operated 1,265 Pizza Hut units in 28 states with significant presence in the Midwest, South and Southeast and 90 Wendy’s units in 3 states. As of the second quarter of 2014, our Pizza Hut operations represented approximately 20% of the domestic Pizza Hut restaurant system and 22% of the domestic Pizza Hut franchised restaurant system as measured by number of units, excluding licensed units which operate with a limited menu and no delivery in certain of our markets.
Wendy’s Acquisitions. Between July 2013 and December 2013, we acquired 91 Wendy’s units in three separate transactions. Effective July 14, 2014 we acquired an additional 56 Wendy’s units primarily located in North Carolina from another Wendy’s franchisee. These acquisitions represent our entry into a second brand which we currently expect will be expanded through opportunistic acquisitions of restaurants in additional markets and organic growth through development of new restaurants that meet our investment objectives. All of the acquired Wendy’s restaurants are owned and operated by NPCQB and are located in and around the Kansas City and Salt Lake City metropolitan areas and in North Carolina (with a heavy concentration in the Greensboro-Winston Salem, North Carolina area) and Virginia.
Our Fiscal Year. We operate on a 52- or 53-week fiscal year ending on the last Tuesday in December. Fiscal years 2014 and 2013 contain 52 and 53 weeks, respectively. Each quarterly period in 2014 and 2013 has 13 weeks, except the fourth quarter of 2013 which had 14 weeks.

Unless otherwise noted, the discussion below references both our Pizza Hut and Wendy’s operations.
Our Sales
Net Product Sales. Net product sales are comprised of sales of food and beverages from our restaurants, net of discounts. For the 26 weeks ended July 1, 2014, pizza sales accounted for approximately 77% of our Pizza Hut net product sales. Hamburger and chicken sandwiches accounted for approximately 63% of our Wendy’s net product sales. Various factors influence sales at a given unit, including customer recognition of the Pizza Hut and Wendy’s brands, our level of service and operational effectiveness, pricing, marketing and promotional efforts and local competition. Several factors affect our sales in any period, including the number of units in operation, comparable store sales and seasonality. “Comparable store sales” refer to period-over-period net product sales comparisons for units under our operation for at least 12 months.

19


Fees and Other Income. Fees and other income for our Pizza Hut operations are comprised primarily of delivery fees charged to customers, vending receipts and other fee income and are not included in our comparable store sales metric.
Seasonality. Our Pizza Hut business is moderately seasonal in nature with net product sales typically being higher in the first half of the fiscal year. Our Wendy’s business is also moderately seasonal in nature with net product sales typically being higher in the spring and summer months. As a result of these seasonal fluctuations, our operating results may vary between fiscal quarters. Further, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

Restaurants and Formats. We operate our Pizza Hut restaurants through three different formats to cater to the needs of our customers in each respective market. Delivery units, or “Delcos,” are typically located in strip centers and provide delivery and carryout, with a greater proportion being located in more densely populated areas. Red Roof units, or “RRs,” are traditional free-standing, dine-in restaurants which offer on-location dining room service as well as carryout service. Restaurant-Based Delivery units, or “RBDs,” conduct delivery, dine-in, and carryout operations from the same free-standing location. At July 1, 2014, 82% of our Pizza Hut units include the WingStreet product line. We converted 184 units and opened 12 Delco’s with the WingStreet product line during the 26 weeks ended July 1, 2014 and currently expect to convert 196 additional units to WingStreet by the middle of fiscal 2015. The WingStreet menu includes bone-in and bone-out fried chicken wings which are tossed in one of eight sauces and appetizers which are available for dine-in, carryout and delivery.
    
Free-standing Wendy’s restaurants generally include a pick-up window in addition to a dining room. Approximately 65% to 70% of sales at our Wendy’s units are transacted through the pick-up window. Each Wendy’s restaurant offers an extensive menu specializing in hamburger sandwiches and featuring filet of chicken breast sandwiches, which are prepared to order with the customer’s choice of condiments. The Wendy’s menu also includes chicken nuggets, chili, french fries, baked potatoes, freshly prepared salads, soft drinks, Frosty™ desserts and kids’ meals.
The following table sets forth certain information with respect to each year-to-date fiscal period:
 
 
26 weeks Ended
 
 
July 1, 2014
 
June 25, 2013
 
Number of restaurants open at the end of the period:
 
 
 
 
  Pizza Hut
 
 
 
 
Delco
578

 
542

 
RR
165

 
173

 
RBD
522

 
530

 
   Total Pizza Hut units
1,265

(1) 
1,245

(1) 
  Wendy’s units
90

 

 
   Total units
1,355

 
1,245

 
 
(1) 
Includes 1,036 units and 697 units offering the WingStreet product line at July 1, 2014 and June 25, 2013, respectively.
Our Costs
Our operating costs and expenses are comprised of cost of sales, direct labor, other restaurant operating expenses and general and administrative expenses. Our cost structure is highly variable with approximately 70% of operating costs variable to sales and volume of transactions.
Cost of Sales. Cost of sales includes the cost of food and beverage products sold, less rebates from suppliers, as well as paper and packaging, and is primarily influenced by fluctuation in commodity prices. Historically, our Pizza Hut cost of sales has primarily been comprised of the following: cheese: 30-35%; dough: 16-20%; meat: 16-20%; and packaging: 8-10%. These costs can fluctuate from year-to-year given the commodity nature of the cost category, but are constant across regions. We are a member of the RSCS, a cooperative designed to operate as a central procurement service for the operators of Yum! restaurants, and participate in various cheese hedging and procurement programs that are directed by the RSCS for cheese, meat and certain other commodities to help reduce the price volatility of those commodities from period-to-period. Based on information provided by the RSCS, the RSCS typically hedges approximately 30% to 50% of the Pizza Hut system’s anticipated cheese purchases through a combination of derivatives taken under the direction of the RSCS. Additionally, the RSCS has entered into contractual pricing arrangements with the supplier to restaurants in the Pizza Hut system on certain volumes of cheese purchases that may cause the prices paid by us to exceed or be less than the current block cheese price.


20


Our Wendy’s cost of sales is primarily comprised of the following: meat: 40-42%; packaging: 11-13%; potatoes: 8-10%; and dairy: 8-10%. These costs can fluctuate from year-to-year given the commodity nature of the cost category, but are constant across regions.Wendy’s and its franchisees have established Quality Supply Chain Co-op, Inc. to manage contracts for the purchase and distribution of food, proprietary paper, operating supplies and equipment under national contracts with pricing based upon total system volume for the Wendy’s system in the United States and Canada.
Direct Labor. Direct labor includes the salary, payroll taxes, fringe benefit costs and workers’ compensation expense associated with restaurant based personnel. Direct labor is highly dependent on federal and state minimum wage rate legislation given that the vast majority of our workers are hourly employees. To control labor costs, we are focused on proper scheduling and adequate training of our store employees, as well as retention of existing employees.

Other restaurant operating expenses. Other restaurant operating expenses include all other costs directly associated with operating a restaurant facility, which primarily represents royalties, advertising, rent and depreciation (facilities and equipment), utilities, delivery expenses (for our Pizza Hut operations), supplies, repairs, insurance and other restaurant-related costs.    

Beginning in fiscal 2012, PHI began offering development incentives totaling $80,000 per new unit developed (the “Development Incentive”), subject to certain threshold criteria. These incentives are recorded as a reduction to other restaurant operating expenses at the time development of a new unit is completed. The offering of Development Incentives was renewed for fiscal 2013 and fiscal 2014 and is renewable annually at PHI’s discretion. We developed or relocated 12 units during the 26 weeks ended July 1, 2014 that were eligible for the incentive and earned Development Incentives of $1.0 million and we currently expect to develop an additional 22 units, including unit relocations, during fiscal 2014.
Additionally, PHI is offering development incentives totaling $10,000 per unit converted to the WingStreet platform (the “WingStreet Incentive”), for fiscal 2013 through fiscal 2015. WingStreet Incentives earned under the program are recorded as a reduction to other restaurant operating expenses upon completion of each unit conversion and the WingStreet Incentives will be received within 12 months of unit conversion. We converted 184 units during the 26 weeks ended July 1, 2014 that were eligible for the incentive and earned WingStreet Incentives of $1.8 million. We currently expect to convert an additional 196 units by the middle of fiscal 2015.
Our blended average Pizza Hut royalty rate (excluding Development Incentives and WingStreet Incentives) as a percentage of total sales was 4.9% for both the 26 week periods ended July 1, 2014 and June 25, 2013. Our blended average Wendy’s royalty rate as a percentage of total sales was 3.9% for the 26 weeks ended July 1, 2014.
General and administrative expenses. General and administrative expenses include field supervision and personnel costs and the corporate and administrative functions that support our restaurants, including employee wages and benefits, travel, information systems, recruiting and training costs, credit card transaction fees, professional fees, supplies and insurance.
Trends and Uncertainties Affecting Our Business
We believe that as a franchisee of such a large number of Pizza Hut and Wendy’s restaurants, our financial success is driven less by variable factors that affect regional restaurants and their markets, and more by trends affecting the food purchase industry – specifically the Quick Service Restaurants or “QSR” industry. The following discussion describes certain key factors that may affect our future performance.

Recent Results of Operations
During the initial six weeks of our third quarter, our Pizza Hut business is benefiting from changes in promotional activities that are favorably impacting our margins and top line performance relative to our second quarter.  This sequential improvement in these operating metrics is expected to improve our year-over-year profitability trends in our third quarter relative to our results to-date. 
General Economic Conditions and Consumer Spending
Continued high unemployment rates and legislative uncertainty have caused the consumer to experience a real and perceived reduction in disposable income which has negatively impacted consumer spending in most segments of the restaurant industry over the last several years, including the segment in which we compete. Specifically, we believe pressures on low and lower-middle income customers continue to be significant, and we believe that these customers are particularly interested in receiving value at a reasonable price in the current environment.
Competition

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The restaurant business is highly competitive. The QSR industry is a fragmented market, and includes well-established competitors.
Our Pizza Hut restaurants face competition from national and regional chains, as well as independent operators, which affects pricing strategies and margins. Additionally, frozen pizzas and take-and-bake pizzas are competitive alternatives in the pizza segment. Limited product variability within our segment can make differentiation among competitors difficult. Thus, companies in the pizza segment continuously promote and market new product introductions, price discounts and bundled deals, and rely heavily on effective marketing and advertising to drive sales.

Our Wendy’s restaurants face competition from other food service operations within the same geographical area. Wendy’s restaurants compete with other restaurant companies and food outlets, primarily through the quality, variety, convenience, price, and value perception of food products offered. The location of units, quality and speed of service, attractiveness of facilities, effectiveness of marketing and new product development by Wendy’s and its competitors are also important factors. The price charged for each menu item may vary from market to market (and within markets) depending on competitive pricing and the local cost structure.
Commodity Prices
Commodity prices of packaging products (liner board) and ingredients such as cheese, dough (wheat), and meat, can vary. The prices of these commodities can fluctuate throughout the year due to changes in supply and demand. Our costs can also fluctuate as a result of changes in ingredients or packaging instituted by PHI. For the second quarter of fiscal 2014, the block cheese price averaged $2.10 per pound, an increase of $0.32 or 18% versus the average price for the prior year. Additionally, meat prices increased $0.52 per pound or 35% versus the average price for the second quarter of fiscal 2013.
Based upon current market conditions and information provided by the RSCS, we currently expect overall commodity inflation for our Pizza Hut operations to be approximately 4% to 6% for fiscal 2014, without giving full effect to the RSCS directed hedging programs, with commodity inflation of approximately 5% for the first half of fiscal 2014. This inflation will place significant pressure on our margins. We currently expect our overall commodity inflation for our Wendy’s operations to be approximately 2% for fiscal 2014.
Labor Cost
The restaurant industry is labor intensive and known for having a high level of employee turnover given low hourly wages and the part-time composition of the workforce. Direct labor is highly dependent on federal and state minimum wage rate legislation given the vast majority of workers are hourly employees whose compensation is either determined or influenced by the minimum wage rate. Certain states’ minimum wage rates are adjusted annually for inflation. These increases in state minimum wage rates are currently expected to increase direct labor expense by approximately $0.7 million in fiscal 2014. However, there are currently a number of federal and state initiatives and proposals to further increase minimum wage rates, which could be material to our operations. Labor costs for our Pizza Hut restaurants, to the extent that our delivery sales mix increases due to acquisition of units or customer preference, would be expected to increase due to the more labor intensive nature of the delivery transaction.
The federal government and several state governments have proposed or enacted legislation regarding health care, including legislation that in some cases requires employers to either provide health care coverage to their full-time employees, pay a penalty or pay into a fund that would provide coverage for them. We continue to evaluate the effects on our business of the Patient Protection and Affordable Care Act, which was signed into law on March 23, 2010, and the related Health Care and Education Reconciliation Act of 2010, which was signed into law on March 30, 2010 (collectively, the “Federal Health Care Acts”). The provisions of the Federal Health Care Acts having the greatest potential financial impact on us are scheduled to become effective in 2015. Based upon our current evaluation, without taking mitigating steps we expect that the Federal Health Care Acts will likely increase our future costs and could have a material adverse effect on our business, results of operations and financial condition, but we are currently unable to quantify the amount of the impact with any degree of certainty.
Additionally, changes in federal labor laws and regulations relating to union organizing rights and activities could result in portions of our workforce being subjected to greater organized labor influence, thereby potentially increasing our labor costs, and could have a material adverse effect on our business, results of operations and financial condition.
Inflation and Deflation
Inflationary factors, such as increases in food and labor costs, directly affect our operations.
Significant increases in average gasoline prices in the regions in which we operate could increase our delivery driver reimbursement costs. We estimate that every $0.25 per gallon change in average gas prices in our markets impacts our annual operating results by approximately $0.7 million. However, as gas prices change, the impact upon our operations is somewhat

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mitigated for price increases by a transfer of sales from the delivery occasion to the carryout access mode, which is perceived as a higher value by consumers and benefits us with lower labor costs for the carryout transaction.
If the economy experiences deflation, which is a persistent decline in the general price level of goods and services, we may suffer a decline in revenues as a result of the falling prices. In that event, given our fixed costs and minimum wage requirements, it is unlikely that we would be able to reduce our costs at the same pace as any declines in revenues. Consequently, a period of prolonged or significant deflation would likely have a material adverse effect on our business, results of operations and financial condition. Similarly, if we reduce the prices we charge for our products as a result of declines in comparable store sales or competitive pressures, we may suffer decreased revenues, margins, income and cash flow from operations.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our unaudited Consolidated Financial Statements. The preparation of these financial statements requires estimation and judgment that affect the reported amounts of revenues, expenses, assets, and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. If these estimates differ materially from actual results, the impact on the unaudited Consolidated Financial Statements may be material. Our critical accounting policies are available under Item 7 of our 2013 Form 10-K filed on March 7, 2014. There have been no significant changes with respect to these policies during the 26 weeks ended July 1, 2014.
Results of Operations
The table below presents (i) comparable store sales indices, (ii) selected restaurant operating results as a percentage of net product sales and (iii) sales by occasion for the 13-week and 26-week periods ended July 1, 2014 and June 25, 2013:

23


 
13 Weeks Ended
 
26 Weeks Ended
Consolidated(2)
July 1, 2014
 
June 25, 2013
 
July 1, 2014
 
June 25, 2013
Comparable store sales
(5.6
)%
 
(3.7
)%
 
(5.1
)%
 
(2.9
)%
Net product sales, (in thousands)
$
273,232

 
$
249,403

 
$
555,535

 
$
514,074

Fees and other income, (in thousands)
$
12,674

 
$
12,555

 
$
26,624

 
$
26,853

Net product sales
100
 %
 
100
 %
 
100
 %
 
100
 %
Direct restaurant costs and expenses:
 
 
 
 
 
 
 
Cost of sales
31.7
 %
 
28.8
 %
 
31.4
 %
 
28.9
 %
Direct labor
29.6
 %
 
28.2
 %
 
29.6
 %
 
28.4
 %
Other restaurant operating expenses
33.4
 %
 
31.6
 %
 
32.5
 %
 
31.2
 %
 
 
 
 
 
 
 
 
Pizza Hut
 
 
 
 
 
 
 
Comparable store sales
(5.6
)%
 
(3.7
)%
 
(5.1
)%
 
(2.9
)%
Net product sales, (in thousands)
$
240,173

 
$
249,403

 
$
492,591

 
$
514,074

Fees and other income, (in thousands)
$
12,674

 
$
12,555

 
$
26,624

 
$
26,853

Net product sales
100
 %
 
100
 %
 
100
 %
 
100
 %
Direct restaurant costs and expenses:
 
 
 
 
 
 
 
Cost of sales
31.4
 %
 
28.8
 %
 
31.2
 %
 
28.9
 %
Direct labor
29.8
 %
 
28.2
 %
 
29.7
 %
 
28.4
 %
Other restaurant operating expenses
34.2
 %
 
31.6
 %
 
33.1
 %
 
31.2
 %
 
 
 
 
 
 
 
 
Wendy’s
 
 
 
 
 
 
 
Comparable store sales
N/A(1)

 
N/A

 
N/A(1)

 
N/A

Net product sales, (in thousands)
$
33,059

 
N/A

 
$
62,944

 
N/A

Net product sales
100
 %
 
N/A

 
100
 %
 
N/A

Direct restaurant costs and expenses:
 
 
 
 
 
 
 
Cost of sales
33.6
 %
 
N/A

 
33.6
 %
 
N/A

Direct labor
28.2
 %
 
N/A

 
28.9
 %
 
N/A

Other restaurant operating expenses
27.5
 %
 
N/A

 
28.3
 %
 
N/A

 
(1)
Comparable store sales are only reported for locations that have been operated by the Company for at least 12 months.
(2)
Prior year operations consisted of Pizza Hut only.

 
13 Weeks Ended
 
26 Weeks Ended
 
July 1, 2014
 
June 25, 2013
 
July 1, 2014
 
June 25, 2013
Pizza Hut Sales by occasion:
 
 
 
 
 
 
 
Delivery
38
%
 
37
%
 
39
%
 
38
%
Carryout
48
%
 
49
%
 
48
%
 
48
%
Dine-in
14
%
 
14
%
 
13
%
 
14
%
 
 
 
 
 
 
 
 
Wendy’s sales by occasion:
 
 
 
 
 
 
 
Pick-up window
65
%
 
N/A

 
65
%
 
N/A

Counter service
35
%
 
N/A

 
35
%
 
N/A

Activity with respect to unit count is set forth in the table below:
 

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26 Weeks Ended
 
July 1, 2014
 
June 25, 2013
 
Consolidated
Wendy’s
Pizza Hut
 
Pizza Hut
Beginning of period
1,354

91

1,263

 
1,227

Acquired



 
1

Developed(1)
12


12

 
21

Closed(1)
(11
)
(1
)
(10
)
 
(4
)
End of period
1,355

90

1,265

 
1,245

Equivalent units(2)
1,350

91

1,259

 
1,231

 
(1) 
For Pizza Hut, three units were relocated or rebuilt and are included in both developed and closed total above for both the 26 weeks ended July 1, 2014 and June 25, 2013, respectively.
(2) 
Equivalent units represent the number of units open at the beginning of a given period, adjusted for units opened, closed, temporarily closed, acquired or sold during the period on a weighted average basis.

Unless otherwise noted, the discussion below references both our Pizza Hut and Wendy’s operations.

13 Weeks Ended July 1, 2014 Compared to the 13 Weeks Ended June 25, 2013

Our Pizza Hut Operations
Net Product Sales. Pizza Hut net product sales for the 13 weeks ended July 1, 2014 compared to the 13 weeks ended June 25, 2013 were $240.2 million and $249.4 million, respectively, a decrease of $9.2 million or 3.7%, resulting from a decline in comparable store sales of 5.6% for the second quarter of 2014, rolling over last year’s comparable store sales decrease of 3.7%. The comparable store sales decline was partially offset by a 2.0% increase in equivalent units for the second quarter of 2014 as compared to the prior year.
Fees and Other Income. Fees and other income for the second quarter of 2014, as compared to the same period of 2013, were $12.7 million and $12.6 million, respectively, an increase of $0.1 million or 0.9%. The increase was due to an increase in customer delivery charge income due to increased equivalent delivery units as compared to the prior year.
Cost of Sales. Pizza Hut cost of sales for the second quarter of 2014 as compared to 2013, was $75.5 million and $71.8 million, respectively, an increase of $3.7 million or 5.2%. Cost of sales increased 2.6% as a percentage of net product sales, to 31.4%, compared to 28.8% in the prior year primarily due to increased ingredient costs, primarily meats and cheese.
Direct Labor. Pizza Hut direct labor costs for the second quarter of 2014, as compared to 2013, were $71.6 million and $70.4 million, respectively, an increase of $1.2 million, or 1.7%. Direct labor costs were 29.8% of net product sales for the second quarter of 2014, a 1.6% increase compared to the prior year. The increase in direct labor costs as a percentage of net product sales was primarily due to the deleveraging effect of negative comparable store sales on semi-fixed and fixed labor costs.
Other Restaurant Operating Expenses. Other restaurant operating expenses (“OROE”) for our Pizza Hut units for the second quarter of 2014 were $82.2 million compared to $78.8 million for the prior year, an increase of $3.4 million, or 4.3%. OROE were 34.2% of net product sales for the second quarter of 2014 compared to 31.6% of net product sales for the prior year, an increase of 2.6%.
Significant changes in OROE as a percentage of net product sales were as follows:
OROE as a percentage of net product sales for the 13 weeks ended June 25, 2013
31.6
%
Deleveraging effect on rent and occupancy and increased costs
1.2

Delivery driver insurance expense
0.6

Depreciation expense
0.5

Other
0.3

OROE as a percentage of net product sales for the 13 weeks ended July 1, 2014
34.2
%
Depreciation expense included in OROE for our Pizza Hut operations was $9.8 million or 4.1% of net product sales for the second quarter of 2014 compared to $8.9 million or 3.6% of net product sales for the prior year.
Our Wendy’s Operations
Net Product Sales. Wendy’s net product sales for the second quarter of 2014 were $33.1 million.

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Cost of Sales. Wendy’s cost of sales for the second quarter of 2014 was $11.1 million or 33.6% of net product sales.
Direct Labor. Wendy’s direct labor costs for the second quarter of 2014 were $9.3 million or 28.2% of net product sales.
Other Restaurant Operating Expenses. Wendy’s OROE for the second quarter of 2014 were $9.1 million or 27.5% of net product sales. Depreciation expense included in OROE for our Wendy’s operations was $0.9 million or 2.8% of net product sales and rent expense was $2.0 million or 6.1% of net pro