Sculptor Capital Management
Annual Report 2017

Plain-text annual report

THE SECOND CUP LTD. Annual Report 2017 Vision — To be the Canadian specialty coffee brand of choice across Canada, committed to superior quality, innovation and profitable growth. 2 THE SECOND CUP LTD. Table of Contents Letter from the Chairman Letter from the President & CEO Pinkberry Café Revitalization Continues Driving Innovation A Look at 2018 Financial Highlights Management's Discussion & Analysis Audited Financial Statements Shareholder Information 2 3 4 6 8 12 15 16 36 65 ANNUAL REPORT 2017 1 Letter from the Chairman Second Cup strengthened significantly during 2017. Garry Macdonald became CEO mid-year and has brought stability to the organization. The company’s capital structure improved materially and at year end was debt free with $4.5 million of cash. The year saw a successful return to Second Cup‘s asset light business model. The year ended with 12 corporate stores compared with a peak of 47 in 2015. Product innovation stepped up, highlighted by the successful introduction of Pinkberry frozen yogurt in a number of test stores. Pinkberry has proven to be a highly complementary addition to Second Cup’s core offering, resulting in growth in store sales and profitability. The Pinkberry program is now being rolled out across the country. As a result of the debt exchange last August, the shareholders of Serruya Private Equity became Second Cup’s largest shareholders. Michael and Aaron Serruya joined the Second Cup Board of Directors. The Serruya family has a long track record of value creation in businesses similar to Second Cup. We expect the company to generate positive cash flow in the future. With a solid financial foundation, Second Cup may now actively consider new opportunities to create value for shareholders. There is much additional opportunity for improvement at Second Cup, but today the company is stronger than it has been in many years. For this I thank our management team, franchisees, directors and shareholders. Michael Bregman Chairman 2 THE SECOND CUP LTD. Letter from the President & CEO Last May when I assumed the leadership role at Second Cup, I was thrilled to join the iconic Canadian brand and excited by the growth potential. As I reflect on the past twelve months, I am pleased with the significant improvement in profitability and the innovation that will further enhance our brand presence, and create added value and returns for our franchisee partners and shareholders. We ended 2017 with an incredible 383% growth in EBITDA (adjusted) and in Q4 it was more than double compared to the same quarter in the prior year. Growing same store sales remains a priority. We ended the year at -0.2%, an improvement from -1.1% in 2016. There were numerous product innovations in 2017 with a focus on differentiated, premium offerings that have mass appeal. These included a new Better For You menu, our unparalleled Flash Cold Brew and new fresh food offerings including Bagels and Cheese Melts. We will continue to drive sales and profit improvement through innovation and differentiation in our new product development including enhancements to breakfast, lunch and snack programs. Our Rewards program membership grew by 30% and continues to be valued by customers and franchisee partners. We know from our research that it is the number one driver of brand choice among coffee drinkers and Rewards members spend more per transaction. We have plans to further enhance the Rewards member experience this year. The most promising new product introduction is Pinkberry frozen yogurt - recognized as the premium brand leader in the frozen yogurt category. The roll out began late last year and response to this complimentary, premium offering has been very favourable, attracting new customers to our cafés and driving incremental sales. We are aggressively working to launch Pinkberry in more cafés across the network in time for the peak frozen yogurt season. Second Cup has great real estate locations. In 2017 many more of our cafés were renovated to reflect the modernized brand with improvements in costs. We will continue to focus on expanding our traditional café model in carefully selected, high profile locations, as well as our concept upgrades and renovations while restoring our asset light business model. We ended the year with 12 corporately-owned cafés, which is down from a peak of 47 stores in 2015. One of our priorities in 2018 will be to expand the Second Cup footprint nanionally to add brand value and access. In support of this initiative, we have developed a new non-traditional format program and a new co-brand licensing format, offering our premium quality Second Cup branded/ signature products in smaller footprint venues with a lower capital cost profile. Partnering examples in the non-traditional sector may include compatible QSR chains, entertainment venues, institutional, petroleum, convenience, etc. Second Cup is an incredible brand. The company is in a much stronger position today and I wish to thank the dedicated management team, staff at Coffee Central and our committed franchisee partners. I am very appreciative of the support of our Board of Directors. I look forward to a year of accelerated growth to help Second Cup realize its full potential. Garry Macdonald President & CEO ANNUAL REPORT 2017 3 Pinkberry Second Cup entered into a category exclusive licensing agreement with Pinkberry Canada Inc., and in Q4 2017 we began rolling out the Pinkberry Frozen Yogurt program in Second Cup cafés across the country. Early results have been very positive with Pinkberry contributing significantly to sales and profitability as well as attracting new customers. The Pinkberry brand is the leading premium brand in the frozen yogurt category. Launched in California in 2005, Pinkberry has developed a cult-like following and is made with high-quality fresh ingredients, fresh hand-cut fruit and premium toppings. This licensing agreement brings together two great brands and provides Canadians with an opportunity to experience the best in frozen yogurt and the best specialty coffee. “Pinkberry is a delicious product that has been well-received by my customers. It has brought in new customers that I have never seen in the nearly five years we’ve been open. Customers are coming in exclusively for Pinkberry. Canadians like frozen yogurt at any time of the year. I can’t wait for the summer and expect to see my patio filled with Pinkberry fans!” — Tamara Belamy Second Cup Franchisee Partner and Advisory Council Member 4 THE SECOND CUP LTD.  ANNUAL REPORT 2017 5 Café Revitalization Continues In 2017 we continued to modernize our Second Cup cafés to reflect the updated brand design in new and existing locations. We continue to work on enhancing the experience while delivering cost efficiency. The Pinkberry frozen yogurt concept has now been integrated into the café design and is a standard offering. We have designated one of our downtown Toronto cafés as an innovation centre for testing new ideas to drive sales and profitability that we then rapidly roll-out across the system. “I have a very loyal customer base and they love the new design of the café. It’s bright and airy and has reenergized my staff. The new merchandising displays really show off our premium food and beverage products. With Pinkberry, we now have another reason for customers to visit more often and to bring in new customers.” — Jeetesh Jogie Second Cup Franchisee Partner Toronto, ON 6 THE SECOND CUP LTD.  ANNUAL REPORT 2017 7 Full fl avour, extra smooth. Mocca Classic Black 8 THE SECOND CUP LTD. Rethink the cold. Vanilla Bean CHEESE MELTS BAGEL BAR Comfort classics made better. Fresh, toasted bagels & spreads. Full fl avour, extra smooth. Mocca Classic Black Vanilla Bean Rethink the cold. Driving Innovation Second Cup significantly advanced its food and beverage offerings last year with numerous introductions and a focus on products that are differentiated and have mass appeal to drive incremental sales. FLASH COLD BREW Second Cup has made uncompromising improvements to every aspect of our coffee process, from farm to cup, to ensure we're delivering the best tasting coffee. Flash Cold Brew was introduced last spring and has resulted in significant growth in our cold coffee category, the fastest growing segment in the coffee market. The result of this specialized, Flash Brew method is a superior coffee taste profile that's full flavour and extra smooth. FRESH FOOD Expanding Second Cup’s premium, fresh, local food offering in the breakfast and lunch dayparts is a key strategy for café sales growth. In 2017 major advancements were made with the launch of a fresh Bagel and Spreads program and a line of premium Cheese Melt sandwiches – a classic, remastered. ANNUAL REPORT 2017 9 BETTER FOR YOU MENU In the first quarter of last year we launched a Better For You menu to meet the growing customer demand for healthier options. A line of smoothies is at the core of the program and opened the door to a whole new group of customers for our cafés. Additional low calorie and high-protein bakery and sandwich menu items compliment the offer. This program will be expanded with new menu innovation underway. 10 THE SECOND CUP LTD. Simply Rewarding Members earn FREE coffee! SECOND CUP COFFEE CO. REWARDS A free Rewards program remains a top driver of brand choice for coffee consumers and continues to be a customer favourite. In 2017 our loyalty member base grew by 30% and members’ average transaction is significantly higher than the average. With Second Cup Coffee Co. Rewards, members earn points for every dollar they spend and through personalized bonus point offers sent by email and on the mobile app. DOWNLOAD THE APP Second Cup Coffee Co.TM Rewards Program available at participating Second Cup Coffee Co.TM Cafés in Canada. TMTrademark of The Second Cup Ltd. See secondcup.com/rewards for full program details, terms and conditions. ANNUAL REPORT 2017 11 Always Delicious NOW CLEAN LABEL! Going Clean... Always Delicious NO Preservatives NO Artifi cial Colours NO Artifi cial Flavours NO High-Fructose Corn Syrup Committed to Clean Label beverages. fresh is our secret ingredient Made with non-fat milk and hand-cut fresh fruit. Copyright © 2018 Pinkberry Canada Inc. All Rights Reserved. All Trademarks Are The Exclusive Property Of Pinkberry Canada Inc. 12 THE SECOND CUP LTD. Going Clean... Always Delicious NO Preservatives NO Artifi cial Colours NO Artifi cial Flavours NO High-Fructose Corn Syrup Committed to Clean Label beverages. A look at 2018 Second Cup’s dramatic improvement in our profitability last year sets the stage for an accelerated growth plan in 2018. The focus is on driving same store sales with innovation led by the expansion of Pinkberry, as well as upgrading and expanding Second Cup in traditional and non-traditional formats. You can expect more exciting fresh food, beverage and Rewards innovation this year. Leading the Canadian coffee market with Clean Label beverages In January, Second Cup led the Canadian coffee market with a move to Clean Label beverages which now represent over 70% of the beverage menu. Clean Label products contain no artificial colours, flavours, preservatives or high fructose corn syrup. Canadian consumers are making more informed food choices. They care about what's in their food and drinks, and they're looking for options they can feel good about. “At Second Cup, we're on a continual mission to provide the most innovative premium coffee experience in the country - and we believe that our Clean Label commitment is another important step in that journey." — Garry Macdonald President & CEO ANNUAL REPORT 2017 13 14 THE SECOND CUP LTD. Financial Highlights The following table sets out selected IFRS and certain non-GAAP financial measures of the Company and should be read in conjunction with the Audited Financial Statements of the Company for the 52 weeks ended December 30, 2017. ( In thousands of Canadian dollars, except same café sales, number of cafés, per share amounts, and number of common shares.) December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended $41,326 $46,743 $154,153 $163,738 System sales of cafés1 Same café sales1 Number of cafés – end of period Total revenue Operating costs and expenses Operating income (loss)1 EBITDA1 Adjusted EBITDA1 Net income (loss) and comprehensive income (loss) Adjusted net income (loss) and comprehensive income (loss)1 Basic and diluted earnings (loss) per share as reported Adjusted basic and diluted earnings (loss) per share1 (1.1%) 286 $6,085 $5,092 $993 $1,339 $1,339 $655 $655 $0.04 $0.04 (1.0%) 294 $7,500 $7,199 $302 $667 $667 $147 $147 $0.01 $0.01 (0.2%) 286 $23,636 $22,660 $976 $2,434 $2,721 ($3,097) $110 ($0.21) $0.01 (1.1%) 294 $30,351 $31,336 ($985) $563 $563 ($975) ($975) ($0.08) ($0.08) $45,314 Total assets – end of period $44,700 $45,314 $44,700 Number of weighted average common shares issued and outstanding 17,041,473 12,830,945 14,485,081 12,830,945 1 See the section “Definitions and Discussion on Certain non-GAAP Financial Measures” for further analysis. System wide sales (in millions of Canadian dollars) Number of Second Cup cafés (in Canada) 200 150 100 50 0 191.4 182.8 174.9 163.7 154.2 2013 2014 2015 2016 2017 400 350 300 250 200 150 100 50 0 356 347 310 294 286 2013 2014 2015 2016 2017 ANNUAL REPORT 2017 15 Management’s Discussion and Analysis CAUTION REGARDING FORWARD-LOOKING STATEMENTS Certain statements in this Management’s Discussion and Analysis (“MD&A”) may constitute forward-looking statements within the meaning of applicable securities legislation. The terms the “Company”, “Second Cup”, “we”, “us”, or “our” refer to The Second Cup Ltd. Forward-looking statements include words such as “may”, “will”, “should”, “expect”, “anticipate”, “believe”, “plan”, “intend” and other similar words. These statements reflect current expectations regarding future events and financial performance and speak only as of the date of this MD&A. The MD&A should not be read as a guarantee of future performance or results and will not necessarily be an accurate indication of whether or not those results will be achieved. Forward-looking statements are based on a number of assumptions and are subject to known and unknown risks, uncertainties and other factors, many of which are beyond Second Cup’s control that may cause Second Cup’s actual results, performance or achievements, or those of Second Cup cafés, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. The following are some of the factors that could cause actual results to differ materially from those expressed in the underlying forward-looking statements: competition; availability of premium quality coffee beans; the ability to attract qualified franchisees; the location of Second Cup cafés; the closure of Second Cup cafés; loss of key personnel; compliance with government regulations; potential litigation; the ability to exploit and protect the Second Cup trademarks; changing consumer preferences and discretionary spending patterns including, but not restricted to, the impact of weather and economic conditions on such patterns; reporting of system sales by franchisees; and the financial performance and financial condition of Second Cup. The foregoing list of factors is not exhaustive, and investors should refer to the risks described under “Risks and Uncertainties” below and in Second Cup’s Annual Information Form, which is available at www.sedar.com. Although the forward-looking statements contained in this MD&A are based on what management believes are reasonable assumptions, there can be no assurance that actual results will be consistent with these forward-looking statements and, as a result, the forward-looking statements may prove to be incorrect. As these forward-looking statements are made as of the date of this MD&A, Second Cup does not undertake to update any such forward-looking statements whether as a result of new information, future events or otherwise. Additional information about these assumptions and risks and uncertainties is contained in the Company’s filings with securities regulators. These filings are also available on the Company’s website at www.secondcup.com. INTRODUCTION The following MD&A has been prepared as of February 23, 2018 and is intended to assist in understanding the financial performance and financial condition of The Second Cup Ltd. (“Second Cup” or the “Company”) for the 13 weeks (the “Quarter”) and 52 weeks (the “Year”) ended December 30, 2017, and should be read in conjunction with the Audited Financial Statements of the Company for the 52 weeks ended December 30, 2017, accompanying notes and the Annual Information Form, which are available at www.sedar.com. Past performance may not be indicative of future performance. All amounts are presented in thousands of Canadian dollars, except number of cafés, per share amounts or unless otherwise indicated and have been prepared in accordance with International Financial Reporting Standards (“IFRS”). The Company also reports certain non-IFRS measures such as system sales of cafés, same café sales, operating income (loss), EBITDA, adjusted EBITDA, adjusted net income (loss) and adjusted net income (loss) per share that are discussed in the “Definitions and Discussion of Certain non-GAAP Financial Measures” in this MD&A. 16 THE SECOND CUP LTD. TABLE OF CONTENTS Core Business, Strategic Imperatives, and Key Performance Drivers Capabilities Financial Highlights Operational Review Selected Quarterly Information Liquidity and Capital Resources Evaluation of Disclosure Controls and Procedures Critical Accounting Estimates Changes in Accounting Policies Risks and Uncertainties Outlook Definitions and Discussion on Certain Non-GAAP Financial Measures 18 18 20 21 24 25 28 29 30 32 33 33 ANNUAL REPORT 2017 17 CORE BUSINESS, STRATEGIC IMPERATIVES, AND KEY PERFORMANCE DRIVERS Core business Second Cup is a Canadian specialty coffee retailer with 286 cafés operating under the trade name Second Cup™ in Canada, of which 12 are Company-owned and the balance is operated by franchisees. Second Cup owns the trademarks, trade names, operating procedures and systems and other intellectual property used in connection with the operation of Second Cup cafés in Canada, excluding the Territory of Nunavut. The Company was incorporated under the Business Corporations Act (Ontario) in 2011. The address of its registered office is 6303 Airport Road, 2nd Floor, Mississauga, Ontario, L4V 1R8. The website is www.secondcup.com. The common shares are listed on the Toronto Stock Exchange under the symbol “SCU”. The fiscal year follows the method, such that each quarter will consist of 13 weeks and will end on the Saturday closest to the calendar quarter-end. The fiscal year is made up of 52 or 53-week periods ending on the last Saturday of December. Fiscal year 2017 consists of 52 weeks. As at December 30, 2017, the issued share capital consisted of 17,041,473 common shares. Additional information including the Annual Information Form is on SEDAR at www.sedar.com. As a franchisor, Second Cup opens, acquires, closes and refranchises individual café locations in the normal course of business. Strategic imperatives and key performance drivers Second Cup’s vision of being the coffee brand most passionately committed to quality and innovation will drive management’s strategies and actions going forward. Coffee will be at the core of the offering supported by ongoing food and beverage innovation. As the Canadian specialty coffee company, bringing the best coffees in the world to customers is at the core of the brand and fundamental to redefining Second Cup as the coffee brand most passionately committed to quality and innovation. In January 2018, Second Cup announced a move to Clean Label beverages, with a commitment to eliminate artificial colours and flavours, preservatives and high fructose corn syrup from all beverages on the menu. In September 2017, Second Cup obtained category exclusive license right from Pinkberry Canada Inc. and began rolling out the Pinkberry Frozen Yogurt program in Second Cup cafés. As at December 30, 2017, Pinkberry was being served at 24 cafés across Canada. The Company is encouraged by its progress in franchising corporate stores to strong operators, returning to an asset light business model, and expects to make further reductions in the number of Company-owned cafés in 2018. CAPABILITIES This section documents factors that affect the Company’s ability to execute strategies, manage key performance drivers and deliver results. This section is qualified by the section “Caution Regarding Forward-Looking Statements” at the beginning of this MD&A. The Second Cup brand The brand – Second Cup Coffee Co.TM – reflects an independent spirit, a commitment to deliver the world’s finest coffee, and the Company’s vision to be the coffee brand most passionately committed to quality and innovation. A proud Canadian company since 1975 with 286 cafés across Canada, Second Cup Coffee Co.™ is a specialty coffee retailer. The Company maintains its commitment to the communities it operates in, celebrating the franchisees’ local ownership and their focus on providing quality and friendly service to each customer in every café. 18 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS The people The franchise network consists of approximately 3,500 team members. Team members range from baristas, managers and franchisees at the cafés to support personnel employed at Coffee Central (head office). Baristas and franchisees complete extensive training and certification to deliver a quality product to our customers. Franchisees and baristas are subject to operational quality checks to monitor performance. Product As of today, 27 beverages achieve the Clean Label standard, representing 70% of Second Cup’s beverage menu. Clean Label beverages contain no artificial colours or flavours, no preservatives and no high fructose corn syrup. Second Cup will continue to reformulate other menu items to meet the Clean Label standard. The Company has a strategic partnership with an independent roaster of coffees. The Company has also partnered with Swiss Water Decaffeinated Coffee Company Inc. to decaffeinate its coffee. This process is 100% chemical- free, unlike other decaffeination methods that use methylene chloride or ethyl acetate to remove the caffeine. This decaffeination process gently removes 99.9% of the caffeine while maintaining the unique taste characteristics of the coffee. The process reflects Second Cup’s commitment to natural and healthy products. Second Cup prides itself that all of its coffee and espresso beverages are certified by third parties such as Rainforest Alliance™ - certification that the coffee is grown and processed in a socially and environmentally responsible manner. The Company offers a fair-trade and organic certified blend of coffee called Cuzco®. In addition to coffee-based products and other beverages, cafés carry a variety of complementary products, including Pinkberry, pastries, sandwiches, muffins, cookies, coffee accessories and coffee-related gift items. The Pinkberry brand is the leading premium brand in the frozen yogurt category. Launched in California in 2005, Pinkberry has developed a cult-like following and is made with high-quality fresh ingredients, fresh hand-cut fruit and premium toppings. Liquidity, capital resources and management of capital The Company’s objectives relating to the management of its capital structure are to: • safeguard its ability to continue as a going concern; • maintain financial flexibility in order to preserve its ability to meet financial obligations; and • deploy capital to provide an adequate return to its shareholders. The Company’s primary uses of capital are to finance increases in non-cash working capital and capital expenditures. On August 10, 2017 (“Issuance Date”), the Company issued 4,210,528 common shares and 300,000 warrants of Second Cup to the four shareholders of SPE Finance LLC (SPE), an affiliate of Serruya Private Equity. The Company also extinguished its $8,000 debt to SPE, cancelled 600,000 of old warrants and became debt-free. These transactions resulted in one-time, non-cash financing charges of $3,290. These charges consist of the difference between the share price of $2.60 on the Issuance Date and the agreed-to share price of $1.90, and the write-off of the unamortized portion of deferred transaction costs related to the debt. Competition The Canadian specialty coffee market is highly competitive and highly fragmented, with few barriers to entry. There are national, regional and local coffee retailers who are specialty coffee providers or quick serve restaurants with broad menus. ANNUAL REPORT 2017 19 Technology Second Cup relies heavily on information technology network infrastructure including point of sale system (“POS”) hardware and software in cafés, gift and loyalty card transactions, and head office financial and administrative functions. The ability to manage operations effectively and efficiently depends on the reliability and capacity of these technology systems, most of which are administered by third party suppliers. The Company has made significant investments in POS systems across its store network as it relies on the POS system to help analysis for both marketing initiatives and royalty calculations. FINANCIAL HIGHLIGHTS The following table sets out selected IFRS and certain non-GAAP financial measures of the Company and should be read in conjunction with the Audited Financial Statements of the Company for the 52 weeks ended December 30, 2017. ( In thousands of Canadian dollars, except same café sales, number of cafés, per share amounts, and number of common shares.) December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended $41,326 $46,743 $154,153 $163,738 System sales of cafés1 Same café sales1 Number of cafés – end of period Total revenue Operating costs and expenses Operating income (loss)1 EBITDA1 Adjusted EBITDA1 Net income (loss) and comprehensive income (loss) Adjusted net income (loss) and comprehensive income (loss)1 Basic and diluted earnings (loss) per share as reported Adjusted basic and diluted earnings (loss) per share1 (1.1%) 286 $6,085 $5,092 $993 $1,339 $1,339 $655 $655 $0.04 $0.04 (1.0%) 294 $7,500 $7,199 $302 $667 $667 $147 $147 $0.01 $0.01 (0.2%) 286 $23,636 $22,660 $976 $2,434 $2,721 ($3,097) $110 ($0.21) $0.01 (1.1%) 294 $30,351 $31,336 ($985) $563 $563 ($975) ($975) ($0.08) ($0.08) $45,314 Total assets – end of period $44,700 $45,314 $44,700 Number of weighted average common shares issued and outstanding 17,041,473 12,830,945 14,485,081 12,830,945 1 See the section “Definitions and Discussion on Certain non-GAAP Financial Measures” for further analysis. 20 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS OPERATIONAL REVIEW Seasonality of System sales of cafés The following table shows the percentage of annual system sales of cafés achieved, on average, in each fiscal reporting quarter over the last three years: % of annual System sales of cafés First Quarter Second Quarter Third Quarter Fourth Quarter 2015 24.7 25.0 23.5 26.8 100.0 2016 23.9 24.6 23.0 28.5 100.0 2017 24.6 24.6 24.0 26.8 100.0 Average 24.4 24.7 23.5 27.4 100.0 Historically, system sales of cafés have been higher in the fourth quarter, which includes the holiday sales periods of November and December. In 2016, Fourth Quarter contains one extra week, for a total of 14 weeks. The Company’s comparative results take into account the inclusion of the additional selling week in 2016. Café network Number of cafés – beginning of period Cafés opened Cafés closed Number of cafés – end of period 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 289 2 (5) 286 298 2 (6) 294 294 4 (12) 286 310 4 (20) 294 The Company ended the Year with 12 (2016 - 22) Company-owned cafés. Café closures are mainly attributable to leases that are not renewed on expiration, under-performing locations and landlord re-development of specific sites. Fourth Quarter Inclusion of an additional week in 2016 has a direct impact on the following analysis of the Fourth Quarter results. System sales of cafés System sales of cafés for the 13 weeks ended December 30, 2017 were $41,326 compared to $46,743 for the 14 weeks ended December 31, 2016 representing a decrease of $5,417 or 11.6%. The decrease in system sales of cafés is primarily due to the reduction in café count. Same café sales During the Quarter, same café sales declined 1.1%, compared to a decline of 1.0% in the comparable Quarter of 2016. The decline is primarily due to reduced transactions. Analysis of revenue Total revenue for the Quarter was $6,085 (2016 - $7,500), a decrease of $1,415, consisting of Company-owned café and product sales, royalty revenue, fees and other revenue. Company-owned cafés and product sales were $1,713 (2016 - $3,210), a decrease of $1,497. The decrease in revenue is primarily due to the reduced Company-owned café count from 22 last year to 12 this Quarter. Reducing Company- owned cafés is consistent with the Company’s strategy of returning to an asset light business model. ANNUAL REPORT 2017 21 Franchise revenue was $4,372 for the Quarter (2016 - $4,290), an increase of $82. The increase in franchise revenue in the Quarter is primarily driven by an increase in franchising fees, partially offset by a decrease in royalties and coordination fees. Operating costs and expenses Operating costs and expenses include the costs of Company-owned cafés and product sales, franchise-related expenses, general and administrative expenses, loss/gain on disposal of assets, and depreciation and amortization. Total operating costs and expenses for the Quarter were $5,092 (2016 - $7,199), a decrease of $2,107. Company-owned cafés and product sales related expenses for the Quarter were $1,772 (2016 - $3,410), a decrease of $1,638. The decrease in costs is due to the reduction in store count of Company-owned cafés and lower product sales as compared to the Quarter in 2016. Franchise related expenses for the Quarter were $1,670 (2016 - $2,006), a decrease of $336. The decrease in franchise related expenses is primarily due to a lower provision for café leases and enhanced operating efficiencies. General and administrative expenses were $1,206 for the Quarter (2016 - $1,502), a decrease of $296. This decrease in expenses is primarily due to a reduction in remunerations and directors’ fees. A loss on disposal of $98 was recognized in the Quarter (2016 - gain of $84). Gain and loss on disposal of assets are related to the franchising of Company-owned cafés to franchise partners. Depreciation and amortization expense was $346 (2016 - $365), a decrease of $19. EBITDA EBITDA for the Quarter was $1,339 (2016 - $667), an increase of $672. The increase is primarily driven by the reduction in franchise related expenses and the increase in franchise revenue, as described. Interest and financing costs Interest and financing income for the Quarter was $5 compared to interest and financing costs of $96 in the same Quarter of 2016. The Company became debt-free in the third quarter this year. Net income (loss) The Company’s net income for the Quarter was $655 or $0.04 per share, compared to a net income of $147 or $0.01 per share in 2016. Reconciliations of net income (loss) to EBITDA, adjusted EBITDA, adjusted net income (loss) and adjusted net income (loss) per share are provided in the section “Definitions and Discussion of Certain non-GAAP Financial Measures”. Year Inclusion of an additional week in 2016 has a direct impact on the following analysis of the Year. System sales of cafés System sales of cafés for the Year were $154,153 (2016 - $163,738), a decrease of $9,585 or 5.9%. The decrease is primarily due to the reduction in café count. Same café sales For the Year, same café sales declined by 0.2% compared to a decline of 1.1% in 2016. The decline in the Year was primarily due to the decline in the fourth quarter same café sales as described above. 22 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS Analysis of revenue Total revenue for the Year was $23,636 (2016 - $30,351), a decrease of $6,715, consisting of Company-owned café and product sales, royalty revenue, fees and other revenue. Company-owned cafés and product sales were $8,562 (2016 - $14,663), a decrease of $6,101. The decrease is due to the reduction of Company-owned café count from 22 to 12 this Year. Reducing Company-owned cafés count is consistent with the Company’s strategy of returning to an asset light business model. Franchise revenue was $15,074 for the Year (2016 - $15,688), a decrease of $614. The decrease in franchise revenue is primarily due to lower royalties and coordination fees as a result of lower café count. Operating costs and expenses Operating costs and expenses include the costs of Company-owned cafés and product sales, franchise-related expenses, general and administrative expenses, loss/gain on disposal of assets, and depreciation and amortization. Total operating costs and expenses for the Year were $22,660 (2016 - $31,336), a decrease of $8,676. Company-owned cafés and product related expenses were $9,303 for the Year (2016 - $15,681), a decrease of $6,378. The decrease in costs is attributable to the reduction of Company-owned café count and lower product sales as compared to 2016. Franchise related expenses were $5,693 for the Year (2016 - $8,103), a decrease of $2,410. This decrease in expenses is primarily due to a reduction in remuneration, an improvement in operational effectiveness and moving from a national franchisee convention format to regional meetings with franchisees this year. General and administrative expenses were $6,009 for the Year (2016 - $5,779), an increase of $230. This increase is driven by higher professional fees related to legal matters and one-time transition costs, partially offset by a reduction in general and administrative remuneration. A loss on disposal of assets of $197 was recognized for the Year (2016 - $225 loss). Gain and loss on disposal of assets are primarily related to the franchising of Company-owned cafés to franchise partners. Depreciation and amortization expense was $1,458 (2016 - $1,548), a decrease of $90. EBITDA EBITDA was $2,434 for the Year (2016 - $563), an increase of $1,871. Adjusted for one-time transition costs of $287 incurred in the second quarter of 2017, adjusted EBITDA was $2,721 compared to an adjusted EBITDA of $563 in 2016. The increase of $2,158 is primarily driven by the reduction in franchise related expenses, lower corporate café operating loss, and lower provision for café leases, partially offset by the decrease in franchise revenue. Interest and financing costs Interest and financing costs was $3,897 for the Year (2016 - $255), an increase of $3,642. The increase is primarily driven by one-time, non-cash financing charges of $3,290. These charges consist of the difference between the share price of $2.60 on the Issuance Date and the agreed-to share price of $1.90, and the write-off of the unamortized portion of deferred transaction costs related to the debt. Net loss The Company’s net loss for the Year was $3,097 or $0.21 loss per share, compared to a net loss of $975 or $0.08 loss per share in 2016. Adjusted for the after-tax expense on fair market value difference on issuance of shares of $3,207 ($0.22 per share), adjusted net income was $110 or $0.01 per share compared to an adjusted net loss of $975 or $0.08 loss per share in 2016. ANNUAL REPORT 2017 23 Reconciliations of net income (loss) to EBITDA, adjusted EBITDA, adjusted net income (loss) and adjusted net income (loss) per share are provide in the section “Definitions and Discussion of Certain non-GAAP Financial Measures”. SELECTED QUARTERLY INFORMATION ( in thousands of Canadian dollars, except Number of cafés, Same café sales, and per share amounts.) System sales of cafés1 Same café sales1 Number of cafés – end of period Total revenue Operating income (loss)1 EBITDA1 Adjusted EBITDA1 Net income (loss) for the period Adjusted net income (loss) for the period1 Basic and diluted earnings (loss) per share Adjusted basic diluted earnings (loss) per share1 System sales of cafés1 Same café sales1 Number of cafés – end of period Total revenue Operating (loss) income1 EBITDA1 Adjusted EBITDA1 Net (loss) income for the period Adjusted net income (loss) for the period1 Basic and diluted (loss) earnings per share Adjusted basic diluted earnings (loss) per share1 Q4 20172 $41,326 (1.1%) 286 $6,085 $993 $1,339 $1,339 $655 $655 $0.04 $0.04 Q4 20162 $46,743 (1.0%) 294 $7,500 $302 $667 $667 $147 $147 $0.01 $0.01 Q3 2017 $37,014 0.0% 289 $5,339 $436 $805 $805 ($2,962) $245 ($0.19) $0.02 Q3 2016 $37,717 (1.2%) 298 $7,656 ($25) $357 $357 ($75) ($75) ($0.01) ($0.01) Q2 2017 $37,898 Q1 2017 $ 37,915 0.7% 291 $6,237 ($138) $230 $517 ($315) ($315) ($0.02) ($0.02) (0.2%) 293 $5,975 ($315) $60 $60 ($475) ($475) ($0.04) ($0.04) Q2 2016 $40,207 Q1 2016 $39,071 (1.3%) 304 $7,761 ($528) ($128) ($128) ($441) ($441) ($0.03) ($0.03) (1.1%) 307 $7,434 ($733) ($332) ($332) ($606) ($606) ($0.05) ($0.05) 1 See the section “Definitions and Discussion on Certain non-GAAP Financial Measures” for further analysis. 2 The Company’s fourth quarter System sales of cafés are higher than other quarters due to the seasonality of the business (see “Seasonality of system sales of cafés” above). 24 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS The system sales decreases quarter over quarter are primarily related to the reduction in total network café count and to a lesser extent to the changes in the same café sales. Seasonal factors and the timing of holidays cause the Company’s revenue to fluctuate from quarter to quarter. Revenue decreases quarter over quarter are primarily related to the reduction of Company-owned cafés count and reduction in café count. LIQUIDITY AND CAPITAL RESOURCES Second Cup collects royalties based on the franchisees’ portion of System sales of cafés, fees, and other amounts from its franchisees and also generates revenues from its Company-owned cafés and product sales. The performance of Second Cup franchisees and Company-owned cafés could impact the ability of the Company to declare and pay dividends to its shareholders. For a more detailed discussion of the risks and uncertainties affecting the Company’s liquidity, see the “Risks and uncertainties” section below. Summary of cash flows Cash flows provided by (used in) operating activities Cash flows provided by (used in) investing activities Cash flows provided by (used in) financing activities Increase (decrease) in cash and cash equivalents during the period Fourth Quarter 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended December 30 2017 December 31, 2016 December 30, 2017 December 31, 2016 $1,583 ($498) $1,862 ($1,253) (150) (124) $1,309 - 1,542 $1,044 4 (297) $1,569 (365) 1,542 ($76) Cash provided by operating activities was $1,583 for the Quarter compared to cash used of $498 for the same Quarter in 2016. The increase in cash of $2,081 is primarily due to changes in non-cash working capital and higher profit. During the Quarter, cash used in investing activities was $150 compared to cash used of nil for the same Quarter in 2016 due to purchases of capital expenditures and intangible assets in 2017. Cash used in financing activities was $124 for the Quarter compared to cash provided by financing activities of $1,542 for the same Quarter in 2016. In 2016, the Company received net cash of $2,000 due to the new term loan. In 2017, the Company paid financing charges related to the issuance of shares. Year Cash provided by operating activities was $1,862 for the Year compared to cash used in operating activities of $1,253 for 2016. The increase in cash of $3,115 was primarily due to changes in non-cash working capital and higher profit. ANNUAL REPORT 2017 25 During the Year, cash provided by investing activities was $4 compared to cash used of $365 for 2016. The change of $369 in cash was primarily due to lower payments for intangible assets and higher proceeds from disposal of capital items. Cash used in financing activities was $297 for the Year compared to cash provided by financing activities of $1,542 in 2016. In 2016, the Company received net cash of $2,000 due to the new term loan. In 2017, the Company paid financing charges related to the issuance of shares. Working capital as at Current assets Current liabilities Working capital (deficiency) December 30, 2017 December 31, 2016 $10,122 9,869 $253 $9,096 10,242 ($1,146) The Company’s working capital was $253 as at December 30, 2017 improved by $1,399 from December 31, 2016, primarily as a result of an increase in cash and cash equivalents and a reduction in accounts payable and accrued liabilities at the end of the Year. Gift card liability ended the Year at $3,432, a decrease of $52 compared to the end of 2016. Based on the historical redemption patterns, the Company believes that it has sufficient financial resources to cover the gift card liability. The Company operates in the franchise industry, in which a working capital deficit is considered normal. Financial instruments The following summarizes the nature of certain risks applicable to the Company’s financial instruments: Financial instrument Financial assets Cash and cash equivalents Restricted cash Trade and other receivables Notes and leases receivable Financial liabilities Risks Credit and interest rate Credit and interest rate Credit Credit Accounts payable and accrued liabilities Liquidity, currency and commodity Gift card liability Deposits from franchisees Term credit facility Liquidity Liquidity Liquidity and interest rate (i) Credit risk Cash and cash equivalents, restricted cash and interest rate swap Credit risk associated with cash and cash equivalents, restricted cash and the interest rate swap is managed by ensuring these assets are placed with institutions of high creditworthiness. Trade and other receivables, and notes and leases receivable Trade and other receivables and notes and leases receivable primarily comprise amounts due from franchisees. Credit risk associated with these receivables is mitigated as a result of the review and evaluation of franchisee account balances beyond a particular age. Prior to accepting a franchisee, the Company undertakes a detailed screening 26 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS process which includes the requirement that a franchisee has sufficient financing. The risk is further mitigated due to a broad franchisee base that is spread across the country, which limits the concentration of credit risk. Other receivables may include amounts owing from large organizations where often those organizations have a simultaneous vendor relationship with the Company’s franchisees. Credit risk is mitigated as a result of the Company directing and maintaining certain controls over the vendor relationship with the franchisees. Specific bad debt provisions are accounted for when the expected recovery is less than the actual receivable. (ii) Liquidity risk Liquidity risk is managed through regular monitoring of forecast and actual cash flows, monitoring maturity dates of financial assets and liabilities, and also the management of the Company’s capital structure. The Company’s main source of income is royalty receipts from its franchisees, corporate café sales, and sales from goods and services. (iii) Currency and commodity risk The Company purchases certain products, such as coffee, in U.S. dollars, thereby exposing the company to risks associated with fluctuations in currency exchange rates. The Company is also directly and indirectly exposed to commodity market risk. The exposure relates to the changes in coffee commodity prices given it is a material input for product offerings. The direct exposure pertaining to the wholesale business is mitigated given that the Company has the ability to adjust its sales price if commodity prices rise over a threshold level. The indirect risk exists where franchisee profitability may be impacted, thus potentially resulting in an impeded ability to collect accounts receivable or the need for other concessions to be made to the franchisee. This risk is mitigated by entering fixed price purchase commitments through coffee commodity brokers and by having the ability to adjust retail selling prices. Contingencies, commitments and guarantees Contractual Obligations Obligations from Operating Leases Purchase Obligations Total Contractual Obligations Total $8,878 2,286 $11,164 1 year $1,488 2,286 $3,774 2 – 3 years 4 – 5 years After 5 years $2,637 Nil $2,637 $2,128 Nil $2,128 $2,625 Nil $2,625 Payments Due by Period Obligations from operating leases Second Cup has lease commitments for Company-owned cafés and also acts as the head tenant on most leases, which in turn it subleases to franchisees. To the extent the Company may be required to make rent payments due to head lease commitments, a provision has been recognized. Head lease commitments Sublease to franchisees December 29, 2018 December 28, 2019 December 26, 2020 December 25, 2021 December 31, 2023 Thereafter $17,954 16,158 13,907 12,034 10,835 27,637 $98,525 $16,466 14,736 12,692 10,938 9,803 25,012 Net $1,488 1,422 1,215 1,096 1,032 2,625 $89,647 $8,878 The Company believes it has sufficient resources to meet the net commitment of $8,878 over the term of the leases. ANNUAL REPORT 2017 27 Purchase obligations Contracts are in place with third party companies to purchase the coffee that is sold in all cafés. In terms of these supply agreements, there is a guaranteed minimum value of coffee purchases of $1,392 (2016 - $1,140) for the subsequent 12 months. The coffee purchase commitment is comprised of two components: unapplied futures commitment contracts and fixed price physical contracts. Due to the Company acting as the primary coordinator of café construction costs on behalf of its franchisees and for Company-operated cafés, there is $894 (2016 - $241) of contractual commitments pertaining to construction costs for new locations and renovations as at the end the Year. Construction costs financed for franchise projects are from deposits received from franchisees and for corporate projects from the Company’s cash flows. Other obligations The Company is involved in litigation and other claims arising in the normal course of business. Judgment must be used to determine whether or not a claim has any merit, the amount of the claim and whether to record a provision, which is dependent on the potential success of the claim. It is believed that no significant losses or expenses will be incurred with such claims. However, there can be no assurance that unforeseen circumstances will not result in significant costs. The outcome of these actions is not determinable at this time, and adjustments, if any, will be recorded in the period of settlement. Related parties Related parties are identified as key management, members of the Board of Directors, and shareholders that effectively exercise significant influence on the Company. Such related parties include any entities acting with or on behalf of the aforementioned parties. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES The Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) must acknowledge they are responsible for establishing and maintaining disclosure controls and procedures and internal control over financial reporting (“ICFR”) for the Company. The control framework used by the CEO and CFO to design the Company’s ICFR is Internal Control over Financial Reporting - Guidance for Smaller Public Companies as issued by COSO. In addition, in respect of: Disclosure controls and procedures The CEO and CFO must certify they have designed the disclosure controls and procedures, or caused them to be designed under their supervision, to provide reasonable assurance that material information relating to the Company is made known to them in a timely manner and that information required under securities legislation is recorded, processed, summarized and reported in a timely manner. As at February 23, 2018, the Company’s management, under the supervision of, and with the participation of, the CEO and CFO, evaluated the design of the disclosure controls and procedures. Based on this evaluation, the CEO and CFO have concluded that, as at December 30, 2017, the Company’s disclosure controls and procedures were appropriately designed. Consistent with the concept of reasonable assurance, the Company recognizes that the relative cost of maintaining these controls and procedures should not exceed their expected benefits. As such, the Company’s disclosure controls and procedures can only provide reasonable, and not absolute, assurance that the objectives of such controls and procedures are met. During the 13 weeks ended December 30, 2017 and up to the date of the approval of the Audited Financial Statements and MD&A, there has been no change that has materially affected, or is reasonably likely to materially affect the Company’s disclosure controls and procedures. 28 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS Internal controls over financial reporting The CEO and CFO must certify they have designed such internal controls over financial reporting, or caused them to be designed under their supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Unaudited Condensed Interim Financial Statements for external purposes in accordance with IFRS. As at February 23, 2018, the Company’s management, under the supervision of, and with the participation of, the CEO and CFO, evaluated the design of the controls over financial reporting. No material weaknesses in the design of these controls over financial reporting were identified. Based on this evaluation, the CEO and CFO have concluded that, as at December 30, 2017, the Company’s controls over financial reporting were appropriately designed and were operating effectively. Consistent with the concept of reasonable assurance, the Company recognizes that the relative cost of maintaining these controls should not exceed their expected benefits. As such, the Company’s internal controls over financial reporting can only provide reasonable, and not absolute, assurance that the objectives of such controls are met. During the 13 weeks ended December 30, 2017 and up to the date of the approval of the Audited Financial Statements and MD&A, there has been no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting. CRITICAL ACCOUNTING ESTIMATES The preparation of the Audited Financial Statements requires management to make estimates, assumptions, and use judgement in applying its accounting policies and estimates and assumptions about the future. Estimates and other judgements are continuously evaluated and are based on management’s experience and other factors, including expectations about future events that are believed to be reasonable under the circumstances. Revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected. The accounting estimates will, by definition, seldom equal the related actual results. Estimates The following are examples of estimates and assumptions the Company makes: • the recoverability of tangible and intangible assets subject to depreciation, amortization, or with indefinite lives; • the derivation of income tax assets and liabilities; • the estimated useful lives of assets; • café lease provisions and restructuring charges; and • the allowance for doubtful accounts. Use of judgement The following discusses the most significant accounting judgements and estimates that the Company has made in the preparation of the Audited Financial Statements: (i) Impairment charges Impairment analysis is an area involving management judgement in determining the recoverable amount of an asset. The recoverable amount of a cash generating unit (“CGU”) is calculated as the higher of the fair value less costs of disposal, and its value in use. Fair value is determined by estimating the net present value of future cash flows derived from such assets using cash flow projections that have been discounted at an appropriate rate and based on a market participant’s view. In calculating the net present value of the future cash flows, certain assumptions are required to be made in respect of highly uncertain matters including: • growth in total revenue; • change and timing of cash flows such as the increase or decrease of expenditures; • selection of discount rates to reflect the risks involved; and • applying judgement in cash flows specific to CGUs. ANNUAL REPORT 2017 29 Changing the assumptions selected by management, in particular the discount rate and the growth rate used in the cash flow projections, could significantly affect the impairment evaluations and recoverable amounts. The Company’s impairment tests include key assumptions related to the scenarios discussed above. (ii) Deferred income taxes The timing of reversal of temporary differences and the expected income allocation to various tax jurisdictions within Canada affect the effective income tax rate used to compute the deferred income taxes. Management estimates the reversals and income allocation based on historical and budgeted operating results and income tax laws existing at the Statements of Financial Position dates. In addition, management occasionally estimates the current or future deductibility of certain expenditures, affecting current or deferred income tax balances and expenses. (iii) Estimated useful lives Estimates for the useful lives of property and equipment are based on the period during which the assets are expected to be available-for-use. The amounts and timing of recorded expenses for depreciation of property and equipment for any period are affected by these estimated useful lives. It is possible that changes in these factors may cause significant changes in the estimated useful lives of property and equipment in the future. (iv) Café lease provisions Café lease provisions require judgement to evaluate the likelihood and measurement of settlements, temporary payouts or subleasing. Management works with landlords and franchises and uses previous experience to obtain adequate information needed to make applicable judgements. (v) Allowance for doubtful accounts The allowance for impairment of trade and other receivables is established when there is objective evidence that the Company will not be able to collect all amount due according to the original terms of the receivable. The carrying amount of the asset is reduced through the use of an allowance account, and the amount of the loss is recognized in expenses in the statement of income. When an account is deemed uncollectible, it is written off against the allowance account. Subsequent recoveries of amounts previously written off are recognized as a recovery in expenses in the statement of income. CHANGES IN ACCOUNTING POLICIES In accordance with the IFRS Interpretations Committee (“IFRIC”) agenda decision addressing the expected manner of recovery of an intangible asset with an indefinite useful life for the purposes of measuring deferred tax in accordance with IAS 12, Income Taxes (“IAS 12”), the IFRIC noted that an intangible asset with an indefinite useful life does not mean infinite life, nor does it mean the expected manner of recovery of the carrying amount would result solely through sale. Therefore, in applying IAS 12, an entity must determine its expected manner of recovery of the carrying value of the intangible asset with an indefinite life and should reflect the tax consequences that follow from that expected manner of recovery. Previously, the Company measured deferred taxes on temporary differences arising from certain indefinite life intangible assets using capital gains rates on the basis that the assets will be recovered through its disposition. As a result of the IFRIC agenda decision, the Company has changed its accounting policy to measure deferred taxes at the income tax rate applicable to ordinary taxable income expected to apply in the years in which the temporary differences are expected to be recovered or settled. The Company adopted this change on a retrospective basis as an accounting policy change in accordance with IAS 8, “Accounting Policies, Changes to Accounting Estimates and Errors” and the impact on the financial statements was an increase to deferred tax liabilities at December 27, 2015 of $2,388, a corresponding adjustment to retained earnings (deficit) of $2,388. 30 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS Recent accounting pronouncements not yet effective In May 2014, the IASB issued IFRS 15, a new comprehensive model for entities to use accounting for revenue arising from contracts with customers. In September 2015, the IASB deferred adoption of the new standard by one year. Several updates have been issued since then to clarify the implementation guidance. The new guidance supersedes the most current revenue recognition guidance, including industry-specific guidance, enhances revenue recognition disclosures, and is now effective commencing in 2018. The guidance allows for either a full retrospective or modified retrospective transition method. We currently expect to apply the modified retrospective transition method. Under current accounting guidance, we recognize initial franchise fees when we have performed all material obligations and services, which generally occurs when the franchised café opens. As required under the new guidance, we anticipate deferring the initial franchise fees and recognizing revenue over the term of the related franchise agreement (generally ten years). We anticipate an increase in deficit as at December 31, 2017, the date of initial adoption and a corresponding increase in deferred revenue reflecting initial franchise fees previously recognized that are now recorded over the term. We anticipate that the new guidance will also change our reporting of the Co-op Fund contributions from franchisees and the related advertising and promotional expenditures, which are currently reported on a net basis in our Statements of Financial Position. Under the new guidance, Co-op Fund contributions from franchisees and advertising and promotional expenditures will be reported on a gross basis. In addition, we anticipate that the estimated breakage income on gift cards will be recognized as gift cards are utilized instead of our current policy of recognizing on a pro rata basis based on historical gift card redemption patterns. We do not believe this guidance will materially impact our recognition of revenue from Company-owned cafes and product sales or our recognition of franchise royalties revenue. IFRS 9 replaces the incurred loss model under IAS 39 with a model on expected credit losses. Under the new standard, expected credit losses will need to be recorded. Under our current accounting, losses are recognized when probable. We are currently assessing the impact of the new standard, however, the new standard will likely increase our allowance for doubtful account provision. IFRS 16, Leases, sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract, the customer (‘lessee’) and the supplier (‘lessor’). This will replace IAS 17, Leases, and related Interpretations. IFRS 16 provides revised guidance on identifying a lease and for separating lease and non- lease components of a contract. IFRS 16 introduces a single accounting model for all leases and requires a lessee to recognize right-of-use assets and lease liabilities for leases with terms of more than 12 months, unless the underlying asset is of low value, and depreciation of lease assets separately from interest on lease liabilities on the Statements of Operations and Comprehensive Loss. Under IFRS 16, lessor accounting for operating and finance leases will remain substantially unchanged. IFRS 16 is effective for annual periods beginning on or after January 1, 2019, with earlier application permitted for entities that apply IFRS 15, Revenue from Contracts with Customers. The guidance allows for either a full retrospective or modified retrospective transition method. The Company currently expects to apply the modified retrospective transition method. Further, the Company currently expects to apply the practical expedients to i) grandfather the assessment of which transactions are leases; ii) recognition exemption of short-term leases; and iii) recognition exemption leases of low-value items. ANNUAL REPORT 2017 31 The Company has completed a preliminary assessment of the potential impact on its financial statements, but has not yet completed its detailed assessment. So far, the most significant impact identified is that the Company will recognize new assets and liabilities for its subleases, operating leases of its head office and corporate cafés. RISKS AND UNCERTAINTIES This section is qualified by the section “Caution Regarding Forward-Looking Statements” at the beginning of this MD&A. The performance of Second Cup is primarily dependent on its ability to maintain and increase the sales of existing cafés, add new profitable cafés to the network and redevelop and modernize cafés as their leases come due. System sales of the café network are affected by various external factors that can affect the specialty coffee industry as a whole. Potential risks include the following: The specialty coffee industry is characterized by intense competition with respect to price, location, coffee and food quality, and numerous factors affecting discretionary consumer spending. Competitors include national and regional chains, independent cafés, all restaurants and food service outlets that serve coffee, and supermarkets that compete in the whole bean and roast and ground segments. Growth of the café network depends on Second Cup’s ability to secure and build desirable locations and find high calibre, qualified franchisees to operate them. Credit markets may affect the ability of franchisees to obtain new credit or refinance existing credit on economically reasonable terms. Second Cup faces competition for café locations and franchisees from its competitors and from franchisors and operators of other businesses. The success of franchisees is significantly influenced by the location of their cafés. There can be no assurance that current café locations will continue to be attractive, or that additional café sites can be located and secured as demographic and traffic patterns change. Also, there is no guarantee that the property leases in respect of the cafés will be renewed or suitable alternative locations will be obtained and, in such event, cafés could be closed. It is possible that the current locations or economic conditions where cafés are located could decline in the future, resulting in reduced sales in those locations. There is no assurance that future sites will produce the same results as past sites. There is also no assurance that a franchisee will continue to pay rental obligations in a timely manner, which could result in Second Cup being obligated to pay the rental obligations pursuant to its head lease commitment, which would adversely affect the profitability of the business. The Canadian specialty coffee industry is also affected by changes in discretionary spending patterns, which are in turn dependent on consumer confidence, disposable consumer income and general economic conditions. Factors such as changes in general economic conditions, recessionary or inflationary trends, job security and unemployment, equity market levels, consumer credit availability and overall consumer confidence levels may affect their business. The specialty coffee industry is also affected by demographic trends, traffic and weather patterns, as well competing cafés. Business could be adversely affected by increased concerns about food safety in general or other unusual events. On May 28, 2015, the government of Ontario enacted the Making Healthy Choices Act, 2015. The Act came into force on January 1, 2017. Restaurant chains and other food service providers with 20 or more locations operating under the same (or substantially the same) name in Ontario have made changes to the information they display on menus, menu boards and displays. Second Cup relies heavily on information technology (IT) network infrastructure. The ability to manage operations effectively and efficiently depends on the reliability and capacity of these IT systems, most of which are administered by third party suppliers. The Company relies on POS for system sales for both marketing trends and royalty calculations. Cafés rely on IT network infrastructure to order goods and process credit, debit and café card 32 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS transactions. Coffee Central financial and administrative functions rely on IT infrastructure for accurate and reliable information. The failure of these systems to operate effectively, or problems with upgrading or replacing systems, could cause a material negative financial result. The Company is continually reviewing its systems and procedures to minimize risk. The company’s cash flow can also be impacted by underperformance of its franchise network through reduced royalties, higher lease exit provisions or the increase in the number of corporate stores. Reduced earnings could impact the company’s ability to comply with its credit facility covenants. The loss of key personnel and/or a shortage of experienced management and hourly employees could have an adverse impact on operations and cafés. A more detailed discussion of the risks and uncertainties affecting Second Cup is set out in the Second Cup’s Annual Information Form, which is available at www.sedar.com. OUTLOOK This section is qualified by the section “Caution Regarding Forward-Looking Statements” at the beginning of this MD&A. Second Cup continues to rollout Pinkberry premium frozen yogurt which is now in 30 cafés across the country. Response to this complimentary, premium offering has been very favourable with new customers attracted to the cafés, driving incremental sales. Pinkberry will be introduced to more cafés across the network in time for the peak frozen yogurt season. In January, Second Cup led the Canadian coffee market with a move to Clean Label beverages which now represent over 70% of the beverage menu. Clean Label products contain no artificial colours, flavours, preservatives or high fructose corn syrup. DEFINITIONS AND DISCUSSION ON CERTAIN NON-GAAP FINANCIAL MEASURES In this MD&A, the Company reports certain non-GAAP financial measures such as system sales of cafés, same café sales, operating income (loss), EBITDA, adjusted EBITDA, adjusted net income (loss) and adjusted net income (loss) per share. Non-GAAP measures are not defined under IFRS and are not necessarily comparable to similarly titled measures reported by other issuers. System sales of cafés System sales of cafés comprise the net revenue reported to Second Cup by franchisees of Second Cup cafés and by Company-owned cafés. This measure is useful in assessing the operating performance of the entire Company network, such as capturing the net change of the overall café network. Changes in system sales of cafés result from the number of cafés and same café sales (as described below). The primary factors influencing the number of cafés within the network include the availability of quality locations and the availability of qualified franchisees. Same café sales Same café sales represent the percentage change, on average, in sales at cafés operating system-wide that have been open for more than 12 months. It is one of the key metrics the Company uses to assess its performance as an indicator of appeal to customers. Two principal factors that affect same café sales are changes in customer count and changes in average transaction size. ANNUAL REPORT 2017 33 Operating income (loss) Operating income (loss) represents revenue, less cost of goods sold, less operating expenses, and less impairment charges. This measure is not defined under IFRS, although the measure is derived from input figures in accordance with IFRS. Management views this as an indicator of financial performance that excludes costs pertaining to interest and financing, and income taxes. EBITDA and adjusted EBITDA EBITDA represents earnings before interest and financing, income taxes, and depreciation and amortization. Adjustments to EBITDA are for items that are not necessarily reflective of the Company’s underlying operating performance. As there is no generally accepted method of calculating EBITDA, this measure is not necessarily comparable to similarly titled measures reported by other issuers. EBITDA is presented as management believes it is a useful indicator of the Company’s ability to meet debt service and capital expenditure requirements, and evaluate liquidity. Management interprets trends in EBITDA as an indicator of relative financial performance. EBITDA should not be considered by an investor as an alternative to net income or cash flows as determined in accordance with IFRS. Adjusted net income (loss) and adjusted net income (loss) per share Adjustments to net earnings (loss) and net earnings (loss) per share are for items that are not necessarily reflective of the Company’s underlying operating performance. These measures are not defined under IFRS, although the measures are derived from input figures in accordance with IFRS. Management views these as indicators of financial performance. 34 THE SECOND CUP LTD. MANAGEMENT’S DISCUSSION AND ANALYSIS Reconciliations of net income (loss) to operating income (loss), EBITDA, adjusted EBITDA, adjusted net income (loss) and adjusted net income (loss) per share are provided below: Net income (loss) Income taxes (recovery) Interest and financing costs Operating income (loss) Net income (loss) Income taxes (recovery) Interest and financing costs Depreciation of property and equipment Amortization of intangible assets EBITDA Add (deduct) impact of the following: One-time transition costs Adjusted EBITDA 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 $655 343 (5) $993 $147 59 96 $302 ($3,097) 176 3,897 $976 ($975) (265) 255 ($985) 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 $655 343 (5) 228 118 1,339 - $1,339 $147 59 96 291 74 $667 - $667 ($3,097) 176 3,897 1,002 456 2,434 287 $2,721 ($975) (265) 255 1,168 380 563 - $563 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 Net income (loss) $655 $147 ($3,097) ($975) Add impact of the following: After-tax fair value difference on shares issued and other costs Adjusted net income (loss) - $655 - $147 3,207 $110 - ($975) 13 weeks ended 14 weeks ended 52 weeks ended 53 weeks ended December 30, 2017 December 31, 2016 December 30, 2017 December 31, 2016 Net income (loss) per share $0.04 $0.01 ($0.21) ($0.08) Add impact of the following: After-tax fair value difference on shares issued and other costs Adjusted net income (loss) per share - $0.04 - $0.01 0.22 $0.01 - ($0.08) ANNUAL REPORT 2017 35 Audited Financial Statements For the 52 weeks ended December 30, 2017 and 53 weeks ended December 31, 2016 INDEPENDENT AUDITOR’S REPORT February 23, 2018 To the Shareholders of The Second Cup Ltd. We have audited the accompanying financial statements of The Second Cup Ltd., which comprise the statements of financial position as at December 30, 2017 and December 31, 2016 and the statements of operations and comprehensive loss, statements of changes in shareholders’ equity and statements of cash flows for the fifty-two and fifty-three week periods then ended, and the related notes, which comprise a summary of significant accounting policies and other explanatory information. Management’s responsibility for the financial statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements present fairly, in all material respects, the financial position of The Second Cup Ltd. as at December 30, 2017 and December 31, 2016 and its financial performance and its cash flows for the fifty-two and fifty-three week periods then ended, respectively, in accordance with International Financial Reporting Standards. Chartered Professional Accountants, Licensed Public Accountants 36 THE SECOND CUP LTD. Statements of Financial Position As at December 30, 2017 and December 31, 2016 (Expressed in thousands of Canadian dollars) 2017 2016 ASSETS Current assets Cash and cash equivalents Restricted cash (note 23) Trade and other receivables (note 6) Notes and leases receivable (note 7) Inventories (note 8) Prepaid expenses and other assets Income tax receivable Non-current assets Notes and leases receivable (note 7) Property and equipment (note 9) Intangible assets (note 10) Total assets LIABILITIES Current liabilities Accounts payable and accrued liabilities (note 11) Provisions (note 12) Other liabilities (note 13) Gift card liability Deposits from franchisees Income tax payable Non-current liabilities Provisions (note 12) Other liabilities (note 13) Long-term debt (note 14) Deferred income taxes (note 19) Total liabilities SHAREHOLDERS’ EQUITY Total liabilities and shareholders’ equity Contingencies, commitments and guarantees (note 24) See accompanying notes to financial statements. Approved by the Directors February 23, 2018 Michael Bregman, Director Rael Merson, Director $4,573 1,359 3,716 64 205 205 - 10,122 74 2,132 32,372 $44,700 $3,974 934 459 3,432 979 91 9,869 230 179 - 6,160 16,438 28,262 $44,700 $3,004 1,947 3,023 139 200 251 532 9,096 173 3,434 32,611 $45,314 $3,700 1,598 217 3,484 1,243 - 10,242 530 267 7,181 6,206 24,426 20,888 $45,314 ANNUAL REPORT 2017 37 Statements of Operations and Comprehensive Loss For the periods ended December 30, 2017 and December 31, 2016 (Expressed in thousands of Canadian dollars, except per share amounts) Revenue (note 15) Company-owned cafés and product sales Franchise revenue Operating costs and expenses (note 16) Company-owned cafés and cost of product sales Franchise General and administrative Loss on disposal of assets Depreciation and amortization Income (loss) from operations Interest and financing costs (notes 14 and 18) Loss before income taxes Income taxes (note 19) Net loss and comprehensive loss for the period Basic and diluted loss per share (note 20) See accompanying notes to financial statements. 2017 $8,562 15,074 22,636 9,303 5,693 6,009 197 1,458 22,660 976 3,897 (2,921) 176 ($3,097) ($0.21) 2016 $14,663 15,688 30,351 15,681 8,103 5,779 225 1,548 31,336 (985) 255 (1,240) (265) ($975) ($0.08) 38 THE SECOND CUP LTD. Statements of Changes in Shareholders’ Equity For the periods ended December 30, 2017 and December 31, 2016 (Expressed in thousands of Canadian dollars) Share Capital Warrants Contributed Surplus Retained Earnings (Deficit) Total Balance – December 26, 2015 (note 2.x) Net loss for the period Stock option plan expense (note 26) Issuance of warrants (note 14) $8,652 – – – Balance – December 31, 2016 $8,652 Net loss for the period Stock option plan recovery (note 26) Warrants extinguished (note 14) Warrants issued (note 14) Shares issued (note 3) Balance – December 30, 2017 See accompanying notes to financial statements. $– – – – 10,619 $19,271 $– – – 271 $271 $– – (271) 165 – $165 $61,736 ($48,849) $21,539 – 53 – $61,789 $– (42) – – – (975) – – ($49,824) ($3,097) – – – – (975) 53 271 $20,888 ($3,097) (42) (271) 165 10,619 $61,747 ($52,921) $28,262 ANNUAL REPORT 2017 39 Statements of Cash Flows For the periods ended December 30, 2017 and December 31, 2016 (Expressed in thousands of Canadian dollars) 2017 2016 CASH PROVIDED BY (USED IN) Operating activities Net loss for the period Items not involving cash Depreciation of property and equipment Amortization of intangible assets Amortization of deferred financing costs Share-based compensation expense Deferred income taxes (note 19) Loss on disposal of capital related items Fair value difference on shares issued and other costs (note 4) Bad debt expense for notes and leases receivable Change in fair value of interest rate swap (note 5) Changes in non-cash working capital & other (note 21) Cash provided by (used in) operating activities Investing activities Proceeds from disposal of capital related items Cash payments for capital expenditures (note 21) Cash payments for intangible assets (note 21) Notes receivable repayment Cash provided by (used in) investing activities Financing activities Repayment of term loan (note 14) Proceeds from new term loan Transaction costs Cash (used in) provided by financing activities Increase (decrease) in cash and cash equivalents during the period Cash and cash equivalents – Beginning of the period Cash and cash equivalents – End of the period See accompanying notes to financial statements. Supplemental cash flow information is provided in note 21. Information on non-cash transactions and supplemental cash flow information are described further in notes 5, 14, 21, and 22. ($3,097) 1,018 456 139 60 30 197 3,290 43 — (274) 1,862 473 (383) (217) 131 4 — — (297) (297) 1,569 3,004 $4,573 ($975) 1,168 403 — 53 238 225 — — (77) (2,288) (1,253) 334 (382) (393) 76 (365) (6,000) 8,000 (458) 1,542 (76) 3,080 $3,004 40 THE SECOND CUP LTD. Notes to the Financial Statements For the periods ended December 30, 2017 and December 31, 2016 (Expressed in thousands of Canadian dollars, except per share amounts) 1. ORGANIZATION AND NATURE OF BUSINESS The Second Cup Ltd. (“Second Cup” or “the Company”) is a Canadian specialty coffee retailer with 286 (2016 - 294) cafés operating under the trade name Second Cup™ in Canada, of which 12 (2016 - 22) are Company-operated and the balance operated by franchisees. The Company owns the trademarks, trade names, operating procedures, systems and other intellectual property used in connection with the operation of Second Cup cafés in Canada. The Company was incorporated under the Business Corporations Act (Ontario) in 2011 and is domiciled in Canada. The address of its registered office and principal place of business is 6303 Airport Road, 2nd Floor, Mississauga, Ontario, L4V 1R8. The Company hereafter refers to its head office activities as “Coffee Central”. The Company’s website is www.secondcup.com. The common shares of the Company are listed on the Toronto Stock Exchange under the symbol “SCU”. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES a. Basis of preparation The financial statements (the “financial statements”) have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). The financial statements have been prepared on the historical cost basis except for certain financial instruments that are measured at fair values at the end of each reporting period. The Company’s functional currency is the Canadian dollar. The Company’s fiscal year follows the method implemented by many retail entities, such that each quarter will consist of 13 weeks and will end on the Saturday closest to the calendar quarter end. The fiscal year is made up of 52 or 53- week periods ending on the last Saturday of December. Fiscal 2017 is a 52-week period (2016 - 53 weeks). The Company manages an advertising and co-operative fund (the “Co-op Fund”) established to collect and administer funds contributed for use in advertising and promotional programs, and initiatives designed to increase sales and enhance the reputation of the Second Cup brand. Contributions to the Co-op Fund are required to be made from both franchised and Company-operated cafés and are based on a percentage of café sales. The revenue, expenses and cash flows of the Co-op Fund are not consolidated, but are netted on the Statement of Financial Position in accounts payable if there is a surplus, or in accounts receivable if there is a deficit to the extent that the Company will recover the deficit from franchisees. The assets and liabilities of the Co-op Fund are included in the assets and liabilities of the Company on the Statements of Financial Position. The policy is established because the contributions to the Co-op Fund are segregated, designated for a specific purpose and the Company is acting as an agent. Since the decisions as to the content and nature of the marketing campaigns are made solely by a body made up of six franchisees elected by their peers and includes representation from each region of our network (the “Advisory Council”) and fulfilled by third parties, the Company does not have the primary responsibility for completing marketing campaigns using the Co-op Fund contributions provided by each franchisee. b. Segmented information and reporting Operating segments are reported in a manner consistent with the internal reporting provided to the Chief Executive Officer. The Company substantially operates and is managed as one reportable segment. Operating revenues are comprised of royalties, the sale of goods from Company-operated cafes, the sale of goods through retail and other ancillary channels, and other service fees. Management is organized based on the Company’s operations as a whole rather than the specific revenue streams. ANNUAL REPORT 2017 41 c. Critical accounting estimates, assumptions and the use of judgement The preparation of financial statements requires management to make estimates, assumptions, and use judgement in applying its accounting policies and in determining estimates and assumptions about the future. Estimates and other judgements are continuously evaluated and are based on management’s experience and other factors, including expectations about future events that are believed to be reasonable under the circumstances. Revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected. The accounting estimates will, by definition, seldom equal the related actual results. Estimates The following are examples of critical estimates, assumptions and judgements the Company makes in determining the amounts reported in the financial statements: • the determination of the recoverable amounts of tangible and intangible assets subject to depreciation, amortization, or with indefinite lives; • the derivation of income tax assets and liabilities; • the estimated useful lives of assets; • café lease provisions and restructuring charges; and • the allowance for doubtful accounts. Use of judgement The following discusses the critical judgements and accounting estimates that the Company has made in the preparation of the financial statements: (i) Impairment charges Impairment analysis is an area involving management judgement in determining the recoverable amount of an asset. The recoverable amount of a cash generating unit (“CGU”) is calculated as the higher of the fair value less costs of disposal, and its value in use. Fair value is determined by estimating the net present value of future cash flows derived from such assets using cash flow projections that have been discounted at an appropriate rate and based on a market participant’s view. In calculating the net present value of the future cash flows, certain assumptions are required to be made in respect of highly uncertain matters including: • growth in total revenue; • change and timing of cash flows such as the increase or decrease of expenditures; • selection of discount rates to reflect the risks involved; and • applying judgement in cash flows specific to CGUs. Changing the assumptions selected by management, in particular the discount rate and the growth rate used in the cash flow projections, could significantly affect the impairment evaluations and recoverable amounts. The Company’s impairment tests include key assumptions related to the scenarios discussed above. Further details are provided in note 17 to the financial statements. (ii) Deferred income taxes The timing of reversal of temporary differences and the expected income allocation to various tax jurisdictions within Canada affect the effective income tax rate used to compute the deferred income taxes. Management estimates the reversals based on historical and budgeted operating results and income tax laws existing at the reporting dates. In addition, management occasionally estimates the current or future deductibility of certain expenditures, affecting current or deferred income tax balances and expenses. 42 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS (iii) Estimated useful lives The useful lives of property and equipment are based on the period during which the assets are expected to be available-for-use. The amounts and timing of recorded expenses for depreciation of property and equipment for any period are affected by these estimated useful lives. It is possible that changes in these factors may cause significant changes in the amount of depreciation recorded in respect of the Company’s property and equipment in the future. (iv) Café lease provisions Café lease provisions are based on the evaluation of the likelihood and measurement of settlements, temporary payouts, or sub-leasing. Management works with landlords, franchisees and uses previous experience to obtain adequate information needed to make these assessments. (v) Allowance for doubtful accounts The allowance for impairment of trade and other receivables is established when there is objective evidence that the Company will not be able to collect all amounts due according to the original terms of the receivable. The carrying amount of the asset is reduced through the use of an allowance account, and the amount of the loss is recognized in expenses in the statement of operations and comprehensive loss. When an account is deemed uncollectible, it is written off against the allowance account. Subsequent recoveries of amounts previously written off are recognized as a recovery in expenses in the statement of operations and comprehensive loss. d. Financial instruments Financial assets and liabilities are recognized when the Company becomes a party to the contractual provisions of the instrument. Financial assets are derecognized when the rights to receive cash flows from the assets have expired or have been transferred and the Company has transferred substantially all risks and rewards of ownership. Financial liabilities are derecognized when obligations are discharged, cancelled or they expire. Financial assets and liabilities are offset and the net amount reported in the Statements of Financial Position when there is a legally enforceable right to offset the recognized amounts and there is an intention to settle on a net basis or realize the asset and settle the liability simultaneously. Hedge accounting is not used. On recognition, the Company classifies its financial instruments in the following categories depending on the purpose for which the instruments were acquired: Categorization Recognition method Financial instrument Financial assets Cash and cash equivalents Restricted cash Loans and receivables Loans and receivables Trade and other receivables Loans and receivables Notes and leases receivable Loans and receivables Financial liabilities Accounts payable and accrued liabilities Other financial liabilities Gift card liability Deposits from franchisees Term credit facility Other financial liabilities Other financial liabilities Other financial liabilities Amortized cost Amortized cost Amortized cost Amortized cost Amortized cost Amortized cost Amortized cost Amortized cost ANNUAL REPORT 2017 43 (i) Cash and cash equivalents, restricted cash, trade and other receivables, and notes and leases receivable: Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. Loans and receivables are initially recognized at the amount expected to be received, and if necessary, less a present value discount if collection is to be expected beyond one year. Subsequently, loans and receivables are measured at amortized cost using the effective interest method less a provision for impairment, if necessary. (ii) Transaction costs: Long-term debt and share capital are accounted for at fair value, net of any transaction costs incurred. Long-term debt, subsequently, is accounted for at amortized cost using the effective interest method. Transaction costs associated with instruments recognized at amortized cost are amortized over the expected life of the instrument. This classification has been selected as it results in better matching of the transaction costs with the periods benefiting from the transaction costs. e. Cash and cash equivalents and restricted cash Cash and cash equivalents include cash on hand, deposits held with banks and other short-term highly liquid investments with original maturities of three months or less. Restricted cash represents cash on deposit with banks that are held in trust of the Co-op Fund and Development Fund as well as $240 held as security for cash management services. f. Leases receivable The Company has entered into lease agreements acting as the lessor with certain franchisees relating to point of sale systems (“POS”). The lease term is for the major part of the economic life of the POS although the title is not transferred. Leases are recognized as finance type leases and recorded as leases receivable at an amount equal to the net investment in the lease. Leases receivable are initially recognized at the amount expected to be received, less a present value discount if collection is to be expected beyond one year. Subsequently, leases receivable are measured at amortized cost using the effective interest method less a provision for impairment. g. Inventories Inventories are stated at the lower of cost and net realizable value, with cost being determined on an average cost basis for items that are interchangeable. For inventory items that are not interchangeable, specific costs are attributed to the specific individual items. Net realizable value is the estimated recoverable amount less applicable selling expenses. If carrying value exceeds net realizable amount, a write-down is recognized. The write-downs are reversed if the circumstances that caused the initial write-down no longer exist. h. Property and equipment Property and equipment are stated at cost less accumulated depreciation net of any impairment losses. Cost includes expenditures that are directly attributable to the acquisition of the asset. Subsequent costs are included in the asset’s carrying value or recognized as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Company and the cost can be measured reliably. The carrying value of a replaced asset is removed when replaced. Repairs and maintenance costs are charged to the Statements of Operations and Comprehensive Loss during the period in which they are incurred. Where property and equipment construction projects are of a sufficient size and duration, an amount is capitalized for the costs used to finance construction. Depreciation is calculated using the straight-line basis as this approach best reflects consumption and benefit patterns pertaining to the asset’s use. Depreciation is charged commencing when the asset is available for use. The following rates are based on the expected useful lives of the assets: Leasehold improvements lesser of 10 years and the remaining term of the lease Equipment, furniture, fixtures and other Computer hardware 3 to 7 years 3 years 4 4 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS Intangible assets i. Intangible assets consist of trademarks and software, which are amortized or assessed for impairment as follows: (i) Trademarks Trademarks consist of trade names, operating procedures and systems and other intellectual property used in connection with the operation of the Second Cup cafés in Canada and are recorded at the historical cost less impairment write-downs. The trademark is an indefinite life intangible asset that is tested annually for impairment or at any time an indicator for impairment exists. The trademark assets do not have continual renewal requirements nor is there any deterioration incurred due to usage. As a result of the combination of the aforementioned, the trademark assets are considered to have indefinite lives. (ii) Software Purchased software costs are recorded at cost and are amortized commencing when the asset is available for use. Amortization is calculated using the straight-line basis as management believes this approach best reflects consumption and benefit patterns pertaining to the asset’s use. The following rate is based on the expected useful life of the asset: Software 3 to 7 years Where software implementation projects are of a sufficient size and duration, an amount is capitalized for the costs used to finance development. j. Provisions Provisions are recognized when there is a present legal or constructive obligation as a result of past events; it is more likely than not that an outflow of resources will be required to settle the obligation; and the amount can be reliably estimated. Provisions are measured at the best estimate of the expenditure required to settle the obligation at the end of the reporting period and are discounted to present value where the effect is material. Evaluations are performed to identify onerous contracts and, where applicable, provisions are recorded for such contracts. Provisions for café closures are estimates for costs expected to be incurred by the Company for operational franchise- owned cafés. Lease and other occupancy costs not expected to be fully paid by the franchisee are recorded as the Company has liability on the café head lease. k. Other liabilities (i) Deferred revenue The Company has entered into several supply agreement contracts and receives allowances from certain suppliers in consideration for the café network achieving certain volume thresholds over the term of the supply agreement. Deferred revenue is amortized over the term of the supply agreements based on the proportion of volume thresholds met during the fiscal year or other rational basis. Cash received from franchisees for the commencement of a new franchise term, licensing fees, construction management, or a pending transfer arrangement are deferred as deposits from franchisees until the revenue recognition criteria are met. (ii) Leasehold inducements Leasehold inducements are amortized to rent expense on a straight-line basis over the term of the lease. ANNUAL REPORT 2017 45 Income taxes l. Income taxes comprise of current and deferred income taxes. Income taxes are recognized in the Statements of Operations and Comprehensive Loss except to the extent that they relate to items recognized directly in equity, in which case the income tax is also recognized directly in equity. Current income taxes are the expected taxes payable on the taxable income for the period, using tax rates enacted, or substantively enacted, at the end of the reporting period, and any adjustment to tax payable in respect of previous periods. Deferred income taxes are recognized in respect of temporary differences arising between the tax bases of assets and liabilities and their carrying values in the financial statements. Deferred income taxes are determined on a non- discounted basis using tax rates and laws that have been enacted or substantively enacted at the Statements of Financial Position dates, and are expected to apply when the deferred income tax asset or liability is recovered or settled. Deferred income tax assets are recognized to the extent that it is probable that future taxable profit will be available against which the deductible temporary differences can be utilized. m. Gift card liability The gift card program allows customers to prepay for future purchases by loading a dollar value onto their gift cards through cash or credit/debit cards in the cafés or online through credit cards, when and as needed. The gift card liability represents liabilities related to unused balances on the card net of estimated breakage. These balances are included as sales from franchised cafés, or as revenue of Company-operated cafés, at the time the customer redeems the amount in a café for products. Gift cards do not have an expiration date and outstanding unused balances are not depleted. When it is determined the likelihood of the remaining balance of a gift card being redeemed by the customer is remote, the amount is recorded as breakage. The determination of the gift card breakage rate is based upon Company-specific historical load and redemption patterns. The 2017 analysis determined that a breakage rate of 3% was applicable to gift card sales, which is consistent with 2016 experience. Gift card breakage is recognized on a pro rata basis based on historical gift card redemption patterns. Breakage income is fully allocated to the Co-op Fund and not recorded in earnings. n. Deposits from franchisees The development process of a new or to be renovated café requires a deposit from a franchisee at the outset. Deposits from franchisees are applied against the cost of constructing a new café or the renovation of an existing café. o. Revenue recognition Revenue is recognized when it is probable that economic benefits will flow to the Company and delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. Revenue is measured at the fair value of the consideration received or receivable. Revenue is reduced for estimated customer returns, rebates and other revenue related concessions. (i) Royalties Royalty revenue from franchised cafés is based on agreed percentage royalty rates of the franchise location sales. Revenue is recognized on an accrual basis in accordance with the substance of the relevant agreement, provided that it is probable that the economic benefits will flow to the Company and the amount of revenue can be measured reliably. 46 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS (ii) Services and other Services and other consists of initial franchise fees, renewal fees, transfer fees earned on the sale of cafes from one franchisee to another, construction administration fees, purchasing coordination fees, and other ancillary fees (such as IT support and training fees). (iii) Company-owned cafés and product sales Company-owned cafés and product sales revenue includes the sale of goods from Company owned cafés, as well as products sold in grocery stores through wholesale distribution channels and third party licensing agreements. p. Operating costs and expenses (i) Company-owned cafés and cost of product sales Company-owned cafés and cost of product sales represents the product cost of goods sold in Company-operated cafés and through the wholesale grocery channel, plus the cost of direct labour to prepare and deliver the goods to the customers in the Company-operated cafés and any occupancy related costs. (ii) Franchise Franchise costs represent the cost of direct labour to support the network, travel and franchisee meetings, business development initiatives as well as professional fees directly related to franchise operations. (iii) General and administrative General and administrative costs include labour and related expenses for head office, professional fees not directly attributable to franchise operations and occupancy costs. q. Operating leases Operating lease payments are recognized as an expense on a straight-line basis over the lease term. Leasehold inducements are amortized to rent expense on a straight-line basis over the lease term. For the purposes of determining the lease term, option periods are considered for which failure to renew the lease imposes an economic penalty on the Company of such an amount that the renewal appears to be reasonably assured at the inception of the lease. r. Directors’ deferred share unit plan Units granted under the Directors’ deferred share unit plan have graded vesting for each month of service completed over the course of one year. Units are paid out in cash upon the termination of the director. Units are granted based on a weighted average price of the Company’s shares on the five most recent days preceding the grant date. The fair value of the grants is amortized over the respective vesting period using the graded amortization method. Compensation expense is adjusted for changes in fair value of the Company’s share price thereafter. Any dividends paid during the vesting period will be accrued based on the total number of units granted. Amounts recognized are recorded in general and administrative expenses. Recorded values of the plan are presented as accounts payable and accrued liabilities in the Statements of Financial Position. s. Impairment of financial assets At each reporting date, the Company assesses whether there is objective evidence that a financial asset is impaired. The criteria used to determine if there is objective evidence of an impairment loss include: • significant financial difficulty of the borrower/lessee; • delinquencies in interest or principal payments; and • it becomes probable that the borrower/lessee will enter bankruptcy or other financial reorganization. ANNUAL REPORT 2017 47 If such evidence exists, an impairment loss is recognized for assets carried at amortized cost as follows: The loss is the difference between the amortized cost of the loan or receivable and the present value of the estimated future cash flows, discounted using the instrument’s effective interest rate. The carrying value of the asset is reduced by this amount either directly or indirectly through the use of an allowance account. Notes receivable and leases receivable are assessed for impairment on an individual basis based on the ability of the debtor/lessee to make the required payments and the value of the security. When there is no longer reasonable assurance that a note receivable or lease receivable will be collected, its carrying value is reduced and a charge is recorded in operating expenses. Impairment losses on financial assets carried at amortized cost are reversed in subsequent years if the amount of the loss decreases and the decrease can be related objectively to an event’s occurring after the impairment was recognized. Impairment of non-financial assets t. Property and equipment and intangible assets without indefinite lives are tested for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Assets with indefinite lives are subject to an annual impairment test or any time an impairment indicator exists. The yearend date has been selected as the mandatory annual test date. For the purpose of measuring recoverable amounts, assets are grouped at the lowest levels for which there are separately identifiable cash inflows that are largely independent of the cash inflows from their assets or group of assets, which represent a cash generating unit (CGU). The recoverable amount of each particular CGU is the higher of an asset’s fair value less costs of disposal and value in use. CGUs have been determined to be as follows: • franchising, distribution, and wholesale; and • Company-operated cafés; each Company-operated café is considered a separate CGU. The impairment analysis involves comparing the carrying value of the CGUs with their estimated recoverable amounts. An impairment loss is recognized for the amount by which the CGU’s carrying value exceeds its recoverable amount. Impairment losses for a CGU reduce first the carrying value of any goodwill allocated to that CGU. Any remaining impairment loss is charged pro rata to the other assets in the CGU. Impairment losses, other than goodwill impairment, are evaluated for potential reversals when events or circumstances warrant such consideration. u. Related parties For the purposes of these financial statements, a party is considered related to the Company if such party or the Company has the ability to, directly or indirectly, control or exercise significant influence over the other entity’s financial and operating decisions, or if the Company and such party are subject to common influence. Related parties may be individuals or other entities and include members of key management of the Company. All transactions with related parties are recorded at fair value. v. Share-based compensation For share option awards granted as part of the stock option plan, a fair value is determined at the date of grant and that fair value is recognized in the financial statements over the vesting period. Proceeds arising from the exercise of share option awards are credited to share capital, as are the recognized grant-date fair values of the exercised share option awards. Share option awards which are determined to be settled on a net-equity basis are accounted for as equity instruments. Share option awards which are determined to be settled on a net-cash settlement basis are accounted as liability instruments. The stock option plan was introduced in May 2014 and is further discussed in note 26. 48 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS w. Reclassification Certain comparable figures have been reclassified to conform to the current period’s financial statement presentation. The reclassification has been made to enhance the presentation of the company’s activities and the financial statements. This reclassification has been made to enhance the presentation of the Company’s activities and the financial statements. x. Changes in accounting policies In accordance with the IFRS Interpretations Committee (“IFRIC”) agenda decision addressing the expected manner of recovery of an intangible asset with an indefinite useful life for the purposes of measuring deferred tax in accordance with IAS 12, Income Taxes (“IAS 12”), the IFRIC noted that an intangible asset with an indefinite useful life does not mean infinite life, nor does it mean the expected manner of recovery of the carrying amount would result solely through sale. Previously, the Company measured deferred taxes on temporary differences arising from certain indefinite life intangible assets using capital gains rates on the basis that the assets will be recovered through its disposition. As a result of the IFRIC agenda decision, the Company has changed its accounting policy to measure deferred taxes at the income tax rate applicable to ordinary taxable income expected to apply in the years in which the temporary differences are expected to be recovered or settled. The Company adopted this change on a retrospective basis as an accounting policy change in accordance with IAS 8, “Accounting Policies, Changes to Accounting Estimates and Errors” and the impact on the financial statements was an increase to deferred tax liabilities at December 27, 2015 of $2,388 and a corresponding adjustment to retained earnings (deficit) of $2,388. Recent accounting pronouncements not yet effective In May 2014, the IASB issued IFRS 15, a new comprehensive model for entities to use accounting for revenue arising from contracts with customers. In September 2015, the IASB deferred adoption of the new standard by one year. Several updates have been issued since to clarify the implementation guidance. The new guidance supersedes the most current revenue recognition guidance, including industry-specific guidance, enhances revenue recognition disclosures, and is now effective commencing in 2018. The guidance allows for either a full retrospective or modified retrospective transition method. We currently expect to apply the modified retrospective transition method. Under current accounting guidance, we recognize initial franchise fees when we have performed all material obligations and services, which generally occurs when the franchised café opens. As required under the new guidance, we anticipate deferring the initial franchise fees and recognizing revenue over the term of the related franchise agreement (generally ten years). We anticipate an increase in deficit as at December 31, 2017, the date of initial adoption and a corresponding increase in deferred revenue reflecting initial franchise fees previously recognized that are now recorded over the term. We anticipate that the new guidance will also change our reporting of the Co-op Fund contributions from franchisees and the related advertising and promotional expenditures, which are currently reported on a net basis in our Statements of Financial Position. Under the new guidance, Co-op Fund contributions from franchisees and advertising and promotional expenditures will be reported on a gross basis. In addition, we anticipate that the estimated breakage income on gift cards will be recognized as gift cards are utilized instead of our current policy of recognizing on a pro rata basis based on historical gift card redemption patterns. We do not believe this guidance will materially impact our recognition of revenue from Company-owned cafes and product sales or our recognition of franchise royalties revenue. ANNUAL REPORT 2017 49 IFRS 9 replaces the incurred loss model under IAS 39 with a model on expected credit losses. Under the new standard, expected credit losses will need to be recorded. Under our current accounting, losses are recognized when probable. We are currently assessing the impact of the new standard and expect the new standard will likely increase our allowance for doubtful account provision. IFRS 16, Leases, sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract, the customer (‘lessee’) and the supplier (‘lessor’). This will replace IAS 17, Leases, and related Interpretations. IFRS 16 provides revised guidance on identifying a lease and for separating lease and non- lease components of a contract. IFRS 16 introduces a single accounting model for all leases and requires a lessee to recognize right-of-use assets and lease liabilities for leases with terms of more than 12 months, unless the underlying asset is of low value, and depreciation of lease assets separately from interest on lease liabilities on the Statements of Operations and Comprehensive Loss. Under IFRS 16, lessor accounting for operating and finance leases will remain substantially unchanged. IFRS 16 is effective for annual periods beginning on or after January 1, 2019, with earlier application permitted for entities that apply IFRS 15, Revenue from Contracts with Customers. The guidance allows for either a full retrospective or modified retrospective transition method. The Company currently expects to apply the modified retrospective transition method. Further, the Company currently expects to apply the practical expedients to i) grandfather the assessment of which transactions are leases; ii) recognition exemption of short-term leases; and iii) recognition exemption leases of low-value items. The Company has completed a preliminary assessment of the potential impact on its financial statements, but has not yet completed its detailed assessment. So far, the most significant impact identified is that the Company will recognize new assets and liabilities for its subleases, operating leases of its head office and corporate cafés. 3. SHARE CAPITAL The Company is authorized to issue an unlimited number of common shares. Common shares are classified as equity and have no par value. Incremental costs directly attributable to the issue of new common shares are shown in equity as a deduction, net of tax, from the proceeds. On August 10, 2017, the Company issued 4,210,528 common shares and 300,000 warrants of Second Cup to the four shareholders of SPE Finance LLC (SPE), an affiliate of Serruya Private Equity. See note 4 Management of Capital for further details. Shares outstanding at the fiscal year ended December 30, 2017 are 17,041,473 (2016 - 12,830,945). 4. MANAGEMENT OF CAPITAL On August 10, 2017, the Company issued 4,210,528 common shares and 300,000 warrants of Second Cup to the four shareholders of SPE Finance LLC (SPE), an affiliate of Serruya Private Equity. The Company also extinguished its $8,000 debt to SPE and cancelled 600,000 of old warrants. These transactions resulted in one-time, non-cash financing charges of $3,290. These charges consist of the difference between the share price of $2.60 on the issuance date and the agreed-to share price of $1.90, and the write-off of the unamortized portion of deferred transaction costs related to the debt. The Company’s objectives relating to the management of its capital structure are to: • safeguard its ability to continue as a going concern; • maintain financial flexibility in order to preserve its ability to meet financial obligations; and • deploy capital to provide an adequate return to its shareholders. The Company’s primary uses of capital are to finance increases in non-cash working capital and capital expenditures. 50 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS 5. FINANCIAL INSTRUMENTS AND FINANCIAL RISK MANAGEMENT Financial instruments The following summarizes the nature of certain risks applicable to the Company’s financial instruments: Financial instrument Financial assets Cash and cash equivalents Restricted cash Trade and other receivables Notes and leases receivable Financial liabilities Interest rate swap Risks Credit and interest rate Credit and interest rate Credit Credit Credit, liquidity, and interest rate Accounts payable and accrued liabilities Liquidity, currency, and commodity Gift card liability Deposits from franchisees Term credit facility Liquidity Liquidity Liquidity and interest rate Fair value of financial instruments The fair values of cash and cash equivalents, restricted cash, trade and other receivables, accounts payable and accrued liabilities, provisions, other liabilities and gift card liability approximate their carrying values due to their short-term maturity. The fair value of notes and leases receivable approximates their carrying value as the implicit interest used to discount the base value is considered to be based on an appropriate credit and risk rate pertaining to the debtor. The following table summarizes the financial instruments measured at fair value: Interest rate swap Opening fair value Repaid during the year Change in fair value Closing fair value 2017 $– – – $– 2016 ($77) – 77 $– The interest rate swap expired in the third quarter of 2016. Financial instruments that are measured subsequent to initial recognition at fair value are to be categorized in Levels 1 to 3 of the fair value hierarchy, based on the degree to which the fair value is observable. The three levels of the fair value hierarchy are: • Level 1 – inputs derived from quoted prices (unadjusted) in active markets for identical assets or liabilities; • Level 2 – inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices); and • Level 3 – fair value derived from valuation techniques that include inputs for the asset or liability that are not based on observable market data (unobservable inputs). At December 30, 2017, there were no financial instruments classified as Level 2. ANNUAL REPORT 2017 51 There were no changes between levels in the period ended December 30, 2017 versus the period ended December 31, 2016. Credit risk a. Cash and cash equivalents, restricted cash and interest rate swap Credit risk associated with cash and cash equivalents, restricted cash and the interest rate swap is managed by ensuring these assets are placed with institutions of high creditworthiness. b. Trade and other receivables, notes and leases receivable Trade and other receivables and notes and lease receivable primarily comprise amounts due from franchisees. Credit risk associated with these receivables is mitigated as a result of the review and evaluation of franchisee account balances beyond a particular age. Prior to accepting a franchisee, the Company undertakes a detailed screening process which includes the requirement that a franchisee has sufficient financing. The risk is further mitigated due to a broad franchisee base that is spread across the country, which limits the concentration of credit risk. Other receivables may include amounts owing from large organizations where often those organizations have a simultaneous vendor relationship with the Company’s franchisees. Credit risk is mitigated as a result of the Company directing and maintaining certain controls over the vendor relationship with the franchisees. Specific bad debt provisions are accounted for when the expected recovery is less than the actual receivable. An analysis of aging of trade and other receivables from the billing date net of an allowance for doubtful accounts is as follows: 0-30 Days 31-60 Days 61-90 Days > 90 Days Gross amount as at December 30, 2017 Allowance for doubtful accounts Net amount 2017 Gross amount as at December 31, 2016 Allowance for doubtful accounts Net amount 2016 $3,452 (18) $3,434 $2,630 (38) $2,592 $158 (60) $98 $173 (67) $106 $109 (40) $69 $247 (112) $135 $2,322 (2,207) $115 $2,163 (1,973) $190 Total $6,041 (2,325) $3,716 $5,213 (2,190) $3,023 Trade and other receivables include a combined allowance for doubtful accounts of $2,325 (December 31, 2016 - $2,190). Credit terms vary by customer in the range of 30 to 90 days. The net amount due of $115 aged over 90 days has no specific terms of repayment. Trade and other receivables are further discussed in note 6. The payment maturity dates of the notes and leases receivable as at December 30, 2017, net of an allowance for doubtful accounts, are as follows: 2017 2016 < 90 Days $22 $32 90 Days to < 1 year 1 year to < 2 years 2 years and after $42 $107 $42 $105 $32 $68 Total $138 $312 Notes and leases receivable included a combined allowance for doubtful accounts of $55 (December 31, 2016 - $12). Notes and leases receivable are further discussed in note 7. 52 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS Liquidity risk Liquidity risk is managed through regular monitoring of forecast and actual cash flows, monitoring maturity dates of financial assets and liabilities, and also the management of the Company’s capital structure and debt leverage as outlined in note 14. The Company’s main source of income is royalty receipts from its franchisees, corporate café sales, and sales from goods and services. Commodity and currency risk The Company purchases certain products, such as coffee, in U.S. dollars, thereby exposing the company to risks associated with fluctuations in currency exchange rates. The Company is also directly and indirectly exposed to commodity market risk. The exposure relates to the changes in coffee commodity prices given it is a material input for product offerings. The direct exposure pertaining to the wholesale business is mitigated given that the Company has the ability to adjust its sales price if commodity prices rise over a threshold level. The indirect risk exists where franchisee profitability may be impacted, thus potentially resulting in an impeded ability to collect accounts receivable or the need for other concessions to be made to the franchisee. This risk is mitigated by entering fixed price purchase commitments through coffee commodity brokers and by having the ability to adjust retail selling prices. 6. TRADE AND OTHER RECEIVABLES Trade and other receivables Less: Allowance for doubtful accounts Net trade and other receivables 2017 $6,041 (2,325) $3,716 2016 $5,213 (2,190) $3,023 During the period, $464 (2016 - $576 expense) was recorded as a charge pertaining to trade and other receivables. 7. NOTES AND LEASES RECEIVABLE Notes receivable – current Lease receivable – current Less: Allowance for doubtful accounts – current Notes and leases receivable – current Notes receivable – long-term Lease receivable – long-term Less: Allowance for doubtful accounts – long-term Notes and leases receivable – long-term Notes and leases receivable 2017 $26 75 (37) 64 18 74 (18) 74 $138 2016 $71 70 (2) 139 32 151 (10) 173 $312 Notes and leases receivable are discounted using an effective discount rate ranging between eight and nine percent. ANNUAL REPORT 2017 53 8. INVENTORIES Inventories relate to goods held for resale, at the corporate cafés, and equipment for construction, and are comprised of the following: 2017 $180 25 $205 Equipment, furniture, fixtures and construction in process Computer hardware Leasehold improvements $2,396 (1,297) 1,099 76 – 635 (585) 469 (336) $5,826 (2,467) 3,359 236 20 (635) (769) 344 (689) $1,358 $1,866 $2,522 (1,164) 1,358 43 – 2 (403) 55 (296) 759 2,462 (1,703) $759 $4,677 (2,811) 1,866 324 14 (2) (389) 70 (608) 1,275 4,613 (3,338) $1,275 $835 (532) 303 50 – – (4) 3 (142) $210 $881 (671) 210 2 – – (1) 1 (114) 98 881 (783) $98 2016 $161 39 $200 Total $9,057 (4,296) 4,761 362 20 – (1,358) 816 (1,167) $3,434 $8,080 (4,646) 3,434 369 14 – (793) 126 (1,018) 2,132 7,956 (5,824) $2,132 Merchandise held for resale Supplies 9. PROPERTY AND EQUIPMENT Net carrying value As at December 26, 2015 Cost Accumulated depreciation As at December 26, 2015 Additions from operations Additions from franchise stores reacquired Reclass of transfers from construction in process Disposals – original cost Disposals – accumulated depreciation Depreciation As at December 31, 2016 Net carrying value As at December 31, 2016 Cost Accumulated depreciation As at December 31, 2016 Additions from operations Additions from franchise stores reacquired Reclass of transfers from construction in process Disposals – original cost Disposals – accumulated depreciation Depreciation As at December 30, 2017 Cost Accumulated depreciation As at December 30, 2017 54 THE SECOND CUP LTD. 10. INTANGIBLE ASSETS Net carrying value As at December 26, 2015 Cost Accumulated amortization As at December 26, 2015 Additions Disposals – original cost Disposals – accumulated amortization Amortization As at December 31, 2016 Cost Accumulated amortization As at December 31, 2016 Additions Amortization As at December 30, 2017 Cost Accumulated amortization As at December 30, 2017 11. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities consist of: Accounts payable – trade Accrued liabilities Accrued salaries, wages, benefits, and incentives Sales tax payable – government remittances payable NOTES TO THE FINANCIAL STATEMENTS Trademarks Software Total $31,144 – 31,144 – – – – $31,144 $31,144 – 31,144 – – 31,144 31,144 – $31,144 $2,615 (1,120) 1,495 393 (29) 11 (403) $1,467 $2,979 (1,512) 1,467 217 (456) 1,228 3,194 (1,966) $1,228 2017 $2,247 848 574 305 $3,974 $33,759 (1,120) 32,639 393 (29) 11 (403) $32,611 $34,123 (1,512) 32,611 217 (456) 32,372 34,338 (1,966) $32,372 2016 $1,825 1,492 127 256 $3,700 ANNUAL REPORT 2017 55 12. PROVISIONS As at December 26, 2015 Provisions charged during the period Provisions utilized during the period As at December 31, 2016 Current portion Long-term portion As at December 31, 2016 Provisions charged during the period Provisions utilized during the period As at December 30, 2017 Current portion Long-term portion As at December 30, 2017 Head lease liabilities Café leases (a) Other (b) $26 – (26) $– $– – $– – – $– $– – $– $2,421 794 (1,113) $2,102 $1,572 530 $2,102 239 (1,274) $1,067 $837 230 $1,067 $190 186 (350) $26 $26 – $26 480 (409) $97 $97 – $97 Total $2,637 980 (1,489) $2,128 $1,598 530 $2,128 719 (1,683) $1,164 $934 230 $1,164 a. Café leases Provisions for café leases are estimates for costs to be incurred by the Company as a result of the following circumstances: a) closure of cafés, and b) franchisee failure to make payment of occupancy costs at an operational café. Provisions for café closures of $239 (2016 - $794) were charged in the year and are reflected in the franchise line on the Statements of Operations and Comprehensive Loss. b. Other Provisions for other items of $480 (2016 - $186) were charged in the year. The remaining provision will be settled throughout the course of 2018. 13. OTHER LIABILITIES Deferred revenue – current Leasehold inducements – current Other liabilities – current Deferred revenue – long-term Leasehold inducements – long-term Other liabilities – long-term Deferred revenue Leasehold inducements Other liabilities 56 THE SECOND CUP LTD. 2017 $423 36 459 – 179 $179 $423 215 $638 2016 $181 36 217 52 215 $267 $233 251 $484 14. LONG-TERM DEBT Face value of long-term debt Unamortized transaction costs NOTES TO THE FINANCIAL STATEMENTS 2017 $– – $– 2016 $8,000 (819) $7,181 On August 10, 2017, the Company issued 4,210,528 common shares and 300,000 warrants of Second Cup to the four shareholders of SPE Finance LLC (SPE), an affiliate of Serruya Private Equity. The Company also extinguished its $8,000 debt to SPE and cancelled 600,000 of old warrants. These transactions resulted in one-time, non-cash financing charges of $3,290. These charges consist of the difference between the share price of $2.60 on the issuance date and the agreed- to share price of $1.90, and the write-off of the unamortized portion of deferred transaction costs related to the debt. 15. REVENUE Franchise revenue Royalties Services and other Company-owned cafés and product sales 2017 2016 $10,299 4,775 15,074 8,562 $23,636 $10,509 5,179 15,688 14,663 $30,351 ANNUAL REPORT 2017 57 16. OPERATING COSTS AND EXPENSES Company-owned cafés and cost of product sales Cost of product sales Labour and related expenses Occupancy and other Depreciation of property and equipment Loss on disposal of assets Franchise Labour and related expenses Travel and franchisee meetings Professional fees and other General and administrative Labour and related expenses Professional fees and other Occupancy Other Depreciation and amortization 17. IMPAIRMENT OF ASSETS 2017 $3,270 2,966 3,067 308 197 9,808 3,939 345 1,409 5,693 2,045 3,503 461 6,009 1,150 2016 $5,795 4,873 5,013 394 225 16,300 4,330 670 3,103 8,103 2,003 3,322 454 5,779 1,154 $22,660 $31,336 Impairment of trademarks a. The Company’s trademarks are allocated fully to the franchising, distribution, and wholesale CGU. The CGU’s recoverable amount has been determined using fair value less costs of disposal. Key assumptions The Company uses a discounted cash flow methodology, which includes the use of estimates and assumptions that are sensitive to change and require judgement. This methodology used to test impairment is classified as Level 3 per the hierarchy described in note 5. These key judgements include estimates of discount rates, forecast growth in system sales and other estimates impacting future cash flows. Changes in these estimates and assumptions may have a significant impact on recoverable amounts. General market uncertainty and the competitive operating environment for the Company and other similar retail entities were also factors taken into account in the analysis. The changes in the market growth rates reflect the current general economic pressures now impacting the national economy. 58 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS Probability weighted cash flow projections are used based on financial forecasts covering a three-year period. These projections are approved by the Board of Directors based on management’s expectations of potential outcomes. Cash flows beyond the three-year period are extrapolated using the estimated growth rates as stated in the table below. The valuation of the franchising, distribution, and wholesale business CGU is based on various probabilities assigned to each forecasted cash flows. The analysis performed as at December 30, 2017 does not indicate any impairment (2016 - $nil). The following are key assumptions used in the fair value less costs of disposal calculation as well as a sensitivity analysis for the various range of assumptions used and the related impact. Discount rate Forecast same café sales avg. growth rate Avg. growth rate used to extrapolate cash flows beyond the forecast period Amount by which recoverable amount exceeds Low growth High growth Low growth High growth 2017 2016 12.0% 16.0% 0.0% 4.5% – 5.5% 0.0% 0.0% 12.0% (1.0%) 0.0% 16.0% 2.5% – 4.0% 0.0% carrying amount $6,500 $5,300 $4,500 $28,400 b. Corporate cafes – Impairment of leasehold improvements, equipment, furniture, fixtures, and other Impairment indicators include when an individual Company-operated café experiences poor performance directly impacting cash flows. The impairment analysis is based on historical and forecasted performance measures for each café with impairment indicators. The asset’s recoverable amount has been determined using value in use. The recoverable amount was compared to the net book value of the assets. This methodology used to test impairment is classified as Level 3 per the hierarchy described in note 5. As a result of the impairment test, impairment charges of $nil for the year ended December 30, 2017 (2016 - $nil) were recorded to assets that were not able to be redeployed to a different CGU as the carrying amount exceeded the recoverable amount. A sensitivity of 2% increase or decrease in sales for each CGU pertaining to the impacted assets would not have had an impact on the impairment recorded. 18. INTEREST AND FINANCING COSTS Fair value difference on shares issued and other costs Interest expense Amortization of deferred financing costs Interest income 2017 $3,290 505 139 (37) $3,897 2016 $– 259 31 (35) $255 ANNUAL REPORT 2017 59 19. INCOME TAXES Income taxes, as reported, differ from the amount that would be computed by applying the combined Canadian federal and provincial statutory income tax rate to income before income taxes. The reasons for the differences are as follows: 2016 ($1,240) 26.68% (331) 22 19 25 ($265) ($503) 238 ($265) 2016 15.00% 11.68% 26.68% Total $5,869 238 99 6,206 30 (76) Other ($827) 150 – (677) 51 (37) ($663) $6,160 Loss before income taxes Combined Canadian federal and provincial tax rate Tax recovery at statutory rate Increased (reduced) by following differences Change in tax rates Non-deductible permanent differences Other Income tax expense (recovery) Current income tax expense (recovery) Deferred income tax expense (recovery) Income tax expense (recovery) 2017 ($2,922) 26.70% (780) 19 786 151 $176 $146 30 $176 The blended weighted average statutory income tax rate is an aggregate of the following: Basic federal rate Weighted average provincial rate Combined Canadian federal and provincial tax rates 2017 15.00% 11.70% 26.70% The movement in deferred income tax (assets) and liabilities during the year is as follows: Property and equipment Trademarks Warrants As at December 26, 2015 (Note 2.x) $1,944 $4,752 Charged (credited) to the income statement Charged to equity As at December 31, 2016 Charged (credited) to the income statement Charged to equity As at December 30, 2017 67 – 2,011 (21) – 21 – 4,773 – – $1,990 $4,773 $– – 99 99 – (39) $60 60 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS 20. BASIC AND DILUTED LOSS PER SHARE Loss per share is based on the weighted average number of shares outstanding during the period. Share option awards and warrants to purchase shares are excluded due to anti-dilutive impact. Basic and diluted loss per share is determined as follows: Net loss Weighted average number of shares issued and outstanding Basic and diluted loss per share 21. SUPPLEMENTAL CASH FLOW INFORMATION Changes in non-cash working capital & other (inflow (outflow)): Trade and other receivables Inventories Prepaid expenses and other assets Accounts payable and accrued liabilities Provisions Other liabilities Gift card liability Deposits from franchisees & change in restricted cash Income taxes Cash payments for capital expenditures Cash payments for capital expenditures Cash payments for intangible assets Supplementary information Interest paid Income taxes paid 2017 ($3,097) 14,485,081 ($0.21) 2016 ($975) 12,830,945 ($0.08) 2017 ($693) (5) 46 293 (964) 154 (52) 324 623 ($274) ($383) (217) ($600) $505 $– 2016 $411 29 176 (1,658) (483) (282) (70) (566) 155 ($2,288) ($382) (393) ($775) $318 $– 22. MOVEMENT OF NON-CASH FINANCING ACTIVITIES The Company recognized the following non-cash financing activities as a result of the changes as described in Note 4 Management of Capital: i) a decrease of $7,146 in long-term debt; ii) an increase of $10,760 in share capital; and iii) a net decrease of $106 in warrants. ANNUAL REPORT 2017 61 23. RESTRICTED CASH The Company has established certain accounts that have been classified as restricted cash primarily representing: a) deposits from franchisees for the cost of constructing a new café or the renovation of an existing café, b) funds contributed for use in advertising and promotional programs where the Company is acting as an agent on behalf of the Co-op Fund, and c) a deposit held by the Company’s bank as security for cash management services. Development Fund Co-op Fund Security Deposit held by bank Total Restricted Cash A summary of activities in 2017 and 2016 in the Co-op Fund is provided as follows: Co-op Fund – opening balance Contributions by franchisees Contributions by Company for Company-owned cafés Other contributions by Company Payments to third party suppliers for goods and services Repayments to Company in respect of promissory notes Co-op Fund – closing balance 2017 $408 711 240 $1,359 2017 $487 2,586 290 – (2,652) – $711 2016 $1,220 487 240 $1,947 2016 $319 2,728 238 150 (2,594) (354) $487 24. CONTINGENCIES, COMMITMENTS AND GUARANTEES The Company has lease commitments for Company-operated cafés and acts as the head tenant on most leases, which it in turn subleases to franchisees. To the extent the Company may be required to make rent payments due to head lease commitments, a provision has been recognized (note 12). The Company’s lease commitments as at December 30, 2017 are as follows: December 29, 2018 December 28, 2019 December 26, 2020 December 25, 2021 December 31, 2022 Thereafter Head lease commitments $17,954 16,158 13,907 12,034 10,835 27,637 $98,525 Sublease to franchisees $16,466 14,736 12,692 10,938 9,803 25,012 $89,647 Net $1,488 1,422 1,215 1,096 1,032 2,625 $8,878 The Company believes it has sufficient resources to meet the net commitment of $8,878 over the term of the leases. 62 THE SECOND CUP LTD. NOTES TO THE FINANCIAL STATEMENTS The Company is involved in litigation and other claims arising in the normal course of business. Judgement must be used to determine whether or not a claim has any merit, the amount of the claim and whether to record a provision, which is dependent on the potential success of the claim. It is believed that no significant losses or expenses will be incurred with such claims. However, there can be no assurance that unforeseen circumstances will not result in significant costs. The outcome of these actions is not determinable at this time, and adjustments, if any, will be recorded in the period of settlement. Contracts are in place with third party companies to purchase the coffee that is sold in all cafés. In terms of these supply agreements, there is a guaranteed minimum value of coffee purchases of $1,392 (2016 - $1,140) for the subsequent 12 months. The coffee purchase commitment is comprised of two components: unapplied futures commitment contracts and fixed price physical contracts. Due to the Company acting as the primary coordinator of café construction costs on behalf of its franchisees and for Company-operated cafés, there is $894 (2016 - $241) of contractual commitments pertaining to construction costs for new locations and renovations as at the end of the fiscal year. Construction costs are financed for franchise projects from deposits received from franchisees and for corporate projects from the Company’s cash flows. 25. RELATED PARTIES Related parties are identified as key management, members of the Board of Directors and shareholders that effectively exercise significant influence on the Company. Such related parties include any entities acting with or on behalf of the aforementioned parties. Compensation of key management Key management is defined as the senior management team and the Board of Directors. The following summarizes the compensation expense of key management personnel and the composition thereof: Salaries and short-term employee benefits Termination costs Share-based compensation Total compensation 26. SHARE-BASED COMPENSATION 2017 $2,236 247 60 $2,543 2016 $2,455 – 73 $2,528 Stock option plan The stock option plan was introduced in May 2014 to advance the interests of the Company by: • providing eligible persons with incentives; • encouraging share ownership by participants; • increasing the proprietary interest of participants in the success of the Company; • encouraging participants to remain with the Company or its affiliates; and • attracting new directors and employees. Stock options are to be settled on a net-equity basis. Compensation expense/gain for stock awards is recognized using the fair value when the stock awards are granted using the Black-Scholes option pricing model. All options vest in tranches and are amortized over the awards’ vesting period using the accelerated expense attribution method. ANNUAL REPORT 2017 63 Recognition of the expense/gain is recorded as a charge to operating expenses with a corresponding increase/ decrease to contributed surplus. The following weighted average assumptions have been used to estimate the weighted average fair value per award of $0.39 granted as of December 30, 2017: Risk-free interest rate (%) Volatility (%) Expected term (years) The table below summarizes all activity for the year ended December 30, 2017: Assumption 1.63 32.63 7.8 As at December 31, 2016 Granted Forfeited As at December 30, 2017 Stock option plan recovery during the period Number of share options outstanding Weighted average share option price 670,000 50,000 (460,000) 260,000 $4.08 1.60 4.25 $3.30 $42 The range of exercise prices for share options outstanding at December 30, 2017 is $1.60 to $4.54. Of the share options outstanding, 76,000 share options are exercisable. The weighted average years to expiration are approximately eight years. Share award options are able to be exercised upon vesting. 27. DIRECTORS’ DEFERRED SHARE UNIT PLAN A summary of the status of the Company’s directors’ deferred share unit plan is presented below: Notional units outstanding as at December 26, 2015 Deferred units granted Change in fair value Notional units outstanding as at December 31, 2016 Expensed in the period Notional units outstanding as at December 31, 2016 Deferred units granted Change in fair value Notional units outstanding as at December 30, 2017 Expensed in the period Notional units Recorded value 75,403 36,878 – 112,281 $219 110 (90) $239 $20 Notional units Recorded value 112,281 45,047 – 157,328 $239 98 4 $341 $102 The average fair value price of deferred units granted was $2.18 (2016 - $2.98). 64 THE SECOND CUP LTD. Shareholder Information CORPORATE HEAD OFFICE The Second Cup Ltd. 6303 Airport Road, 2nd Floor Mississauga, Ontario Canada L4V 1R8 Registrar and Transfer Agent Computershare Trust Company of Canada Auditors PricewaterhouseCoopers LLP Market Information Shares Listed: Toronto Stock Exchange Symbol: SCU Investor Inquiries Ba Linh Le Vice President, Finance and Chief Financial Officer Tel: (905) 362-1827 Fax: (905) 362-1121 E-mail: investor@secondcup.com Website www.secondcup.com THE SECOND CUP LTD. Board of Directors THE SECOND CUP LTD. Senior Management Team Michael Bregman (1),(2) Chairman Melinda Lee (1) Garry Macdonald Alton McEwen (2) Paul W. Phelan Michael Serruya (1) Aaron Serruya Alan Simpson (2) Committees of the Board (1) Audit Committee (2) Governance, Human Resources and Compensation Committee Garry Macdonald President and Chief Executive Officer Ba Linh Le Vice President, Finance and Chief Financial Officer Vanda Provato Vice President, Marketing and Category Chris Sonnen Vice President, Coffee Experience Audra Wosik Vice President, Franchising Ted Tai Vice President, Operations John Kazmierowski Vice President, Development-Leasing & Construction ANNUAL REPORT 2017 65 

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