filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
Our fiscal year typically includes 52 weeks, comprised of three twelve-week quarters and one sixteen-week quarter. Every five or six years our fiscal year includes an extra (or 53rd) week in the fourth quarter. Fiscal 2018, 2017 and 2016 each consisted of 52 weeks.
Description of the Business
Domino’s is the largest pizza company in the world based on global retail sales, with more than 15,900 locations in over 85 markets around the world. Founded in 1960, our roots are in convenient pizza delivery, while a significant amount of our sales also come from carryout customers. Although we are a highly-recognized global brand, we focus on serving the local neighborhoods in which we live and do business through our large network of franchise owners and Company-owned stores. On average, we and our franchisees sell more than 3 million pizzas each day throughout our global system.
Our business model is straightforward: we handcraft and serve quality food at a competitive price, with easy ordering access and efficient service, enhanced by our technology innovations. Our dough is generally made fresh and distributed to stores around the world by us and our franchisees.
Domino’s generates revenues and earnings by charging royalties to our franchisees. Royalties are ongoing percent-of-sales fees for use of the Domino’s brand marks. The Company also generates revenues and earnings by selling food, equipment and supplies to franchisees primarily in the U.S. and Canada, and by operating a number of our own stores. Franchisees profit by selling pizza and other complementary items to their local customers. In our international markets, we generally grant geographical rights to the Domino’s Pizza brand to master franchisees. These master franchisees are charged with developing their geographical area, and they may profit by sub-franchising and selling food and equipment to those sub-franchisees, as well as by running pizza stores. Everyone in the system can benefit, including the end consumer, who can purchase Domino’s menu items for themselves and their family conveniently and economically.
Our business model can yield strong returns for our franchise owners and Company-owned stores. It can also yield significant cash flow to us, through a consistent franchise royalty payment and supply chain revenue stream, with moderate capital expenditures. We have historically returned cash to shareholders through dividend payments and share repurchases since becoming a publicly-traded company.
Fiscal 2018 Highlights
| • | Global retail sales (which are total retail sales at Company-owned and franchised stores worldwide) increased 10.6% as compared to 2017. |
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| • | Same store sales increased 6.6% in our U.S. stores and increased 3.5% in our international stores. |
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| • | Our revenues increased 23.1%. |
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| • | Our income from operations increased 9.7%. |
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| • | Our net income increased 30.3%. |
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| • | Our diluted earnings per share increased 43.2%. |
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The adoption of Accounting Standards Codification 606, Revenue from Contracts with Customers (“ASC 606”) in 2018 resulted in the recognition of $358.5 million in revenue in 2018 related to U.S. franchise contributions to Domino’s National Advertising Fund Inc. (“DNAF”), our consolidated not-for-profit advertising fund. In 2017, under accounting standards in effect at that time, we had presented these contributions net with the related disbursements in our consolidated statement of income. Refer to Note 1 to the consolidated financial statements for additional information related to the adoption of this new accounting standard.
During 2018, we continued our rapid global expansion with the opening of 1,058 net new stores. Our international franchise segment led the way with 800 net new store openings, including the opening of our 10,000th international store. We also continued our strong U.S. and international same store sales performance with 31 straight quarters of positive U.S. same store sales and 100 straight quarters of positive international same store sales. Our Domino’s Piece of the Pie Rewards loyalty program continues to contribute to our U.S. same store sales performance. Additionally, we remained focused on growing online ordering and improving the digital customer experience through our technology platforms, including the recent launch of Domino’s Delivery HotSpots. Our emphasis on technology innovation helped the Domino’s system generate more than half of global retail sales from digital channels in 2018. Overall, we believe our focus in 2018 on global growth and technology will continue to strengthen our brand in the future.
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Fiscal 2017 Highlights
| • | Global retail sales increased 12.7% as compared to 2016. |
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| • | Same store sales increased 7.7% in our U.S. stores and increased 3.4% in our international stores. |
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| • | Our revenues increased 12.8%. |
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| • | Our income from operations increased 14.8%. |
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| • | Our net income increased 29.5%. |
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| • | Our diluted earnings per share increased 35.6%. |
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During 2017, we continued our rapid global expansion with the opening of 1,045 net new stores. Our international franchise segment led the way with 829 net new store openings. We continued our focus on growing online ordering and the digital customer experience as well as other technological advancements. In 2017, as part of an industry-first collaboration with Ford Motor Company, Domino’s began a meaningful test of delivery using self-driving vehicles. Our emphasis on technology innovation helped the Domino’s system generate more than half of global retail sales from digital channels in 2017.
Critical accounting policies and estimates
The following discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, our management evaluates its estimates, including those related to revenue recognition, long-lived and intangible assets, insurance and legal matters, share-based payments and income taxes. We base our estimates on historical experience and on various other assumptions that we believe are 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. Actual results may differ from those estimates. Changes in our accounting policies and estimates could materially impact our results of operations and financial condition for any particular period. We believe that our most critical accounting policies and estimates are:
Revenue recognition. We earn revenues through our network of U.S. Company-owned and franchised stores, dough manufacturing and supply chain centers and international operations. Retail sales from franchise stores are reported to the Company by its franchisees and are not included in Company revenues. Retail sales from Company-owned stores and royalty revenues resulting from the retail sales from franchised stores are recognized as revenues when the items are delivered to or carried out by customers. Retail sales are generally reported and related royalties paid to the Company based on a percentage of retail sales, as specified in the related standard franchise agreement (generally 5.5% of U.S. franchise retail sales and, on average, 3.0% of international franchise retail sales). The Company also generates revenues from U.S. franchise advertising contributions to DNAF, its consolidated not-for-profit advertising fund (generally 6.0% of U.S. franchise retail sales). Although these revenues are restricted to be used only for advertising and promotional activities to benefit franchised stores, the Company has determined there are not performance obligations associated with the franchise advertising contributions received by DNAF that are separate from its U.S. royalty payment stream and as a result, these franchise contributions and the related expenses are presented gross in the Company’s consolidated statement of income.
Revenues from Company-owned stores and revenues from franchised stores (including U.S. franchise royalties and fees and U.S. franchise advertising revenues) can fluctuate from time-to-time as a result of store count and sales level changes. This can occur when a Company-owned store is sold to a franchisee. If a Company-owned store that generated $1,000,000 in revenue in fiscal 2017 was sold to a franchisee in fiscal 2018, revenues from Company-owned stores would have declined by $1,000,000 in fiscal 2018, while U.S. franchise royalty revenues would have increased by $55,000 and U.S. franchise advertising revenues would have increased by $60,000 in fiscal 2018, as we generally collect 5.5% of a U.S. franchisee’s retail sales as royalty revenue and 6.0% of a U.S. franchisee’s retail sales for advertising contributions. Sales of food from our supply chain centers are recognized as revenues upon delivery of the food to franchisees, while sales of equipment and supplies are generally recognized as revenues upon shipment of the related products to franchisees.
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Long-lived and intangible assets. We record long-lived assets, including property, plant and equipment and capitalized software, at cost. For acquisitions of franchise operations, we estimate the fair values of the assets and liabilities acquired based on physical inspection of assets, historical experience and other information available to us regarding the acquisition. We depreciate and amortize long-lived assets using useful lives determined by us based on historical experience and other information available to us. We evaluate the potential impairment of long-lived assets at least annually or whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Our evaluation is based on various analyses, including the projection of undiscounted cash flows. For Company-owned stores, we perform related impairment tests on an operating market basis, which the Company has determined to be the lowest level for which identifiable cash flows are largely independent of other cash flows. If the carrying amount of a long-lived asset exceeds the amount of the expected future undiscounted cash flows of that asset, the Company estimates the fair value of the asset. If the carrying amount of the asset exceeds the estimated fair value of the asset, an impairment loss is recognized and the asset is written down to its estimated fair value.
We have not made any significant changes in the methodology used to project the future market cash flows of Company-owned stores during the years presented. Same store sales fluctuations and the rates at which operating costs will fluctuate in the future are key factors in evaluating recoverability of the related assets. If our same store sales significantly decline or if operating costs increase and we are unable to recover these costs, the carrying value of our Company-owned stores, by market, may be unrecoverable and we may be required to recognize an impairment charge.
A significant portion of our goodwill relates to acquisitions of U.S. franchise stores and is included in our U.S. stores segment, specifically, in our Company-owned stores division. We evaluate goodwill annually for impairment by comparing the fair value of the reporting unit (which is primarily determined using the present value of future cash flows) to its carrying value. If the carrying value of the reporting unit exceeds the fair value, goodwill would be impaired. We have not made any significant changes in the methodology used to evaluate goodwill impairment during the years presented. At December 30, 2018, the fair value of our business operations with associated goodwill exceeded their recorded carrying value, including the related goodwill. If cash flows generated by our Company-owned stores were to decline significantly in the future or there were negative revisions to the market multiple assumption, we may be required to recognize a goodwill impairment charge. However, based on the latest impairment analysis, we do not believe it is reasonably likely that there could be changes in assumptions that would trigger impairment. The Company did not record any impairment charges during fiscal 2018, fiscal 2017 or fiscal 2016.
We adopted ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”) during 2018. ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating “Step 2” from the goodwill impairment test. As the fair value of our business operations exceeded their recorded carrying value in “Step 1” of the impairment test, the adoption of this standard did not have an impact on our evaluation of goodwill impairment.
Insurance and legal matters. We are a party to lawsuits and legal proceedings arising in the ordinary course of business. Management closely monitors these legal matters and estimates the probable costs for the resolution of such matters. These estimates are primarily determined by consulting with both internal and external parties handling the matters and are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. Legal judgments can be volatile and difficult to predict. Accordingly, if our estimates relating to legal matters proved inaccurate for any reason, we may be required to increase or decrease the related expense in future periods. We had accruals for legal matters of approximately $1.9 million at December 30, 2018 and $1.7 million at December 31, 2017.
For certain periods prior to December 1998 and for periods after December 2001, we maintain insurance coverage for workers’ compensation, general liability and owned and non-owned auto liability under insurance policies requiring payment of a deductible for each occurrence up to between $500,000 and $3.0 million, depending on the policy year and line of coverage. The related insurance reserves are based on undiscounted independent actuarial estimates, which are based on historical information along with assumptions about future events. Specifically, various methods, including analyses of historical trends and actuarial valuation methods, are utilized to estimate the cost to settle reported claims and claims incurred but not yet reported. The actuarial valuation methods develop estimates of the future ultimate claim costs based on the claims incurred as of the balance sheet date. When estimating these liabilities, several factors are considered, including the severity, duration and frequency of claims, legal cost associated with claims, healthcare trends and projected inflation.
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Our methodology for determining our exposure has remained consistent throughout the years presented. Management believes that the various assumptions developed and actuarial methods used to determine our self-insurance reserves are reasonable and provide meaningful data that management uses to make its best estimate of our exposure to these risks. Changes in assumptions for such factors as medical costs and legal actions, as well as changes in actual experience, could cause our estimates to change in the near term which could result in an increase or decrease in the related expense in future periods. A 10% change in our self-insurance liability at December 30, 2018 would have affected our income before provision for income taxes by approximately $5.3 million for fiscal 2018. We had accruals for insurance matters of approximately $53.3 million at December 30, 2018 and $51.4 million at December 31, 2017.
Share-based payments. We recognize compensation expense related to our share-based compensation arrangements over the requisite service period based on the grant date fair value of the awards. The grant date fair value of each restricted stock and performance-based restricted stock award is equal to the market price of our stock on the date of grant. The grant date fair value of each stock option award is estimated using the Black-Scholes option pricing model. The pricing model requires assumptions, including the expected life of the stock option, the risk-free interest rate, the expected dividend yield and expected volatility of our stock over the expected life, which significantly impact the assumed fair value. We account for forfeitures as they occur. Additionally, our stock option, restricted stock and performance-based restricted stock arrangements provide for accelerated vesting and the ability to exercise during the remainder of the ten-year stock option life upon the retirement of individuals holding the awards who have achieved specified service and age requirements.
Management believes that the methods and various assumptions used to determine compensation expense related to these arrangements are reasonable, but if the assumptions change significantly for future grants, share-based compensation expense will fluctuate in future years.
Income taxes. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We measure deferred tax assets and liabilities using current enacted tax rates that will apply in the years in which we expect the temporary differences to be recovered or paid. Judgment is required in determining the provision for income taxes, related reserves and deferred tax assets and liabilities. These include establishing a valuation allowance related to the ability to realize certain deferred tax assets, if necessary. On an ongoing basis, management will assess whether it remains more likely than not that the net deferred tax assets will be realized. The Company did not have any valuation allowances recorded for deferred tax assets as of December 30, 2018 or December 31, 2017. Our accounting for deferred tax assets represents our best estimate of future events. Our net deferred tax assets assume that we will generate sufficient taxable income in specific tax jurisdictions, based on our estimates and assumptions. Changes in our current estimates due to unanticipated events could have a material impact on our financial condition and results of operations.
The amounts recorded on the balance sheet relating to uncertain tax positions consider the ultimate resolution of revenue agent reviews based on estimates and assumptions. We believe we have appropriately accounted for our uncertain tax positions; however, tax audits, changes in tax laws and other unforeseen matters may result in us owing additional taxes. We adjust our reserves for uncertain tax positions when facts and circumstances change or due to the passage of time. The completion of a tax audit or the expiration of a statute of limitations associated with uncertain tax positions are examples of situations when we may adjust our reserves. Management believes that our tax positions comply with applicable tax law and that we have adequately provided for these matters. However, to the extent the final tax outcome of these matters is different than our recorded amounts, we may be required to adjust our tax reserves resulting in additional income tax expense or benefit in future periods.
Same Store Sales Growth
| 2018 (1) | 2017 | 2016 | ||||||||||
| U.S. Company-owned stores | 4.8 | % | 8.7 | % | 10.4 | % | ||||||
| U.S. franchise stores | 6.8 | % | 7.6 | % | 10.5 | % | ||||||
| U.S. stores | 6.6 | % | 7.7 | % | 10.5 | % | ||||||
| International stores (excluding foreign currency impact) | 3.5 | % | 3.4 | % | 6.3 | % | ||||||
| (1) | In the first quarter of 2018, the Company began managing its franchised stores in Alaska and Hawaii as part of its U.S. Stores segment. Prior to 2018, store counts, retail sales and royalty revenues from these franchised stores were included in the Company’s international operations in the tables above. Consolidated results of the Company have not been impacted by this change and prior year amounts have not been reclassified to conform to the current year presentation due to immateriality. |
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Store Growth Activity
| U.S. Company- owned Stores | U.S. Franchise Stores | Total U.S. Stores | International Stores | Total | ||||||||||||||||
| Store count at January 3, 2016 | 384 | 4,816 | 5,200 | 7,330 | 12,530 | |||||||||||||||
| Openings | 8 | 186 | 194 | 1,178 | 1,372 | |||||||||||||||
| Closings | (1 | ) | (22 | ) | (23 | ) | (68 | ) | (91 | ) | ||||||||||
| Transfers | 1 | (1 | ) | — | — | — | ||||||||||||||
| Store count at January 1, 2017 | 392 | 4,979 | 5,371 | 8,440 | 13,811 | |||||||||||||||
| Openings | 16 | 213 | 229 | 891 | 1,120 | |||||||||||||||
| Closings | — | (13 | ) | (13 | ) | (62 | ) | (75 | ) | |||||||||||
| Transfers | (16 | ) | 16 | — | — | — | ||||||||||||||
| Store count at December 31, 2017 | 392 | 5,195 | 5,587 | 9,269 | 14,856 | |||||||||||||||
| Openings | 12 | 255 | 267 | 916 | 1,183 | |||||||||||||||
| Closings | — | (9 | ) | (9 | ) | (116 | ) | (125 | ) | |||||||||||
| Transfers (1) | (14 | ) | 45 | 31 | (31 | ) | — | |||||||||||||
| Store count at December 30, 2018 | 390 | 5,486 | 5,876 | 10,038 | 15,914 | |||||||||||||||
Income Statement Data
| (dollars in millions) | 2018 (1) (2) | 2017 | 2016 | |||||||||||||||||||||
| U.S. Company-owned stores | $ | 514.8 | $ | 490.8 | $ | 439.0 | ||||||||||||||||||
| U.S. franchise royalties and fees | 391.5 | 351.4 | 312.3 | |||||||||||||||||||||
| Supply chain | 1,943.3 | 1,739.0 | 1,544.3 | |||||||||||||||||||||
| International franchise royalties and fees | 224.7 | 206.7 | 177.0 | |||||||||||||||||||||
| U.S. franchise advertising | 358.5 | — | — | |||||||||||||||||||||
| Total revenues | 3,432.9 | 100.0 | % | 2,788.0 | 100.0 | % | 2,472.6 | 100.0 | % | |||||||||||||||
| U.S. Company-owned stores | 398.2 | 377.7 | 331.9 | |||||||||||||||||||||
| Supply chain | 1,732.0 | 1,544.3 | 1,373.1 | |||||||||||||||||||||
| Cost of sales | 2,130.2 | 62.1 | % | 1,922.0 | 68.9 | % | 1,704.9 | 69.0 | % | |||||||||||||||
| Operating margin | 1,302.7 | 37.9 | % | 866.0 | 31.1 | % | 767.7 | 31.0 | % | |||||||||||||||
| General and administrative | 372.5 | 10.8 | % | 344.8 | 12.4 | % | 313.6 | 12.7 | % | |||||||||||||||
| U.S. franchise advertising | 358.5 | 10.4 | % | — | — | % | — | — | % | |||||||||||||||
| Income from operations | 571.7 | 16.7 | % | 521.2 | 18.7 | % | 454.0 | 18.3 | % | |||||||||||||||
| Interest expense, net | (143.0 | ) | (4.2 | )% | (121.1 | ) | (4.3 | )% | (109.4 | ) | (4.4 | )% | ||||||||||||
| Income before provision for income taxes | 428.7 | 12.5 | % | 400.2 | 14.4 | % | 344.7 | 13.9 | % | |||||||||||||||
| Provision for income taxes | 66.7 | 2.0 | % | 122.2 | 4.4 | % | 130.0 | 5.2 | % | |||||||||||||||
| Net income | $ | 362.0 | 10.5 | % | $ | 277.9 | 10.0 | % | $ | 214.7 | 8.7 | % | ||||||||||||
| (1) | In 2018, the Company began managing its franchised stores in Alaska and Hawaii as part of its U.S. Stores segment. Prior to 2018, store counts, retail sales and royalty revenues from these franchised stores were included in the Company’s international operations in the tables above. Consolidated results of the Company have not been impacted by this change and prior year amounts have not been reclassified to conform to the current year presentation due to immateriality. Also, see Note 12 to the consolidated financial statements for additional information related to the store transfers between U.S. Company-owned stores and U.S. franchise stores. |
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| (2) | The adoption of ASC 606 in 2018 resulted in the recognition of $358.5 million in revenue in 2018 related to U.S. franchise contributions to DNAF. In prior years, under accounting standards in effect at that time, we had presented these contributions net with the related disbursements in our consolidated statement of income. Refer to Note 1 to the consolidated financial statements for additional information related to the adoption of this new accounting standard. |
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2018 compared to 2017
(tabular amounts in millions, except percentages)
Revenues. Revenues primarily consist of retail sales from our Company-owned stores, royalties, advertising contributions and fees from our U.S. franchised stores, royalties and fees from our international franchised stores and sales of food, equipment and supplies from our supply chain centers to all of our U.S. franchised stores and certain international franchised stores. Company-owned store and franchised store revenues may vary from period to period due to changes in store count mix. Supply chain revenues may vary significantly as a result of fluctuations in commodity prices as well as the mix of products we sell.
Consolidated revenues increased $644.9 million or 23.1% in 2018. The adoption of ASC 606 in 2018 resulted in the recognition of $358.5 million in revenue in 2018 related to U.S. franchise contributions to DNAF. In 2017, under accounting standards in effect at that time, we had presented these contributions net with the related disbursements in our consolidated statement of income. Refer to Note 1 to the consolidated financial statements for additional information related to the adoption of this new accounting standard. The remaining increase was due primarily to higher supply chain food volumes as well as higher U.S. franchise, Company-owned store and international franchise revenues resulting from retail sales growth. These changes in revenues are more fully described below.
U.S. stores. Revenues from U.S. stores are primarily comprised of retail sales from U.S. Company-owned store operations and royalties, advertising contributions and other fees from U.S. franchised stores, as summarized in the following table.
| 2018 | 2017 | |||||||||||||||
| U.S. Company-owned stores | $ | 514.8 | 40.7 | % | $ | 490.8 | 58.3 | % | ||||||||
| U.S. franchise royalties and fees | 391.5 | 31.0 | % | 351.4 | 41.7 | % | ||||||||||
| U.S. franchise advertising | 358.5 | 28.3 | % | — | — | % | ||||||||||
| Total U.S. stores revenues | $ | 1,264.8 | 100.0 | % | $ | 842.2 | 100.0 | % | ||||||||
U.S. stores revenues increased $422.6 million, or 50.2%, in 2018. This increase was driven by the adoption of ASC 606, which requires a gross presentation of U.S. franchise advertising contributions in our consolidated statement of income, as well as higher royalty revenues earned on higher franchise same store sales and an increase in the average number of stores open in 2018 as compared to the prior year. Higher U.S. Company-owned same store sales also contributed to the increase in revenue. These changes in U.S. stores revenues are more fully described below.
U.S. Company-owned stores. Revenues from U.S. Company-owned store operations increased $24.0 million or 4.9% in 2018 due primarily to a 4.8% increase in same store sales as compared to 2017.
U.S. franchise royalties and fees. Revenues from U.S. franchise operations increased $40.1 million or 11.4% in 2018. The increase was driven by a 6.8% increase in same store sales as compared to 2017 and an increase in the average number of stores open during the year. Revenues further benefited from higher fees paid by franchisees for the use of our internally developed technology platforms. U.S. franchise royalties and fees were reduced by $17.9 million in 2018 due to the adoption of ASC 606, primarily related to the reclassification of certain advertising revenues from U.S. franchise royalties and fees to U.S. franchise advertising revenues.
U.S. franchise advertising. Revenues from U.S. franchise advertising contributions were $358.5 million in 2018. In years prior to 2018, based on accounting guidance in effect at the time, the U.S. franchise advertising contributions were shown net with the related disbursements in our consolidated statement of income. In 2018, we adopted ASC 606, which required these revenues and expenses to be presented gross on our consolidated statement of income. Refer to Note 1 to the consolidated financial statements for additional information related to the adoption of this new accounting standard.
Supply chain. Revenues from supply chain operations are primarily comprised of sales of food, equipment and supplies from our supply chain centers to all of our U.S. franchised stores and certain international franchised stores, as summarized in the following table.
| 2018 | 2017 | |||||||||||||||
| U.S. supply chain | $ | 1,760.8 | 90.6 | % | $ | 1,574.9 | 90.6 | % | ||||||||
| International supply chain | 182.5 | 9.4 | % | 164.1 | 9.4 | % | ||||||||||
| Total supply chain | $ | 1,943.3 | 100.0 | % | $ | 1,739.0 | 100.0 | % | ||||||||
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U.S. supply chain. U.S. supply chain revenues increased $185.9 million or 11.8% in 2018, driven primarily by higher volumes from increased order counts at the store level, higher market basket pricing to stores and store count growth. Our market basket pricing to stores increased 4.0% during 2018, which resulted in an estimated $52.9 million increase in U.S. supply chain revenues.
International supply chain. International supply chain revenues increased $18.4 million or 11.2% in 2018, driven primarily by higher volumes from increased order counts at the store level.
International franchise royalties and fees. International franchise revenues primarily consist of royalties from retail sales and other fees from our international franchise stores. Revenues from international franchise operations increased $18.0 million or 8.7% in 2018. This increase was due primarily to an increase in the average number of international stores open during 2018 as well as higher same store sales. The negative impact of changes in foreign currency exchange rates of approximately $1.1 million in 2018 partially offset these increases. Excluding the impact of foreign currency exchange rates, same store sales increased 3.5% in 2018 compared to 2017.
Cost of sales / Operating margin. Consolidated cost of sales consists primarily of U.S. Company-owned store and supply chain costs incurred to generate related revenues. Components of consolidated cost of sales primarily include food, labor and occupancy costs. The changes to the consolidated operating margin, which we define as revenues less cost of sales are summarized in the following table.
| 2018 | 2017 | |||||||||||||||
| Consolidated revenues | $ | 3,432.9 | 100.0 | % | $ | 2,788.0 | 100.0 | % | ||||||||
| Consolidated cost of sales | 2,130.2 | 62.1 | % | 1,922.0 | 68.9 | % | ||||||||||
| Consolidated operating margin | $ | 1,302.7 | 37.9 | % | $ | 866.0 | 31.1 | % | ||||||||
The $436.7 million or 50.4% increase in consolidated operating margin was primarily driven by the adoption of ASC 606, which requires a gross presentation of U.S. franchise advertising contributions on our consolidated statement of income. Higher U.S. and international franchise revenues, as well as higher supply chain and Company-owned store margins also contributed to the increased operating margin in 2018. Franchise royalties and fees and U.S. franchise advertising revenues do not have a cost of sales component, so changes in these revenues have a disproportionate effect on the operating margin.
As a percentage of total revenues, our consolidated operating margin increased 6.8 percentage points in 2018 due primarily to the adoption of ASC 606, which requires a gross presentation of U.S. franchise advertising contributions on our consolidated statement of income. Company-owned store operating margin decreased 0.4 percentage points in 2018 and supply chain operating margin decreased 0.3 percentage points in 2018. These changes in margin are more fully discussed below.
U.S. Company-owned stores. The changes to U.S. Company-owned store operating margin, which do not include other store-level costs such as royalties and advertising, are summarized in the following table.
| 2018 | 2017 | |||||||||||||||
| Revenues | $ | 514.8 | 100.0 | % | $ | 490.8 | 100.0 | % | ||||||||
| Cost of sales | 398.2 | 77.3 | % | 377.7 | 76.9 | % | ||||||||||
| Store operating margin | $ | 116.6 | 22.7 | % | $ | 113.2 | 23.1 | % | ||||||||
The $3.4 million or 3.1% increase in the U.S. Company-owned store operating margin was due primarily to higher same store sales and lower insurance expense but was partially offset by higher food and labor costs. As a percentage of store revenues, the store operating margin decreased 0.4 percentage points in 2018, as discussed in more detail below.
| • | Food costs increased 0.7 percentage points to 27.4% in 2018, due primarily to higher food prices. |
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| • | Labor costs increased 0.6 percentage points to 30.1% in 2018, due primarily to an increase in labor rates in certain markets. |
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| • | Insurance costs decreased 0.4 percentage points to 3.0% in 2018, due primarily to better claims experience and leveraging of higher same store sales. |
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| • | Occupancy costs, which include rent, telephone, utilities and depreciation, decreased 0.2 percentage points to 7.7%, due primarily to the leveraging of higher same store sales. |
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Supply chain. The changes to the supply chain operating margin are summarized in the following table.
| 2018 | 2017 | |||||||||||||||
| Revenues | $ | 1,943.3 | 100.0 | % | $ | 1,739.0 | 100.0 | % | ||||||||
| Cost of sales | 1,732.0 | 89.1 | % | 1,544.3 | 88.8 | % | ||||||||||
| Supply chain operating margin | $ | 211.3 | 10.9 | % | $ | 194.7 | 11.2 | % | ||||||||
The $16.6 million or 8.5% increase in the supply chain operating margin was due primarily to higher volumes from increased store orders. As a percentage of supply chain revenues, the supply chain operating margin decreased 0.3 percentage points in 2018, due primarily to higher delivery and labor costs, offset in part by procurement savings.
General and administrative expenses. General and administrative expenses increased $27.7 million, or 8.0%, in 2018 due primarily to continued investments in technological initiatives and other strategic areas. Higher expense related to professional fees, advertising and stock compensation also contributed to the increase. General and administrative expenses were reduced by $17.1 million in 2018 due to the adoption of ASC 606, primarily related to the reclassification of certain advertising expenses from general and administrative expenses to U.S. franchise advertising expenses.
U.S. franchise advertising. U.S. franchise advertising expenses were $358.5 million in 2018. In years prior to 2018, U.S. franchise advertising expenses were shown net with the related contributions in our consolidated statement of income. In 2018, we adopted ASC 606, which required these revenues and expenses to be presented gross on our consolidated statement of income. Refer to Note 1 to the consolidated financial statements for additional information related to the adoption of this new accounting standard.
Interest income. Interest income increased $1.9 million to $3.3 million in 2018 due to a higher average cash balance and higher interest rates on our cash equivalents.
Interest expense. Interest expense increased $23.8 million to $146.3 million in 2018. This increase was driven by higher average borrowings resulting from our 2018 Recapitalization and 2017 Recapitalization, offset in part by a lower weighted average borrowing rate in 2018. We also recorded approximately $3.3 million of incremental interest expense in 2018 in connection with the 2018 Recapitalization. During 2017, we recorded $5.8 million of incremental interest expense in connection with our 2017 Recapitalization.
The Company’s weighted average borrowing rate decreased to 4.0% in 2018 from 4.2% in 2017 due to the lower interest rates on the debt outstanding 2018 as compared 2017.
Provision for income taxes. Provision for income taxes decreased $55.5 million to $66.7 million in 2018 due primarily to a lower effective tax rate resulting from the lower federal statutory rate of 21% related to the 2017 Tax Act enacted in December 2017. Lower excess tax benefits on equity-based compensation, which are recorded as a reduction to the income tax provision, partially offset this decrease. Excess tax benefits recorded were lower by $3.4 million in 2018 as compared to 2017. The effective tax rate decreased to 15.6% in 2018 as compared to 30.6% in 2017.
2017 compared to 2016
(tabular amounts in millions, except percentages)
Revenues. Consolidated revenues increased $315.4 million or 12.8% in 2017. The increase was due primarily to higher supply chain food volumes as well as higher Company-owned store, U.S. franchise and international franchise revenues resulting from same store sales and store count growth. These changes in revenues are more fully described below.
U.S. stores. U.S. stores revenues are summarized in the following table.
| 2017 | 2016 | |||||||||||||||
| U.S. Company-owned stores | $ | 490.8 | 58.3 | % | $ | 439.0 | 58.4 | % | ||||||||
| U.S. franchise royalties and fees | 351.4 | 41.7 | % | 312.3 | 41.6 | % | ||||||||||
| Total U.S. stores revenues | $ | 842.2 | 100.0 | % | $ | 751.3 | 100.0 | % | ||||||||
Higher U.S. Company-owned same store sales, royalty revenues earned on higher franchise same store sales and an increase in the average number of stores open drove an increase in overall U.S. store revenues of $90.9 million or 12.1%. These results are more fully described below.
U.S. Company-owned stores. Revenues from U.S. Company-owned store operations increased $51.8 million or 11.8% in 2017. This increase was due to an 8.7% increase in same store sales as compared to 2016 and an increase in the average number of stores open during the year.
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U.S. franchise royalties and fees. Revenues from U.S. franchise operations increased $39.1 million or 12.5% in 2017. The increase was driven by a 7.6% increase in same store sales as compared to 2016 and an increase in the average number of stores open during the year. Revenues further benefited from higher fees paid by franchisees for the use of our internally developed technology platforms.
Supply chain. Supply chain revenues are summarized in the following table.
| 2017 | 2016 | |||||||||||||||
| U.S. supply chain | $ | 1,574.9 | 90.6 | % | $ | 1,408.8 | 91.2 | % | ||||||||
| International supply chain | 164.1 | 9.4 | % | 135.5 | 8.8 | % | ||||||||||
| Total supply chain | $ | 1,739.0 | 100.0 | % | $ | 1,544.3 | 100.0 | % | ||||||||
U.S. supply chain. U.S. supply chain revenues increased $166.1 million or 11.8% in 2017. These increases were primarily attributable to higher volumes from increased order counts at the store level as well as store count growth. Our market basket pricing to stores increased 1.7% during 2017, which resulted in an estimated $18.8 million increase in U.S. supply chain revenues.
International supply chain. Revenues from international supply chain operations increased $28.6 million or 21.1% in 2017, driven primarily by higher volumes from increased order counts at the store level. The positive impact of foreign currency exchange rates of $3.4 million in 2017 also contributed to the increases.
International franchise royalties and fees. Revenues from international franchise operations increased $29.7 million or 16.8% in 2017. This increase was due to an increase in the average number of international stores open during 2017 as well as higher same store sales and an increase in technology fees and was offset slightly by the negative impact of changes in foreign currency exchange rates of approximately $0.8 million in 2017. Excluding the impact of foreign currency exchange rates, same store sales increased 3.4% in 2017 compared to 2016.
Cost of sales / Operating margin. The changes to the consolidated operating margin are summarized in the following table.
| 2017 | 2016 | |||||||||||||||
| Consolidated revenues | $ | 2,788.0 | 100.0 | % | $ | 2,472.6 | 100.0 | % | ||||||||
| Consolidated cost of sales | 1,922.0 | 68.9 | % | 1,704.9 | 69.0 | % | ||||||||||
| Consolidated operating margin | $ | 866.0 | 31.1 | % | $ | 767.7 | 31.0 | % | ||||||||
The $98.3 million or 12.8% increase in consolidated operating margin was due to higher U.S. and international franchise revenues as well as higher supply chain and Company-owned store margins. Franchise revenues do not have a cost of sales component, so changes in franchise revenues have a disproportionate effect on the consolidated operating margin.
As a percentage of total revenues, our consolidated operating margin increased 0.1 percentage points in 2017 due to a higher mix of franchise revenues and higher supply chain margin as a percentage of supply chain revenues. Company-owned store operating margin decreased 1.3 percentage points during 2017. These changes in margin are more fully discussed below.
U.S. Company-owned stores. The changes to U.S. Company-owned store operating margin are summarized in the following table.
| 2017 | 2016 | |||||||||||||||
| Revenues | $ | 490.8 | 100.0 | % | $ | 439.0 | 100.0 | % | ||||||||
| Cost of sales | 377.7 | 76.9 | % | 331.9 | 75.6 | % | ||||||||||
| Store operating margin | $ | 113.2 | 23.1 | % | $ | 107.2 | 24.4 | % | ||||||||
The $6.0 million or 5.6% increase in the U.S. Company-owned store operating margin was due primarily to higher same store sales and an increase in the average number of stores open during the year.
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As a percentage of store revenues, the store operating margin decreased 1.3 percentage points in 2017, as discussed in more detail below.
| • | Food costs increased 0.1 percentage points to 26.7% in 2017, due primarily to higher overall commodity prices. |
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| • | Labor costs increased 0.7 percentage points to 29.5% in 2017, due primarily to an increase in labor rates in certain markets. The leveraging of higher same store sales partially offset this increase. |
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| • | Insurance costs increased 0.6 percentage points to 3.4% in 2017, due primarily to incremental insurance expense related to updated independent actuarial estimates for our casualty insurance program. |
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| • | Occupancy costs, which include rent, telephone, utilities and depreciation, decreased 0.2 percentage points to 7.9% in 2017, due primarily to the leveraging of higher same store sales. |
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Supply chain. The changes to the supply chain operating margin are summarized in the following table.
| 2017 | 2016 | |||||||||||||||
| Revenues | $ | 1,739.0 | 100.0 | % | $ | 1,544.3 | 100.0 | % | ||||||||
| Cost of sales | 1,544.3 | 88.8 | % | 1,373.1 | 88.9 | % | ||||||||||
| Supply chain operating margin | $ | 194.7 | 11.2 | % | $ | 171.3 | 11.1 | % | ||||||||
The $23.4 million or 13.7% increase in the supply chain operating margin was due primarily to higher volumes from increased store orders.
As a percentage of supply chain revenues, the supply chain operating margin increased 0.1 percentage point in 2017 due primarily to procurement savings. Increased labor and delivery costs partially offset this increase.
General and administrative expenses. General and administrative expenses increased $31.2 million or 9.9% in 2017, primarily driven by continued investments in technological initiatives (primarily in e-commerce and information technology) as well as investments in other strategic areas. Higher Company-owned store national advertising contributions resulting from higher same store sales also contributed to the increase. These increases were partially offset by lower performance-based compensation expense and a pre-tax gain recognized from the sale of 17 Company-owned stores during the fourth quarter of 2017 of $4.0 million.
Interest income. Interest income increased $0.8 million to $1.5 million in 2017.
Interest expense. Interest expense increased $12.4 million to $122.5 million in 2017. This increase was driven by higher average borrowings and approximately $5.8 million of expenses related to the 2017 Recapitalization. These expenses include a $5.5 million write-off of debt issuance costs and $0.3 million of interest expense that was incurred on the 2012 debt subsequent to the closing of the 2017 Recapitalization but prior to the repayment of the 2012 debt. The increase in interest expense was offset in part by a lower weighted-average borrowing rate.
Our average outstanding debt balance, excluding capital lease obligations, was approximately $2.63 billion in 2017 and approximately $2.23 billion in 2016. The increase in the average outstanding debt balance was due to the issuance of debt in connection with the 2017 Recapitalization. Our weighted average borrowing rate decreased to 4.2% in fiscal 2017, from 4.6% in fiscal 2016. The decreases in the Company’s cash borrowing rate resulted from the lower interest rates on the debt issued as part of the 2017 Recapitalization.
Provision for income taxes. Provision for income taxes decreased $7.8 million to $122.2 million in 2017. Although pre-tax income increased in 2017, the effective tax rate decreased, primarily as a result of the Company’s adoption of ASU 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which requires tax benefits on equity-based compensation to be recorded as a reduction to the income tax provision. The adoption of this standard benefitted the provision for income taxes by $27.2 million in 2017. The effective tax rate decreased to 30.6% in 2017 as compared to 37.7% in 2016.
Liquidity and capital resources
Historically, we have operated with minimal positive working capital or negative working capital, primarily because our receivable collection periods and inventory turn rates are faster than the normal payment terms on our current liabilities. We generally collect our receivables within three weeks from the date of the related sale and we generally experience 35 to 45 inventory turns per year. In addition, our sales are not typically seasonal, which further limits our working capital requirements. These factors, coupled with the use of our ongoing cash flows from operations to service our debt obligations, invest in our business, pay dividends and repurchase our common stock, reduce our working capital amounts. As of December 30, 2018, we had working capital of $14.6 million, excluding restricted cash and cash equivalents of $167.0 million, advertising fund assets, restricted, of $112.7 million and advertising fund liabilities of $107.2 million. Working capital includes total unrestricted cash and cash equivalents of $25.4 million.
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As of December 30, 2018, we had approximately $130.3 million of restricted cash held for future principal and interest payments, $36.5 million of restricted cash held in a three-month interest reserve as required by the related debt agreements and $0.2 million of other restricted cash for a total of $167.0 million of restricted cash and cash equivalents. As of December 30, 2018, we also held $45.0 million of advertising fund restricted cash and cash equivalents, which can only be used for activities that promote the Domino’s Pizza brand.
Our primary source of liquidity is cash flows from operations and availability of borrowings under our variable funding notes. In connection with the 2017 Recapitalization, the Company issued a variable funding note facility which allows for advances of up to $175.0 million of Series 2017-1 Variable Funding Senior Secured Notes, Class A-1 Notes and certain other credit instruments, including letters of credit (the “2017 Variable Funding Notes”). As of December 30, 2018, we had $65.0 million of outstanding borrowings and $61.9 million of available borrowing capacity under our 2017 Variable Funding Notes, net of letters of credit issued of $48.1 million. The letters of credit are primarily related to our casualty insurance programs and certain supply chain center leases. Borrowings under the 2017 Variable Funding Notes are available to fund our working capital requirements, capital expenditures and, subject to other limitations, other general corporate purposes including dividend payments and share repurchases.
2018 Recapitalization
On April 24, 2018, we completed the 2018 Recapitalization in which certain of our subsidiaries issued new notes pursuant to an asset-backed securitization. The notes consisted of $425.0 million Series 2018-1 4.116% Fixed Rate Senior Secured Notes, Class A-2-I with an anticipated term of 7.5 years (the “2018 7.5-Year Fixed Rate Notes”), and $400.0 million Series 2018-1 4.328% Fixed Rate Senior Secured Notes, Class A-2-II with an anticipated term of 9.25 years (the “2018 9.25-Year Fixed Rate Notes” and, collectively with the 2018 7.5-Year Fixed Rate Notes, the “2018 Notes”) in an offering exempt from registration under the Securities Act of 1933, as amended. Gross proceeds from the issuance of the 2018 Notes were $825.0 million. Additional information related to the 2018 Recapitalization transaction is included in Note 4 to our consolidated financial statements.
A portion of the proceeds from the 2018 Recapitalization was used to repay the remaining $490.1 million in outstanding principal and interest under the Company’s 2015 Five-Year Fixed Rate Notes, pre-fund a portion of the principal and interest payable on the 2018 Notes, pay transaction fees and expenses and repurchase and retire shares of the Company’s common stock. In connection with the repayment of the 2015 Five-Year Fixed Rate Notes, the Company expensed approximately $3.2 million for the remaining unamortized debt issuance costs associated with these notes. Additionally, in connection with the 2018 Recapitalization, the Company capitalized $8.2 million of debt issuance costs, which are being amortized into interest expense over the expected terms of the 2018 Notes.
2017 Recapitalization
On July 24, 2017, we completed the 2017 Recapitalization in which certain of our subsidiaries issued new notes pursuant to an asset-backed securitization. The notes consisted of $300.0 million Series 2017-1 Floating Rate Senior Secured Notes, Class A-2-I with an anticipated term of five years (the “2017 Five-Year Floating Rate Notes”), $600.0 million Series 2017-1 3.082% Fixed Rate Senior Secured Notes, Class A-2-II with an anticipated term of five years (the “2017 Five-Year Fixed Rate Notes”), and $1.0 billion Series 2017-1 4.118% Fixed Rate Senior Secured Notes, Class A-2-III with an anticipated term of 10 years (the “2017 Ten-Year Fixed Rate Notes” and, collectively with the 2017 Five-Year Floating Rate Notes and the 2017 Five-Year Fixed Rate Notes, the “2017 Fixed and Floating Rate Notes”) in an offering exempt from registration under the Securities Act of 1933, as amended. The interest rate on the 2017 Five-Year Floating Rate Notes is payable at a rate equal to LIBOR plus 125 basis points. The 2017 Fixed and Floating Rate Notes and the 2017 Variable Funding Notes are collectively referred to as the “2017 Notes”. Gross proceeds from the issuance of the 2017 Notes were $1.9 billion. Additional information related to the 2017 Recapitalization transaction is included in Note 4 to our consolidated financial statements.
A portion of proceeds from the 2017 Recapitalization was used to repay the remaining $910.5 million in outstanding principal and interest under the outstanding 2012 Fixed Rate Notes, pre-fund a portion of the principal and interest payable on the 2017 Notes and pay transaction fees and expenses. In connection with the repayment of the 2012 Fixed Rate Notes, we expensed approximately $5.5 million for the remaining unamortized debt issuance costs associated with these notes. Additionally, in connection with the 2017 Recapitalization, we capitalized $16.8 million of debt issuance costs, which are being amortized into interest expense over the five and ten-year expected terms of the 2017 Fixed and Floating Rate Notes.
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On August 2, 2017, we entered into a $1.0 billion accelerated share repurchase agreement (the “2017 ASR Agreement”) with a counterparty. Pursuant to the terms of the 2017 ASR Agreement, on August 3, 2017, we used a portion of the proceeds from the 2017 Recapitalization to pay the counterparty $1.0 billion in cash and received 4,558,863 shares of the Company’s common stock. Final settlement of the 2017 ASR Agreement occurred on October 11, 2017. In connection with the 2017 ASR Agreement, we received and retired a total of 5,218,670 shares of our common stock at an average price of $191.62.
2015 Recapitalization
On October 21, 2015, we completed the 2015 Recapitalization in which certain of our subsidiaries, among other things, replaced $551.3 million of the 2012 Fixed Rate Notes and its 2012 variable funding notes with new notes issued pursuant to an asset-backed securitization. The notes consisted of $500.0 million of Series 2015-1 3.484% Fixed Rate Senior Secured Notes, Class A-2-I (the “2015 Five-Year Fixed Rate Notes”), $800.0 million Series 2015-1 4.474% Fixed Rate Senior Secured Notes, Class A-2-II (the “2015 Ten-Year Fixed Rate Notes” and collectively with the 2015 Five-Year Fixed Rate Notes, the “2015 Fixed Rate Notes”) and $125.0 million of Series 2015-1 Variable Funding Senior Secured Notes, Class A-1 (the “2015 Variable Funding Notes” and, collectively with the 2015 Fixed Rate Notes, the “2015 Notes”). Gross proceeds from the issuance of the 2015 Notes were $1.3 billion. The 2015 Five-Year Fixed Rate Notes were repaid in connection with the 2018 Recapitalization. Additional information related to the 2015 Recapitalization transaction is included in Note 4 to our consolidated financial statements. The “2018 Notes,” the “2017 Fixed and Floating Rate Notes” and the “2015 Fixed Rate Notes” are collectively referred to as the “2018, 2017 and 2015 Notes.”
In connection with the 2015 Recapitalization, we used a portion of proceeds to make an optional prepayment of approximately $551.3 million in aggregate principal amount of the 2012 Fixed Rate Notes, at par, pay scheduled principal catch-up amounts on the 2012 Fixed Rate Notes, make an interest reserve deposit, pre-fund a portion of the principal and interest payable on the 2015 Fixed Rate Notes and pay transaction fees and expenses. In connection with the 2015 Recapitalization, we recorded $17.4 million of debt issuance costs, which are being amortized into interest expense over the five and ten-year expected terms of the 2015 Fixed Rate Notes. Additionally, in connection with the 2015 Recapitalization, we wrote off approximately $6.9 million of these costs in connection with the extinguishment of $551.3 million of previous fixed rate notes. Further, in connection with the 2015 Recapitalization, we incurred approximately $8.1 million of net expenses.
On October 27, 2015, we entered into a $600.0 million accelerated share repurchase agreement (the “2015 ASR Agreement”) with a counterparty. Pursuant to the terms of the 2015 ASR Agreement, on October 30, 2015, we used a portion of the proceeds from the 2015 Recapitalization to pay the counterparty $600.0 million in cash and received approximately 4,858,994 shares of the Company’s common stock. During the first quarter of 2016, we received and retired 456,936 shares of our common stock in connection with the final settlement of the 2015 ASR Agreement.
2018, 2017 and 2015 Notes
The 2018, 2017 and 2015 Notes have original scheduled principal payments of $35.3 million in each of 2019 through 2021, $888.0 million in 2022, $26.3 million in each of 2023 and 2024, $1.14 billion in 2025, $14.0 million in 2026 and $1.27 billion in 2027. However, in accordance with our debt agreements, the payment of principal on the outstanding senior notes shall be suspended if the leverage ratio for the Company is less than or equal to 5.0x total debt, as defined, to adjusted EBITDA, as defined, and no catch-up provisions are applicable. As of December 30, 2018, we also had $65.0 million outstanding under our variable funding notes with a legal maturity date in July 2022, subject to two additional one-year extensions at the option of the Company, subject to certain conditions.
The 2018, 2017 and 2015 Notes are subject to certain financial and non-financial covenants, including a debt service coverage calculation, as defined in the related agreements. In the event that certain covenants are not met, the 2018, 2017 and 2015 Notes may become due and payable on an accelerated schedule.
Under the provisions of the Company’s previously existing debt agreements, during the first and second quarters of 2017, the Company met the maximum leverage ratios of less than 4.5x and accordingly, did not make previously scheduled debt amortization payments in accordance with the debt agreements. Subsequent to the 2017 Recapitalization and through 2018, the Company’s leverage ratios exceeded the new maximum leverage ratio of 5.0x and, accordingly, the Company began making the scheduled amortization payments.
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Share Repurchase Programs
The Company’s open market share repurchase programs have historically been funded by excess operating cash flows, excess proceeds from our recapitalization transactions and borrowings under our variable funding notes. The Company used cash of approximately $591.2 million in 2018, $1.06 billion in 2017 and $300.3 million in 2016 for share repurchases. The Company’s Board of Directors authorized a share repurchase program to repurchase up to $750.0 million of the Company’s common stock on February 14, 2018. The Company had approximately $158.8 million left under this share repurchase program as of December 30, 2018. From December 31, 2018 through February 14, 2019, the Company repurchased and retired an additional 33,549 shares of common stock for a total of approximately $8.1 million, or an average price of $242.74 per share.
Capital Expenditures
In the past three years, we have invested approximately $268.5 million in capital expenditures. In 2018, we invested $119.9 million in capital expenditures which primarily related to investments in our supply chain centers, our digital ordering platform, our proprietary internally developed point-of-sale system (Domino’s PULSE), our internal enterprise systems, asset upgrades and reimages for our existing Company-owned stores and new Company-owned stores. We did not have any material commitments for capital expenditures as of December 30, 2018.
The following table illustrates the main components of our cash flows:
| Fiscal Year Ended | ||||||||||||
| (In millions) | December 30, 2018 | December 31, 2017 (1) | January 1, 2017 (1) | |||||||||
| Cash Flows Provided By (Used In) | ||||||||||||
| Net cash provided by operating activities | $ | 394.2 | $ | 341.3 | $ | 292.5 | ||||||
| Net cash used in investing activities | (88.3 | ) | (83.7 | ) | (55.3 | ) | ||||||
| Net cash used in financing activities | (322.8 | ) | (197.1 | ) | (375.8 | ) | ||||||
| Exchange rate changes | (0.5 | ) | 0.1 | (1.3 | ) | |||||||
| Change in cash and cash equivalents, restricted cash and cash equivalents | $ | (17.4 | ) | $ | 60.4 | $ | (139.9 | ) | ||||
| (1) | In 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, which requires that restricted cash and cash equivalents be included as components of total cash and cash equivalents as presented on the consolidated statement of cash flows. The prior year amounts have been recast. Refer to Note 1 to the consolidated financial statements for additional information related to the adoption of this new accounting standard. |
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Operating Activities
Cash provided by operating activities increased $52.9 million in 2018, primarily due to an increase in net income of $84.1 million. This increase was partially offset by the negative impact of changes in operating assets and liabilities of $32.1 million. Our cash outflows for operating assets and liabilities in 2018 were higher than in 2017 due primarily to higher inventory balances and the timing of payments on accounts payable and accrued liabilities.
Cash provided by operating activities increased $48.8 million in 2017 from 2016, primarily due to an increase in net income of $63.2 million. Net income in 2017 included a $27.2 million benefit from the adoption of ASU 2016-09, which requires tax benefits on equity-based compensation to be recorded as a reduction to the provision from income taxes in net income and as a component of cash provided by operating activities. In 2016, these tax benefits were recorded directly to stockholders’ deficit and as a financing activity in the statement of cash flows. Cash provided by operating activities was also positively impacted by an increase in non-cash amounts of $18.1 million. These increases were offset in part by the negative impact of changes in operating assets and liabilities of $32.5 million, primarily related to the timing of payments on accounts payable and accrued liabilities during 2017 as compared to 2016.
We are focused on continually improving our net income and cash flow from operations and management expects to continue to generate positive cash flows from operating activities for the foreseeable future.
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Investing Activities
Cash used in investing activities was $88.3 million in 2018, which consisted primarily of $119.9 million of capital expenditures (driven primarily by investments in supply chain centers, technology initiatives and our Company-owned stores) and purchases of restricted advertising fund investments of $70.2 million. These uses of cash were partially offset by maturities of restricted advertising fund investments of $94.0 million. The Company adopted ASC 606 in the first quarter of 2018, which superseded the agency guidance the Company historically applied to present advertising fund activities net in the Company’s consolidated statement of cash flows. Refer to Note 1 to the consolidated financial statements for additional information related to the Company’s adoption of ASC 606. These uses of cash were offset in part by the proceeds from the sale of assets of $8.4 million.
Cash used in investing activities was $83.7 million in 2017, which consisted primarily of $90.0 million of capital expenditures (driven by investments in our technological initiatives, supply chain centers and Company-owned stores), offset in part by the proceeds from the sale of assets of $6.8 million.
Cash used in investing activities was $55.3 million in 2016, which consisted primarily of $58.6 million of capital expenditures (driven by investments related to the reimaging of our existing Company-owned stores and investments in our supply chain centers and training facilities, our proprietary internally developed point-of-sale system, our digital ordering platform, our internal enterprise systems and other technology initiatives), offset in part by proceeds from the sale of assets of $4.9 million.
Financing Activities
Cash used in financing activities was $322.8 million in 2018. We issued $825.0 million of debt in connection with our 2018 Recapitalization and borrowed $145.0 million under our variable funding notes. However, these increases in cash were offset by repayments of long-term debt of $604.1 million (of which $490.0 million was an optional prepayment on our 2015 Five-Year Fixed Rate Notes using a portion of the proceeds received from the 2018 Recapitalization and $80.0 million related to the repayment of borrowings under the 2017 Variable Funding Notes), purchases of common stock of $591.2 million, funding dividend payments to our shareholders of $92.2 million, and cash paid for financing costs related to our 2018 Recapitalization of $8.2 million. We also received proceeds of $9.8 million from the exercise of stock options and made $7.0 million in tax payments for restricted stock upon vesting.
Cash used in financing activities was $197.1 million in 2017. We issued $1.9 billion of debt in connection with our 2017 Recapitalization, which was offset by purchases of common stock of $1.06 billion, repayments of long-term debt of $928.2 million (of which, $910.2 million was repayment of the remaining 2012 Fixed Rate Notes using a portion of the proceeds received from the 2017 Recapitalization), funding dividend payments to our shareholders of $84.3 million, and cash paid for financing costs related to our 2017 Recapitalization of $16.8 million. We also made $9.4 million in tax payments for restricted stock upon vesting and received proceeds of $6.1 million from the exercise of stock options.
Cash used in financing activities was $375.8 million in 2016. Purchases of common stock totaled $300.3 million, repayments of long-term debt and capital lease obligations totaled $122.3 million, and funding dividend payments to our shareholders totaled $73.9 million. The net tax impact of equity-based compensation was $42.5 million, proceeds from issuance of debt (from our draws on our variable funding note facility) totaled $63.0 million, and proceeds from the exercise of stock options totaled $15.2 million.
Our ability to continue to fund these items and continue to reduce debt could be adversely affected by the occurrence of any of the events described in Item 1A. Risk Factors. There can be no assurance that our business will generate sufficient cash flows from operations or that future borrowings will be available under the 2017 Variable Funding Notes or otherwise to enable us to service our indebtedness, or to make anticipated capital expenditures. Our future operating performance and our ability to service, extend or refinance the 2018, 2017 and 2015 Notes and to service, extend or refinance the 2017 Variable Funding Notes will be subject to future economic conditions and to financial, business and other factors, many of which are beyond our control.
Impact of inflation
Inflation did not have a material impact on our operations in 2018, 2017 or 2016. Severe increases in inflation, however, could affect the global and U.S. economies and could have an adverse impact on our business, financial condition and results of operations. Further discussion on the impact of commodities and other cost pressures is included above as well as in Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
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New accounting pronouncements
The impact of new accounting pronouncements adopted during 2018 and the estimated impact of new accounting pronouncements that we will adopt in future years is included in Note 1 to the consolidated financial statements.
Contractual obligations
The following is a summary of our significant contractual obligations at December 30, 2018.
| (dollars in millions) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total | |||||||||||||||||||||
| Long-term debt (1): | ||||||||||||||||||||||||||||
| Principal | $ | 35.3 | $ | 35.3 | $ | 35.3 | $ | 953.0 | $ | 26.3 | $ | 2,457.1 | $ | 3,542.1 | ||||||||||||||
| Interest (2) | 142.0 | 144.0 | 141.4 | 125.7 | 104.8 | 281.9 | 939.8 | |||||||||||||||||||||
| Capital leases (3) | 2.4 | 2.4 | 2.4 | 2.5 | 2.5 | 23.8 | 36.0 | |||||||||||||||||||||
| Operating leases (4) | 40.8 | 37.5 | 34.5 | 30.8 | 27.4 | 100.3 | 271.3 |
| (1) | We have outstanding long-term secured notes with varying maturities. For additional information, see Note 4 of the Notes to Consolidated Financial Statements under “Part II – Item 8 – Financial Statements and Supplementary Data.” |
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| (2) | Represents interest payments on our 2018, 2017 and 2015 Notes and 2017 Variable Funding Notes. The interest rate on the 2017 Variable Funding Notes will be payable at a per year rate equal to LIBOR plus 150 basis points. |
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| (3) | The principal portion of the capital lease obligation amounts above, which totaled $17.0 million at December 30, 2018, are classified as debt in our consolidated financial statements. |
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| (4) | We lease certain retail store and supply chain center locations, supply chain vehicles, various equipment and our World Resource Center under leases with expiration dates through 2034. |
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As of December 30, 2018, we have entered into additional operating leases for supply chain center tractors and trailers and a build-to-suit arrangement for a new building constructed by the Company’s landlord that had not yet commenced with estimated future minimum rental commitments of approximately $39.1 million. We have also entered into an additional finance lease for a supply chain center that had not yet commenced with estimated future minimum rental commitments of approximately $28.7 million. These leases are expected to commence in 2019 with lease terms of up to 15 years. These amounts are not included in the table above.
Liabilities for unrecognized tax benefits of $2.0 million are excluded from the above table, as we are unable to make a reasonably reliable estimate of the amount and period of payment. For additional information on unrecognized tax benefits see Note 6 to the consolidated financial statements included in this Form 10-K.
Off-balance sheet arrangements
We are party to letters of credit and, to a lesser extent, financial guarantees with off-balance sheet risk. Our exposure to credit loss for letters of credit and financial guarantees is represented by the contractual amounts of these instruments. Total conditional commitments under letters of credit as of December 30, 2018 were approximately $48.1 million and relate to our insurance programs and supply chain center leases. The Company has guaranteed lease payments related to certain franchisees’ lease arrangements. The maximum amount of potential future payments under these guarantees is $2.4 million as of December 30, 2018. We believe that none of these arrangements has or is likely to have a material effect on our results of operations, financial condition, revenues or expenses, capital expenditures or liquidity.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This Annual Report on Form 10-K includes various forward-looking statements about the Company within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”) that are based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. The following cautionary statements are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.
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These forward-looking statements generally can be identified by the use of words such as “anticipate,” “believe,” “could,” “should,” “estimate,” “expect,” “intend,” “may,” “will,” “plan,” “predict,” “project,” “seek,” “approximately,” “potential,” “outlook” and similar terms and phrases that concern our strategy, plans or intentions, including references to assumptions. These forward-looking statements address various matters including information concerning future results of operations and business strategy, the expected demand for future pizza delivery, our expectation that we will meet the terms of our agreement with our third-party supplier of pizza cheese, our belief that alternative third-party suppliers are available for our key ingredients in the event we are required to replace any of our supply partners, our intention to continue to enhance and grow online ordering, digital marketing and technological capabilities, our expectation that there will be no material environmental compliance-related capital expenditures, our plans to expand U.S. and international operations in many of the markets where we currently operate and in selected new markets, our expectation that the contribution rate for advertising fees payable to DNAF will remain in place for the foreseeable future, and the availability of our borrowings under the 2017 Variable Funding Notes for, among other things, funding working capital requirements, paying capital expenditures and funding other general corporate purposes, including payment of dividends.
Forward-looking statements relating to our anticipated profitability, estimates in same store sales growth, the growth of our U.S. and international business, ability to service our indebtedness, our future cash flows, our operating performance, trends in our business and other descriptions of future events reflect management’s expectations based upon currently available information and data. While we believe these expectations and projections are based on reasonable assumptions, such forward-looking statements are inherently subject to risks, uncertainties and assumptions about us, including the risk factors listed under Item 1A. Risk Factors, as well as other cautionary language in this Form 10-K.
Actual results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors, including but not limited to, the following:
| • | our substantial increased indebtedness as a result of the 2015 Recapitalization, 2017 Recapitalization and 2018 Recapitalization and our ability to incur additional indebtedness or refinance or renegotiate key terms of that indebtedness in the future; |
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| • | the impact a downgrade in our credit rating may have on our business, financial condition and results of operations; |
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| • | our future financial performance and our ability to pay principal and interest on our indebtedness; |
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| • | the effectiveness of our advertising, operations and promotional initiatives; |
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| • | the strength of our brand, including our ability to compete in the U.S. and internationally in our intensely competitive industry; |
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| • | the impact of social media and other consumer-oriented technologies on our business, brand and reputation; |
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| • | new product, digital ordering and concept developments by us, and other food-industry competitors; |
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| • | our ability to maintain good relationships with our franchisees and their ongoing level of profitability; |
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| • | our ability to successfully implement cost-saving strategies; |
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| • | our ability and that of our franchisees to successfully operate in the current and future credit environment; |
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| • | changes in the level of consumer spending given general economic conditions, including interest rates, energy prices and consumer confidence; |
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| • | our ability and that of our franchisees to open new restaurants and keep existing restaurants in operation; |
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| • | changes in operating expenses resulting from changes in prices of food (particularly cheese), fuel and other commodity costs, labor, utilities, insurance, employee benefits and other operating costs; |
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| • | the impact that widespread illness or general health concerns, severe weather conditions and natural disasters may have on our business and the economies of the countries where we operate; |
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| • | changes in foreign currency exchange rates; |
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| • | our ability to retain or replace our executive officers and other key members of management and our ability to adequately staff our stores and supply chain centers with qualified personnel; |
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| • | our ability to find and/or retain suitable real estate for our stores and supply chain centers; |
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| • | changes in government legislation or regulation, including changes in laws and regulations regarding information privacy and consumer protection; |
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| • | adverse legal judgments or settlements; |
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| • | food-borne illness or contamination of products; |
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| • | data breaches, power loss, technological failures, user error or other cyber risks; |
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| • | the effect of war, terrorism or catastrophic events; |
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| • | our ability to pay dividends and repurchase shares; |
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| • | changes in consumer taste, spending and traffic patterns and demographic trends; |
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| • | changes in accounting policies; and |
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| • | adequacy of our insurance coverage. |
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In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Annual Report on Form 10-K might not occur. All forward-looking statements speak only as of the date of this Form 10-K and should be evaluated with an understanding of their inherent uncertainty. Except as required under federal securities laws and the rules and regulations of the Securities and Exchange Commission, we will not undertake and specifically decline any obligation to publicly update or revise any forward-looking statements to reflect events or circumstances arising after the date of this Form 10-K, whether as a result of new information, future events or otherwise.
Readers are cautioned not to place undue reliance on the forward-looking statements included in this Form 10-K or that may be made elsewhere from time to time by, or on behalf of, us. All forward-looking statements attributable to us are expressly qualified by these cautionary statements.
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