NPC International, Inc.
NPC Restaurant Holdings, LLC (Form: 10-Q, Received: 11/09/2016 17:20:13)
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 September 27, 2016
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. 129 th  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 November 9, 2016 , there were 1,000 units of membership interests outstanding.



Table of Contents


INDEX
 
 
 
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 

2

Table of Contents

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)
 
 
September 27,
2016
 
December 29,
2015
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
16,053

 
$
32,717

Accounts and other receivables
5,430

 
7,278

Inventories
10,156

 
10,067

Prepaid expenses and other current assets
5,483

 
7,133

Assets held for sale
2,615

 
2,904

Income taxes receivable
1,773

 
3,016

Total current assets
41,510

 
63,115

Facilities and equipment, less accumulated depreciation of $192,086 and $163,993, respectively
230,599

 
203,468

Franchise rights, less accumulated amortization of $83,073 and $68,307, respectively
623,192

 
620,518

Goodwill
296,126

 
294,626

Other assets, net
29,197

 
28,969

Total assets
$
1,220,624

 
$
1,210,696

Liabilities and member’s equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
36,300

 
$
34,926

Accrued liabilities
56,737

 
44,847

Accrued interest
7,134

 
11,436

Current portion of insurance reserves
13,215

 
12,829

       Current portion of debt
2,950

 
4,158

Total current liabilities
116,336

 
108,196

Long-term debt
576,249

 
577,011

Other deferred items
42,060

 
40,834

Insurance reserves
22,118

 
21,203

Deferred income taxes
183,296

 
189,763

Total long-term liabilities
823,723

 
828,811

Commitments and contingencies


 


Member’s equity:
 
 
 
Membership interests (1,000 units authorized, issued and outstanding as of September 27, 2016 and December 29, 2015)

 

Member’s capital
280,565

 
273,689

Total member’s equity
280,565

 
273,689

Total liabilities and member’s equity
$
1,220,624

 
$
1,210,696

See accompanying notes to the unaudited consolidated financial statements.

3

Table of Contents

NPC RESTAURANT HOLDINGS, LLC
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands)  
 
13 Weeks Ended
 
39 Weeks Ended
 
September 27,
2016
 
September 29,
2015
 
September 27,
2016
 
September 29,
2015
Sales:
 
 
 
 
 
 
 
Net product sales
$
291,250

 
$
288,025

 
$
886,501

 
$
876,547

Fees and other income
13,830

 
12,627

 
42,098

 
39,549

Total sales
305,080

 
300,652

 
928,599

 
916,096

Costs and expenses:
 
 
 
 
 
 
 
Cost of sales
85,512

 
85,541

 
255,748

 
255,871

Direct labor
87,218

 
87,127

 
263,481

 
264,135

Other restaurant operating expenses
101,242

 
99,275

 
297,657

 
292,150

General and administrative expenses
19,387

 
17,773

 
56,501

 
51,887

Corporate depreciation and amortization of intangibles
5,634

 
5,316

 
16,223

 
15,825

Net facility impairment and closure costs
1,392

 
1,050

 
3,966

 
5,727

Other
151

 
(153
)
 
(38
)
 
240

Total costs and expenses
300,536

 
295,929

 
893,538

 
885,835

Operating income
4,544

 
4,723

 
35,061

 
30,261

Interest expense
11,174

 
10,240

 
33,716

 
31,197

(Loss) income before income taxes
(6,630
)
 
(5,517
)
 
1,345

 
(936
)
Income tax benefit
(2,137
)
 
(3,401
)
 
(3,092
)
 
(3,867
)
Net (loss) income
$
(4,493
)
 
$
(2,116
)
 
$
4,437

 
$
2,931

 

See accompanying notes to the unaudited consolidated financial statements.

4

Table of Contents

NPC RESTAURANT HOLDINGS, LLC
CONSOLIDATED STATEMENT OF MEMBER’S EQUITY
(Unaudited)
(in thousands)
 
 
Member’s
equity
Balance at December 29, 2015
$
273,689

Net income
4,437

Adjustment to Parent
2,439

Balance at September 27, 2016
$
280,565

See accompanying notes to the unaudited consolidated financial statements.

5

Table of Contents

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

 
39 weeks ended
 
September 27,
2016
 
September 29,
2015
Operating activities
 
 
 
Net income
$
4,437

 
$
2,931

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Depreciation and amortization
51,908

 
47,151

Amortization of debt issuance costs
3,222

 
2,893

Deferred income taxes
(4,717
)
 
(5,491
)
Net facility impairment and closure costs
3,966

 
5,727

Other
(342
)
 
335

Changes in assets and liabilities, excluding the effect of acquisitions:
 
 
 
Accounts receivable
1,956

 
4,379

Inventories
284

 
512

Prepaid expenses and other current assets
2,213

 
2,388

Accounts payable
1,374

 
(237
)
Income taxes
1,243

 
(798
)
Accrued interest
(4,302
)
 
(6,663
)
Accrued liabilities
9,735

 
6,649

Insurance reserves
1,301

 
3,622

Other deferred items
(2,618
)
 
20

Other assets
(309
)
 
(148
)
Net cash provided by operating activities
69,351

 
63,270

Investing activities
 
 
 
Capital expenditures
(45,313
)
 
(41,997
)
Acquisitions of Wendy’s business, net of cash acquired
(44,783
)
 

Proceeds from sale-leaseback transactions
7,155

 
1,408

Proceeds from sale or disposition of assets
1,252

 
521

Net cash used in investing activities
(81,689
)
 
(40,068
)
Financing activities
 
 
 
Borrowings under revolving credit facility
15,900

 
59,000

Payments under revolving credit facility
(15,900
)
 
(59,000
)
Payments on term bank facilities
(4,326
)
 
(3,119
)
Net cash used in financing activities
(4,326
)
 
(3,119
)
Net change in cash and cash equivalents
(16,664
)
 
20,083

Beginning cash and cash equivalents
32,717

 
12,063

Ending cash and cash equivalents
$
16,053

 
$
32,146

 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
Net cash paid for interest
$
34,783

 
$
34,848

Net cash paid for income taxes
$
781

 
$
2,808

Non-cash investing activities:
 
 
 
Accrued capital expenditures
$
5,525

 
$
4,138



See accompanying notes to the unaudited consolidated financial statements.

6

Table of Contents

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 by NPC International Holdings, Inc. (“NPC Holdings” or “Parent”), an entity controlled by Olympus Growth Fund V, L.P. and certain of its affiliated entities (“Olympus” or “Sponsor”), herein referred to as the “Transactions”.
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 (“GAAP”) 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.
The preparation of the unaudited interim consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions about future events relating to the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited interim consolidated financial statements and the reported amount of sales and expenses during the reporting periods. Estimates are revised when facts and circumstances change. As such, actual results could differ materially from those estimates.
As further reflected in Note 4 to the unaudited interim consolidated financial statements, the Company adopted Accounting Standards Update ("ASU") No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30) (“ASU 2015-03”) during the first quarter of 2016, which simplifies the presentation of debt issuance costs. As shown in the table below, pursuant to the guidance in ASU 2015-03 the Company reclassified unamortized debt issuance costs associated with its term loan and senior note obligations in its previously reported consolidated balance sheet as of December 29, 2015 as follows (in thousands):
 
As presented December 29, 2015
 
Reclassifications
 
As adjusted December 29, 2015
Other assets
$
39,063

 
$
(10,094
)
 
$
28,969

 
 
 
 
 
 
Long-term debt
$
587,105

 
$
(10,094
)
 
$
577,011


In August 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments (Topic 230) . This update provides clarification regarding how certain cash receipts and cash payments are presented and classified in the statement of cash flows. This update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. This update is effective for annual and interim periods for fiscal years beginning after December 15, 2017. Early adoption is permitted for financial statements that have not been previously issued. The update will be applied on a retrospective basis. The Company is currently evaluating the effect of this standard on its consolidated financial statements.
In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718) , amending the accounting for stock-based compensation and requiring excess tax benefits and deficiencies to be recognized as a component of income tax expense rather than equity. This guidance also requires excess tax benefits to be presented as an operating activity on the statement of cash flows and allows an entity to make an accounting policy election to either estimate expected forfeitures or to account for

7


them as they occur. The ASU is effective for reporting periods beginning after December 15, 2016, with early adoption permitted. The Company is currently evaluating the effect of this standard on its consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases , which requires lessees to recognize a lease liability and a right of use asset for all leases, including operating leases, with a term greater than 12 months on its balance sheet. The ASU also expands the required quantitative and qualitative disclosures surrounding leases. This ASU is effective for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years, with earlier application permitted. This ASU will be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The Company is currently evaluating the effect of this standard on its consolidated financial statements.
In May 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 GAAP when it becomes effective. In July 2015, the FASB approved a one-year deferral of the effective date of the new revenue recognition standard which will become effective for the Company beginning with the first quarter of fiscal 2018. The standard can be adopted either retrospectively to each prior reporting period presented or as a cumulative effect adjustment as of the date of adoption. Under the proposal, early application would be permitted, but not before the original effective date. 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 – Business Combination     
In January 2016, NPCQB acquired three Wendy’s restaurants, including fee-owned properties, from a Wendy’s franchisee for approximately $8.0 million . During the second quarter of fiscal 2016, the Company sold one of the fee-owned properties for $1.4 million and leased it back and plans to sell and lease back the remaining two fee-owned properties.
On July 25, 2016, NPCQB completed the acquisition of 39 Wendy’s restaurants, including four restaurants that were recently constructed, from a subsidiary of The Wendy’s Company (“Wendy’s”) for approximately $36.8 million , plus amounts for working capital. The units are located in the Raleigh-Durham, North Carolina metropolitan area.
The asset acquisitions were funded with cash on hand. The acquisitions were accounted for using the purchase method of accounting. As a result of these acquisitions, purchase accounting adjustments were made to the underlying assets based upon the valuations. These estimates of fair value are preliminary, and are therefore subject to further refinement. The total purchase price, net of cash acquired, was allocated as follows ( in thousands ):
Facilities and equipment
 
$
24,431

Franchise rights
 
17,385

Goodwill
 
1,500

Other
 
1,467

  Total purchase price
 
$
44,783

                  
All of the goodwill recognized will be deductible for income tax purposes. The weighted average amortization period assigned to the acquired franchise rights was approximately 19 years .
The pro forma impact of these Wendy’s asset acquisitions on the results of operations is included in the table below for periods prior to the acquisition dates in which the acquisitions were not previously consolidated. The pro forma results of operations are not necessarily indicative of the results that would have occurred had the acquisitions been consummated at the beginning of the periods presented, nor are they necessarily indicative of future operating results.
 
 
unaudited, (in thousands)
 
13 Weeks Ended
39 Weeks Ended
 
September 27,
2016
 
September 29,
2015
 
September 27,
2016
 
September 29,
2015
Total sales
$
309,605

 
$
316,552

 
$
965,540

 
$
963,795

Net (loss) income
(4,234
)
 
(1,982
)
 
5,321

 
3,333

The Consolidated Statements of Operations for the 39 weeks ended September 27, 2016 included total sales of $14.6 million related to the Wendy’s units acquired during 2016. It is impracticable to disclose earnings for the post-acquisition period for these acquired units as earnings of such units are not tracked on an individual basis.

Note 3 – Goodwill and Other Intangible Assets
Changes in goodwill for the 39 weeks ended September 27, 2016 are summarized below ( in thousands ):
Balance at December 29, 2015
$
294,626

  Acquisitions of Wendy’s business
1,500

Balance at September 27, 2016
$
296,126


8



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 performed qualitative assessments on both of its reporting units. As a result of the Company’s annual impairment testing in the second quarter, the Company determined that goodwill was not impaired.
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 ):
 
 
September 27, 2016
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Book
Value
Amortizable intangible assets:
 
 
 
 
 
Franchise rights
$
706,265

 
$
(83,073
)
 
$
623,192

Favorable leasehold interests
13,172

 
(4,558
)
 
8,614

Unfavorable leasehold interests
(16,873
)
 
9,397

 
(7,476
)
 
$
702,564

 
$
(78,234
)
 
$
624,330


 
December 29, 2015
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Book
Value
Amortizable intangible assets:
 
 
 
 
 
Franchise rights
$
688,825

 
$
(68,307
)
 
$
620,518

Favorable leasehold interests
13,850

 
(4,354
)
 
9,496

Unfavorable leasehold interests
(17,105
)
 
8,139

 
(8,966
)
 
$
685,570

 
$
(64,522
)
 
$
621,048

Amortization expense on intangible assets was $4.7 million and $4.5 million for the 13-week periods ended September 27, 2016 and September 29, 2015 , respectively and $13.7 million and $13.5 million for the 39-week periods ended September 27, 2016 and September 29, 2015 , respectively.
Note 4 – Debt
The Company’s debt consisted of the following ( in thousands ):
 
    
 
September 27,
2016
 
December 29,
2015
Term Loan
$
396,937

 
$
401,263

Unamortized debt issuance costs
(5,686
)
 
(7,581
)
Term Loan notes less unamortized debt issuance costs
391,251

 
393,682

 
 
 
 
Senior Notes
190,000

 
190,000

Unamortized debt issuance costs
(2,052
)
 
(2,513
)
Senior Notes less unamortized debt issuance costs
187,948

 
187,487

Revolving Facility ($110 million) (1)

 

 
579,199

 
581,169

Less current portion
2,950

 
4,158

 
$
576,249

 
$
577,011

 
(1)  
At September 27, 2016 , the Company had $80.4 million of borrowing capacity available under its revolving credit facility (“Revolving Facility”), net of $29.6 million of outstanding letters of credit. At December 29, 2015, the Company had $80.9 million of borrowing capacity available under its Revolving Facility, net of $29.1 million of outstanding letters of credit.


9


The Company’s debt facilities contain restrictions on additional borrowings, certain asset sales, dividend payments, certain investments and related-party transactions, as well as requirements to maintain various financial ratios. At September 27, 2016 , the Company was in compliance with all of its financial covenants.

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 made a mandatory prepayment of $3.3 million on March 31, 2016 based on its fiscal 2015 results. The Company currently expects that it will not be required to make a mandatory prepayment in fiscal 2017. However, because this is a preliminary estimate, it is possible that an excess cash flow mandatory prepayment could ultimately be required.
Note 5 – Fair Value Measurements
Fair value disclosures enable the reader of the financial statements to assess the inputs used to develop those fair value measurements using 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.
Level 3: Unobservable inputs that are not corroborated by market data, which requires the Company to develop its own assumptions. These inputs are frequently utilized in pricing models, discounted cash flow techniques and other widely accepted valuation methodologies.
The following tables summarize the carrying amounts and fair values of certain assets at September 27, 2016 and December 29, 2015 , (in thousands) :
 
September 27, 2016
 
 
 
 
 
Carrying Amount
 
Level 1 Inputs
 
Level 2 Inputs
 
Level 3 Inputs
Equities (1)
$
10,846

 
$
10,846

 
$

 
$

Fixed income (1)
5,274

 

 
5,274

 

Money market fund (2)
12,689

 

 
12,689

 

 
 
 
 
 
 
 
 
 
December 29, 2015
 
 
 
 
 
Carrying Amount
 
Level 1 Inputs
 
Level 2 Inputs
 
Level 3 Inputs
Equities (1)
$
10,385

 
$
10,385

 
$

 
$

Fixed income (1)
3,748

 

 
3,748

 

Money market fund (2)
29,584

 

 
29,584

 


(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 September 27, 2016 and December 29, 2015 , $0.6 million and $1.5 million , respectively, of the balances in the money market fund related to the Deferred Compensation and POWR Plans and were located in the other assets line item on the Consolidated Balance Sheets. The remaining balances in the money market fund were short-term in nature and were classified in cash and cash equivalents on the Consolidated Balance Sheets.
The estimated fair value of the Company’s outstanding borrowings was as follows (in thousands) :
 

10


 
September 27, 2016
 
December 29, 2015
Term Loan
$
392,243

 
$
389,670

Senior Notes
196,270

 
195,087

Revolving Facility

 

 
$
588,513

 
$
584,757

Carrying value
$
579,199

 
$
581,169

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.  
The Company reviews long-lived assets related to each unit semi-annually in the second and fourth quarters for indicators of impairment and at any other date when events or changes in circumstances indicate that the carrying value of these assets may exceed their fair value and the carrying amount of a unit’s leasehold improvements and equipment may not be recoverable. Based on the best information available, impaired leasehold improvements and certain personal property are written down to estimated fair market value, which becomes the new cost basis. Additionally, when a commitment is made to close a unit beyond the quarter, any remaining leasehold improvements and all personal property are reviewed for impairment and depreciable lives are adjusted.
The table below summarizes restaurant-level impairment (Level 3) for the periods presented (in thousands):
 
13 Weeks Ended
 
39 Weeks Ended
 
September 27, 2016
 
September 29, 2015
 
September 27, 2016
 
September 29, 2015
Total asset impairments and closures
$
1,392

 
$
1,050

 
$
3,966

 
$
5,727

The remaining net book value of the above assets measured on a non-recurring basis at fair value as of September 27, 2016 , subsequent to the impairments, was $0.8 million .

Note 6 – Income Taxes
For the 39 weeks ended September 27, 2016 , the Company recorded an income tax benefit of $3.1 million compared to an income tax benefit of $3.9 million for the same period of the prior year. These tax benefits for both periods were primarily due to general business tax credits in relation to projected taxable income.
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.
During the third quarter of fiscal 2016, NPC released a tax reserve of $2.4 million that was established during the Transactions. As this reserve was established related to an exposure for costs originally incurred by NPC Holdings and charged to equity, the release of this reserve was treated as an adjustment to equity. The liability for uncertain tax positions was $0.1 million and $2.6 million at September 27, 2016 and December 29, 2015 , respectively.
Note 7 – Accrued Liabilities
Accrued liabilities consist of the following ( in thousands ):  
 
September 27, 2016
 
December 29, 2015
Payroll and vacation
$
22,316

 
$
19,279

Accrued real estate and property taxes
5,879

 
5,243

Accrued capital expenditures
5,525

 
3,350

Sales tax payable
5,271

 
5,648

Other
17,746

 
11,327

 
$
56,737

 
$
44,847


11


Note 8 – Commitments and Contingencies

On April 12, 2016, the Company entered into an Amended Franchise Agreement with Pizza Hut, Inc. which sets forth the terms of the Asset Partner Plan which governs the future asset upgrade requirements of the Company including remodel scope and timing of such actions, and supersedes the previous agreements relating to such upgrade requirements. The terms of the Asset Partner Plan included in the Amendment to Franchise Agreement are similar in scope to the description of the proposed plan included in Note 10, Commitments and Contingencies of the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2015.

From time to time, the Company is involved in litigation, most of which is incidental to its business. In the Company’s opinion, no litigation to which the Company currently is a 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 its 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. NPC Op Co B does not have any assets or operations as of September 27, 2016 and has not had any revenues, expenses or cash flows during its existence. The Holdings and subsidiary guarantees are joint and several, full and unconditional. The following summarizes the Company’s condensed consolidating information as of September 27, 2016 and December 29, 2015, and for each of the 13-week and 39-week periods ended September 27, 2016 and September 29, 2015 , respectively ( in thousands ):
Condensed Consolidating Statements of Operations

 
 
 
 
 
 
 
 
 
 
 
 
 
13 Weeks Ended September 27, 2016
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
241,258

 
$
63,822

 
$

 
$

 
$
305,080

Total costs and expenses

 
240,366

 
60,170

 

 

 
300,536

Operating income

 
892

 
3,652

 

 

 
4,544

Interest expense

 
11,174

 

 

 

 
11,174

Equity in net (loss) income of subsidiary
(4,493
)
 
(614
)
 

 

 
5,107

 

(Loss) income before income taxes
(4,493
)
 
(10,896
)
 
3,652

 

 
5,107

 
(6,630
)
Income tax (benefit) expense

 
(6,403
)
 
4,266

 

 

 
(2,137
)
Net (loss) income
$
(4,493
)
 
$
(4,493
)
 
$
(614
)
 
$

 
$
5,107

 
$
(4,493
)



12


 
 
 
 
 
 
 
 
 
 
 
 
 
13 Weeks Ended September 29, 2015
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
249,891

 
$
50,761

 
$

 
$

 
$
300,652

Total costs and expenses

 
245,946

 
49,983

 

 

 
295,929

Operating income

 
3,945

 
778

 

 

 
4,723

Interest expense

 
10,240

 

 

 

 
10,240

Equity in net (loss) income of subsidiary
(2,116
)
 
(1,440
)
 

 

 
3,556

 

(Loss) income before income taxes
(2,116
)
 
(7,735
)
 
778

 

 
3,556

 
(5,517
)
Income tax (benefit) expense

 
(5,619
)
 
2,218

 

 

 
(3,401
)
Net (loss) income
$
(2,116
)
 
$
(2,116
)
 
$
(1,440
)
 
$

 
$
3,556

 
$
(2,116
)


 
39 Weeks Ended September 27, 2016
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
760,240

 
$
168,359

 
$

 
$

 
$
928,599

Total costs and expenses

 
735,473

 
158,065

 

 

 
893,538

Operating income

 
24,767

 
10,294

 

 

 
35,061

Interest expense

 
33,716

 

 

 

 
33,716

Equity in net income of subsidiary
4,437

 
6,718

 

 

 
(11,155
)
 

Income (loss) before income taxes
4,437

 
(2,231
)
 
10,294

 

 
(11,155
)
 
1,345

Income tax (benefit) expense

 
(6,668
)
 
3,576

 

 

 
(3,092
)
Net income
$
4,437

 
$
4,437

 
$
6,718

 
$

 
$
(11,155
)
 
$
4,437


 
 
39 Weeks Ended September 29, 2015
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Total sales
$

 
$
764,369

 
$
151,727

 
$

 
$

 
$
916,096

Total costs and expenses

 
739,355

 
146,480

 

 

 
885,835

Operating income

 
25,014

 
5,247

 

 

 
30,261

Interest expense

 
31,197

 

 

 

 
31,197

Equity in net income of subsidiary
2,931

 
3,483

 

 

 
(6,414
)
 

(Loss) income before income taxes
2,931

 
(2,700
)
 
5,247

 

 
(6,414
)
 
(936
)
Income tax (benefit) expense

 
(5,631
)
 
1,764

 

 

 
(3,867
)
Net income
$
2,931

 
$
2,931

 
$
3,483

 
$

 
$
(6,414
)
 
$
2,931





13



Condensed Consolidating Balance Sheet
 
 
September 27, 2016
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer:
NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Assets:
 
 
 
 
 
 
 
 
 
 
 
Current assets
$

 
$
37,277

 
$
4,233

 
$

 
$

 
$
41,510

Facilities and equipment, net

 
156,226

 
74,373

 

 

 
230,599

Franchise rights, net

 
565,225

 
57,967

 

 

 
623,192

Goodwill

 
290,502

 
5,624

 

 

 
296,126

Investment in subsidiary
280,565

 
113,546

 

 

 
(394,111
)
 

Other assets, net

 
27,008

 
2,189

 

 

 
29,197

Total assets
$
280,565

 
$
1,189,784

 
$
144,386

 
$

 
$
(394,111
)
 
$
1,220,624

Liabilities and member’s equity:
 
 
 
 
 
 
 
 
 
 
 
Current liabilities
$

 
$
98,395

 
$
17,941

 
$

 
$

 
$
116,336

Long-term debt

 
576,249

 

 

 

 
576,249

Other liabilities and deferred items

 
54,507

 
9,671

 

 

 
64,178

Deferred income taxes

 
180,068

 
3,228

 

 

 
183,296

Member’s equity
280,565

 
280,565

 
113,546

 

 
(394,111
)
 
280,565

Total liabilities and member’s equity
$
280,565

 
$
1,189,784

 
$
144,386

 
$

 
$
(394,111
)
 
$
1,220,624

 
 
December 29, 2015
 
Parent
 
Subsidiary
 
Subsidiary
 
Subsidiary
 
 
 
 
 
Guarantor:
Holdings
 
Issuer: NPC
 
Co-Issuer:
NPCQB
 
Co-Issuer:
NPC Op
Co B
 
Eliminations
 
Consolidated
Assets:
 
 
 
 
 
 
 
 
 
 
 
Current assets
$

 
$
58,620

 
$
4,495

 
$

 
$

 
$
63,115

Facilities and equipment, net

 
155,501

 
47,967

 

 

 
203,468

Franchise rights, net

 
577,097

 
43,421

 

 

 
620,518

Goodwill

 
290,502

 
4,124

 

 

 
294,626

Investment in subsidiary
273,689

 
76,784

 

 

 
(350,473
)
 

Other assets, net

 
27,233

 
1,736

 

 

 
28,969

Total assets
$
273,689

 
$
1,185,737

 
$
101,743

 
$

 
$
(350,473
)
 
$
1,210,696

Liabilities and member’s equity:
 
 
 
 
 
 
 
 
 
 
 
Current liabilities
$

 
$
91,472

 
$
16,724

 
$

 
$

 
$
108,196

Long-term debt

 
577,011

 

 

 

 
577,011

Other liabilities and deferred items

 
55,589

 
6,448

 

 

 
62,037

Deferred income taxes

 
187,976

 
1,787

 

 

 
189,763

Member’s equity
273,689

 
273,689

 
76,784

 

 
(350,473
)
 
273,689

Total liabilities and member’s equity
$
273,689

 
$
1,185,737

 
$
101,743

 
$

 
$
(350,473
)
 
$
1,210,696



14



Condensed Consolidating Statements of Cash Flows
 
 
39 Weeks Ended September 27, 2016
 
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
$

 
$
47,822

 
$
21,529

 
$

 
$

 
$
69,351

Investing activities:
 
 
 
 
 
 
 
 
 
 
 
Capital expenditures

 
(32,040
)
 
(13,273
)
 

 

 
(45,313
)
Investment in subsidiary
 
 
(44,276
)
 
 
 
 
 
44,276

 

Return of investment in subsidiary

 
14,232

 

 

 
(14,232
)
 

Acquisition of Wendy’s business, net of cash acquired

 

 
(44,783
)
 

 

 
(44,783
)
Proceeds from sale-leaseback transactions

 
828

 
6,327

 

 

 
7,155

Proceeds from sale or disposition of assets

 
897

 
355

 

 

 
1,252

Net cash flows used in investing activities

 
(60,359
)
 
(51,374
)
 

 
30,044

 
(81,689
)
Financing activities:
 
 
 
 
 
 
 
 
 
 
 
Net payments on debt

 
(4,326
)
 

 

 

 
(4,326
)
Investment from parent
 
 
 
 
44,276

 
 
 
(44,276
)
 

Distribution to parent


 

 
(14,232
)
 

 
14,232

 

Net cash flows (used in) provided by financing activities

 
(4,326
)
 
30,044

 

 
(30,044
)
 
(4,326
)
Net change in cash and cash equivalents

 
(16,863
)
 
199

 

 

 
(16,664
)
Beginning cash and cash equivalents

 
31,918

 
799

 

 

 
32,717

Ending cash and cash equivalents
$

 
$
15,055

 
$
998

 
$

 
$

 
$
16,053



15


 
39 Weeks Ended September 29, 2015
 
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
$

 
$
47,405

 
$
15,865

 
$

 
$

 
$
63,270

Investing activities:
 
 
 
 
 
 
 
 
 
 
 
Capital expenditures

 
(30,678
)
 
(11,319
)
 

 

 
(41,997
)
Return of investment in subsidiary

 
4,708

 

 

 
(4,708
)
 

Proceeds from sale-leaseback transactions

 
1,408

 

 

 

 
1,408

Proceeds from sale or disposition of assets

 
371

 
150

 

 

 
521

Net cash flows used in investing activities

 
(24,191
)
 
(11,169
)
 

 
(4,708
)
 
(40,068
)
Financing activities:
 
 
 
 
 
 
 
 
 
 
 
Net payments on debt

 
(3,119
)
 

 

 

 
(3,119
)
Distribution to parent

 

 
(4,708
)
 

 
4,708

 

Net cash flows used in financing activities

 
(3,119
)
 
(4,708
)
 

 
4,708

 
(3,119
)
Net change in cash and cash equivalents

 
20,095

 
(12
)
 

 

 
20,083

Beginning cash and cash equivalents

 
11,278

 
785

 

 

 
12,063

Ending cash and cash equivalents
$

 
$
31,373

 
$
773

 
$

 
$

 
$
32,146



16



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 The Wendy’s Company and its subsidiaries (“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. 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 this Form 10-Q were prepared for use in, or in connection with, this Form 10-Q.
Non-GAAP Financial Measures
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). This Item 2 includes various financial measures that have not been calculated in accordance with GAAP, commonly referred to as “Non-GAAP Financial Measures”. These Non-GAAP Financial Measures include Adjusted EBITDA and Covenant EBITDA, which is in accordance with the credit agreement for our senior secured credit facilities (“Senior Secured Credit Facilities”).
These measures are not in accordance with, or an alternative to GAAP, and may be different from Non-GAAP Financial Measures used by other companies. These measures have important limitations as analytical tools and should not be considered in isolation, nor as a substitute for, or superior to, analysis of our results as reported under GAAP. We recommend that investors view these measures in conjunction with the GAAP measures included in this report and we have provided reconciliations of reported GAAP amounts to the Non-GAAP amounts. Also, in the applicable sections of this Item 2, we explain the ways in which management uses these Non-GAAP Financial Measures to evaluate our business and the reasons why management believes that these Non-GAAP Financial Measures provide useful information to investors.
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;

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Table of Contents

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 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;
the risks associated with the expansion of our business, including risks relating to the integration of the Wendy’s restaurants 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 and regulations related to healthcare coverage, employee matters (including compensation) and menu labeling, which may adversely affect our business and results of operations;
the loss of our executive officers and certain key personnel;
our ability to service our substantial indebtedness and to comply with the related financial covenants;
restrictions contained in our debt agreements;
the 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, except as may be required by applicable law. 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 29, 2015 (“2015 Form 10-K”) and in Part II, Item 1A of this report as well as our unaudited interim 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
NPC was founded in 1962, is the largest franchisee of any restaurant concept in the United States (U.S.), based on unit count, according to the 2016 “Top 200 Restaurant Franchisees” by the Restaurant Finance Monitor, and is the eighth largest restaurant unit operator, based on unit count, in the U.S.
Our Pizza Hut operations. We are the largest Pizza Hut franchisee and as of September 27, 2016 we operated 1,228 Pizza Hut units in 27 states with significant presence in the Midwest, South and Southeast. As of September 27, 2016 , our Pizza Hut operations represented approximately 19% of the domestic Pizza Hut restaurant system and 21% 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.
Our Wendy’s operations. As of September 27, 2016 , we operated 183 Wendy’s units in 5 states. We desire to expand our Wendy’s operations through the opportunistic acquisitions of restaurants in additional markets and organic growth by developing new restaurants that meet our investment objectives. All of the Wendy’s restaurants are owned and operated by NPCQB and are primarily located in and around the Salt Lake City, Greensboro-Winston Salem, Raleigh-Durham and Kansas City metropolitan areas.
Our Fiscal Year. We operate on a 52- or 53-week fiscal year ending on the last Tuesday in December. Fiscal years 2016 and 2015 each contain 52 weeks. Each quarterly period in fiscal years 2016 and 2015 has 13 weeks.

Our Sales

Net Product Sales. Net product sales are comprised of sales of food and beverages from our restaurants, net of discounts. For the 39 weeks ended September 27, 2016 , pizza sales accounted for approximately 73% of our Pizza Hut net product sales. Hamburger and chicken sandwiches accounted for approximately 50% 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,

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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 .
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.
    
Our Wendy’s restaurants are generally free-standing and include a pick-up window in addition to a dining room with counter service.
The following table sets forth certain information at the end of each year-to-date fiscal period:
 
 
39 Weeks Ended
 
September 27, 2016
 
September 29, 2015
Number of restaurants open at the end of the period:
 
 
 
  Pizza Hut
 
 
 
Delco
618

 
603

RR
125

 
155

RBD
485

 
505

   Total Pizza Hut units
1,228

 
1,263

  Wendy’s units
183

 
143

   Total units
1,411

 
1,406

 
Our Costs
Our operating costs and expenses are comprised of cost of sales, direct labor, other restaurant operating expenses, general and administrative expenses and facility impairment and closure costs. 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 cheese purchases that may cause the prices paid by us to exceed or be less than the current block cheese price.

Our Wendy’s cost of sales is primarily comprised of the following: beef and chicken: 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.

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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 and local minimum wage rate initiatives 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 (“OROE”) include all other costs directly associated with operating a restaurant facility, which primarily represents royalties, advertising, occupancy costs (rent, utilities, repairs and other facility-related expenses), depreciation (facilities and equipment), delivery expenses (for our Pizza Hut operations), supplies, insurance (excluding workers’ compensation) and other restaurant-related costs.    
Our blended average Pizza Hut royalty rate as a percentage of total Pizza Hut sales was 4.9% for both of the 39 week periods ended September 27, 2016 and September 29, 2015 . Our blended average Wendy’s royalty rate as a percentage of total Wendy’s sales was 3.8% and 3.9% for the 39 week periods ended September 27, 2016 and September 29, 2015 , respectively.
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.     
Facility Impairment and Closure Costs. Facility impairment and closure costs include any impairment of long-lived assets, including franchise rights associated with units or designated marketing areas, a unit’s leasehold improvements and equipment where the carrying amount of the asset is not recoverable and may exceed its fair value. When a unit is closed, the associated lease and other costs related to the unit are included in closure costs.
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.
General Economic Conditions and Consumer Spending
Changes in general economic conditions can have a significant impact on consumer spending. Wage stagnation, higher healthcare costs and economic uncertainty, as partially mitigated by lower fuel prices and lower unemployment, appear to have negatively impacted consumer spending in some segments of the restaurant industry, 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
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. In addition to more established competitors, we also face competition from new competitors and concepts such as fast casual pizza concepts. 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. 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.

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
For our Pizza Hut operations, 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 third quarter of

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fiscal 2016 , the block cheese price averaged $1.69 per pound, essentially flat compared to the average price for the third quarter of fiscal 2015 . Additionally, meat prices increased $0.09 per pound or approximately 5% versus the average price for the third quarter of fiscal 2015.

Based upon current market conditions, for fiscal 2016 we currently expect overall ingredient deflation for our Pizza Hut operations of approximately 3% and deflation of approximately 5% for our Wendy’s operations as compared to fiscal 2015.
    
For fiscal 2017, based upon current market conditions, we currently expect overall ingredient inflation for our Pizza Hut operations of approximately 2% to 3% and flat to 1% inflation for our Wendy’s operations as compared to fiscal 2016.

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. To the extent that our Pizza Hut delivery sales mix increases due to changes in occasion mix or the acquisition or relocation of units, our labor costs would be expected to increase due to the more labor intensive nature of the delivery transaction. Direct labor is highly dependent on federal and state minimum wage rate legislation and local minimum wage rate initiatives 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 $0.6 million in fiscal 2016. However, there are currently a number of federal, state and local initiatives and proposals to further increase minimum wage rates, which could be material to our operations.
On May 18, 2016, the Department of Labor (“DOL”) released its final rule increasing the minimum salary that employees must be paid to qualify as exempt from the overtime requirements under the Fair Labor Standards Act (“FLSA”). The new rule increases the salary threshold for the overtime exemption from $455 per week to $913 per week. On an annual basis, this increases the salary threshold from $23,660 to $47,476 per year. These regulations become effective December 1, 2016. The DOL will automatically update the standard salary and compensation levels every three years going forward. The DOL has set the total annual compensation for exempt highly compensated employees at $134,004, up from $100,000. Employers will be able to count non-discretionary bonuses, incentive payments, and commissions towards as much as 10 percent of the salary threshold beginning December 1, 2016. In order to count, these payments must be made on a quarterly or more frequent basis. We are evaluating the effects on our business of this final rule. Based upon our current evaluation, without taking mitigating steps, we currently expect that the FLSA overtime exemption requirements will increase our future costs but we are currently unable to quantify the amount of the impact with a high degree of certainty.
Additionally, changes in federal labor laws and regulations and governmental agency determinations 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. Because most of our employees are paid on an hourly basis, changes in rates related to federal and state minimum wage rate and tip credit laws and local minimum wage rate initiatives will affect our labor costs.
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 $0.8 million. However, as gas prices increase, the impact upon our operations is somewhat 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 rate 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

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Our discussion and analysis of our financial condition and results of operations are based upon our unaudited interim 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 interim consolidated financial statements may be material. Our critical accounting policies are available under Item 7 of our 2015 Form 10-K filed on March 9, 2016. There have been no significant changes with respect to these policies during the 39 weeks ended September 27, 2016 .
As referenced in Item 7 of our 2015 Form 10-K, we perform our annual assessment of goodwill, which is not subject to amortization, for impairment during the second quarter. We performed qualitative assessments for our Pizza Hut and Wendy’s reporting units in the second quarter, and concluded that it was more-likely-than-not that the fair value of these reporting units were greater than their carrying value.


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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 39-week periods ended September 27, 2016 and September 29, 2015 :
 
13 Weeks Ended
 
39 Weeks Ended
Consolidated
September 27, 2016
 
September 29, 2015
 
September 27, 2016
 
September 29, 2015
Net product sales, (in thousands)
$
291,250

 
$
288,025

 
$
886,501

 
$
876,547

Fees and other income, (in thousands)
$
13,830

 
$
12,627

 
$
42,098

 
$
39,549

Net product sales
100
 %
 
100
 %
 
100
%
 
100
 %
Direct restaurant costs and expenses (2) :
 
 
 
 
 
 
 
Cost of sales
29.4
 %
 
29.7
 %
 
28.8
%
 
29.2
 %
Direct labor
29.9
 %
 
30.2
 %
 
29.7
%
 
30.1
 %
Other restaurant operating expenses
34.8
 %
 
34.5
 %
 
33.6
%
 
33.3
 %
 
 
 
 
 
 
 
 
Pizza Hut
 
 
 
 
 
 
 
Comparable store sales (1)
(2.7
)%
 
(0.9
)%
 
0.3
%
 
(1.3
)%
Net product sales, (in thousands)
$
227,428

 
$
237,264

 
$
718,142

 
$
724,820

Fees and other income, (in thousands)
$
13,830

 
$
12,627

 
$
42,098

 
$
39,549

Net product sales
100
 %
 
100
 %
 
100
%
 
100
 %
Direct restaurant costs and expenses (2) :
 
 
 
 
 
 
 
Cost of sales
28.9
 %
 
29.1
 %
 
28.3
%
 
28.6
 %
Direct labor
30.8
 %
 
30.8
 %
 
30.4
%
 
30.6
 %
Other restaurant operating expenses
36.0
 %
 
35.3
 %
 
34.5
%
 
34.1
 %
 
 
 
 
 
 
 
 
Wendy’s