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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-27008
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SCHLOTZSKY'S, INC.
(Exact name of registrant as specified in its charter)
TEXAS 74-2654208
(State or other Jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
203 COLORADO STREET, AUSTIN, TEXAS 78701
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (512) 236-3600
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Name of each exchange
Title of each class on which registered
COMMON STOCK, NO PAR VALUE NASDAQ NATIONAL MARKET
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
PREFERRED STOCK PURCHASE RIGHTS
----------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes |X| No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K [ ].
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 14, 2000 was approximately $40,827,000 based upon
the last sales price on March 14, 2000 on the NASDAQ National Market System
for the Company's common stock. For purposes of this computation, all
officers, directors and 10% beneficial owners of the registrant are deemed to
be affiliates. Such determination should not be deemed an admission that such
officers, directors or 10% beneficial owners are, in fact, affiliates of the
Registrant. Registrant had 7,430,027 shares of Common Stock outstanding on
March 14, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement to be filed with
the Securities and Exchange Commission not later than 120 days after the
close of the registrant's fiscal year are incorporated by reference into Part
III of this Form 10-K.
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SCHLOTZSKY'S, INC.
INDEX TO FORM 10-K
YEAR ENDED DECEMBER 31, 1999
PAGE NO.
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PART I
Item 1. Business........................................................................................... 1
Item 2. Properties......................................................................................... 18
Item 3. Legal Proceedings.................................................................................. 18
Item 4. Submission of Matters to a Vote of Security Holders................................................ 19
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.............................. 20
Item 6. Selected Consolidated Financial Data............................................................... 20
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation........................................................................... 22
Item 7A. Quantitative and Qualitative Disclosures about Market Risk......................................... 32
Item 8. Financial Statements and Supplementary Data........................................................ 32
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure........................................................................... 32
PART III
Item 10. Directors and Executive Officers of the Registrant................................................. 33
Item 11. Executive Compensation............................................................................. 33
Item 12. Security Ownership of Certain Beneficial Owners and Management..................................... 33
Item 13. Certain Relationships and Related Transactions..................................................... 33
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.................................... 36
PART I
ITEM 1. BUSINESS
Schlotzsky's, Inc. (the "Company") was formed effective January 1, 1993,
when Schlotzsky's Franchising Limited Partnership, Schlotzsky's-Houston,
Ltd., Schlotzsky's-San Antonio, Ltd., Schlotzsky's Restaurant Management
Corporation, and Schlotzsky's, Inc. (collectively, the "Predecessor
Entities") were merged into the Company and its two wholly-owned
subsidiaries, Schlotzsky's Restaurants, Inc. and Schlotzsky's Real Estate,
Inc. (the "1993 Merger"). In June 1993, the Company raised $5 million through
the sale of Class A Preferred Stock and used the proceeds to redeem the
preferred stock issued in the 1993 Merger to the investors in the Predecessor
Entities other than John C. Wooley and Jeffrey J. Wooley. The Company's other
subsidiaries, which are wholly-owned, are Schlotzsky's Brands, Inc.,
Schlotzsky's Equipment Corporation, DFW Restaurant Transfer Corp., 56th and
6th, Inc., RAD Acquisition Corp. and SREI Turnkey Development, L.L.C. The
Company and its subsidiaries are Texas corporations, and references to the
"Company" include its predecessors, and its and their subsidiaries, unless
the context otherwise requires. Effective January 1, 2000, the Company formed
Schlotzsky's Brands I, L.L.C., a Delaware Limited Liability Company, and
Schlotzsky's Brand Product, L.P., a Texas Limited Partnership, both of which
are directly or indirectly wholly-owned by the Company.
The Company's principal executive offices are located at 203 Colorado
Street, Austin, Texas 78701, and its telephone number is (512) 236-3600.
GENERAL
The Company is a franchisor of quick service restaurants that feature
made-to-order sandwiches with unique sourdough buns. At December 31, 1999,
the Schlotzsky's-Registered Trademark- Deli system included 23 Company-owned
stores and 736 franchised stores located in 37 states, the District of
Columbia and 13 foreign countries. Of the Company-owned stores, there are
thirteen stores which the Company intends to own and operate on a long term
basis. The other ten stores are being operated as held for sale until they
are re-franchised. The Company's revenues were $41.8 million for 1998 and
$47.9 million for 1999 while system-wide sales of the franchise system for
all stores were approximately $348.5 million for 1998 and $400.3 million for
1999. System-wide sales are based on reported sales of franchised stores, as
well as Company-owned stores, and are a principal driver of Company revenue
because royalty revenue is based on system-wide sales. Weighted average
annual unit volumes for all stores were $503,000 for 1998 and $550,000 for
1999.
STRATEGY
John C. Wooley and Jeffrey J. Wooley acquired the Company in 1981. They
were attracted to the Company by the unique characteristics of The
Schlotzsky's Original sandwich, the only sandwich sold at Schlotzsky's
restaurants at that time, and the strong brand loyalty that had developed for
this sandwich in the Company's markets. From 1981 to 1991, management tested
different strategies to expand the Company's business, including the
development of Company-owned stores and expanded store menus.
In 1991, the Company began implementing a strategy to achieve its
objective of becoming a leader in the specialty sandwich segment of the
restaurant industry in the United States. The key elements of this strategy
are to: offer an expanded menu of consistent, high quality foods featuring
the Company's proprietary bread recipes, complemented by excellent customer
service; use the Turnkey Program to develop new stores in high visibility,
free-standing locations; utilize area developers to decentralize certain
labor intensive aspects of franchisee recruiting and support; develop a
strong network of motivated owner-operator franchisees; and increase
awareness of the Schlotzsky's brand through enhanced marketing and private
label products. Recently, the Company revised its strategy to include
acquiring and developing a limited number of Company-owned stores,
principally for concept development, and focusing the attention of many of
its area developers on franchisee support, rather than recruiting. The
Company initiated national network television advertising in the Spring of
1999.
MENU OF DISTINCTIVE, HIGH QUALITY PRODUCTS. Schlotzsky's-Registered
Trademark- Deli restaurants offer an expanded menu of consistent, high
quality foods featuring the Company's proprietary bread recipes, complemented
by excellent customer service. The menu features made-to-order sandwiches
with bread that is baked fresh from scratch every
1
day for every restaurant. The Schlotzsky's Original sandwich, which was
introduced in 1971, is a variation of the muffaletta sandwich made with three
meats (lean ham, Genoa salami and cotto salami), three cheeses (mozzarella,
cheddar and parmesan), garlic butter, mustard, marinated black olives, onion,
lettuce and tomato on a toasted sourdough bun. The Schlotzsky's Original
sandwich continues to be the most popular item on the Schlotzsky's menu.
Schlotzsky's-Registered Trademark- Deli restaurants now offer an expanded
menu with 15 sandwiches on four types of bread, 10 sourdough crust pizzas,
five salads, soups, chips and other side items, fresh baked cookies and other
desserts, and beverages. At most locations, sandwiches range in price from
$3.00 to $4.75 ($7.00 for an oversized Original), and eight-inch gourmet
pizzas are priced between $3.50 and $4.50.
TURNKEY PROGRAM; HIGH VISIBILITY STORES. The Company and its area
developers encourage franchisees to develop free-standing stores with high
visibility and easy access. The Company believes the location of a store is
as important to its success as the efforts of the franchisee, and works with
area developers and franchisees in identify and acquire superior store
locations. The Company implemented its Turnkey Program as a means of
accelerating the development of high visibility stores and capitalizing on
the Company's experience in evaluating store sites by providing a variety of
services from securing the site, to development and construction of the
store. The Turnkey Program also enhances the quality and consistency of the
free-standing stores developed for franchisees to help them by the Company
because of its experience building prototype stores and its purchasing power
with suppliers and contractors.
AREA DEVELOPERS. The Company has 28 area developers trained to assist
the Company in achieving its expansion goals in the United States. The
Company recently contracted with several area developers to buy down their
portion of franchise fees and royalties in return for cash or the combination
of cash and a note. As a result, store opening schedules for these area
developers were eliminated and certain service requirements, such as
franchisee recruiting, were reduced. Depending on whether their agreements
were revised, area developers may provide a range of services: recruit and
qualify franchisees; assist franchisees in site selection, training,
financing, building and opening stores; provide ongoing operational support;
monitor product and service quality; and help coordinate local advertising.
Prior to 1991, these functions were performed exclusively by Company
personnel. By utilizing its area developer network, the Company believes that
it can effectively support a growing number of franchised stores while
controlling its overhead costs. Area developers receive a portion of
franchise fees and royalties from each store in their territories and are
motivated to help develop their markets and monitor operating performance.
Generally, area developers whose agreements were not revised have been
required to recruit franchisee candidates and meet specific store opening
schedules with the Company in order to maintain their development rights.
MOTIVATED OWNER-OPERATOR FRANCHISEES. The Company is developing a strong
network of owner-operator franchisees. The Company believes that a motivated
owner-operator is an essential key to the success of a store. The
Schlotzsky's system consists almost exclusively of franchised stores, owned
and managed by entrepreneurial franchisees. The Company seeks franchisees who
are committed to providing on-site supervision of store operations and
prefers to limit franchisees to three or four locations in relatively close
proximity. As of December 31, 1999, out of 450 franchisees with stores,
thirteen franchisees have more than five stores each and, in the aggregate,
account for approximately 11% of the stores in the system.
INCREASED BRAND AWARENESS. The Company seeks to increase awareness of
the Schlotzsky's brand through enhanced marketing and private label products.
The Company is directing its franchising efforts to establish a sufficient
number of stores in larger markets to allow expanded cooperative advertising
through newspaper, radio and television. In 1999, the Company started
advertising on national network television, using a portion of the marketing
contributions required from franchisees under their franchise contracts. The
Company has developed a complete line of private label products to increase
Schlotzsky's brand awareness. Private label products are used by franchisees
in preparing foods and many of them are displayed at stores as part of the
standard decor package. Some private label products are sold by franchisees
for home consumption. In 1999, Schlotzsky's brand chips became available for
retail purchase outside of the restaurant system for the first time in the
domestic superstores of one of the world's largest retailers. In addition, a
new line of Schlotzsky's-Registered Trademark- Deli meats, cheeses and
condiments were test marketed in an East Texas based grocery chain and
selected markets during 1999. The Company expects to continue to explore
alternative channels for retail distribution of some of its private label
products.
COMPANY-OWNED STORES. The Company opened its flagship store in Austin,
Texas in 1995 and it has continued to expand its portfolio of Company owned and
operated locations over the past few years. During 1998 and 1999,
2
the Company added primarily prototype units to its group of stores in and
around its home market. At the end of 1999, the Company owned and operated 13
units, primarily in Texas and Georgia, and one location in New York City.
Over the last three years, the Company has also acquired ten other locations
which it does not consider part of its permanent portfolio of Company units.
The Company intends to re-market these locations once sales and operating
results are improved. These stores are classified as "Restaurants Held for
Sale". The operating results of the units held for sale are considered an
operating cost of the Turnkey Program and are reported in Turnkey Development
cost. Results from the restaurants the Company intends to own and operate on
a long term basis, are reflected in restaurant operations figures. The
Company anticipates opening or acquiring additional stores in Texas during
2000. The Company operates these stores primarily for product development,
concept refinement, prototype testing and training, and to build brand
awareness. The Company may acquire or develop a limited number of other
Company-owned stores in the future for these purposes and may acquire or
develop others from time to time with the intent of transferring them to
franchisees.
EXPANSION
At December 31, 1999, the Schlotzsky's system consisted of 759 stores in
37 states, the District of Columbia, and 13 foreign countries. At December
31, 1997 and 1998, the system included 673 and 750 stores, respectively.
STORE LOCATIONS AS OF DECEMBER 31, 1999
NUMBER OF
LOCATION STORES
-------- ------
UNITED STATES:
Texas.............................................. 224
Tennessee.......................................... 38
Arizona............................................ 37
Georgia............................................ 35
Florida............................................ 32
Illinois........................................... 32
North Carolina..................................... 26
Michigan........................................... 23
Indiana............................................ 22
Colorado........................................... 21
Wisconsin.......................................... 21
Alabama............................................ 20
California......................................... 18
Oklahoma........................................... 17
South Carolina..................................... 17
Missouri........................................... 14
Ohio............................................... 13
Kansas............................................. 12
New Mexico......................................... 11
Louisiana.......................................... 10
Minnesota.......................................... 10
Nebraska........................................... 10
Arkansas........................................... 9
Utah............................................... 9
Oregon............................................. 8
Nevada............................................. 7
Kentucky........................................... 6
Virginia........................................... 6
Washington......................................... 6
Mississippi........................................ 5
Idaho.............................................. 4
West Virginia...................................... 4
North Dakota....................................... 3
Hawaii............................................. 2
Pennsylvania....................................... 2
South Dakota....................................... 2
District of Columbia............................... 1
3
New York........................................... 1
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TOTAL DOMESTIC..................................... 738
4
INTERNATIONAL:
Argentina.......................................... 4
Malaysia........................................... 4
Turkey............................................. 3
Australia.......................................... 1
Bahrain............................................ 1
Canada............................................. 1
China.............................................. 1
Germany............................................ 1
Guatemala.......................................... 1
Lebanon............................................ 1
Morocco............................................ 1
Saudi Arabia....................................... 1
Venezuela.......................................... 1
-----
TOTAL INTERNATIONAL:............................... 21
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TOTAL DOMESTIC & INTERNATIONAL:.................... 759
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TURNKEY PROGRAM
The Company instituted the Turnkey Program to further assist franchisees
in obtaining superior sites and to achieve more rapid development of new
stores, especially in selected major markets where the Company believes there
is strong demand by franchisees for good locations. The Company also believes
that the Turnkey Program enhances the Company's ability to recruit qualified
franchisees by securing and developing high profile sites and achieving
critical mass for advertising purposes more quickly in selected markets.
Under the Turnkey Program, the Company works independently or with an area
developer. The Company will typically perform various services including, but
not limited to, site selection, feasibility analysis, environmental studies,
site work, permitting and construction management, receiving a fee and
recognizing revenue upon the completion of these services. The Company may
assign its earnest money contract on a site to a franchisee, an area
developer, or a third-party investor, who then assumes responsibility for
developing the store. The Company may also purchase or lease a selected site,
construct a Schlotzsky's-Registered Trademark- Deli restaurant on the site
and sell, lease or sublease the completed store to a franchisee, or sell the
store to an investor who leases the store to the franchisee.
From inception of the Turnkey Program through 1997, the Company
typically provided credit enhancement in the form of limited guaranties on
the franchisees' leases for leased locations sold to investors. The Company
obtained agreements from the franchisees to indemnify the Company in case the
guaranties are called upon. Upon sale of the leased site or assignment of its
earnest money contract to an investor, the Company deferred revenue generated
(even though proceeds were received in cash) and allocable costs incurred in
connection with the property. When a lease guaranty is terminated, or the
Company's exposure to loss under the guaranty expires, the Company recognizes
the revenue and allocable costs related to the site. Generally, if no credit
enhancement was provided in connection with such transactions, the Company
recognized the revenue and allocable expenses in the periods in which the
transactions occurred.
In 1998, the Company began encouraging ownership of the real estate by
its franchisees through a new mortgage loan program. Under the mortgage
program, the Company provided interim financing to the franchisee, to
purchase a store built under the Turnkey Program or to purchase land and
construct the building for a new store. The interim loan was either sold to,
or refinanced by, an institutional lender. The Company provided credit
enhancement for the franchisee in the form of a limited guaranty in favor of
the lender. These guarantees were usually limited to the first two to five
years and to 15% to 25% of the principal amount of the loan. Generally, the
Company recognized the revenue and allocable expenses in the period in which
the transaction occurred. The Company still provides interim financing for
stores in development or recently opened in anticipation of long-term
financing by a financial institution, although the Company recently
instituted efforts to reduce the level of interim financing it provides by
referring franchisees to certain institutional lenders to provide such
interim financing.
5
In addition, the Company charges a fee when it is requested to manage
construction of a store on property owned by a franchisee or an investor.
This construction management fee is recognized when the services are
performed. The Company anticipates that the total investment in each
developed free-standing location will be approximately $1,300,000 to
$2,400,000 (less for leased locations).
MENU
The Schlotzsky's-Registered Trademark- Deli menu provides customers
with popular food items which the Company believes are fresher, more
flavorful and of greater variety than those offered by competitors. The key
menu groups are made-to-order sandwiches and pizzas, salads, soups, cookies
and other desserts, and beverages. Sandwiches and pizzas are made with
delicatessen-style meats, grilled chicken and specialty cheeses, all of which
are purchased ready for use from approved suppliers. The Company's
distinctive sandwich buns and pizza crusts are baked daily from scratch,
rather than with pre-mixed or frozen dough, to ensure the highest quality and
freshness.
FRANCHISING
The Company has adopted a strategy of franchising, rather than owning
stores. The Company believes that franchisees who own and operate stores are
more highly motivated and manage stores more efficiently than typical
manager-employees. Moreover, franchising allows the Company to expand the
number of stores and penetrate markets more quickly and with less capital
than developing Company-owned stores. Area developers play a role in the
Company's franchising program by recruiting qualified franchisees and by
monitoring and providing support to franchised stores.
AREA DEVELOPERS. In 20 territories where 17 of the Company's area
developers have retained their original service obligations, the area
developers recruit and qualify franchisees according to criteria developed by
the Company. Once a franchisee is approved by the Company, the area developer
works with the Company to assist the franchisee in site selection, training,
store design and layout, construction and financing. Each such area developer
provides store opening assistance, monitors store performance and compliance
with product and service quality standards established by the Company and
helps to coordinate cooperative advertising within his territory. The Company
pays area developers who retained their original service obligations 50% of
all franchise fees paid by franchisees in their territories, although some
area developers received up to 100% of certain franchise fees as an
inducement to develop their territories more quickly. In addition, the
Company also pays these area developers 2.5% constituting approximately 42%
of the royalties received under franchise agreements providing for 6%
royalties and 12.5% to 25% of royalties received under franchise agreements
providing for 4% royalties, in each case with respect to franchisees in their
territories.
The percentage of franchise fees and royalties payable to the other 11
area developers has been reduced to approximately 33% and 21%, respectively,
as a result of several transactions completed during 1999 and at the end of
1998. During the third quarter of 1999, the Company assumed territory
management responsibility for its largest area developer in conjunction with
an option to buy its territories. Net service costs associated with this
arrangement were reduced to 1% effective October 31st and escalate to 2% by
August 16, 2004, compared to the former 2.5% rate. A limited number of
additional transactions are contemplated, but there can be no assurance that
such transactions will be completed. Area developers are not required to own
or operate stores, although some of the Company's area developers are also
franchisees, or have investments in franchisees, under separate franchise
agreements. Area developers are granted exclusive rights to one or more
television markets in the United States, typically for a term of 50 years.
Each area developer pays the Company a nonrefundable fee for the development
rights for a market. The Company has typically received 10% to 50% of the
area developer fee when the area development agreement is signed with the
balance payable with interest over an 18 to 60-month period under a
promissory note from the area developer.
Area development agreements are nonassignable without the prior written
consent of the Company, and consents have been granted from time to time. The
Company retains rights of first refusal with respect to any proposed sale by
the area developer. Area developers are not permitted to compete with the
Company. Area developers typically commit to a store opening schedule for
each territory. The Company has agreed to extend or waive store opening
schedules for certain area developers under certain conditions, and has
eliminated the schedules
6
for those whose royalties were reduced. If an area developer fails to meet
its obligations, the Company can terminate or repurchase its territory.
FRANCHISEES. The Company believes the involvement of owners in daily
store operations is critical to the success of a franchise. The Company
prefers franchisees who will operate no more than three or four stores,
located within a single market. Franchisees are selected on the basis of
various factors, including business background, experience and financial
resources. Because the cost of building and equipping a Schlotzsky's
- -Registered Trademark- Deli restaurant is somewhat higher than for some
other specialty sandwich franchise operations, the Company's franchisees must
make certain minimum investments into their stores and typically must have
substantial cash resources or a relatively high net worth to obtain financing
to build and equip stores. While certain area developers identify and recruit
potential franchisees, all franchisees must be approved by the Company.
FRANCHISE AGREEMENTS. The Company enters into an agreement with each
franchisee granting the franchisee the right to develop a store within a
territory over a defined period of time. Once a site for a store has been
selected by the franchisee and accepted by the Company, additional
documentation specifying that site is signed. Under the Company's current
standard franchise agreement, the franchisee is required to pay a franchise
fee of $30,000 for the franchisee's first store and $20,000 for any
additional store. The franchise fee is payable at the time of signing the
agreement. The current standard franchise agreement provides for a term of 20
years (with one ten-year renewal option) and payment of a royalty of 6% of
sales. As of December 31, 1999, 92 stores operated under franchise agreements
entered into prior to 1991 were paying a royalty of 4% of sales.
The Company has the right to terminate any franchise agreement for
certain specific reasons, including a franchisee's failure to make payments
when due or failure to adhere to the Company's policies and standards. Many
state franchise laws, however, limit the ability of a franchisor to terminate
or refuse to renew a franchise. See "Government Regulation."
FRANCHISEE TRAINING AND SUPPORT. Each franchisee is required to have a
principal operator approved by the Company who satisfactorily completes the
Company's training program and who devotes full business time and efforts to
the operation of the franchisee's stores. Franchisees may also enroll each
store manager in the Company's training program. The Company provides
training at operating Schlotzsky's-Registered Trademark- Deli restaurants
in various locations. In November 1995, the Company opened its new flagship
Schlotzsky's-Registered Trademark- Deli restaurant in Austin, Texas, which
includes training facilities. Most franchisee training is being conducted at
that location. Franchisees are required to pass a minimum skills test before
they can begin operating their first store. An on-site training crew is
provided by the Company or an area developer for three days before and two
days after the opening of a franchisee's first store. Company management and
area developers maintain ongoing communication with franchisees, exchanging
operating and marketing information.
FRANCHISE OPERATIONS. All franchisees are required to operate their
stores in compliance with the Company's policies, standards and
specifications, including matters such as menu items, ingredients, materials,
supplies, services, fixtures, furnishings, decor and signs. Food preparation
is standardized and is limited to baking bread, slicing pre-cooked meats,
cheese and produce, melting cheese and heating sandwiches and pizzas. Because
they usually operate no more than three stores, franchisees are expected to
be actively involved in monitoring operations at each store. Each franchisee
has full discretion to determine the prices to be charged to its customers.
Franchise stores are periodically inspected by area developers and the
Company's field service representatives. The Company's field service
representatives and area developers monitor compliance with the Company's
standards and specifications as set forth in the franchise agreement and the
Company's manuals.
REPORTING. Most Schlotzsky's-Registered Trademark- Deli restaurant
franchisees are required to report weekly sales and other data to the
Company. Other franchisees are required to report monthly. Generally, 6%
royalties are payable weekly by automatic bank drafts and 4% royalties are
payable monthly by check. The Company is evaluating software for use by
franchisees to record and report sales and other operating information and
anticipates that franchisees may be able to license this software beginning
at some point in 2000. Although the Company has the right to audit
franchisees, it relies primarily on voluntary compliance by franchisees to
accurately report sales and remit royalties. However, the Company began
auditing some franchise locations during 1999 and expects to continue
periodically auditing franchise locations during 2000.
7
INTERNATIONAL MASTER LICENSEES. In addition to the Company's expansion
in the United States, the Company has granted nonassignable rights to develop
stores in international markets to master licensees. A master licensee is
typically licensed for 50 years to use the Schlotzsky's trademarks in
designated foreign territories and may grant area development rights and
franchises in those territories. Unlike area developers, master licensees
contract directly with franchisees, and the Company delegates the selection
of franchisees and approval of sites to the master licensees. When a master
license is granted, the master licensee pays the Company a negotiated,
nonrefundable license fee. In some instances, the Company will negotiate a
territorial agreement pursuant to which a foreign territory is reserved and
the principal economic terms of the master license agreement are agreed upon
in return for a nonrefundable fee to be applied toward the master license
fee. The Company normally receives 15% to 35% of the master license fee in
cash when the master license or territorial agreement is signed, with the
balance payable with interest over a term of up to 48 months under a
promissory note from the master licensee. Typically, the Company also
receives one-third to one-half of any sublicense and franchise fees and
one-third of any royalties received by the master licensee. All amounts
payable to the Company by the master licensees must be paid in U.S. dollars.
As of December 31, 1999, the Company had executed master licenses or
territorial agreements covering 49 foreign countries. As with area
developers, if master licensees fail to meet their obligations, the Company
can terminate their rights or repurchase their territories. Master licensees
are subject to various laws and regulations regarding franchising and
licensing in their territories and are responsible for complying with these
laws and regulations.
SITE SELECTION
The Company and its area developers often assist franchisees in
selecting their sites and developing their stores. Each franchisee is
responsible for selecting store locations acceptable to the Company. Site
selection criteria are based on accessibility and visibility of the site and
selected demographic factors, including population, residential and
commercial density, income, age and traffic patterns. The Company prefers
that franchisees select sites for free-standing stores to maximize store
visibility and sales potential. As the table below indicates, the mix of
store sites has changed since the Company adopted a new strategy in 1991
focusing on higher visibility stores.
STORES OPENED STORES OPENED STORES OPENED BETWEEN
AS OF AS OF JANUARY 1, 1992 AND
STORE SITE DECEMBER 31, 1991 DECEMBER 31, 1999 DECEMBER 31, 1999
---------- ----------------- ----------------- ---------------------
Free-Standing................ 24% 56% 60%
End-Cap...................... 31 25 22
In-Line...................... 28 9 6
Other........................ 17 10 12
---- ---- -----
Total........................ 100% 100% 100%
==== ==== =====
The Company has developed a series of prototype store designs and
specifications for free-standing and end-cap stores which it makes available
for use by franchisees. These specifications may be adapted to existing
restaurants and other retail spaces.
UNIT ECONOMICS
The Company believes that the Schlotzsky's-Registered Trademark- Deli
restaurant concept offers attractive unit economics. The cost to a franchisee
of developing and opening a prototype Schlotzsky's-Registered Trademark-
Deli restaurant (excluding restaurants like the Company's flagship store) in
leased space has recently ranged from approximately $400,000 to $700,000,
including leasehold improvements, equipment, fixtures and initial working
capital. The initial cost of owning a free-standing, prototype restaurant
ranges from $1,300,000 to $2,400,000. During the twelve months ended December
31, 1999, the weighted average store sales for Schlotzsky's-Registered
Trademark- Deli restaurants was approximately $550,000, although store
revenue varies significantly depending upon the type, size and location of
the store. The Company believes that food and paper costs for the
Schlotzsky's-Registered Trademark- Deli menu items are relatively low as a
percentage of gross store sales as compared to many quick service restaurant
concepts.
8
FINANCING
With respect to non-Turnkey Program stores, the Company usually does
not, and is not obligated to, provide financing to franchisees for the costs
of developing and opening stores. Both the Company and area developers assist
franchisees in obtaining financing by identifying third party financing
sources. Certain financial institutions have designed equipment leasing
programs specifically for Schlotzsky's franchisees and have developed
guidelines for sale and leaseback financing for Schlotzsky's stores. The
Company has also identified Small Business Administration lenders which have
made loans to Schlotzsky's franchisees. These lenders are not committed to
provide any financing to franchisees and there can be no assurance that
franchisees will be able to finance their costs of opening stores on suitable
terms.
The Company has identified certain financial institutions who provide
mortgage loans to qualified franchisees with stores developed through the
Turnkey Program. These loans typically involve a limited guaranty by the
Company. In certain cases, the Company acquires the right to the land and, in
connection with the sale of the land to a franchisee (or another buyer who
plans to subsequently sell the property to a franchisee), provides interim
financing in anticipation of permanent financing by a financial institution.
The Company has recently instituted efforts to reduce the level of interim
financing it provides. Interim loans the Company has provided have been in
the form of construction draw notes or mortgages. The Company had loaned an
aggregate of approximately $8.9 million to various franchisees through this
program, which had not been assigned to a financial institution as of
December 31, 1999. There can be no assurance that financial institutions will
agree to accept assignments of these or future loans made by the Company on
acceptable terms, if at all.
The Company from time to time agrees to guaranty its franchisees'
obligations to equipment and real property lessors or subordinates all or a
portion of its royalties to the obligations of franchisees on such leases.
These guaranties provide for a limited number of payments or limited time
period during which the Company may be required to perform on its guaranty.
As of December 31, 1999, the Company had guaranteed an aggregate of
approximately $34.2 million of franchisee obligations, which is principally
comprised of real estate leases and mortgages, as well as equipment leases
and other obligations of its franchisees.
PURCHASING; PRIVATE LABELING
Franchisees are required to purchase equipment, furniture, smallwares,
merchandising displays and food from suppliers approved by the Company.
Approximately 80-85% of overall purchases of goods used in daily operations
by the Company's franchised stores are from International Multifoods
Corporation, which provides volume discounts to franchisees based upon
system-wide purchases. The Company believes that comparable goods are
available at competitive prices from numerous other suppliers.
The Company has licensed certain manufacturers to sell Schlotzsky's
private label meats, cheeses, potato chips and other products. The Company
receives licensing fees from these manufacturers based on their sales of
private label products to franchisees. While franchisees are not required to
purchase private label products, other than the Company's proprietary flour
mixes, the Company believes that most franchisees prefer them because they
are of equal or superior quality compared to other brand name products and
generally are less expensive than the supplies available from other approved
sources. In addition, some private label products can be sold separately at
stores for home consumption, enhancing brand awareness and providing
franchisees with additional sales and profit opportunities.
MARKETING
Franchised stores contribute 1% of gross sales to Schlotzsky's N.A.M.F.,
Inc. ("NAMF"), a non-profit corporation administered by the Company. NAMF
funds are used principally to develop and produce radio and television
commercials and print advertising for use in local markets, in-store graphics
and displays, and promotions, but such funds may also be used to pay for
media space or time. NAMF has developed advertising campaigns for use by
franchisees centered around different slogans, such as FUNNY NAME. SERIOUS
SANDWICH.-Registered Trademark-; ACCEPT NO SUBSTITUTESKY'S-Registered
Trademark-; BEST BUNS IN TOWN-Registered Trademark-; and ORIGINAL TASTE
9
EVERY DAY. NAMF'S field marketing representatives coordinate advertising
campaigns and promotions for area developers and franchisees.
In addition, franchisees are required by the terms of their franchise
agreements to spend at least 3% of gross sales on advertising. Effective
January 1, 1999, the Company began collecting 1.75% of the 3% for network
television advertising. Network advertising was initiated during the Spring
of 1999. The Company requested franchisees to form local advertising groups
to pool the remainder of the 3% in order to maximize the benefits of local
advertising for members.
COMPETITION
The food service industry is intensely competitive with respect to
concept, price, location, food quality and service. There are many well
established competitors with substantially greater financial and other
resources than the Company. Such competitors include a large number of
national, regional and local food service companies, including fast food and
quick-service restaurants, casual full-service restaurants, delicatessens,
pizza restaurants and other dining establishments. Some of the Company's
competitors have been in existence longer than the Company and are better
established in markets where Schlotzsky's stores are or may be located. The
Company believes that it competes for franchisees with franchisors of other
restaurants and various concepts.
Schlotzsky's stores compete primarily on the basis of distinctive, high
quality food and convenience, rather than price. The Company believes that
Schlotzsky's stores provide the quick service and convenience of fast food
restaurants while offering more distinctive, higher quality products. Pricing
is designed so that customers perceive good value (high quality food at
reasonable prices), even though Schlotzsky's menu prices are typically higher
than certain competitors' prices.
Competition in the food service business is affected by changes in
consumer taste, economic and real estate conditions, demographic trends,
traffic patterns, the cost and availability of qualified labor, product
availability and local competitive factors. The Company and its area
developers attempt to assist franchisees in managing or adapting to these
factors, but no assurance can be given that some or all of these factors will
not adversely affect some or all of the franchisees.
TRADEMARKS, SERVICE MARKS AND TRADE SECRETS
The Company owns a number of trademarks and service marks registered
with the United States Patent and Trademark Office. The Company has also
registered or made application to register trademarks in foreign countries
where master licenses have been granted. The flour and bread making recipes
and techniques currently used in Schlotzsky's stores are based on a
modification of the Company's original recipe developed jointly by the
Company and Pillsbury Company. The recipes and techniques are protected by
the Company and its suppliers as trade secrets. The Company has not sought
patent protection for these recipes, and it is possible that competitors
could develop flour recipes and baking procedures that duplicate or closely
resemble the Company's. The Company considers its trademarks, service marks
and trade secrets to be critical to the business and actively defends and
enforces them.
GOVERNMENT REGULATION
The Company must comply with regulations adopted by the Federal Trade
Commission (the "FTC") and with several state laws that regulate the offer
and sale of franchises. The Company also must comply with a number of state
laws that regulate certain substantive aspects of the franchisor-franchisee
relationship. The FTC's Trade Regulation Rule on Franchising (the "FTC Rule")
requires that the Company furnish prospective franchisees with a franchise
offering circular containing information prescribed by the FTC Rule.
State laws that regulate the franchisor-franchisee relationship
presently exist in a substantial number of states. Those laws regulate the
franchise relationship, for example, by requiring the franchisor to deal with
its franchisees in good faith, by prohibiting interference with the right of
free association among franchisees, by regulating discrimination among
franchisees with regard to charges, royalties or fees, and by restricting the
development of other restaurants within certain proscribed distances from
existing franchised restaurants. Those laws also restrict a franchisor's
rights with regard to the termination of a franchise agreement (for example,
by requiring "good cause" to exist as a basis for the termination), by
requiring the franchisor to give advance notice to the franchisee of the
10
termination and give the franchisee an opportunity to cure any default, and
by requiring the franchisor to repurchase the franchisee's inventory or
provide other compensation. To date, those laws have not precluded the
Company from seeking franchisees in any given area and have not had a
material adverse effect on the Company's operations.
Each Schlotzsky's store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties or
failures in obtaining the required licenses or approvals can delay and
sometimes prevent the opening of a new store.
Schlotzsky's stores must comply with federal and state environmental
regulations, such as those promulgated under the Federal Water Pollution Act,
Federal Clean Water Act of 1977 and the Federal Resource and Conservation
Recovery Act of 1976, but the Company believes that those regulations have
not had a material effect on their operations. More stringent and varied
requirements of local governmental bodies with respect to zoning, land use,
and environmental factors can delay and sometimes prevent development of new
stores in particular locations.
The Company and its franchisees must comply with the Fair Labor
Standards Act and various state laws governing various matters, such as
minimum wages, overtime and other working conditions. Significant numbers of
the food service personnel in Schlotzsky's stores receive compensation at
rates related to the federal minimum wage and, accordingly, increases in the
minimum wage increase labor costs at those locations.
The Company and its franchisees also must comply with the provisions of
the Americans with Disabilities Act, which requires that employers provide
reasonable accommodation for employees with disabilities and that restaurants
be accessible to customers with disabilities.
EMPLOYEES
As of December 31, 1999, the Company employed 240 persons at its
corporate headquarters and 805 persons at Company-owned restaurants. None of
the Company's employees is covered by a collective bargaining agreement or is
represented by any labor union. The Company believes its relationship with
its employees is good.
RISK FACTORS
In addition to the other information contained in this report, the
following factors should be considered carefully in evaluating the Company:
FORWARD LOOKING STATEMENTS. This report contains statements that
constitute "forward-looking statements" within the meaning of Section 27A of
the Securities Act of 1933, as amended (the "Securities Act" and Section 21E
of the Securities Exchange Act of 1934, as amended (the "Exchange Act")). The
words "expect," "estimate," "anticipate," "contemplate," "predict,"
"believe," "intend," "plan," "project" and similar expressions and variations
thereof are intended to identify forward-looking statements. Such statements
appear in a number of places in this Report and include statements regarding
the intent, belief or current expectations of the Company, its directors or
its officers with respect to, among other things: (i) trends affecting the
Company's financial condition or results of operations; (ii) the Company's
financing plans; (iii) the Company's business and growth strategies,
including strategies related to the Company's Turnkey Program and plans to
reduce the level of interim financing provided during the purchasing and
construction phase of Turnkey Program store development; (iv) plans
concerning the Company's relationship with its area developers; and (v) the
declaration and payment of dividends. Shareholders and prospective investors
are cautioned that any such forward-looking statements are not guaranties of
future performance and involve risks and uncertainties, and that actual
results may differ materially from those projected in the forward-looking
statements as a result of various factors. The accompanying information
contained in this Report including, without limitation, the information set
forth under the headings "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and "Business," as well as information
contained in the Company's other filings with the Securities and Exchange
Commission (the "Commission"), identify important factors that could cause
such differences.
RAPID GROWTH STRATEGY. During 1999, 66 new Schlotzsky's stores were
opened. During 1997 and 1998, the Company and its franchisees opened 120 and
107 stores, respectively. This level of store openings is greater than that
experienced by the Company prior to 1995. The Company relied primarily upon
its franchisees, area
10
developers, the Turnkey Program, and new geographic markets to accomplish
this level of expansion. During 1999, the Company implemented more stringent
criteria in its restaurant site selection process in an effort to increase
sales potential at new locations. It is contemplated that this will result in
fewer openings than were experienced from 1995 to 1998. The number of
openings and the performance of new stores will depend on various factors,
including: (i) the availability of suitable sites for new stores; (ii) the
ability to recruit financially and operationally qualified franchisees; (iii)
the ability of franchisees to negotiate acceptable lease or purchase terms
for new locations, obtain capital required to construct, build-out and
operate new stores, meet construction schedules, and hire and train qualified
store personnel; (iv) the establishment of brand awareness in new markets;
and (v) the ability of the Company to manage this anticipated expansion. Not
all of these factors are within the control of the Company, and there can be
no assurance that the Company will be able to maintain its growth or that the
Company will be able to manage its expanding operations effectively. See
"Business -- Strategy."
TURNKEY PROGRAM. As of December 31, 1999, the Company had developed 149
stores under the Turnkey Program, twenty-one of which were developed during
1999. The Company expects that the Turnkey Program will continue to produce
approximately 30% to 40% of new store development. There can be no assurance
that results experienced to date are indicative of future performance under
the program. The Company may be unable to sell properties acquired under the
Turnkey Program at a profit or at its cost, and the Company could be required
to sell properties at a loss or hold properties indefinitely, diminishing the
capital available to reinvest in the Turnkey Program. The Company may also be
unable to obtain permanent third party financing for interim loans made to
the Company's franchisees, which would further diminish capital available for
the Turnkey Program. During 1999, the Company terminated certain real estate
purchase contracts and wrote off a significantly higher level of
pre-development costs associated with those contracts than had been
experienced in previous years. Most of the sites associated with the
contracts written off no longer met current standards for Turnkey development
sites. There can be no assurance that the Company's more stringent criteria
for site selection will prevent this from recurring. See "-- Credit Risk and
Contingencies," "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources" and "Business
- -- Turnkey Program."
RELIANCE ON AREA DEVELOPERS. The Company relies on certain area
developers along with its own licensing efforts to find qualified franchisees
in their areas. Area developers are independent contractors, and are not
employees of the Company. Through 1998, most area developer agreements
specified a schedule for opening stores in the territory covered by the
agreement. In 1999, the Company eliminated the development schedule for
several area developers in connection with the buy down of their rights to
receive future franchise fees and royalties. In addition, the Company has
agreed in the past to extend or waive development schedules for certain area
developers. There can be no assurance that area developers will be able to
meet their contractual development schedules. Delays in store openings could
adversely affect the future operations of the Company.
From time to time, the Company relies extensively on certain area
developers, many of whom do not have experience operating restaurants. In
those instances, the Company has less direct involvement in recruiting
franchisees and in monitoring the quality of franchised stores. The Company
provides training and support to area developers, but the quality of store
operations and the ability of area developers to meet development schedules
may be diminished by their lack of experience. It may be difficult for the
Company to enforce its area development agreements or to terminate the area
development rights of area developers who fail to meet development schedules
or other standards and requirements imposed by the Company, limiting the
ability of the Company to develop the territories of such area developers.
See "Business -- Franchising."
Between January 1, 1997 and December 31, 1999, 103 of the 293 new stores
opened were within territories controlled by only two area developers. As of
December 31, 1999, these two area developers controlled 15 territories having
a total of 310 stores. As these territories mature, system-wide growth will
depend upon more activity in other territories. The Company believes that the
concentration of store openings among a relatively few area developers is due
primarily to the longer tenure of these area developers with the Company and
the size and maturity of the territories covered by their agreements. As the
Company has reacquired or reduced the percentages of franchise fees and
royalties payable to certain area developers, it has assumed an increasing
level of responsibility for recruiting franchisees and received less
assistance with openings from many of its area developers. In 1999, the
Company assumed responsibility for all service requirements in the
territories controlled by its largest area developer, as well as all or part
of the services performed by several other area developers. Accordingly, its
success in several markets will depend on its ability to perform functions it
had previously relied on area developers to perform.
12
DEPENDENCE ON FRANCHISING CONCEPT. Because royalties from franchisees'
sales are a principal component of the Company's revenue base, the Company's
performance depends upon the ability of its franchisees to promote and
capitalize upon the Schlotzsky's concept and its reputation for quality and
value. The Company believes that the costs to franchisees of opening
Schlotzsky's-Registered Trademark- Deli restaurants, particularly those
incurred under its more stringent site selection criteria, are higher than
the store opening costs incurred by franchisees of many of the Company's
competitors for franchisees. This necessarily limits the number of persons
who are qualified to be franchisees of the Company. The Company has
established criteria to use in evaluating prospective franchisees, but there
can be no assurance that it, or its area developers, will recruit franchisees
who have the level of business abilities or financial resources necessary to
open Schlotzsky's stores on schedule or that franchisees will conduct
operations in a manner consistent with the Company's concepts and standards.
See "Business -- Franchising."
The Company is subject to various state and federal laws relating to the
franchisor-franchisee relationship. The failure by the Company to comply with
these laws could subject the Company to liability to franchisees and to fines
or other penalties imposed by governmental authorities. The Company believes
that the franchising industry is experiencing an increasing trend of
franchisees filing complaints with state and federal governmental authorities
and instituting lawsuits against franchisors claiming that they have engaged
in unlawful or unfair trade practices or violated express or implied
agreements with franchisees. While the Company's experience is consistent
with the trends in the industry, the Company believes that it is in material
compliance with these laws and regulations and its agreements with
franchisees, and that its relations with its franchisees are generally good.
See "Business -- Government Regulation" and "-- Litigation."
IMPORTANCE OF LICENSING FEES. During the past three years, the Company's
revenue from private label licensing fees (brand contribution) has increased
significantly as the volume of system sales has increased, terms with certain
major suppliers have been renegotiated, and franchisees have increased their
participation in the Company's purchasing programs. This revenue is largely
dependent upon the voluntary participation of the franchisees. In 1999,
Schlotzsky's brand chips became available for retail purchase outside of the
restaurant system for the first time in the domestic superstores of one of
the world's largest retailers. In addition, in 1999, a new line of
Schlotzsky's-Registered Trademark- Deli meats, cheese and condiments were
test marketed in an East Texas-based grocery chain and selected other
markets. The Company will continue to explore other alternative retail
channels of distribution for some of its private label products, and
anticipates renegotiating the terms of its contracts with some of its
suppliers, but there can be no assurance that the Company will achieve any
significant or consistent revenue from such sources.
The Company believes its purchasing programs provide franchisees with
significant cost savings and other advantages. There can be no assurance that
the Company's suppliers will not increase prices to franchisees or that
franchisees will not negotiate more favorable terms from other approved
suppliers. Some franchisees may also object to these fees as a source of
revenue to the Company. Any of these developments could result in reduced
purchases by franchisees of private label products and declining private
label licensing revenue to the Company. This could have a material adverse
effect on the financial condition and results of operations of the Company.
See "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Results of Operations."
CREDIT RISK AND CONTINGENCIES. The Company guarantees certain real
estate obligations and equipment leases and other obligations of its
franchisees. The Company entered into guarantees with respect to most of the
leases between its franchisees and the buyers of the sites developed under
the Turnkey Program prior to 1999. These guarantees typically cover lease
payments and other obligations of the franchisee for a period ranging from 18
months to five years, and are effective throughout the term of the 20 year
lease. The Company guarantees a limited portion of most of the loans sold to
institutional lenders or made directly by such lenders for franchisees who
purchased Turnkey Program sites pursuant to the loan financing program which
the Company began implementing during 1998 and continued in 1999.
Under the loan financing program, the Company has made interim mortgage
loans and long-term subordinated loans to certain franchisees. See "Business
- --Turnkey Program" and "Business - Financing." At December 31, 1999, the
Company was contingently liable for approximately $34.2 million which is
principally comprised of guarantees on real estate leases and mortgages,
equipment leases and loans, and other obligations of its franchisees. The
principal amount of the loans outstanding under the loan financing program as
of December 31, 1999 was approximately $8.9 million.
13
The Company charges area developers and master licensees a fee
("developer fee") for the rights to develop a defined territory. Typically, a
portion of the developer fee has been paid in cash and the balance paid with
a promissory note from the area developer or master licensee. The Company
periodically evaluates the credit risk and obtains annual valuations of these
notes from an independent financial services institution with expertise in
valuing instruments of this sort. As of December 31, 1999, the Company held
notes receivable from area developers and master licensees in an aggregate
principal amount of approximately $9.2 million. At December 31, 1999, the
principal balance of these notes had been reserved on the financial
statements of the Company by approximately $407,000. In addition, at December
31, 1999 there was $7.7 million of deferred revenue related to these
transactions. The Company also holds notes receivable from certain
franchisees related to the sale of Company-owned stores and certain other
obligations. As of December 31, 1999, the outstanding principal amount of
these notes was approximately $17.4 million. While the Company considers it
unlikely that there will be defaults on a significant amount of the loans and
notes described above, such defaults could adversely affect the Company's
financial condition. Parties controlled by or related to directors, officers
and principal shareholders of the Company have provided financing to certain
area developers and master licensees and have guarantied obligations of
certain area developers and master licensees to the Company. See "Certain
Transactions -- Master License and Area Development Agreements" and "Business
- -- Franchising -- International Master Licensees."
A wholly owned subsidiary of the Company is the general partner of a
limited partnership that developed a retail shopping center in the Austin
area. The Company has guaranteed the repayment of a loan for this project in
the principal amount of $2.05 million due in October 2009. The Company does
not exercise control over the partnership and does not consider its
investment in the retail shopping center to represent a separate line of
business. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources."
LIMITED OPERATING HISTORY OF PROTOTYPES. Over the past several years,
the Company has refined its store prototypes and currently encourages
franchisees to develop larger, free-standing stores with higher visibility on
superior sites. This has increased the costs to franchisees of opening and
operating stores. The Company and franchisees have a limited history of
operating these prototype stores, and results achieved to date may not be
indicative of future results. There can be no assurance that, on a sustained
basis, the Company will be able to attract and retain franchisees qualified
to assume the increased debt and the management responsibility associated
with the larger operations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the Consolidated Financial
Statements of the Company and the Notes thereto.
GEOGRAPHIC CONCENTRATION. Of the 759 stores in the system at December
31, 1999, 224 were located in Texas. A downturn in the regional economy or
other significant adverse events in Texas could have a material adverse
effect on the Company's financial condition and results of operations.
CERTAIN FACTORS AFFECTING THE RESTAURANT INDUSTRY. The Company and its
franchisees may be affected by risks inherent in the restaurant industry,
including: adverse changes in national, regional or local economic or market
conditions; increased costs of labor (including increases in the minimum
wage); increased costs of food products; management problems; increases in
the number and density of competitors; limited alternative uses for
properties and equipment; changing consumer tastes, habits and spending
priorities; changing demographics; the cost and availability of insurance
coverage; uninsured losses; changes in government regulation; changing
traffic patterns; weather conditions; and local, regional or national health
and safety matters. The Company and its franchisees may be the subject of
litigation based on discrimination, personal injury or other claims,
including claims which may be based upon legislation that imposes liability
on restaurants or their employees for injuries or damages caused by the
negligent service of alcoholic beverages to an intoxicated person or to a
minor. The Company can be adversely affected by publicity resulting from food
quality, illness, injury or other health concerns or operating issues
resulting from one restaurant or a limited number of restaurants in the
Schlotzsky's system. None of these factors can be predicted with any degree
of certainty, and any one or more of these factors could have a material
adverse effect on the Company's financial condition and results of operations.
COMPETITION. The food service industry is intensely competitive with
respect to concept, price, location, food quality and service. There are many
well-established competitors with substantially greater financial and other
resources than the Company. These competitors include a large number of
national, regional and local food service companies, including fast food and
quick service restaurants, casual full-service restaurants, delicatessens,
pizza
14
restaurants and other convenience dining establishments. Some of the
Company's competitors have been in existence longer than the Company and may
be better established in markets where Schlotzsky's stores are or may be
located. The Company believes that it competes for franchisees against
franchisors of other restaurants and various other concepts.
Competition in the food service industry is affected by changes in
consumer taste, economic and real estate conditions, demographic trends,
traffic patterns, the cost and availability of qualified labor, product
availability and local competitive factors. The Company and its area
developers assist franchisees in managing or adapting to these factors, but
no assurance can be given that some or all of these factors will not
adversely affect some or all of the franchisees. See "Business --
Competition."
CONTROL BY PRINCIPAL SHAREHOLDERS. As of December 31, 1999, John C.
Wooley and Jeffrey J. Wooley beneficially owned an aggregate of approximately
15.4% of the outstanding Common Stock. Additionally, Greenfield Capital
Partners B.V. and NethCorp Investments VI B.V., entities of which Floor
Mouthaan, a director of the Company is the managing director, beneficially
owned an aggregate of 5.6% of the outstanding Common Stock. As a result,
these shareholders, if they were to act in concert, would have the ability to
influence the outcome of any issue submitted to a vote of the shareholders.
There are no agreements or understandings among these shareholders regarding
the voting of their shares, but to date they have voted consistently on
matters submitted to a vote of the shareholders.
DEPENDENCE ON MANAGEMENT AND KEY PERSONNEL. The Company's success is
highly dependent upon the efforts of its management and key personnel,
including its Chairman of the Board and President, John C. Wooley. The
Company has employment agreements with John C. Wooley and Jeffrey J. Wooley
each of which includes certain noncompetition provisions that survive the
termination of employment. The employment agreements were entered into
effective February 1998 and will expire in February 2001. The Company also
has obtained certain noncompetition agreements from several other members of
management and key personnel who are not subject to employment agreements.
However, there can be no assurance such noncompetition agreements will be
enforceable. The loss of the services of John C. Wooley or other management
or key personnel could have a material adverse effect on the Company. The
Company does not carry key man life insurance on any of its officers. See
"Management."
GOVERNMENT REGULATION. The restaurant industry is subject to numerous
federal, state and local governmental regulations, including those relating
to the preparation and sale of food and zoning and building requirements. The
Company and its area developers and franchisees are also subject to laws
governing their relationships with employees, including wage and hour laws,
and laws and regulations relating to working and safety conditions and
citizenship or immigration status. The Company's franchise operations are
subject to regulation by the United States Federal Trade Commission and the
Company must also comply with state laws relating to the offer, sale and
termination of franchises and the refusal to renew franchises. The failure to
obtain or maintain approvals to sell franchises could adversely affect the
Company. Increases in the minimum wage rate, employee benefit costs or other
costs associated with employees, could adversely affect the Company and its
area developers and franchisees. See "Business -- Government Regulation."
ABSENCE OF DIVIDENDS. The Company has never paid cash dividends on its
Common Stock and does not anticipate paying any cash dividends in the
foreseeable future.
POTENTIAL VOLATILITY OF STOCK PRICE. There have been periods of
significant volatility in the market price and trading volume of the Common
Stock, which in many cases were unrelated to the operating performance of, or
announcements concerning, the Company. General market price declines or
market volatility in the future could adversely affect the price of the
Common Stock. In addition, the trading price of the Common Stock has been and
is likely to continue to be subject to significant fluctuations in response
to variations in quarterly operating results, the results of the Turnkey
Program, changes in management, competitive factors, regulatory changes,
general trends in the industry, recommendations by securities industry
analysts and other events or factors. This volatility has been exacerbated by
the lack of a significant public float in the Common Stock. There can be no
assurance that an adequate trading market can be maintained for the Common
Stock.
SHARES ELIGIBLE FOR FUTURE SALE. As of December 31, 1999, the Company
had 7,417,714 shares of Common Stock outstanding. A substantial number of
shares will become available for sale in the public market at various
15
times. No predictions can be made as to the effect, if any, that market sales
or the availability of shares for future sale will have on the market price
of the Common Stock. Sales of substantial amounts of Common Stock in the
public market, or the perception that such sales could occur, could adversely
affect the prevailing market price for the Common Stock and could impair the
Company's ability to raise capital through a public offering of equity
securities.
ANTI-TAKEOVER PROVISIONS. The Texas Business Combination Law, which
became effective September 1, 1997, restricts certain transactions between a
public corporation and affiliated shareholders. The statute, which is
applicable to the Company, may have the effect of inhibiting a non-negotiated
merger or other business combinations involving the Company.
The Company's Articles of Incorporation and Bylaws include certain
provisions that may have the effect of discouraging or delaying a change in
control of the Company. Directors are elected for staggered three-year terms,
which has the effect of delaying the ability of shareholders to replace
specific directors or effect a change in a majority of the Board of
Directors. The Bylaws were amended in 1998 to provide that a director may
only be removed for cause by vote of the holders of at least two-thirds of
the shares present in person or by proxy at a meeting of shareholders called
expressly for that purpose. All shareholder action must be effected at a duly
called annual or special meeting of shareholders and shareholders must follow
an advance notification procedure for certain shareholder proposals and
nominations of candidates for election to the Board of Directors.
The Board of Directors has the authority, without further action by the
shareholders, to issue up to 1,000,000 shares of Preferred Stock in one or
more series and to fix the rights, preferences, privileges and restrictions
thereof, and to issue authorized unissued shares of Common Stock. The
issuance of Preferred Stock or additional shares of Common Stock could
adversely affect the voting power of the Common Stockholders and could have
the effect of delaying, deferring or preventing a change in control of the
Company. The issuance of Preferred Stock also could adversely affect other
rights of Common Stockholders, including creation of a preference upon
liquidation or upon the payment of dividends in favor of the holders of
Preferred Stock.
In December 1998, the Company announced that the Board of Directors had
adopted a Shareholder's Rights Plan and approved a dividend of one Right for
each share of Company Common Stock outstanding. Under the plan, each
shareholder of record receives one Right for each share of Common Stock held.
Initially, the Rights are not exercisable and automatically trade with the
Common Stock. There are no separate Rights certificates at this time. Each
Right entitles the holder to purchase one one-hundredth of a share of Company
Class C Series A Junior Participating Preferred Stock for $75.00 (the
"Exercise Price").
The Rights separate and become exercisable upon the occurrence of
certain events, such as an announcement that an "acquiring person" (which may
be a group of affiliated persons) beneficially owns, or has acquired the
rights to own, 20% or more of the outstanding Common Stock, or upon the
commencement of a tender offer or exchange offer that would result in an
acquiring person obtaining 20% or more of the outstanding shares of Common
Stock.
Upon becoming exercisable, the Rights entitle the holder to purchase
Common Stock with a value of $150 for $75. Accordingly, assuming the Common
Stock had a per share value of $75 at the time, the holder of a right could
purchase two shares for $75. Alternatively, the Company may permit a holder
to surrender a Right in exchange for stock or cash equivalent to one share of
Common Stock (with a value of $75) without the payment of any additional
consideration. In certain circumstances, the holders have the right to
acquire common stock of an acquiring company having a value equal to two
times the Exercise Price of the Rights.
The Rights have certain anti-takeover effects. The Rights will cause
substantial dilution to an acquiring person. Accordingly, the existence of
the Rights may deter certain acquirers from making takeover proposals or
tender offers.
In 1999, the Company entered into an Option Agreement with its largest
area developer pursuant to which it agreed that if there is a change in
control of the Company (defined to include the acquisition of at least 20% of
the outstanding common stock by someone other than John C. Wooley or Jeffrey
J. Wooley), the Company is obligated to pay between $2.8 million and $3.8
million to prevent the option to reacquire the area developer agreement from
lapsing. Such payment is applicable to the exercise price, if and when paid.
16
In December 1999, the Company entered into a Credit Agreement with Wells
Fargo Bank, (Texas), N.A., as agent for a group of lenders, pursuant to which
the Company obtained a new credit facility for up to $40,000,000, in the
aggregate. Under the Credit Agreement, the acquisition of beneficial
ownership of more than 33% of the outstanding stock of the Company by a
person or group of related persons constitutes a default, resulting in the
possible acceleration of outstanding indebtedness.
17
ITEM 2. PROPERTIES
In March 1997, the Company entered into a lease with a limited liability
company owned by John C. Wooley and Jeffrey J. Wooley for a new corporate
headquarters facility in Austin. This lease will expire in 2007. The facility
consists of approximately 41,000 square feet of office and storage space. The
Company moved to this new facility in November 1997. In addition, this
limited liability company has provided the Company with storage space over
the last ten years rent free. During that period the Company was using up to
approximately 20,000 square feet of storage. Subsequent to December 31, 1999,
the location of the space was sold and the Company had to lease another
storage location. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Results of Operations."
The Company operates 23 restaurants in eight states. Thirteen of these
stores are considered to be in the Company's portfolio of restaurants to be
held for the long term, and their operating results are reflected in the
Restaurant Operations figures. Of these units, eleven are in Texas, one is in
Georgia, and one is in New York. The remaining ten stores are considered held
for sale, and their results are included in the Turnkey Development segment.
These locations include three in Georgia, two in Texas, one in Alabama, one
in Utah, one in Mississippi, one in Arizona, and one in Illinois. The
properties consist of land, building, leasehold improvements, and restaurant
equipment. The equipment is typically owned, and the land and building is
either owned or leased.
As of December 31, 1999, the Company had 59 store sites in various
stages of development under the Turnkey Program. Development was completed on
3 sites and these sites are operating and under lease or mortgage. Nine of
the sites in development are in various stages of construction and 47 sites
remain in the pre-development stage. The Company also owns an additional five
sites, which it contemplates remarketing. It is contemplated that sites
acquired under the Turnkey Program will be sold to franchisees and investors
at various stages of development or after completion. See "Business --
Turnkey Program."
Schlotzsky's Real Estate, Inc., a wholly-owned subsidiary of the
Company, is the 1% general partner of a limited partnership which owns a
17,600 square foot shopping center in suburban Austin. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
ITEM 3. LEGAL PROCEEDINGS
The State of New Mexico Taxation and Revenue Department assessed the
Company $131,000 for gross receipts taxes, penalties and interest for the
years 1987 through 1993. The assessment imposed gross receipts taxes on
franchise fees and royalties received by the Company from New Mexico
franchisees and NAMF contributions by those franchisees. The Company filed a
protest with the New Mexico Taxation and Revenue Department claiming that the
assessment violated the Commerce Clause of the United States Constitution
because the Company does not have any physical presence in or substantial
nexus with New Mexico. In November 1999, the Company accepted an amnesty
offer from the state of New Mexico, withdrew its protest and paid $121,000 in
full satisfaction of all claims by the state through 1998. The Company had
reserved a liability for taxes and attorneys' fees in respect of this
assessment in excess of the amount paid. If other state taxing authorities
attempt to impose taxes on receipts derived by the Company from franchisees
in those states, the Company's financial condition and results of operations
could be materially adversely affected.
On February 8, 1999, the Lone Star Ladies Investment Club, et al., filed
a consolidated amended class action lawsuit in the Western District of Texas
against the Company and four of its officers and directors (Monica Gill,
Executive Vice President and Chief Financial Officer; John M. Rosillo,
director; Jeffrey J. Wooley, Senior Vice President and director; and John C.
Wooley, President and Chairman of the Board of Directors). The complaint
alleges securities fraud arising from a change in the timing of recognition
of revenue from the sale of real estate properties in connection with which
the Company provided limited guaranties on franchisees' leases of the
properties. In April 1998, Registrant announced that 1997 earnings would be
lower than previously announced because it would defer revenue received in
the fourth quarter from such real estate transactions rather than recognizing
it during the period in which the transaction occurred, as previously
contemplated. Plaintiffs seek monetary damages in an unspecified amount. On
August 5, 1999, the Defendants' Motion to dismiss the consolidated complaint
was granted, with prejudice. Plaintiffs filed a notice of appeal on September
28, 1999, and filed their appellate brief on or about December 12, 1999.
Defendants filed their brief in response on February 25,
18
2000. The Company believes that the allegations are without merit and intends
to vigorously defend against the appeal.
The Company is subject to routine litigation in the ordinary course of
business, including contract, franchisee, area developer and
employment-related litigation. In the course of enforcing its rights under
existing and former franchise agreements and area developer agreements, the
Company is subject to complaints and letters threatening litigation
concerning the interpretation and application of these agreements, for
example, in cases of administration of the NAMF advertising funds, default or
termination of franchisees or area developers, requirements or payments
relating to products used in the stores (such as private label licensing),
and the Turnkey Program. The Company endeavors to treat its franchisees and
area developers reasonably and fairly and in compliance with applicable
contractual provisions with due regard for the protection of the Company's
trademarks, service marks and goodwill. None of these routine matters,
individually or in the aggregate, are believed by the Company to be material
to its business or financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The authorized capital stock of the Company consists of 30,000,000
shares of Common Stock, no par value, and 1,000,000 shares of Class C
Preferred Stock, no par value. The Company's Common Stock is traded on the
National Market of the National Association of Securities Dealers Automated
Quotation System ("NASDAQ") under the Symbol "BUNZ". Trading began on
December 15, 1995 in connection with the Company's initial public offering.
No public market existed for the Common Stock prior to that time. As of March
14, 2000, 7,430,027 shares of outstanding Common Stock were owned by
approximately 5,700 beneficial owners constituting 270 shareholders of record.
The high and low bid prices as reported by NASDAQ for the period from
January 1, 1998 to December 31, 1999 are set forth below:
HIGH LOW
------ ------
FISCAL 1998
First Quarter................. 23 3/8 14 3/4
Second Quarter................ 22 5/8 13 3/16
Third Quarter................. 18 1/2 9 1/8
Fourth Quarter................ 11 1/4 9 1/4
FISCAL 1999
First Quarter................. 13 5/16 10
Second Quarter................ 12 1/2 10 1/8
Third Quarter................. 12 1/4 7 5/8
Fourth Quarter................ 8 1/4 6
These quotations may reflect inter-dealer prices, without retail mark-up,
mark-down or commissions and may not necessarily represent actual
transactions. The Company has never paid and has no current plans to pay cash
dividends on its Common Stock. The Company currently intends to retain
earnings for use in the operation and expansion of the Company's business and
does not anticipate paying cash dividends in the foreseeable future. The
declaration and payment of future dividends will be at the sole discretion of
the Board of Directors and will depend on the Company's profitability,
financial condition, capital needs, future prospects and other factors deemed
relevant by the Board of Directors.
On December 18, 1998, the Board of Directors adopted resolutions
regarding the designation, preferences, and rights of Class C Series A Junior
Participating Preferred Stock in connection with the adoption of a
Shareholders' Rights Plan. See "Risk Factors - Anti Takeover Provisions."
The Transfer Agent and Registrar for the Company's Common Stock is
Harris Trust and Savings Bank of Chicago, Illinois.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data for
the Company for the periods and the dates indicated. The historical
consolidated financial data as of and for the years ended December 31, 1997,
1998 and 1999 have been derived from the audited consolidated financial
statements of the Company and its predecessor entities, included elsewhere
herein. The balance sheet data and statement of operations data as of and for
the years ended December 31, 1995 and 1996 has been derived from the
Company's audited financial statements not included or incorporated herein.
The selected financial data should be read in conjunction with, and are
qualified in their entirety by, the Consolidated Financial Statements of the
Company and related Notes and other financial information included elsewhere
in this report.
20
FISCAL YEARS ENDED DECEMBER 31,
------------------------------------------------------------------
1995 1996 1997 1998 1999
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Royalties......................................... $ 7,425 $10,747 $14,561 $18,885 $21,547
Franchise fees.................................... 1,494 1,775 1,555 1,365 843
Developer fees (1)................................ 2,666 1,993 325 270 1,057
Restaurant sales.................................. 505 3,610 6,364 7,720 14,816
Brand contribution................................ 397 1,295 2,915 4,003 6,173
Turnkey development............................... 41 726 1,139 8,314 1,687
Other fees and revenue............................ 324 568 1,110 1,291 1,815
---------- ---------- ---------- ---------- ----------
Total revenue................................. 12,852 20,714 27,969 41,848 47,938
Costs and expenses:
Service costs:
Royalties....................................... 2,405 3,791 5,373 7,225 6,601
Franchise fees.................................. 767 959 813 697 389
Restaurant operations:
Cost of sales................................... 189 1,183 2,014 2,513 4,404
Labor costs..................................... 408 1,424 2,493 3,205 5,482
Operating expenses.............................. 251 1,040 1,952 2,168 3,358
Turnkey development costs......................... 332 519 368 4,806 5,164
General and administrative........................ 5,419 6,509 7,686 11,472 13,677
Depreciation and amortization..................... 458 779 1,155 1,885 2,855
---------- ---------- ---------- ---------- ----------
Total costs and expenses...................... 10,229 16,204 21,854 33,971 41,930
---------- ---------- ---------- ---------- ----------
Income from operations.......................... 2,623 4,510 6,115 7,877 6,008
Other:
Interest income ................................ 286 786 1,050 2,296 3,142
Interest expense................................ (435) (331) (297) (238) (2,279)
Other income.................................... 138 132 195 -- --
---------- ---------- ---------- ---------- ----------
Total other income (expense).................. (11) 587 948 2,058 863
---------- ---------- ---------- ---------- ----------
Income before continuing operations before
income taxes.................................... 2,612 5,097 7,063 9,935 6,871
Income taxes.................................... (1,017) (1,902) (2,614) (3,729) (2,525)
Income from continuing operations.................... 1,595 3,195 4,449 6,206 4,346
Cumulative effect of change in accounting
principle..................................... -- -- -- -- (3,820)
Extraordinary Gain.............................. 38 -- -- -- --
---------- ---------- ---------- ---------- ----------
Net income........................................... $ 1,633 $ 3,195 $ 4,449 $ 6,206 $ 526
========== ========== ========== ========== ==========
Income from continuing operations - basic .47 .58 .74 .84 .59
Income from continuing operations - diluted .42 .57 .71 .82 .58
Net income per share - basic......................... $0.47 $ 0.58 $ 0.74 $ 0.84 $ 0.07
Net income per share - diluted....................... $0.42 $ 0.57 $ 0.71 $ 0.82 $ 0.07
Working capital...................................... $18,750 $13,515 $42,563 $26,842 $16,606
Total assets......................................... 36,708 40,979 79,521 104,822 132,759
Long-term debt, less current maturities.............. 3,029 3,129 1,936 9,219 21,275
Stockholders' equity................................. 28,974 32,312 66,991 73,963 74,735
(1) Effective January 1, 1999, The Company implemented a change in accounting
principle regarding revenue recognition of developer fees. See discussion
in Item 7.
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company derives its revenue from several sources: royalties,
franchise fees, developer fees (consisting of area developer and master
licensee fees), Company-owned restaurant sales, Turnkey development, brand
contribution (private label licensing fees), and other franchise-related
activities. Between 1991 and 1994, developer fees grew to represent a
significant portion of total revenue as the Company sold development rights
for most of the television markets in the United States and certain
international territories. Franchise fees, Turnkey development and brand
contribution increased following this period as the rate at which stores
opened increased. Since the Company has sold developer rights for virtually
all of the United States, developer fees derived from these non-recurring
transactions have declined as a percentage of total revenue, while typically
brand contributions, franchise fees and royalties based on franchise store
sales and revenue from the Turnkey Program have increased.
Royalties are based on a percentage of franchisees' net sales and are
recognized by the Company in the same period that the franchise store sales
occur. Generally, royalties are earned at the rate of 6% of sales for stores
opened after 1991 and 4% of sales for stores opened before that time.
Royalties are paid by means of weekly automatic drafts by the Company on
franchisee bank accounts for 6% royalty stores. As of December 31, 1999, 92
franchised stores were paying royalties on a monthly basis at the rate of 4%.
This number of stores will decline as older franchise agreements expire (the
majority of which will expire after 2000). A portion of the royalties
received by the Company are paid to its area developers as royalty service
costs for providing on-going services to franchisees in their territories.
See "Business -- Franchising --Area Developers." Royalties have increased
since 1992 due not only to the growth in the number of stores, but also to
increases in average weekly sales. The increase in average weekly sales is
due primarily to the conversion of older franchise stores to the
Schlotzsky's-Registered Trademark- Deli restaurant concept, as well as the
selection of more free-standing locations for newer stores, which have better
visibility and generally experience higher sales than the smaller "in-line"
stores located in strip shopping centers which are characteristic of stores
opened prior to 1992.
Franchise fees are payments received by the Company from franchisees and
are typically recognized into revenue as stores open. The franchise fee for a
franchisee's initial store is currently $30,000. The franchise fee for each
additional store committed to and opened by a franchisee is $20,000. Expenses
associated with franchise fees are shown as franchise fee service costs and
include the portion of the franchise fee paid to area developers. The Company
generally pays area developers approximately one-half of the franchise fees
collected from franchisees in their development areas. As the Company
reacquires a limited number of territories and buys down the percentage of
participation by certain area developers, the Company expects that franchise
fee service costs will decrease as a percentage of franchise fees to less
than 50%.
Restaurant sales are reported from Company-owned stores, and declined
between 1991 and 1994 as a result of the Company's strategy adopted in 1991
to develop only franchised stores. The number of Company-owned stores
declined from 22 to two stores between 1990 and 1994. Restaurant sales
increased significantly in 1996 because the Company's flagship restaurant in
Austin, Texas was in operation the entire year and because two additional
stores were acquired from franchisees during 1996. As of December 31, 1999,
thirteen Company stores were being operated primarily for product
development, concept refinement, brand leadership and training franchisees.
Management does not believe that the operating costs for Company-owned stores
are necessarily indicative of costs for franchised stores on a system-wide
basis. Restaurant sales should increase as the Company continues to acquire
or open a limited number of additional Company-owned stores. See "Business --
Strategy -- Company-Owned Stores."
The Company charges developers a nonrefundable fee for the exclusive
rights to develop a defined territory for a specified term. Typically, a
portion of the developer fee is paid in cash and the balance is paid with a
promissory note. See "Business -- Franchising -- Area Developers" and "--
International Master Licensees." Prior to 1999, when the Company had
fulfilled substantially all of its contractual responsibilities and
obligations, such as training, providing manuals, and, in the case of master
licensees, reasonable efforts to obtain trademark registration, it recognized
as revenue the cash portion of the fee and the value of the promissory note,
as determined by an independent third party valuation. As a result of recent
positions taken by the Securities and Exchange Commission, the Company made a
change in its accounting policy for revenue recognition of developer fees
22
effective January 1, 1999. With the change in accounting principle, revenue
generated from developer transactions will be recognized over the term of the
development schedule within the developer contracts generally about a ten
year period. Developer fees recognized in 1997 and 1998 under the previous
accounting policy were less than in previous years as most of the remaining
domestic territories had been sold and fees from the licensing of
international territories, which are not aggressively marketed by management,
were sporadic. Fees recognized in 1999 primarily represent amortization of
prior years' fees pursuant to the change in accounting principle.
Revenue is also generated from brand contribution (private label
licensing fees) and the Turnkey Program. The Company has licensed
manufacturers to produce Schlotzsky's private label products and began
receiving licensing fees from sales of private label foods to franchisees in
late 1994. This revenue has increased significantly to $2,915,000 for 1997,
$4,003,000 for 1998 and $6,173,000 for 1999. The Company believes that
private label licensing fees will increase as a greater portion of the
systems' menu ingredients are covered by the program, system-wide sales grow,
terms with various suppliers are renegotiated and alternative channels of
distribution are exploited. See "Business -- Purchasing; Private Labeling"
and "Risk Factors -- Importance of Licensing Fees."
The Company instituted the Turnkey Program to further assist franchisees
in obtaining superior sites and to achieve more rapid penetration in those
selected major markets where the Company believes there is strong demand by
franchisees for good locations. Under the Turnkey Program, the Company works
independently or with an area developer to identify superior store sites
within a territory. The Company will typically perform various consulting
services including, but not limited to, site selection, feasibility analysis,
environmental studies, site work, permitting and construction management,
receiving a fee and recognizing revenue upon the completion of these
services. The Company may assign its earnest money contract on a site to a
franchisee, or a third-party investor, who then assumes responsibility for
developing the store. The Company may also purchase or lease a selected site,
design and construct a Schlotzsky's-Registered Trademark- Deli restaurant on
the site and sell, lease or sublease the completed store to a franchisee.
Where the Company does not sell the property to a franchisee, the Company
sells the improved property, or, in the case of a leased property, assigns
the lease and any sublease, to an investor.
The Company anticipates that the total investment in each developed
free-standing location will be approximately $1,300,000 to $2,400,000 (less
for leased locations). From inception of the Turnkey Program through 1997,
the Company typically provided a credit enhancement in the form of a limited
guaranty on the franchisee's lease for leased locations. Upon sale of the
leased site or assignment of its earnest money contract, the Company has
deferred revenue generated (even though proceeds were received in cash) and
allocable costs incurred in connection with the property. When a lease
guaranty is terminated, or the Company's exposure to loss under the guaranty
has passed, the Company recognizes the revenue and allocable costs related to
the site. Generally, if no credit enhancement is provided in connection with
such transactions, the Company may recognize the revenue and allocable
expenses in the periods in which the transactions occur. During 1998, the
Company began emphasizing ownership of the real estate by franchisees through
a program which entails acquiring the rights to a superior site and reselling
the property, or its rights (with any improvements), to a franchisee whose
mortgage loan is financed by a third party financial institution. The Company
provides credit enhancement for the franchisee in the form of a limited
guaranty in favor of the lender. Generally, in those cases, the Company
recognizes the revenue and allocable expenses in the period in which the
transaction occurs. In some cases, the Company may interim finance land and
building costs in anticipation of permanent financing by a financial
institution. The Company believes that the Turnkey Program enhances the
Company's ability to recruit qualified franchisees by securing and developing
high profile sites and achieving critical mass for advertising purposes more
quickly in selected markets. In addition, the Company charges a fee when it
is requested to manage construction of a store on property owned by a
franchisee or an investor. This construction management fee is recognized
when the store is completed.
23
The following table sets forth (i) the percentage relationship to total
revenue of the listed items included in the Company's consolidated statements of
operations, except as otherwise indicated, and (ii) selected store data.
FISCAL YEARS ENDED DECEMBER 31,
---------------------------------------------
1997 1998 1999
------------ ------------ ------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Royalties......................................... 52.1% 45.1% 44.9%
Franchise fees.................................... 5.6 3.3 1.8
Developer fees.................................... 1.2 0.6 2.2
Restaurant sales.................................. 22.7 18.4 30.9
Brand contribution................................ 10.4 9.6 12.9
Turnkey development............................... 4.1 19.9 3.5
Other fees and revenue............................ 3.9 3.1 3.8
------------ ------------- ------------
Total revenue................................. 100.0 100.0 100.0
Costs and expenses:
Service costs:
Royalties(1).................................... 36.9 38.3 30.6
Franchise fees(2)............................... 52.3 51.1 46.1
Restaurant operations:
Cost of sales(3)................................ 31.6 32.6 29.7
Labor costs(3).................................. 39.2 41.5 37.0
Operating expenses(3)........................... 30.7 28.1 22.7
Turnkey development costs (4) .................... 32.3 57.8 306.1
General and administrative........................ 27.5 27.4 28.5
Depreciation and amortization..................... 4.1 4.5 6.0
Total costs and expenses...................... 78.1 81.2 87.5
------------ ------------- ------------
Income from operations.......................... 21.9 18.8 12.5
Other:
Interest income................................. 3.8 5.5 6.6
Interest expense................................ (1.1) (0.6) (4.8)
Other income (expense).......................... 0.7 0.0 0.0
------------ ------------- ------------
Total other income............................ 3.4 4.9 1.8
------------ ------------- ------------
Income before income taxes and cumulative effect of
change in accounting principle.................. 25.3 23.7 14.3
Provision for income taxes...................... 9.3 8.9 5.3
------------ ------------- ------------
Income before cumulative effect of change
in accounting principle......................... 15.9% 14.8% 9.1%
============ ============= ============
Cumulative effect of change in accounting principle,
net of tax..................................... -- -- (8.0%)
------------ ------------- ------------
Net income.......................................... 15.9% 14.8% 1.1%
============ ============= ============
STORE DATA:
System-wide sales(5)........................... $270,400 $348,500 $400,300
Change in same store sales(6).................. 3.4% 3.1% 2.8%
Weighted average annual store sales(7)......... $455,000 $503,000 $550,000
Weighted average weekly store sales(7)......... $ 8,753 $ 9,671 $ 10,579
Change in average weighted weekly
store sales(8) .............................. 11.3% 10.5% 9.4%
Number of stores opened during period.......... 120 107 66
Number of stores closed during period.......... 20 30 57
Number of stores in operation at end
of period.................................... 673 750 759
- --------------------------------------------
(1) Expressed as a percentage of royalties.
(2) Expressed as a percentage of franchise fees.
(3) Expressed as a percentage of restaurant sales.
24
(4) Expressed as a percentage of Turnkey development.
(5) In thousands. Includes sales for all stores, as reported by franchisees or
derived by the Company from other data reported by franchisees.
(6) Same store sales are based upon stores which were open for the entire
period indicated and for at least eighteen months as of the end of the
corresponding prior period, including stores which were temporarily closed
and reopened within six months.
(7) In actual dollars (rounded in the case of average annual store sales).
(8) Percentage change in weighted average weekly store sales from previous
fiscal year.
RESULTS OF OPERATIONS
FISCAL YEAR 1999 COMPARED TO 1998
REVENUE. Total revenue increased 14.6% from $41,848,000 to $47,938,000.
Royalties increased 14.1% from $18,885,000 to $21,546,000. This increase
was due to the full year impact of stores opened in 1998 and the addition of
66 restaurants opened during the period from January 1, 1999 to December 31,
1999. Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, a 9.4% increase in average weekly
sales and a 2.8% increase in same store sales. In addition, this increase is
directly related to the 14.9% increase in system sales. Royalties increased
at a lower rate during 1999 than 1998, primarily due to 57 closings which
occurred during 1999. However, the majority of closings tended to be
underperforming stores and stores that had been temporarily closed and the
franchisee had not made any significant effort to reopen or relocate within
the time required by the franchise agreement. In addition, the Company's
first national, network television advertising campaign was completed in 1999
impacting sales for the system.
Franchise fees decreased 38.2% from $1,365,000 to $843,000. This
decrease was a result of 41 fewer openings during 1999, as compared to 1998.
The fewer number of openings is principally the result of the Company's
increasing emphasis on superior site selection for larger freestanding stores
with higher visibility and on more highly qualified and better capitalized
franchisees.
Developer fees increased 291.5% from $270,000 to $1,057,000. While the
level of developer transactions increased, developer fees reported for the
year are primarily attributable to recognition of deferred revenue from
transactions which occurred prior years due to the change in accounting
principle. As a result of the change, developer fees are now being recognized
over the term of the development schedules. Because of the change in the
accounting principle, the Company anticipates that revenue recognized from
developer fees will be a more consistent amount from period to period during
the next several years.
Restaurant sales increased 91.9% from $7,720,000 to $14,816,000. This
increase was attributable to Company-owned stores added during 1998 and the
addition of five stores to the Company portfolio during 1999. In the future,
it is contemplated that several more Company-owned stores will be developed,
operated and maintained by the Company in certain key markets, but that the
total number of Company units will remain at a small percentage of the
franchise system.
Private label licensing fees (brand contributions) increased 54.2% from
$4,003,000 to $6,173,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well
as the increasing volume of system-wide sales and greater franchisee
participation in the Company's purchasing programs. In addition, sales of
private label products through alternative channels of distribution was
greater than it had been in previous years, but still constituted less than
2.4% of the fees recognized in 1999.
Turnkey development revenue decreased 79.7% from $8,314,000 to
$1,687,000. In 1999, the Company placed less emphasis on generating a
material margin on the transactions it completed, but rather focused on
bringing the best value in terms of project cost to its franchisees, while
recovering some portion of its overhead cost. In addition, in 1998,
$2,102,000 of the revenue was related to transactions completed in 1997
involving the Company's lease guaranties, which were terminated in 1998. The
1999 revenue includes approximately $363,000 of rental revenue from sites
completed and under lease. The Company anticipates that Turnkey development
may remain at this lower level in the future as a greater emphasis is placed
on superior sites and controlling the cost to franchisees of each project.
25
Other fees and revenues increased 40.8% from $1,289,000 to $1,815,000.
This change was primarily due to the increased level of supplier
contributions to the Company's annual convention held in June 1999, and a
one-time gain on the sale of the Company's limited partnership interest in an
entity that owns a small shopping center in suburban Austin, Texas.
COSTS AND EXPENSES. Royalty service costs decreased 8.6% from $7,225,000
to $6,601,000, and as a percentage of royalties declined from 38.3% to 30.6%.
This decrease reflects the impact of the reacquisition and reduction of
certain area developers interests in royalties during 1999. Area developers
generally receive approximately 42% or 21% of the royalties from stores in
their territories (depending on whether their share of royalties is 2.5% or
1.25%). The Company expects royalty service costs as a percentage of royalty
revenue to continue to decrease because the Company recently assumed
territory management responsibility for its largest area developer in
conjunction with an option to buy its territories (exercisable until 2012).
Under this option agreement, net service costs associated with this territory
management are 1% of royalties effective October 31, 1999 and escalate to 2%
by August 16, 2004, versus the current 2.5% rate. The Company may buy-down
the rights and obligations of certain area developers and may re-acquire the
full development rights to a limited number of territories over the next few
years.
Restaurant cost of sales, which consists of food, beverage and paper
costs, increased 75.2% from $2,513,000 to $4,404,000, but as a percentage of
restaurant sales decreased from 32.6% to 29.7%. Restaurant labor costs
increased 71.0% from $3,205,000 to $5,482,000, but as a percentage of
restaurant sales decreased from 41.5% to 37.0%. Restaurant operating expenses
increased 54.9% from $2,168,000 to $3,358,000, but, again, as a percentage of
restaurant sales decreased from 28.1% to 22.7% for 1999, as compared to 1998.
These percentage decreases were primarily due to operational efficiencies
experienced and cost controls implemented in the management of the
Company-owned stores. The decreases are also due to the increasing sales
outpacing the increased costs associated with operating the units.
Turnkey development costs increased 7.4% from $4,806,000 to $5,164,000
and as a percentage of Turnkey development revenue increased from 57.8% to
306.1%. These increases are primarily the result of fewer revenue
transactions in 1999 compared to 1998. In addition the Company experienced
approximately $900,000 in write-offs of Turnkey development costs associated
with sites under contract which were removed from consideration during the
period. Most of the sites written off either demonstrated higher than
expected development costs or no longer met current, more stringent standards
for Turnkey development sites.
General and administrative expenses increased 19.2% from $11,471,000 to
$13,678,000, and as a percentage of total revenue remained relatively stable
at 28.5%. The Company previously announced its goal of maintaining year 2000
general and administrative expenses at about the 1999 level.
Depreciation and amortization increased 51.5% from $1,885,000 to
$2,856,000, and as a percentage of revenue increased from 4.5% to 6.0%. The
dollar and percentage increases were principally due to amortization of
goodwill and other intangibles acquired in 1998 and 1999, such as area
developer territories and certain franchise rights, and depreciation related
to the additional stores the Company was operating during the year.
Interest income increased 36.9% from $2,296,000 to $3,142,000. This
increase was a result of a greater level of funds outstanding in the form of
Turnkey Mortgages and interim construction financing under the Turnkey
Program and an increase in the notes receivable related to the sale of
limited development rights. The Company plans to reduce the level of interim
construction financing by referring franchisees to third party financing
sources.
Interest expense increased 858% from $238,000 to $2,279,000. This
increase was the result of a greater level of debt outstanding during the
current period. The Company expects interest expense will trend slightly
upward as a result of the 1999 debt financing used to fund the re-acquisition
of certain area developer rights.
INCOME TAX EXPENSE. Income tax expense reflects a combined federal and
state effective tax rate of 36.8% for 1999, which is slightly lower than the
effective combined tax rate for the comparable period in 1998. Based on
projections of taxable income, the Company anticipates that its effective
combined rate for federal and state taxes will remain fairly stable.
26
FISCAL YEAR 1998 COMPARED TO 1997
REVENUE. Total revenue increased 49.6% from $27,969,000 to $41,848,000.
Royalties increased 29.7% from $14,561,000 to $18,885,000. This increase
was due to the full year impact of stores opened in 1997 and the addition of
107 restaurants opened during the period from January 1, 1998 to December 31,
1998. Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, a 10.5% increase in average
weekly sales and a 3.1% increase in same store sales.
Franchise fees decreased 12.2% from $1,555,000 to $1,365,000. This
decrease was a result of 13 fewer openings during 1998, as compared to 1997.
The fewer number of openings is principally the result of the Company's
increasing emphasis on superior site selection for larger freestanding stores
with higher visibility and on more highly qualified and better capitalized
franchisees.
Developer fees decreased 16.9% from $325,000 to $270,000. This decrease
was primarily the result of less emphasis on these transactional fees and the
fact that the development rights to most domestic markets have been sold. The
change in accounting principle did not affect revenue recognition of
developer fees.
Restaurant sales increased 21.3% from $6,364,000 to $7,720,000. This
increase was attributable to a 6.2% increase in sales volume at the Company's
flagship store and the relocation and reopening of two Company-owned stores
during 1998.
Private label licensing fees (brand contributions) increased 37.3% from
$2,915,000 to $4,003,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well
as the increasing volume of system-wide sales and greater franchisee
participation in the Company's purchasing programs.
Turnkey development revenue increased from $1,139,000 to $8,314,000. In
contrast with 1997 when 33 of 40 Turnkey Program transactions involved the
Company's credit enhancement on franchisee leases, only five of the 69
Turnkey Program transactions involved such lease guaranties in 1998. Of the
$8,314,000, $2,102,000 was related to transactions completed during 1997
involving the Company's lease guaranties, which were terminated during 1998.
The remainder of the transactions in 1998 involved sales of rights to real
estate to franchisees or investors (who acquired with the objective of
selling developed properties to franchisees). Revenue in 1998 also included
approximately $258,000 of rental revenue from sites completed and under lease.
Other fees and revenues increased 16.1% from $1,110,000 to $1,289,000.
This change was primarily due to the increased level of supplier
contributions to the Company's annual convention held in July 1998.
COSTS AND EXPENSES. Royalty service costs increased 34.5% from
$5,373,000 to $7,225,000. This increase was a direct result of the increase
in royalty revenue for 1998, as compared to 1997. Royalty service costs as a
percentage of royalties grew from 36.9% to 38.3%. This increase reflects the
growing percentage of restaurants serviced by the area developer system and
whose area developers received approximately 42% of the royalties from the
stores in their territories.
Restaurant cost of sales, which consists of food, beverage and paper
costs, increased 24.8% from $2,014,000 to $2,513,000, and as a percentage of
restaurant sales increased from 31.6% to 32.6%. Also, restaurant labor costs
increased 28.6% from $2,493,000 to $3,205,000, and as a percentage of
restaurant sales increased from 39.2% to 41.5% for the same period in 1997.
These percentage increases were primarily due to operational inefficiencies
experienced in re-opening two Company-owned stores. Restaurant operating
expenses have increased 11.1% from $1,952,000 to $2,168,000, but as a
percentage of restaurant sales decreased from 30.7% to 28.1% for 1998, as
compared to 1997. This decrease is due to the increasing sales outpacing the
increased costs associated with operating the new stores.
Turnkey development costs increased from $368,000 to $4,806,000 and as a
percentage of Turnkey development revenue increased from 32.3% to 57.8%.
These increases are primarily the result of $1,063,000 of costs deferred in
1997 being recognized in 1998, the addition of staff to the Turnkey Program
in late 1997 and during 1998 and certain costs being recognized for sites no
longer being pursued.
27
General and administrative expenses increased 49.3% from $7,686,000 to
$11,471,000, and as a percentage of total revenue remained relatively stable
at 27.4%.
Depreciation and amortization increased 63.1% from $1,156,000 to
$1,885,000, and as a percentage of revenue increased from 4.1 to 4.5%. This
dollar increase was principally due to amortization of goodwill and other
intangibles acquired in 1997 and 1998, and depreciation related to the
additional stores the Company was operating during the year.
OTHER. Net interest income increased 173.3% from $753,000 to $2,058,000.
This increase was a result of funds being loaned for Turnkey mortgages and
interim construction financing under the Turnkey Development Program.
INCOME TAX EXPENSE. Income tax expense reflects a combined federal and
state effective tax rate of 37.5% for 1998, which is slightly higher than the
effective combined tax rate for the comparable period in 1997.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $4,297,000 for 1999. Accounts
payable and accrued liabilities decreased $6,671,000, primarily because of
development territory purchases that were accrued in 1998 and funded in 1999.
The Company used only a net $2,791,000 of cash primarily in continuing its
construction and mortgage program for the Turnkey Program. Net cash of
$32,547,000 was used in investing activities primarily consisting of the
reacquisition of certain area developer rights and the royalty stream
associated with them. Also, the Company completed three Company owned stores
and used net cash of $5,629,000 to loan to the franchise system for national
advertising.
At December 31, 1999, the Company had approximately $40,730,000 of debt
outstanding. During 1999, the Company borrowed approximately $26,134,000 in
connection with the re-acquisition of certain domestic development rights and
drew on its line of credit to fund Turnkey development activities. During
1998, the Company had borrowed $5,000,000 primarily in connection with the
re-acquisition of certain domestic development rights. As of December 31,
1999, the Company had drawn substantially all of the $15,000,000 available
under the Company's line of credit from a financial institution to finance
Turkey Program capital requirements. In December 1999, the Company announced
it had obtained a new credit facility for up to $40,000,000, consisting of
$35,000,000 to refinance (i) repurchases of certain area developers'
interests in royalties into a long term facility, and (ii) renewal of a
revolving line of credit used to develop Company restaurants and restaurants
being developed through the Turnkey Program. The remaining $5,000,000
supports a letter of credit benefiting the Schlotzsky's National Advertising
Association, Inc. in its purchase of national television advertising. The
credit facility imposes a number of covenants on the Company, including
limitations on additional borrowings, capital expenditures, contingent
liabilities, and requirements to maintain certain financial ratios, working
capital and net worth. While the Company is currently in compliance with
these covenants, failure to do so would have material adverse consequences to
the Company. These notes bear interest at rates ranging from the lender's
prime interest rate to 10.6% and all mature by the end of 2001.
The Company guaranties certain real estate leases, equipment leases and
other obligations of franchisees. At December 31, 1999, these contingent
liabilities totaled approximately $34,249,000. Included in this amount is a
construction loan for a limited partnership in which the Company and its
subsidiary, Schlotzsky's Real Estate, Inc., own a combined 10% interest in
capital and profits. The loan, for which the Company is liable for the full
amount, had a balance of approximately $2,048,000 at December 31, 1999, bears
interest at prime plus 1.25% and matures January 2016. Monthly payments are
being made by the limited partnership.
The Company plans to develop additional Company-owned stores in the next
18 months in the Austin market and certain selected other markets. Funds of
approximately $10,000,000 are estimated to be required for the development of
these Company-owned stores. The Company anticipates funding these
developments through long-term financing or available working capital.
28
The Company continues to refine its Turnkey Program and expects that it
will have 30 to 80 sites under contract or at various stages of development
at any given time. The Company has used the net proceeds from its public
offerings and the proceeds from sites sold and contracts assigned to finance
the activity of the Turnkey Program to date. Even with a lower level of
anticipated activity in the Turnkey Program, the capital required to finance
the Turnkey Program will be significant. The tables below provide a summary
of Turnkey Program activity since its inception and a summary of the status
of the Turnkey Program at December 31, 1999.
FOR THE YEAR ENDED
DECEMBER 31,
Turnkey Program revenue consists of the following: ----------------------------------------------
1997 1998 1999
------------ ------------ -----------
Sales to investors and franchisees............................ $ 31,361,869 $ 29,596,310 $ 5,520,693
Development and construction management fees.................. 190,000 176,562 --
------------ ------------ -----------
Gross Turnkey Program revenue............................ 31,551,869 29,772,872 5,520,693
Turnkey Program development costs............................. (28,829,065) (23,382,340) (4,228,655)
------------ ------------ -----------
Net revenue from Turnkey Program projects................ 2,722,804 6,390,532 1,292,038
Rental income................................................. 303,091 258,187 363,386
Interim construction interest................................. 1,270 238,888 31,731
Deferred revenue recognized................................... -- 1,426,819 --
Revenue deferred.............................................. (1,888,555) -- --
------------ ------------ -----------
Total Turnkey Program revenue............................ $ 1,138,610 $ 8,314,426 $ 1,687,155
============ ============ ===========
The following table reflects system performance of the Turnkey Program
for the years ended December 31, 1998 and 1999.
NUMBER OF UNITS
---------------
1998 1999
---- ----
Sites in process at beginning of year........................... 78 86
Sites beginning development during the year..................... 122 55
Sites removed from consideration during the period.............. (41) (68)
Sites inventoried as Company-owned stores....................... (1) (2)
Sites inventoried as real estate or restaurants held for sale... (2) --
Sites sold - revenue recognized................................. (69) (9)
Sites sold - revenue deferred................................... -- --
Other........................................................... (1) (3)
---- ----
Sites in process at end of year................................. 86 59
==== ====
INVESTED AT
DECEMBER 31,
1999
------------
Sites under development or to be sold........................... 4 9 $ 8,325,000
Predevelopment Site (prequalification).......................... 82 50 1,895,000
---- ---- ------------
Total....................................................... 86 59 $ 10,130,000
==== ==== ============
The Company believes that cash flow from operations, together with the
proceeds of the Turnkey Program, collections from notes receivable and
borrowings under existing credit facilities described above will be sufficient
to meet the Company's anticipated operating cash needs for the foreseeable
future.
YEAR 2000 COMPLIANCE
The year 2000 issue is a result of many computer programs being written
using two digits, e.g. "99", to define a year. Date-sensitive software may
recognize the year "00" as the year 1900 rather than the year 2000. This
would result in errors and miscalculations or even system failure causing
disruptions in business activities and transactions.
29
The Company's computer software programs utilize four digits to define
the applicable calendar year and therefore the Company believes that it has
no material internal risk concerning the Year 2000 issue. The Company
received responses from many of its major restaurant equipment suppliers
indicating that they and the products they sell to the Company's restaurant
system also have no material internal risk from the Year 2000 issue. To date,
none of the Company's major suppliers have indicated that they have
experienced or that they anticipate material internal risks. The Company is
continuing an in-depth inquiry concerning the readiness of its major
suppliers and those of the restaurant system. The Company has assessed and,
where practicable, attempted to mitigate its risks with respect to the
failure of these entities to be Year 2000 compliant. The Company attempted to
educate its franchise system during 1999 to prepare them to anticipate Year
2000 issues which could affect them locally. The Company believes that its
costs associated with monitoring readiness and mitigating risks concerning
the Year 2000 issue have not been material. There can be no assurance that
third parties will continue to be Year 2000 compliant. The impact on the
Company's operations, if any, from the inability of any of its suppliers and
franchisees to Year 2000 compliant is not reasonably estimable (except that
if there is a national or regional crisis in the financial, transportation or
utility infrastructure, it would likely adversely affect most commercial
enterprises, including the Company.)
QUARTERLY COMPARISONS
Since the adoption of the Schlotzsky's-Registered Trademark- Deli
restaurant concept in 1991, the Company has experienced growth in royalties
and franchise fees. Store openings typically mark the recognition of
franchise fees and the beginning of the royalty stream to the Company.
Accordingly, a large number of store openings has a significant impact on the
amount and timing of revenue. The timing of store openings can also affect
the same store sales and other period-to-period comparisons. There were 135
store openings in 1996, 120 in 1997, 107 in 1998 and 66 in 1999. At July 1,
1995, the initial franchise fee was increased from $17,500 to $20,000 and was
further increased to $30,000 effective August 1, 1998. The net profitability
from developer fees is substantially higher than that derived from royalties
and franchise fees because of the relatively lower costs associated with
developer fees.
Effective January 1, 1999, the Company changed its accounting policy
related to revenue recognition of developer fees. Prior to 1999, the Company
recognized developer fee revenue at the time the agreement was executed, its
obligations substantially completed, and the fee paid. This was typically in
the period in which the transaction occurred. However, based on a recent
change of its position related to these types of fees by the Securities and
Exchange Commission, the Company made a change in accounting principle
whereby revenue generated from developer transactions will be recognized over
the term of the development schedule specific to each contract. The change in
accounting principle will result in these fees being recognized over an
average of an approximately ten years. This change was made effective January
1, 1999. The quarterly results for 1999 reflect the application of this new
accounting principle. In addition, the first quarter of 1999 reflects the
cumulative effect of the change in accounting principle of $3,820,000 (net of
tax) for the impact of the change for developer transactions that occurred
prior to 1999. It is anticipated that as a result of the change in accounting
principle, and the growth of the royalty base, revenue from developer fees
will be fairly stable in actual dollars for the next several years but will
decline as a percentage of total revenue. Moreover, the Company anticipates
that other revenue will also continue to increase contributing to a further
decline in revenue recognized from developer fees will decline as a
percentage of total revenue, resulting in more normalized margins. The
Company also believes restaurant sales and private label licensing fees
(brand contributions) will continue to increase as a percentage of revenue.
In 1997, the Company recorded a significant fourth quarter adjustment
related to activities within the Turnkey Program. The adjustment included the
deferral of approximately $1,889,000, representing the excess of proceeds
received of approximately $24,268,000 over the related development costs of
approximately $22,380,000, in connection with the transfer of title or
assignment of earnest money contracts on 33 Turnkey Program properties to
various third-party investors. Revenue is deferred only in those Turnkey
Program transactions for which the Company provides a credit enhancement to
the third-party investor in the form of a guaranty on the franchisee lease
assigned at the same time that the sale or assignment of the property occurs.
The Company also deferred certain costs of approximately $894,000 associated
with the acquisition, development and, in some instances, construction of the
Turnkey Program properties. The applicable tax effect of the adjustments was
approximately $368,000. During 1998, only five of the 69 Turnkey Program
transactions involved the Company's guaranty on franchisees' leases with
third party investors who acquired properties from the Company. Accordingly,
most of the revenue from Turnkey Program transactions during 1998 was
recognized in the period in which the transactions occurred. Turnkey Program
revenue in 1999 was a result of transactions that involved the sale of the
site or land contract to a franchisee. Revenue for 1999 also included
approximately $363,000 of rental revenue.
30
Management believes that the Company experiences only moderate
seasonality. The Company attempts to make store sales less seasonal by
offering a variety of products which tend to sell better during various
seasons.
The following table presents unaudited quarterly results of operations
for the 1997, 1998 and 1999 fiscal years.
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
PRESENTATION OF QUARTERLY FIGURES
1997 1998 1999
------------------------------ --------------------------------- ----------------------------------
1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH
(Dollars in thousands, except per share data)
REVENUES:
Royalties $3,278 $3,606 $3,820 $3,858 $4,259 $ 4,720 $ 4,875 $ 5,032 $ 5,014 $ 5,560 $ 5,631 $ 5,341
Franchise fees 353 240 411 551 340 380 340 305 245 193 205 200
Developer fees (1) -- 125 -- 200 -- -- -- 270 228 243 282 305
Restaurant sales 1,324 1,439 1,636 1,965 1,616 1,885 1,745 2,475 2,543 3,839 4,233 4,201
Brands contribution 535 807 791 783 860 1,006 1,052 1,085 1,201 1,602 1,712 1,659
Turnkey development 685 762 1,374 (1,683) 1,125 1,732 2,845 2,612 670 160 420 437
Other fees and revenue 160 361 312 276 254 590 207 238 296 318 441 759
------------------------------- --------------------------------- ---------------------------------
Total revenues 6,335 7,340 8,344 5,950 8,454 10,313 11,064 12,017 10,197 11,915 12,924 12,902
COSTS AND EXPENSES 4,969 5,575 6,405 4,906 6,812 8,216 9,052 9,890 8,778 10,603 11,342 11,208
------------------------------- --------------------------------- ---------------------------------
OPERATING INCOME 1,366 1,765 1,939 1,044 1,642 2,097 2,012 2,127 1,419 1,312 1,582 1,694
NET INCOME BEFORE
CUMULATIVE EFFECT OF
CHANGE
IN ACCOUNTING PRINCIPLE 889 1,162 1,234 1,164 1,342 1,571 1,582 1,712 1,187 924 1,109 1,126
CUMULATIVE EFFECT OF CHANGE
IN ACCOUNTING PRINCIPLE
(NET OF TAX) -- -- -- -- -- -- -- -- (3,820) -- -- --
------------------------------ --------------------------------- ----------------------------------
NET INCOME/(LOSS) $ 889 $1,162 $1,234 $1,164 $1,342 $ 1,571 $ 1,582 $ 1,712 $(2,633) $ 924 $1,109 $1,126
============================== ================================= ==================================
INCOME PER COMMON SHARE
-BASIC
INCOME BEFORE CUMULATIVE
EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE $ 0.16 $ 0.21 $ 0.22 $ 0.16 $ 0.18 $ 0.21 $0.21 $ 0.23 $0.16 $0.12 $0.15 $0.15
CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING
PRINCIPLE -- -- -- -- -- -- -- -- (0.52) -- -- --
------------------------------ --------------------------------- ----------------------------------
NET INCOME/(LOSS) $ 0.16 $ 0.21 $ 0.22 $ 0.16 $ 0.18 $ 0.21 $0.21 $0.23 $(0.36) $0.12 $0.15 $0.15
============================== ================================= ==================================
INCOME PER COMMON SHARE -
DILUTED
INCOME BEFORE CUMULATIVE
EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE $ 0.16 $ 0.21 $ 0.21 $ 0.15 $ 0.18 $ 0.21 $0.21 $0.23 $0.16 $0.12 $0.15 $0.15
CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING
PRINCIPLE -- -- -- -- -- -- -- -- (0.51) -- -- --
------------------------------ --------------------------------- ----------------------------------
NET INCOME/(LOSS) $ 0.16 $ 0.21 $ 0.21 $ 0.15 $ 0.18 $ 0.21 $0.21 $0.23 $(0.35) $0.12 $0.15 $0.15
============================== ================================= ==================================
STORE OPENINGS 29 21 28 42 30 31 24 22 17 18 17 14
- ----------
(1) The quarterly amounts shown for 1999 differ from those reported in the
Forms 10-Q for the first three quarters. The amounts originally reported
have been revised to reflect the impact of the change in accounting
principle implemented January 1, 1999 as discussed by Note 1 to the
financial statements.
31
IMPACT OF INFLATION
The Company believes that inflation did not have a material impact on its
operations for the periods reported. Significant increases in labor, employee
benefits, food costs and other operating expenses could have a material
adverse effect on franchisees' store operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Changes in short-term interest rates on loans from financial institutions
could materially affect the Company's earnings because the underlying
obligations are either variable, or fixed for such a short period of time as
to effectively become variable.
At December 31, 1999 a hypothetical 100 basis point increase in interest
rates would result in a reduction of approximately $350,000 in annual pre-tax
earnings. The estimated reduction is based upon the increased interest expense
of our variable rate debt and assumes no change in the volume or composition
of debt at December 31, 1999. The fair values of the Company's bank loans are
not significantly affected by changes in market interest rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the financial statements referred to in the index on
page F-1 setting forth the Consolidated Financial Statements of Schlotzsky's,
Inc. and Subsidiaries, together with the report of Grant Thornton LLP dated
February, 2000.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On May 8, 1998, the Company reported on Form 8-K that Coopers & Lybrand
L.L.P., the Company's auditors for fiscal years 1994 through 1997, resigned
effective May 4, 1998. Their reports on the financial statements never
contained an adverse opinion, disclaimer of opinion, and were never qualified
or modified as to uncertainty, audit scope or accounting principles.
The Company has never been advised by Coopers & Lybrand that (1)
internal controls necessary for the Company to develop reliable financial
statements did not exist; (2) Coopers & Lybrand would no longer be able to
rely on management's representations or that it was unwilling to be associated
with the financial statements prepared by management; (3) Coopers & Lybrand
needed to expand significantly the scope of its audit; (4) Coopers & Lybrand
had received information which did or which might, if further investigated,
impact the fairness or reliability of a report or financial statement
previously issued or to be issued or which did or might cause Coopers &
Lybrand to be unwilling to rely on management's representations or be
associated with the Company's financial statements; or (5) Coopers & Lybrand
did not conduct such further investigation or expanded audit, or was not able
to resolve its concerns about the Company, because of its pending resignation
as the Company's accountant or any other reason.
On April 28, 1998, Coopers & Lybrand informed the Company that there was
a disagreement with management concerning the timing of the recognition of
revenue from certain of the Company's Turnkey Program transactions. The
transactions at issue were fiscal year 1997 sales of real estate with leases
to franchisees guaranteed by the Company. The issue was resolved to Coopers &
Lybrand's satisfaction before the filing of the Company's Annual Report on
Form 10-K. The issue was discussed with the Audit Committee of the Board of
Directors, and the Company authorized Coopers & Lybrand to discuss the issue
with the Company's successor accountants. A letter from Coopers & Lybrand
L.L.P. expressing agreement with the Company's statements in such report on
Form 8-K was included as an exhibit to such report.
On June 19, 1998, the Company reported on Form 8-K that on June 18,
1998, Grant Thornton LLP was engaged by the Company's Board of Directors as
the new independent accountant of the Company to replace Coopers & Lybrand
L.L.P. During the two fiscal years, and any interim period, preceding June 18,
1998, neither the Company nor anyone on its behalf consulted Grant Thornton
LLP on accounting principles, audit opinions or financial reporting matters.
32
The Company requested Grant Thornton LLP to review the disclosures
required in the report on Form 8-K before it was filed with the Commission and
provided them with the opportunity to furnish the Company with a letter
addressed to the Commission containing any new information, or any
clarification of the Company's views or statements by Grant Thornton LLP that
it did not agree with the statements made in the report. Grant Thornton LLP
informed the Company that it reviewed the disclosures and did not intend to
furnish the Company with such a letter.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with regard to directors and executive officers and their
business experience is set forth under "Election of Directors" in the
Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders
to be held on May 26, 2000, and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
Information with regard to executive compensation and pension or similar
plans is set forth under "Compensation of Directors" and "Compensation of
Executive Officers" in the Registrant's definitive Proxy Statement for the
Annual Meeting of Shareholders to be held on May 26, 2000, and is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with regard to security ownership of certain beneficial
owners and management is set forth under "Security Ownership of Certain
Beneficial Owners and Management" in the Registrant's definitive Proxy
Statement for the Annual Meeting of Shareholders to be held on May 26, 2000,
and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with regard to certain relationships and related transactions
is set forth under "Election of Directors; Certain Relationships and Related
Transactions," in the Registrant's definitive Proxy Statement for the Annual
Meeting of Shareholders to be held on May 26, 2000, and is incorporated herein
by reference.
33
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS. Reference is made to the index on page F-1 for a
list of all financial statements filed as part of this Report.
(a)(2) FINANCIAL STATEMENTS SCHEDULES. Reference is made to the index on page
F-1 for a list of all financial statement schedules filed as part of this
Report.
(a)(3) EXHIBITS
--------
3.1 -- Articles of Incorporation of the Registrant, as amended. (1)
3.2 -- Statement of Resolutions Regarding the Designation, Preferences and Rights of Class C Series A
Junior Participating Preferred Stock of the Registrant. (2)
3.3 -- Bylaws of the Registrant, as amended.(3)
4.1 -- Specimen stock certificate evidencing the Common Stock. (1)
4.2 -- Schlotzsky's, Inc. Employee Stock Purchase Plan. (4)
4.3 -- Rights Agreement by and between Schlotzsky's, Inc. and Harris Trust and Savings Bank dated
December 18, 1998. (2)
10.1 -- Form of Unit Franchise Agreement entered into by the Registrant and franchisees.(1)
10.2 -- Form of Unit Development Agreement entered into by the Registrant and franchisees.(1)
10.3 -- Form of Area Developer Agreement entered into by the Registrant and area developers.(1)
10.4 -- Form of Master License Agreement entered into by the Registrant and area master licensees.(1)
10.5(a) -- Form of Territorial Agreement entered into by the Registrant and master licensees.(1)
10.5(b) -- Form of Master Development Agreement entered into by the Registrant and master licensees.(1)
10.6 -- Preferred Stock Repurchase Agreement, dated October 1993, among the Company, John C. Wooley,
Jeffrey J. Wooley, and the purchasers of Class A Preferred Stock.(1)
10.7 -- Preferred Stock Purchase Agreement, dated July 20, 1994, among the Registrant and the
purchasers.(1)
10.8 -- Registration Rights Agreement, dated July 20, 1994, by and between the Registrant and the
shareholders named therein.(1)
10.9 -- Second Amended Agreement among Shareholders, dated July 20, 1994, by and among the Registrant
and the Shareholders described therein.(1)
10.10 -- Loan/Compromise and Settlement Agreement, dated April 7, 1994,
between the Federal Deposit 10.10 Insurance Corporation as Receiver of Bank of
the Hills, Austin, Texas, and the Registrant.(1)
10.11 -- Promissory Note, dated May 18, 1993, of the Registrant to First State Bank, Austin, Texas in
the original principal amount of $381,249.99.(1)
10.12(a) -- Promissory Note, dated April 15, 1993, of the Registrant to Janet P. Newberger and Lester Baum,
as trustees of the 1992 Newberger Family Trust, in the original principal amount of $750,000.(1)
10.12(b) -- Promissory Note, dated March 31, 1994, by and between the Registrant and Janet P. Newberger and
Lester Baum, co-trustees of the 1992 Newberger Family Trust.(1)
10.12(c) -- Second Modification Agreement, dated effective December 31, 1994, by and between the Registrant
and Janet P. Newberger and Lester Baum, as trustees of the 1992 Newberger Family Trust.(1)
10.12(d) -- Promissory Note, dated September 6, 1995, of the Registrant to JanMor Corporation, in the
original principal amount of $400,000.(1)
10.13 -- Promissory Note, dated February 1, 1995, of the Registrant to
Liberty National Bank, Austin, Texas in the original principal
amount $220,000, Security Agreement, dated February 1, 1995 and
Guaranty, dated February 1, 1995, by and between John C. Wooley and Liberty National Bank.(1)
10.14 -- Real Estate Lien Note and Deed of Trust, Security Agreement and Financing Statement, dated
March 31, 1995, of the Registrant to Texas Bank, N.A. in the original principal amount of
$500,000.(1)
10.15 -- Promissory Note, dated April 14, 1995, between the Registrant and First State Bank in the
original principal amount of $2,000,000.(1)
10.16 -- Promissory Note and Security Agreement, dated July 15, 1993, of the Registrant to R. M. Wilkin,
Inc. in the original principal amount of $450,000.(1)
36
10.17 -- Commitment Letter, dated July 7, 1995, by and between AT&T Commercial Finance Corporation and
the Registrant in an amount not to exceed $1,100,000.(1)
10.18 -- Term Sheet, dated July 19, 1995 by and between BeneVent-Noro and the Registrant.(1)
10.19 -- Promissory Note, dated December 1, 1994, by and between Bee Cave/Westbank, Ltd. and Liberty
National Bank in the original principal amount of $1,150,000.(1)
10.20 -- Loan Commitment, dated July 18, 1995, by and between Manns Capital Corporation and Bee
Cave/Westbank, Ltd., and Letter Amendment to Permanent Loan Commitment, dated July 28, 1995.(1)
10.21 -- Promissory Note, dated August 18, 1995, by and between the Registrant and First State Bank in
the original principal amount of $850,000.(1)
10.22 -- Operating Lease for 218 South Lamar, dated May 27, 1994, by and between William C. Pfluger, et
al. and Schlotzsky's Restaurants, Inc.(1)
10.23 -- Lease Agreement, September 8, 1995, by and between the Registrant and Austin CBD 29, Inc.(1)
10.24 -- Deed of Trust and Real Estate Lien Note, dated December 31, 1993, by and between Schlotzsky's
Real Estate, Inc. and Austin CBD Block 29, Ltd.(1)
10.25(a) -- Franchise Financing Program Procedures for Qualified Franchisees, dated April 15, 1994, by and
between Captec Financial Group, Inc. and the Registrant.(1)
10.25(b) -- Ultimate Net Loss Agreement, dated April 15, 1994, by and between the Registrant and Captec
Financial Group, Inc.(1)
10.25(c) -- Amendment to Ultimate Net Loss Agreement, dated March 30, 1995.(1)
10.26(a) -- Franchise finance letter of understanding, dated February 21, 1994, by and between Stephens
Franchisee Finance and the Registrant.(1)
10.26(b) -- Franchisee Financing Agreement, dated September 1, 1994, between the Registrant and Stephens
Diversified Leasing, Inc.(1)
10.27 -- Agreement, dated July 1, 1994, by and among Thomas Development Corporation, Micardo, Inc. and
the Registrant.(1)
10.28 -- Earnest Money Contract, dated May 20, 1994, among Schlotzsky's Real Estate, Inc., William C.
Pfluger, et al., Schlotzsky's Restaurants, Inc., the Registrant and John C. Wooley.(1)
10.29 -- Unsecured Promissory Note, dated June 29, 1993, from John C. Wooley payable to the Registrant
in the original principal amount of $280,000.(1)
10.30 -- Unsecured Promissory Note, dated June 29, 1993, from Jeffrey J. Wooley payable to the
Registrant in the original principal amount of $150,000.(1)
10.31 -- Unsecured Promissory Note, dated January 1, 1993, from John C. Wooley payable to the Registrant
in the original principal amount of $319,712.45.(1)
10.32 -- Unsecured Promissory Note, dated January 1, 1993, from Jeffrey J. Wooley payable to the
Registrant in the original principal amount of $76,540.93.(1)
10.33 -- Unsecured Promissory Note, dated February 6, 1995, from John C. Wooley payable to the
Registrant in the original principal amount of $131,000.(1)
10.34 -- Unsecured Promissory Note, dated February 6, 1995, from Jeffrey J. Wooley payable to the
Registrant in the original principal amount of $6,000.(1)
10.35(a) -- Schlotzsky's, Inc. 1993 Third Amended and Restated Stock Option Plan of the Registrant. (5)
10.35(b) -- Amendments to 1993 Third Amended and Restated Stock Option Plan. (4)
10.36(a) -- Employment Agreement, dated as of March 1, 1998, by and between the Registrant and John C.
Wooley. (6)
10.36(b) -- Employment Agreement, dated as of March 1, 1998, by and between the Registrant and Jeffrey J.
Wooley. (6)
10.36(c) -- Employment Agreement, dated January 1, 1994, by and between the Registrant and Kelly R.
Arnold.(1)
10.36(d) -- Employment Agreement, dated January 1, 1994, by and between the Registrant and Karl D.
Martin.(1)
10.37(a) -- Indemnity Agreement, dated June 30, 1993, by and between the Registrant and John C. Wooley.(1)
10.37(b) -- Indemnity Agreement, dated June 30, 1993, by and between the Registrant and Jeffrey J.
Wooley.(1)
10.38 -- Form of Indemnification Agreement for Directors and Officers of the Registrant.(1)
10.39 -- Schlotzsky's 1995 Nonemployee Directors Stock Option Plan, and form of Stock Option
38
Agreement.(1)
10.40 -- Warrant Certificate, dated March 31, 1994, of the Registrant to William C. Pfluger for 75,000
warrants.(1)
10.41 -- Confidentiality Agreement, dated December 8, 1989, by and between Bunge Foods Corporation and
Schlotzsky's Franchising Limited Partnership.(1)
10.42 -- Real Estate Lien Note dated December 31, 1993, from CBD Block 29, Ltd. to Schlotzsky's Real
Estate, Inc. in the original principal amount of $302,209.12.(1)
10.43 -- Promissory Note, dated October 4, 1995, from the Registrant to First State Bank, Austin, Texas
in the original principal amount of $576,000.(1)
10.44 -- Promissory Note dated October 25, 1995, from the Registrant to United Bank & Trust in the
original principal amount of $500,000.(1)
10.45 -- Promissory Note dated November 1995 from Registrant and Schlotzsky's Restaurants, Inc. to AT&T
Commercial Finance Corporation in the original principal amount of $1,100,000.(1)
10.46 -- Promissory Note dated November 17, 1995 from Registrant to Comerica Bank -- Texas in the
original principal amount of $245,000.(1)
10.47 -- Form of Guaranty between Schlotzsky's, Inc. and landlord with respect to Turnkey restaurants.
(7)
10.48 -- Form of Tenant Acknowledgment with Indemnification between Schlotzsky's Real Estate, Inc. and
Franchisee concerning Turnkey restaurants. (7)
10.49 -- Form of Promissory Note from franchisee/borrower to Schlotzsky's Real Estate, Inc.(8)
10.50 -- Form of Loan Agreement between franchisee/borrower and Schlotzsky's Real Estate, Inc.(8)
10.51 -- Form of Assignment of Note and Lien from Schlotzsky's Real Estate, Inc. to mortgage lender.(8)
10.52 -- Form of Limited Guaranty between Schlotzsky's, Inc. and mortgage lender with respect to Turnkey
restaurants.(8)
10.53 -- Credit Agreement, as amended, with Wells Fargo.(8)
10.54 -- Credit Agreement with Texas Capital Bank, N.A. (9)
10.55 -- Option Agreement between DFW Restaurant Transfer Corp. and NS Associates I, Ltd. (10)
10.56 -- Management Agreement between DFW Restaurant Transfer Corp. and NS Associates I, Ltd. (10)
10.57* -- Credit Agreement with Wells Fargo Bank (Texas), National Association, as agent.
18 -- Letter regarding change in accounting principle
21.1* -- List of subsidiaries of the Registrant.
23.1* -- Consent of Grant Thornton LLP.
27.1* -- Financial Data Schedule - fiscal year ending 1999.
- ----------
* Filed herewith.
(1) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-1 (File No. 33-98004) filed with the Securities and Exchange
Commission on October 12, 1995, as amended, and incorporated herein by
reference.
(2) Previously filed as a Exhibit to the Registrant's Registration of certain
Classes of Securities on Form 8-A filed with the Securities and Exchange
Commission on December 18, 1998 and incorporated herein by reference.
(3) Previously filed as an Exhibit to the Registrant's Report on Form 8-K filed
December 18, 1998 and incorporated herein by reference.
(4) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-8 (File No. 333-57077) filed with the Securities and Exchange
Commission on June 17, 1998, as amended, and incorporated herein by
reference.
(5) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-1 (File No. 333-34921) filed with the Securities and Exchange
Commission on September 4, 1997, as amended, and incorporated herein by
reference.
(6) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form
10-Q filed with the Securities and Exchange Commission on November 16, 1998
and incorporated herein by reference.
(7) Previously filed as an Exhibit to the Registrant's Annual Report on Form
10-K filed with the Securities and Exchange Commission on April 14, 1998,
as amended, and incorporated herein by reference.
(8) Previously filed as an Exhibit to the Registrant's Annual Report on Form
10-K filed with the Securities and Exchange Commission on March 31, 1999
and incorporated herein by reference.
(9) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form
10-Q filed with the Securities and Exchange Commission on August 16, 1999.
(10) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form
10-Q filed with the Securities and Exchange Commission on November 12,
1999.
38
(b) REPORTS ON FORM 8-K
None
39
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934 as amended, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.
SCHLOTZSKY'S, INC.
By: /s/
-----------------------------------
John C. Wooley,
Chairman of the Board and
Chief Executive Officer
Date: March 30, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE CAPACITY DATE
--------- -------- ----
/s/
- -------------------------------------------------------
John C. Wooley Chairman of the Board and March 30, 2000
Chief Executive Officer
(Principal Executive Officer)
/s/
- -------------------------------------------------------
Monica L. Gill Chief Financial Officer, Treasurer March 30, 2000
and Executive Vice President
(Principal Financial Officer and
Principal Accounting Officer)
/s/
- -------------------------------------------------------
Jeffrey J. Wooley Director, Senior Vice President March 30, 2000
and Secretary
/s/
- -------------------------------------------------------
John M. Hester Controller March 30, 2000
/s/
- -------------------------------------------------------
John L. Hill, Jr. Director March 30, 2000
/s/
- -------------------------------------------------------
Azie Taylor Morton Director March 30, 2000
/s/
- -------------------------------------------------------
Raymond A. Rodriguez Director March 30, 2000
/s/
- -------------------------------------------------------
Floor Mouthaan Director March 30, 2000
40
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Consolidated Financial Statements:
Report of Independent Certified Public Accountants.................................................... F-2
Consolidated Balance Sheets at December 31, 1998 and 1999 ............................................ F-3
Consolidated Statements of Income for the years ended
December 31, 1997, 1998 and 1999................................................................... F-4
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1997, 1998 and 1999................................................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1998 and 1999................................................................... F-6
Notes to Consolidated Financial Statements............................................................ F-7
Financial Statement Schedule:
Report of Independent Accountants..................................................................... S-1
Schedule II - Valuation and Qualifying Accounts....................................................... S-2
All other schedules are omitted as the required information is not
applicable or the information is presented in the consolidated financial
statements, related notes or other schedules.
F-1
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors
Schlotzsky's, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of
Scholotzsky's, Inc. (a Texas corporation) and Subsidiaries as of December 31,
1999 and 1998, and the related consolidated statements of income,
stockholders' equity, and cash flows for each of the three years in the
period ended December 31, 1999. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Schlotzsky's, Inc. and Subsidiaries as of December 31, 1999 and 1998, and the
consolidated results of their operations and their consolidated cash flows
for each of the three years in the period ended December 31, 1999, in
conformity with accounting principles generally accepted in the United States.
As discussed in Note 1 to the financial statements, the Company changed
its method of revenue recognition for Developer fees.
GRANT THORNTON LLP
Dallas, Texas
March 2, 2000
F-2
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
DECEMBER 31,
---------------------------
1998 1999
----------- ----------
Cash and cash equivalents......................................................... $15,384,991 $4,895,302
Temporary cash investments........................................................ 1,439,077 18,000
Receivables from Turnkey Program Development...................................... 1,229,468 51,603
Royalties receivable.............................................................. 762,141 1,306,465
Notes receivable, current portion................................................. 4,246,574 5,737,363
Real estate and restaurants held for sale, current portion........................ -- 7,909,870
Turnkey notes and other receivables, current portion.............................. 13,326,956 8,908,286
Other receivables................................................................. 3,086,065 4,480,022
Prepaid expenses and other assets................................................. 572,996 1,326,405
Turnkey Program development....................................................... 5,924,562 10,130,175
Deferred Federal income tax asset................................................. 617,499 1,021,828
------------ ------------
Total current assets.................................................... 46,590,329 45,785,319
Property, equipment and leasehold improvements, net............................... 18,529,746 19,861,420
Real estate and restaurants held for sale, less current portion................... 9,215,485 5,985,937
Notes receivable, less current portion............................................ 6,875,915 13,239,897
Turnkey notes and other receivables, less current portion......................... 2,185,429 --
Notes receivable from related parties, less current portion....................... 2,609,775 8,257,528
Investments and advances.......................................................... 1,530,947 564,446
Deferred Federal income tax asset................................................. -- 1,615,959
Intangible assets, net............................................................ 16,815,059 36,541,153
Other noncurrent assets........................................................... 469,069 907,722
------------ ------------
Total assets............................................................ $104,821,754 $132,759,381
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable - trade.......................................................... $4,752,369 $5,527,504
Current maturities of long-term debt.............................................. 5,382,585 19,455,430
Deferred revenue, current portion................................................. -- 1,206,206
Accrued liabilities............................................................... 9,613,593 2,990,522
------------ ------------
Total current liabilities............................................... 19,748,547 29,179,662
Deferred revenue, less current portion............................................ 1,298,486 7,570,095
Deferred Federal income tax liability............................................. 593,614 --
Long-term debt, less current maturities........................................... 9,218,515 21,275,043
------------ ------------
Total liabilities....................................................... 30,859,162 58,024,800
Commitments and contingencies
Stockholders' equity:
Preferred stock:
Class C--no par value
Authorized--1,000,000 shares; issued--none................................... -- --
Common stock, no par value, 30,000,000 shares authorized, 7,401,942
and 7,427,714 issued at December 31, 1998 and 1999, respectively............ 62,877 63,135
Additional paid-in capital...................................................... 57,533,997 57,779,291
Retained earnings............................................................... 16,470,718 16,997,155
Treasury stock (10,000 shares), at cost......................................... (105,000) (105,000)
------------ ------------
Total stockholders' equity.............................................. 73,962,592 74,734,581
------------ ------------
Total liabilities and stockholders' equity.............................. $104,821,754 $132,759,381
------------ ------------
------------ ------------
The accompanying notes are an integral part of the consolidated financial statements.
F-3
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
-----------------------------------------
1997 1998 1999
----------- ----------- -----------
Revenue:
Royalties........................................................ $14,561,377 $18,885,390 $21,546,495
Franchise fees................................................... 1,554,585 1,365,000 843,333
Developer fees................................................... 325,000 270,380 1,057,499
Restaurant sales................................................. 6,364,042 7,720,432 14,815,504
Brand contribution............................................... 2,915,233 4,003,247 6,173,389
Turnkey program development...................................... 1,138,610 8,314,426 1,687,155
Other fees and revenue........................................... 1,110,289 1,289,037 1,815,041
----------- ------------ ------------
Total revenues........................................... 27,969,136 41,847,912 47,938,416
Expenses:
Service costs:
Royalties..................................................... 5,373,151 7,225,320 6,600,899
Franchise fees................................................ 812,625 697,250 388,500
Restaurant operations:
Cost of sales................................................. 2,014,096 2,513,156 4,403,842
Labor costs................................................... 2,493,478 3,205,225 5,482,218
Operating expenses............................................ 1,951,618 2,167,784 3,358,236
Turnkey development costs........................................ 367,656 4,806,099 5,163,896
General and administrative....................................... 7,685,858 11,471,412 13,677,516
Depreciation and amortization.................................... 1,155,600 1,884,854 2,855,647
----------- ------------ ------------
Total expenses........................................... 21,854,082 33,971,100 41,930,754
----------- ------------ ------------
Income from operations................................... 6,115,054 7,876,812 6,007,662
Other:
Interest income.................................................. 1,049,938 2,296,023 3,142,647
Interest expense................................................. (296,978) (237,761) (2,279,116)
Other income..................................................... 195,661 -- --
----------- ------------ ------------
Income before income taxes and cumulative effect of
change in accounting principle......................... 7,063,675 9,935,074 6,871,193
Provision for income taxes......................................... 2,614,260 3,728,609 2,525,164
----------- ------------ ------------
Income before cumulative effect of change in
accounting principle................................... 4,449,415 6,206,465 4,346,029
Cumulative effect of change in accounting principle, net of tax.... -- -- (3,819,592)
----------- ------------ ------------
Net Income............................................... $ 4,449,415 $ 6,206,465 $ 526,437
----------- ------------ ------------
----------- ------------ ------------
Income per common share - basic:
Income before cumulative effect of change in accounting principle.. $ 0.74 $ 0.84 $ 0.59
Cumulative effect of change in accounting principle................ -- -- (0.52)
----------- ------------ ------------
Net Income................................................ 0.74 0.84 0.07
----------- ------------ ------------
----------- ------------ ------------
Income per common share - diluted:
Income before cumulative effect of change in accounting principle.. $ 0.71 $ 0.82 $ 0.58
Cumulative effect of change in accounting principle................ -- -- (0.51)
----------- ------------ ------------
Net Income................................................ $ 0.71 $ 0.82 $ 0.07
----------- ------------ ------------
----------- ------------ ------------
Proforma amounts assuming the change in accounting principle is
applied retroactively (1997 and 1998 amounts are unaudited) ......
Net Income................................................ $ 4,931,511 $ 6,999,226 $ 4,346,029
Basic income per share.................................... $ 0.82 $ 0.95 $ 0.59
Diluted income per share.................................. $ 0.79 $ 0.92 $ 0.58
Weighted average shares outstanding - basic...................... 5,994,403 7,382,983 7,409,496
Weighted average shares outstanding - diluted.................... 6,229,369 7,577,407 7,476,199
The accompanying notes are an integral part of the consolidated financial statements.
F-4
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
COMMON STOCK
--------------------------- ADDITIONAL TOTAL
NUMBER OF STATED CAPITAL PAID-IN RETAINED TREASURY STOCKHOLDERS'
SHARES AMOUNT CAPITAL EARNINGS STOCK EQUITY
----------- -------------- ----------- ------------ ------------ -------------
Balance, January 1, 1997................. 5,539,922 $ 44,257 $26,493,165 $ 5,774,599 $ -- $32,312,021
Public sale of stock..................... 1,731,825 17,318 29,615,201 -- -- 29,632,519
Options exercised........................ 57,201 572 485,802 40,239 -- 526,613
Warrants exercised....................... 5,468 55 69,936 -- -- 69,991
Net income............................... -- -- -- 4,449,415 -- 4,449,415
--------- ------------- ----------- ----------- ----------- -----------
Balance, December 31, 1997............... 7,334,416 62,202 56,664,104 10,264,253 -- 66,990,559
Options exercised........................ 44,089 441 399,175 -- -- 399,616
Warrants exercised....................... 23,437 234 224,761 -- -- 224,995
Treasury stock purchase (10,000 shares) . -- -- -- -- (105,000) (105,000)
Tax benefit from employee stock
transactions........................... -- -- 245,957 -- -- 245,957
Net income............................... -- -- -- 6,206,465 -- 6,206,465
--------- ------------- ----------- ----------- ----------- -----------
Balance, December 31, 1998............... 7,401,942 62,877 57,533,997 16,470,718 (105,000) 73,962,592
Options exercised........................ 5,825 58 52,887 -- -- 52,945
Tax benefit from employee stock
transactions........................... -- -- 25,072 -- -- 25,072
Issuance of common stock in connection
with employee stock purchase plan...... 19,947 200 167,335 -- -- 167,535
Net income............................... -- -- -- 526,437 -- 526,437
--------- ------------- ----------- ----------- ----------- -----------
Balance, December 31, 1999............... 7,427,714 $ 63,135 $57,779,291 $16,997,155 $ (105,000) $74,734,581
========= ============= =========== =========== =========== ===========
The accompanying notes are an integral part of the consolidated financial statements.
F-5
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
----------------------------------------------
1997 1998 1999
------------ ---------- --------------
Cash flows from operating activities:
Income before cumulative effect of change in accounting
principle........................................................ $ 4,449,415 $6,206,465 $ 4,346,029
Adjustments to reconcile income before cumulative effect adjustment
to net cash provided by operating activities:
Depreciation and amortization.................................... 1,155,600 1,884,854 2,855,647
Bad debt expense................................................. 100,000 972,724 1,246,401
Financed fees.................................................... (272,003) (2,250,000) (5,016,250)
Payments received on financed fees............................... 743,534 409,150 515,643
Other............................................................ (308,632) (175,553) 95,000
Changes in assets and liabilities:
Royalties and other receivables................................ (6,995,423) 218,880 (760,416)
Prepaid expenses and other assets.............................. (336,748) 11,514 (276,105)
Turnkey program development.................................... 1,621,773 (19,918,229) (2,790,694)
Other noncurrent assets........................................ (188,915) -- (503,653)
Deferred revenue............................................... 1,191,615 (1,556,894) 2,662,105
Deferred federal income tax asset.............................. 26,988 556,575 --
Accounts payable and accrued liabilities....................... 4,420,923 7,124,284 (6,670,818)
------------ ---------- --------------
Net cash provided by (used in) operating activities.......... 5,608,127 (6,516,230) (4,297,111)
------------ ---------- --------------
Cash flows from investing activities:
Expenditures for property and equipment............................ (7,436,003) (17,245,185) (7,668,434)
Sale of property and equipment..................................... 1,655,123 146,861 1,553,498
Acquisition of investments and intangible assets................... (2,721,814) (8,712,762) (21,072,889)
Sale of investments and intangible assets.......................... -- -- 2,699,913
Advances on notes receivable....................................... (693,100) (5,838,021) (44,689,244)
Collections on notes receivable.................................... 627,032 12,313,822 40,837,126
Sale of/(acquisitions) of investments.............................. (190,928) (1,421,077) 1,421,077
Advances to limited partnership, stockholders, and affiliates...... (37,940) (188,431) (10,855,191)
Distributions and collections from limited partnership,
stockholders and affiliates...................................... -- -- 5,226,659
------------ ---------- --------------
Net cash used in investing activities........................ (8,797,630) (20,944,793) (32,547,485)
------------ ---------- --------------
Cash flows from financing activities:
Sale of stock...................................................... 30,073,141 -- --
Repurchase of stock................................................ -- (105,000) --
Stock issue costs.................................................. (440,622) -- --
Options and warrants exercised..................................... 596,604 624,611 220,480
Proceeds from issuance of notes payable and long-term debt......... 1,112,709 16,060,000 48,475,524
Principal payments on notes payable and long-term debt............. (2,537,239) (4,987,645) (22,341,097)
------------ ---------- --------------
Net cash provided by (used in) financing activities.......... 28,804,593 11,591,966 26,354,907
------------ ---------- --------------
Net increase (decrease) in cash and cash equivalents................. 25,615,090 (15,869,057) (10,489,689)
Cash and cash equivalents at beginning of year....................... 5,638,958 31,254,048 15,384,991
------------ ---------- --------------
Cash and cash equivalents at end of year............................. $31,254,048 $15,384,991 $ 4,895,302
============ =========== ==============
The accompanying notes are an integral part of the consolidated financial statements.
F-6
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Schlotzsky's, Inc. and Subsidiaries (the "Company") is a franchisor of
quick service restaurants ("Schlotzsky's-Registered Trademark-Deli") that
feature made-to-order sandwiches, which has 759 Company-owned and franchised
stores located in 37 states, the District of Columbia, Argentina, Australia,
Bahrain, Canada, China, Germany, Guatemala, Lebanon, Malaysia, Morocco, Saudi
Arabia, Turkey and Venezuela. Approximately 30% of franchised stores are
located in Texas. In addition, the Company had granted territorial rights to
Area Developers located in all 50 states and to Master Licensees in 49
foreign countries for a fee which is typically payable in cash and promissory
notes receivable generally collateralized by the related territorial rights.
The Company also operates a Turnkey Development Program (the "Turnkey
Program") to further assist franchisees in obtaining store sites.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts
of Schlotzsky's, Inc., a Texas corporation, and its wholly-owned
subsidiaries. All significant intercompany balances and transactions are
eliminated in consolidation.
REVENUE RECOGNITION AND CHANGE IN ACCOUNTING PRINCIPLE
Effective January 1, 1999, the Company changed its accounting policy
related to revenue recognition of developer fees. Prior to 1999, the Company
recognized developer fee revenue at the time the agreement was executed, its
obligations substantially completed, and the fee paid. This was typically in
the period in which the transaction occurred. However, as a result of recent
positions taken by the Securities and Exchange Commission, the Company made a
change in accounting principle whereby revenue generated from developer
transactions will be recognized over the term of the development schedule
specific to each contract. The change in accounting principle will result in
these fees being recognized over an average of ten years. The Company
considers the new revenue recognition method to result in a better matching
of revenues and obligations related to such revenues. The effect of the
change in 1999 resulted in the deferral of $6,062,845 of net revenue
previously recognized in prior years. 1999 income before the cumulative
effect adjustment included $1,057,499 of amortized deferred net revenue
related to developer fees. This change was reported as a cumulative effect of
change in accounting principle for $3,819,592 (net of $2,243,253 in income
tax benefits) and is included in 1999 net income.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH EQUIVALENTS
Cash equivalents include unrestricted highly liquid investments
purchased with an original maturity date of three months or less. At December
31, 1998 and 1999, cash equivalents totaling approximately $11,232,000 and
$4,755,000, respectively, consisted primarily of money market accounts and
overnight repurchase agreements.
TEMPORARY CASH INVESTMENTS
F-7
Temporary cash investments include amounts invested in certificates of
deposit with an original maturity date of greater than three months.
F-8
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
RECEIVABLES FROM TURNKEY PROGRAM DEVELOPMENT
Receivables from Turnkey Program development are comprised of amounts
held in escrow on behalf of the Company at title companies or institutional
investors.
TURNKEY NOTES AND OTHER RECEIVABLES
Turnkey notes receivable consist of mortgage, draw notes and
construction receivables relating to the sale of Turnkey sites and funding of
construction of Turnkey units, respectively.
NOTES RECEIVABLE
Notes receivable consist of Area Developer, Master Licensee, and
Franchisee promissory notes. As of December 31, 1998 and 1999, the Company
has recorded a valuation allowance of approximately $593,000 and $407,000,
respectively.
PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements are stated at cost, net
of accumulated depreciation and amortization. Expenditures for normal
maintenance of property and equipment are charged against income as incurred.
Expenditures which significantly extend the useful lives of the assets are
capitalized. The costs of assets retired or otherwise disposed of and the
related accumulated depreciation and amortization balances are removed from
the accounts and any resulting gain or loss is included in income.
Depreciation and amortization is calculated using the straight-line method
over the estimated useful lives of the assets, or lease term for leasehold
improvements, if less.
REAL ESTATE AND RESTAURANTS HELD FOR SALE
Real estate and restaurants held for sale consist of properties owned by
the Company which it intends to remarket. The operating results of these
restaurants are considered a part of the Turnkey Program and are included in
Turnkey development costs in the consolidated income statement. These
properties are stated at the lower of cost or net realizable value. A number
of these properties which the Company intends to remarket or liquidate
within the next twelve months have been classified as current. Generally,
these properties have been acquired over the last twenty-four months. Each
property is reviewed individually in terms of its carrying value and the
expected net realizable value. The Company believes that no impairment of
these assets has occurred and that no reductions to the carrying amounts is
warranted.
INVESTMENTS
Investments are stated at the lower of cost or market. Limited
partnership investments are accounted for under the equity method, and
accordingly, the Company's investment is adjusted for allocated profits,
losses and distributions.
TURNKEY PROGRAM
Under the Turnkey Program, the Company works independently or with an
area developer to identify superior store sites within a territory. The
Company typically performs various services including, but not limited to,
site selection, feasibility analysis, environmental studies, site work,
permitting and construction management, receiving a fee and recognizing
revenue upon the completion of these services.
F-9
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
TURNKEY PROGRAM, CONTINUED
The Company may assign its earnest money contract on a site to a franchisee,
or a third-party investor, who then assumes the responsibility for developing
the store. The Company also may purchase or lease a selected site, design and
construct a Schlotzsky's-Registered Trademark-Deli restaurant on the site and
sell, lease or sublease the completed store to a franchisee. Where the
Company does not sell the property to a franchisee, the Company sells the
improved property, or, in the case of a leased property, assigns the lease
and any sublease, to an investor. From inception of the Turnkey Program
through 1997, the Company typically provided credit enhancement in the form
of limited guaranties on the franchisees' leases for leased locations sold to
investors. The Company obtained agreements from the franchisees to indemnify
the Company in case the guaranties are called upon. Upon sale of the leased
site or assignment of its earnest money contract, the Company has deferred
revenue generated (even though proceeds were received in cash) and allocable
costs incurred in connection with the property. When a lease guaranty is
terminated, or the Company's exposure to loss under the guaranty has passed,
the Company recognizes the revenue and allocable costs related to the site as
"Turnkey Program development costs". Generally, if no credit enhancement is
provided in connection with such transactions, the Company recognizes the
revenue and allocable expenses in the periods in which the transactions occur.
During 1998, the Company began emphasizing ownership of the real estate
by franchisees through a program which entails acquiring the rights to a
superior site and reselling the property, or its rights (with any
improvements), to a franchisee whose permanent mortgage loan will be financed
by a third party financial institution. The Company provides credit
enhancement for the franchisee in the form of a limited guaranty in favor of
the lender. These guarantees are usually for loan payments required to be
made during the first two to five years and are limited to 15% to 25% of the
principal amount of the loan. Generally, in those cases, the Company
recognizes the revenue and allocable expenses in the period in which the
transaction occurs. The Company has often interim financed land and building
costs in anticipation of permanent financing by a financial institution. In
addition, the Company charges a fee when it is requested to manage
construction of a store on property owned by a franchisee or an investor.
This construction management fee is recognized when the store is completed.
Turnkey Program development is stated at the lower of cost or estimated
net realizable value. Land, site development, building and equipment costs,
including capitalized carrying costs (primarily interest incurred and
property taxes until the property is ready for sale), are accumulated and
accounted for on a site specific basis.
Turnkey Program revenue consists of the following:
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------------------
1997 1998 1999
----------- ----------- ----------
Sales to investors and franchisees................................. $31,361,869 $29,596,310 $5,520,693
Development and construction management fees....................... 190,000 176,562 --
----------- ----------- ----------
Gross Turnkey Program revenue............................ 31,551,869 29,772,872 5,520,693
Capitalized Turnkey Program development costs...................... (28,829,065) (23,382,340) (4,228,655)
----------- ----------- ----------
Net revenue from Turnkey Program projects................ 2,722,804 6,390,532 1,292,038
Rental income...................................................... 303,091 258,187 363,386
Interim construction interest...................................... 1,270 238,888 31,731
Deferred revenue recognized........................................ -- 1,426,819 --
Revenue deferred................................................... (1,888,555) -- --
----------- ----------- ----------
Total Turnkey Program revenue............................ $1,138,610 $8,314,426 $1,687,155
=========== =========== ==========
F-10
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
The following table reflects system performance of the Turnkey Program for
the years ended December 31, 1998 and 1999.
NUMBER OF UNITS
-------------------------
1998 1999
------------ ----------
Sites in process at beginning of year............................. 78 86
Sites beginning development during the year....................... 122 55
Sites removed from consideration during the period................ (41) (68)
Sites inventoried as Company-owned stores......................... (1) (2)
Sites inventoried as real estate or restaurants held for sale..... (2) --
Sites sold........................................................ (69) (9)
Other............................................................. (1) (3)
------------ ----------
Sites in process at end of year................................... 86 59
============ ==========
INVESTED AT
DECEMBER 31,
1999
--------------
Sites under development or to be sold............................. 4 9 $ 8,235,000
Predevelopment sites (prequalification)........................... 82 50 1,895,000
------------ ---------- --------------
Total....................................................... 86 59 $ 10,130,000
============ ========== ==============
Turnkey Program sites in process at end of year and certain sites
inventoried as real estate or restaurants held for sale are classified as
current assets as management expects to complete and sell such sites within
the next year.
INTANGIBLE ASSETS
Intangible assets consist primarily of the Company's original franchise
rights, royalty values and goodwill, and developer and franchise rights
related to the Company's reacquisition of franchises and developer rights.
Intangible assets are amortized over their estimated useful lives ranging
from four to 40 years.
The Company evaluates the propriety of the carrying amount of its
intangible assets, as well as the amortization period for each intangible
when conditions warrant. If an indicator of impairment is present, the
Company compares the projected undiscounted cash flows for the related
business with the unamortized balance of the related intangible asset. If the
undiscounted cash flows are less than the carrying value, management
estimates the fair value of the intangible asset based on future operating
cash flows for the next 10 years, discounted at the Company's primary
borrowing rate. The excess of the unamortized balance of the intangible asset
over the fair value, as determined, is charged to impairment loss. The
Company believes that no impairment of its intangibles has occurred and that
no reduction of the carrying amounts or estimated useful lives is warranted.
REVENUE RECOGNITION
Royalties:
Royalties are paid to the Company by franchisees at 4% to 6% of gross
franchise sales. Royalties are recognized in the period of the related gross
franchise sales.
F-11
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
Franchise Fees:
Proceeds from the awarding of a franchise are recognized as revenue when
the Company has performed substantially all services for the franchisee as
stipulated in the franchise agreement, typically at store opening. Franchise
fees collected but not yet recognized are recorded, net of deferred direct
incremental expenses, as deferred revenue in the accompanying consolidated
financial statements.
Developer Fees:
The Company has conveyed rights to certain persons, under agreements
("Area Developer Agreements") to act as an area developer within a specific
development area for a specified term. Developers within the United States
("Area Developers") locate prospective new franchisees, perform site
selection duties and provide services to the franchisees during and
subsequent to the store opening. The Company charges the Area Developers a
nonrefundable fee for the rights conveyed. The Company typically collects a
portion of the fee in cash at closing of the Area Developer Agreements, and
extends terms on the remainder.
International developers ("Master Licensees") have the exclusive right to
develop and license the development and operation of Schlotzsky's-Registered
Trademark- Deli restaurants using the Company's system and trademarks within
the development area. The rights to develop and sublicense the development and
operation of Schlotzsky's-Registered Trademark- Deli restaurants in the
foreign territory are granted pursuant to the terms and conditions under an
agreement with a Master Licensee ("Master License Agreement").
The Company has also entered into Master Development Agreements or
Territorial Agreements (collectively the "Territorial Agreements") which, for
a nonrefundable reservation fee, grants the right to negotiate exclusive
territorial rights to develop Schlotzsky's-Registered Trademark- Deli
restaurants in the territory, subject to and in accordance with terms and
conditions of a Master License Agreement; however, the right to develop,
operate and sublicense the development and operation of Schlotzsky's-Registered
Trademark- Deli restaurants in the territory is not granted until the
execution of the Master License Agreement. The Territorial Agreement specifies
the desired economic terms and basic form of the Master License Agreement. The
Company requires the Master Licensee to obtain clauses, covenants and
agreements to comply with and conform to the business practices or laws of the
respective territory. The cost of conforming the contract of the Master
License Agreement is the responsibility of the Master Licensee. If the Company
cannot reasonably satisfy itself of the enforceability of such clauses,
covenants and agreements within the territory, the Company will not be
obligated to grant a Master License Agreement and any rights granted under the
Territorial Agreements will terminate immediately upon notice by the Company.
The Company ordinarily collects approximately 15% to 35% of cash at
closing of either a Territorial Agreement or Master License Agreement, with
the remainder financed typically over a term not exceeding four years,
depending on the creditworthiness of the maker and guarantor of the note.
Area Developers and Master Licensees are generally required to meet
certain performance requirements under their agreements which include minimum
store opening schedules, performance standards and compliance with the terms
of their notes to the Company, if any. During 1999, the Company eliminated
the development schedule for several area developers in connection with the
buy down of their rights to receive future franchise fees and royalties. In
addition, the Company has agreed in the past to extend or waive development
schedules for certain area developers. Otherwise, failure to meet these
requirements could result in the Company terminating their agreements.
F-12
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
In general, the Area Developers and Master Licensees receive a fee for
recruitment and development, including advertising, soliciting, qualifying
and closing sales as well as consultation and advice in establishment,
construction, financing and opening of restaurants in their territory. The
Area Developers portion of the fee, in general, is equal to one-third to
one-half of franchise fee paid by franchisees to the Company depending on the
level of services required by their agreements. Master Licensees collect the
initial sublicense and developer fees and then remit a portion of these fees
back to the Company. The Company expects to receive approximately one-third
to one-half of these fees from the Master Licensee.
In addition, Area Developers and Master Licensees receive a portion of
the ongoing royalties from the franchised restaurants for providing service
and support to the franchisees in their development area. Area Developers
typically receive 1.25% or 2.5% out of the 6% ongoing royalties depending on
the level of services required by their agreements, and Master Licensees
typically retain two-thirds of ongoing royalties, remitting one-third to the
Company.
EXPENSE RECOGNITION
Royalty Service Costs:
Royalty service costs include the portion of the royalty stream paid to
Area Developers.
Franchise Fee Development Costs:
In accordance with the Area Developer Agreements, the Company pays Area
Developers approximately one-half of the initial franchise fees collected
from franchise sales in a specified development area. These costs are
recognized as expenses when the related franchisee fee is recognized.
Franchise fee development costs paid, but not yet recognized, are recorded as
a reduction of gross deferred revenue in the accompanying consolidated
financial statements.
Turnkey Development Costs:
In providing the Turnkey program services, the Company has incurred
certain personnel and overhead costs that are a direct result of Turnkey
activities. Certain costs are allocated to specific Turnkey projects and
deferred until the site is sold, or no longer pursued, and related gain or
loss is recognized.
INCOME TAXES
The Company recognizes deferred tax assets or liabilities computed based
on the difference between the financial statement and income tax basis of
assets and liabilities using the enacted marginal tax rate. Deferred income
tax expenses or credits are based on the changes in the asset or liability
from period to period.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments include cash and cash equivalents,
certificates of deposit, receivables, notes receivable, accounts payable,
accrued liabilities and debt. The carrying value of financial instruments
approximates fair value at December 31, 1998 and 1999.
ADVERTISING EXPENSE
The Company expenses advertising costs as incurred. Total advertising
expense amounted to approximately $315,000, $393,000, and $893,000 for the
years ended December 31, 1997, 1998, and 1999, respectively.
F-13
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
INCOME PER SHARE
The Company computes income per share based on the weighted average
number of common shares outstanding. Diluted income per share is computed
based on the weighted average number of shares outstanding, plus the
additional common shares that would have been outstanding, if dilutive
potential common shares consisting of stock options had been issued.
FISCAL YEAR
The Company utilizes a "4-4-5 week" quarterly reporting schedule for
royalties, restaurant operations and royalty service costs. As a result of
this reporting schedule, the fiscal year will include 53 weeks of activity
for these line items once every 5-6 years. The financial statements for 1997
and 1999 reflect 52 weeks of operations for these items, while 1998 includes
53 weeks. Further, the fourth quarter of 1998 contained 14 weeks. In years
having a 14 week fourth quarter, royalty revenue, restaurant sales, royalty
service costs, restaurant operating expenses and net income in the fourth
quarter are not comparable to results in each of the first three quarters or
to the corresponding quarters in the preceding or subsequent fiscal years,
and can be expected to decline in the following quarter. For all other areas
of the financial statements, the Company reports all fiscal quarters as
ending on March 31, June 30, September 30 and December 31.
RECLASSIFICATIONS
Certain reclassifications were made to previously reported amounts in
the accompanying consolidated financial statements and notes to make them
consistent with the current presentation format.
2. NOTES RECEIVABLE
Notes receivable consist of the following:
DECEMBER 31,
---------------------------
1998 1999
------------ -------------
Notes receivable from Area Developers (under Area Development Agreements)
and Master Licensees (under Master License and Territorial Agreements),
collateralized by their respective territories, net of valuation
allowance of $593,000 and $407,000, respectively, bearing interest
ranging from 6% to 9%
due through in installments through December 2003................... $ 2,828,977 $ 5,271,112
Notes receivable from franchisees, Area Developers, and Master Licensees
bearing interest at 8% to 10%, some notes collateralized by their
restaurants, others uncollateralized, net of valuation allowance of
$100,000 and $179,196 respectively, due in
installments through January 2023.................................. 821,245 2,048,592
Notes receivable from franchisees bearing interest ranging from 7.5% to
10.5%, collateralized by franchisees' property and equipment due in
installments through June 2019, net of
valuation allowance of $57,442 at December 31, 1999................. 7,270,096 11,415,975
Other................................................................. 202,171 241,581
------------ -------------
11,122,489 18,977,260
Current portion....................................................... (4,246,574) (5,737,363)
------------ -------------
Notes receivable, less current portion................................ $ 6,875,915 $ 13,239,897
============ =============
F-14
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. NOTES RECEIVABLE FROM RELATED PARTIES
Notes receivable from related parties consist of the following:
DECEMBER 31,
-------------------------
1998 1999
------------- ----------
Note receivable from National Advertising Association, a non-profit
corporation, bearing interest at a varying rate equal to the prime $
rate, due on demand at any time on or before December 31, 2010. ........ -- $5,168,315
Note receivable from Master Licensee, an organization of which a former
member of the Company's Board of Directors is Managing Director,
bearing interest at 9%, due in installments through
December 1999........................................................... 275,000 275,000
Notes receivable from certain stockholders of the Company, bearing
interest at 7.5%, due in installments through 2001...................... 292,619 386,469
Notes receivable from related entities controlled by stockholders of the
Company, bearing interest at 9%, collateralized by real estate, due in
installments through 2001............................................... 530,688 563,208
Note receivable from Master Licensee, an organization of which a member
of the Company's management is a shareholder, bearing interest at 8%,
due in installments through December 2006............................... 455,000 455,000
Notes receivable from Master Licensee, an organization of which the
Company is a preferred shareholder, bearing interest at 9%, due in
installments through December 2007...................................... 1,098,316 1,512,012
------------- ----------
2,651,623 8,360,004
Current portion........................................................... (41,848) (102,476)
------------- ----------
Notes from related parties receivable, less current portion............... $ 2,609,775 $8,257,528
============= ==========
From time to time, the Company makes advances to certain stockholders,
related partnerships and affiliates (see notes 6 and 15).
4. TURNKEY NOTES AND OTHER RECEIVABLES
Notes and other receivables related to Turnkey projects consist of the
following:
DECEMBER 31,
--------------------------
1998 1999
------------- ----------
Construction draw notes and other receivables from franchisees,
bearing interest ranging from 8.5% to 10% collateratized by real
estate, due through August 2000......................................... $ 6,539,353 $ 5,806,567
Mortgage notes receivable from franchisees, bearing interest ranging from
7.6% to 10.0% collateralized by real estate, due in installments
through October 2000.................................................... 7,336,345 3,101,719
Other receivables from franchisees........................................ 1,636,687 --
------------- ----------
15,512,385 8,908,286
Current portion........................................................... (13,326,956) (8,908,286)
------------- ----------
Turnkey notes and other receivables, less current portion ................ $ 2,185,429 --
============= ==========
F-15
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements consist of the following:
DEPRECIABLE DECEMBER 31,
DEPRECIATION LIFE --------------------------
METHOD (YEARS) 1998 1999
------------- ----------- ---------- ----------
Building................................ Straight Line 32 $6,417,164 $7,718,096
Furniture, fixtures and
Equipment............................. Straight Line 3 to 7 6,223,498 7,846,491
Leasehold improvements.................. Straight Line 13 to 32 5,733,128 6,207,170
----------- -----------
18,373,790 21,771,757
Accumulated depreciation and amortization............................ (2,158,523) (3,832,588)
----------- -----------
16,215,267 17,939,169
Land................................................................. 2,314,479 1,922,251
----------- -----------
Property, equipment and leasehold improvements, net.................. $18,529,746 $19,861,420
=========== ===========
During 1999, the Company purchased buildings, leasehold improvements and
furniture, fixtures and equipment in connection with their expansion of the
Company-owned restaurants in the amounts of $2,530,582, $1,866,289, and
$474,042, respectively.
Depreciation and amortization of property, equipment and leasehold
improvements totaled approximately $566,000, $1,060,000 and $1,918,000 for
the years ended December 31, 1997, 1998 and 1999, respectively.
6. INVESTMENTS AND ADVANCES
Investments and advances consist of the following:
DECEMBER 31,
-------------------------
1998 1999
------------ ----------
Limited partnership:
Investment................................................ $ 96,538 $ 1,375
Advances.................................................. 774,463 --
------------ ----------
871,001 1,375
Building art................................................ 263,071 263,071
Investments in Master Licensees............................. 396,875 300,000
------------ ----------
Investments and advances.................................... $ 1,530,947 $ 564,446
============ ==========
LIMITED PARTNERSHIP
The Company owns a 10% general partnership interest in an entity engaged
in the acquisition, development and construction of certain commercial real
estate. The partnership has the following assets, liabilities and partners'
capital:
DECEMBER 31,
-----------------------
1998 1999
---------- ----------
Assets.................................................... $2,239,960 $2,410,294
Liabilities............................................... 1,933,276 2,199,214
Partners' capital......................................... 306,684 211,080
F-17
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. INVESTMENTS AND ADVANCES - (CONTINUED)
The partnership's net profits, losses and distributions are allocated
based upon methods set forth in the partnership agreement. The Company is
allocated 25% of distributions and like amount of net profits until the other
limited partner has received an aggregate amount equal to its aggregate
contribution. Thereafter, remaining net profits and all losses are allocated
1% to the Company.
The Company was the guarantor of all partnership indebtedness which
consisted of borrowings under a $1,150,000 bank line of credit with
approximately $1,093,000 outstanding at December 31, 1998. In September 1999,
the partnership refinanced the debt under the bank line of credit and debt
owed to Schlotzsky's, Inc. in the aggregate amount of $2,048,000. The terms
of this loan with the new financial institution require a guarantee from
Schlotzsky's, Inc. for the entire loan amount, which is also collateralized
by real estate, and related leases and rents.
INVESTMENTS IN MASTER LICENSEES
The Company had a minority interest in two Master Licensees and was
guarantor of debt of one in the amount of $400,000 at December 31, 1998.
During 1999, the lender assigned this note back to the Company who is now in
the lender position to the Master Licensee.
7. INTANGIBLE ASSETS
Intangible assets consist of the following:
AMORTIZATION DECEMBER 31,
PERIOD ------------------------------
(YEARS) 1998 1999
------------ -------------- ------------
Original franchise rights........................... 40 $ 5,688,892 $ 5,688,892
Royalty value and goodwill.......................... 20 3,122,117 3,916,116
Developer and franchise rights acquired............. 20 to 40 9,789,263 29,168,608
Debt issue costs.................................... 5 to 25 65,136 233,224
Other intangible assets............................. 5 318,449 948,204
-------------- ------------
18,983,857 39,955,044
Less accumulated amortization....................... (2,168,798) (3,413,891)
-------------- ------------
Intangible assets, net.............................. $ 16,815,059 $36,541,153
============== ============
In 1997, the Company reacquired the developer rights in Connecticut,
Maryland, Virginia and various western territories. The aggregate purchase
price of these developer rights was approximately $1,734,000. Also, the
Company reacquired franchise rights in Houston and Austin, Texas for
approximately $1,018,000.
In 1998, the Company reacquired certain developer and franchise rights
in Georgia, Michigan, and certain portions of Ohio, Texas and various western
territories. In addition, the Company reacquired the international licensing
rights to Belgium, Luxemburg, and The Netherlands.
F-18
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. INTANGIBLE ASSETS - (CONTINUED)
In 1999, the Company acquired 100% of the area developers' interest in
territories in North Carolina, Florida, Southern California, Austin, Texas
and Canada. The Company also acquired 50% of several area developers'
interests in parts of Arizona, Illinois, Indiana, Michigan, Kentucky,
Tennessee, Virginia, South Carolina, North Carolina, Kansas, and Missouri. In
addition, in exchange for a $2.3 million note receivable, a cash payment of
$250,000, and a note payable of $500,000, the Company acquired an option to
purchase the development rights of its largest area developer during an
option period from August 16, 2004 to February 16, 2012 at prices ranging
from $28 million to $38.3 million. If a change in control, as defined, of the
Company occurs, the Company is obligated to pay between $2.8 million and $3.8
million to prevent the purchase option from lapsing. Such payment is
applicable to the exercise price, if and when paid.
The developer rights acquired under these transactions are being
amortized on a straight-line basis over 40 years. Amortization of intangible
assets totaled approximately $502,000, $747,000, and $938,000 for the years
ended December 31, 1997, 1998 and 1999, respectively.
8. ACCRUED LIABILITIES
Accrued liabilities consist of the following:
DECEMBER 31,
-------------------------
1998 1999
----------- -----------
Accrued legal and professional.................................... $ 392,277 $ 154,827
Developer service costs........................................... 910,848 568,884
Repurchase of development territories............................. 6,550,000 --
Accrued liability-option cost..................................... -- 500,000
Other accrued liabilities......................................... 1,760,468 1,766,811
---------- ----------
$9,613,593 $2,990,522
========== ==========
9. DEFERRED REVENUE
Franchise fees, developer fees and revenue from the Turnkey Program,
collected but not yet recognized in income less related direct incremental costs
paid but not yet charged to expense are as follows:
Deferred revenue consists of the following:
DECEMBER 31,
-------------------------
1998 1999
----------- -----------
Deferred developer fees........................................... $ -- $ 7,736,711
Deferred franchise fees........................................... 1,687,500 1,342,500
Deferred direct incremental costs:
Deferred franchise fee development service costs............... (838,750) (632,500)
Other ......................................................... (12,000) (3,500)
Deferred revenue, net -- Turnkey Program.......................... 461,736 333,090
---------- ----------
$1,298,486 $8,776,301
Current portion .................................................. -- (1,206,206)
---------- ----------
Deferred revenue, long term....................................... $1,298,486 $7,570,095
========== ==========
F-19
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. LONG-TERM DEBT
Long-term debt consists of the following:
DECEMBER 31,
-----------------------------
1998 1999
----------- ------------
Capitalized lease, bearing an effective interest rate of 11.24%,
collateralized by real property; monthly principal and interest
installments of $12,615 through 2020.................................... $ 1,225,298 $ 1,203,718
Capitalized lease bearing an effective interest rate of 13.67%,
collateralized by real property; monthly principal and interest
installments of $6,312 due through 2017................................. 534,937 527,656
Capitalized lease bearing an effective interest rate of 12.85%,
collateralized by real property; monthly principal and interest
installments of $5,361 due through 2027................................. 513,359 511,297
Various unsecured notes payable to individuals and corporations,
bearing interest at 7.00%, due in periodic principal and interest
installments through 2003............................................... -- 2,885,846
Note payable to a financial institution bearing interest at the lesser
of LIBOR + 1.75% or the bank's prime lending rate, collateralized by
the Company's receivables and intangibles, with
the principal due March, 1999.......................................... 5,000,000 --
Note payable to a financial institution bearing interest at the lesser
of LIBOR + 1.75% or the bank's prime lending rate, collateralized by
the Company's receivables and intangibles, with
the principal due December, 2001........................................ 6,360,000 --
Syndicated notes payable to various financial institutions bearing
interest at the lesser of the maximum rate or the base rate. The base
rate is the greater of the prime rate of Wells Fargo Bank or the
Federal Funds rate plus 0.5%. The maximum rate is the maximum rate of
interest under applicable law that the lender may charge the
borrower. $15,000,000 matures September 30, 2000. The remaining
$20,000,000 has monthly principal and interest payments
of $333,333 through December, 2004. ................................... -- 35,000,000
Various notes payable to individuals and corporations, bearing interest
at 6.0% to 9.0% per annum, due in periodic principal and interest
installments through 2004, and collateralized by equipment
and assignment of royalties from certain franchisees................... 545,439 201,618
Other..................................................................... 422,067 400,338
----------- ------------
14,601,100 40,730,473
Current maturities...................................................... (5,382,585) (19,455,430)
----------- ------------
Long-term debt, less current maturities............................... $ 9,218,515 $ 21,275,043
=========== ============
In December 1999, the Company secured financing from a bank syndicate which
provided an aggregate of $40,000,000 in three credit facilities. The first
facility was a $20,000,000 loan refinancing of $15,000,000 of outstanding debt
plus an additional $5,000,000 for additional area developer buy backs. This
facility has a five year term. The second facility is a $15,000,000 revolving
line of credit for working capital purposes which matures September 30, 2000.
The third facility is a $5,000,000 letter of credit in favor of the media buyer
for Schlotzsky's National Advertising Association, Inc. of which Schlotzsky's,
Inc. is a guarantor. This facility expires September 30, 2000. The credit
facility contains certain financial ratio and leverage covenants. Under the
credit facility, the acquisition of beneficial ownership of more than 33% of
the outstanding stock of the Company by a person or group of related persons
constitutes a default, resulting in the possible acceleration of outstanding
indebtedness.
F-20
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. LONG-TERM DEBT - (CONTINUED)
The aggregate annual maturities of long-term debt at December 31, 1999 are
as follows:
YEAR ENDED
DECEMBER 31,
-----------
2000......................................... $ 19,455,430
2001......................................... 4,713,012
2002......................................... 4,252,395
2003......................................... 4,254,452
2004......................................... 4,254,104
Thereafter................................... 3,801,080
------------
$ 40,730,473
============
The net book value of assets held under capital leases were approximately
$2,432,000 and $2,321,000 at December 31, 1998 and 1999, respectively.
11. INCOME TAXES
The provision for federal and state income taxes consists of the
following:
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------
1997 1998 1999
---------- ---------- ----------
Federal:
Current ....................................... $2,416,124 $2,813,396 $2,658,905
Deferred ...................................... 26,988 556,575 (370,649)
---------- ---------- ----------
Total federal.......................... 2,443,112 3,369,971 2,288,256
State ........................................... 171,148 358,638 236,908
---------- ---------- ----------
Total provision for income taxes................. $2,614,260 $3,728,609 $2,525,164
========== ========== ==========
The differences between the income tax expense and the amount that would
result if the Federal statutory rate was applied to the pretax financial income
were as follows:
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------
1997 1998 1999
---------- ---------- ----------
Expense at Federal statutory rate of 34%......... $2,401,650 $3,377,925 $2,336,206
Nondeductible items, including amortization...... 99,653 69,922 77,716
State income taxes, net of Federal benefit....... 112,957 236,701 197,408
Other............................................ -- 44,061 (86,166)
---------- ---------- ----------
$2,614,260 $3,728,609 $2,525,164
========== ========== ==========
F-21
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
11. INCOME TAXES - (CONTINUED)
Deferred taxes are provided for the temporary differences between the
financial reporting bases and the tax bases of the Company's assets and
liabilities. The temporary differences that give rise to the deferred tax assets
or liabilities are as follows:
DECEMBER 31,
-------------------------
1998 1999
---------- -----------
Deferred Tax Assets:
Receivables..................................... $ 265,167 $ 493,238
Deferred revenue................................ 307,004 3,261,210
Accrued liabilities............................. 117,753 12,460
Other........................................... 36,563 42,442
---------- -----------
Gross deferred tax assets....................... 726,487 3,809,350
---------- -----------
Deferred Tax Liabilities:
Property, equipment and intangibles............. 593,614 1,161,695
Installment sale................................ 99,202 --
Other........................................... 9,786 9,868
---------- -----------
Gross deferred tax liabilities.................... 702,602 1,171,563
---------- -----------
Net deferred tax asset.......................... $ 23,885 $ 2,637,787
========== ===========
12. STOCKHOLDERS' EQUITY
SHAREHOLDERS' RIGHTS PLAN
In December 1998, the Company announced that the Board of Directors had
adopted a Shareholder's Rights Plan and approved a dividend of one Right for
each share of Company Common Stock outstanding. Under the plan, each shareholder
of record receives one Right for each share of Common Stock held. Initially, the
Rights are not exercisable and automatically trade with the Common Stock. There
are no separate Rights certificates at this time. Each Right entitles the holder
to purchase one one-hundredth of a share of Company Class C Series A Junior
Participating Preferred Stock for $75.00 (the "Exercise Price").
The Rights separate and become exercisable upon the occurrence of certain
events, such as an announcement that an "acquiring person" (which may be a group
of affiliated persons) beneficially owns, or has acquired the rights to own, 20%
or more of the outstanding Common Stock, or upon the commencement of a tender
offer or exchange offer that would result in an acquiring person obtaining 20%
or more of the outstanding shares of Common Stock.
Upon becoming exercisable, the Rights entitle the holder to purchase Common
Stock with a value of $150 for $75. Accordingly, assuming the Common Stock had a
per share value of $75 at the time, the holder of a right could purchase two
shares for $75. Alternatively, the Company may permit a holder to surrender a
Right in exchange for stock or cash equivalent to one share of Common Stock
(with a value of $75) without the payment of any additional consideration. In
certain circumstances, the holders have the right to acquire common stock of an
acquiring company having a value equal to two times the Exercise Price of the
Rights.
F-22
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCK-BASED COMPENSATION PLANS
The Company sponsors the "Schlotzsky's, Inc. Third Amended and Restated
Stock Option Plan" (the "Option Plan"), which is a stock-based incentive
compensation plan, as described below. The Company applies APB Opinion No. 25
and related Interpretations in accounting for the Option Plan. In 1995, the FASB
issued SFAS No. 123 "Accounting for Stock-Based Compensation" which, if adopted
by the Company, would change the methods the Company applies in recognizing the
cost of the Option Plan. Adoption of the cost recognition provisions of SFAS No.
123 is optional and the Company has decided not to elect these provisions of
SFAS No. 123. However, pro forma disclosures as if the Company adopted the cost
recognition provisions of SFAS No. 123 in 1995 are required by SFAS No. 123 and
are presented below. The Company also has an employee stock purchase plan that
it adopted in 1998.
THE STOCK OPTION PLAN
Under the Option Plan, the Company was originally authorized to issue
800,000 shares of common stock pursuant to "awards" granted in the form of
incentive stock options (qualified under Section 422 of the Internal Revenue
Code of 1986, as amended) and non-qualified stock options. Awards may be granted
to key employees of the Company. In February 1998, the Compensation Committee of
the Board of Directors amended the Option Plan to provide for an additional
150,000 shares of common stock to be authorized for issuance as non-qualified
stock options under its provisions, and in May 1998, the shareholders approved
amendments to the Option Plan, including an additional 500,000 shares of common
stock to be authorized for issuance as either incentive stock options or
non-qualified stock options.
Options granted in 1998 and 1999 generally vest ratably over three years.
Options granted before 1998 generally vest ratably over five years.
F-23
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCK-BASED COMPENSATION PLANS - (CONTINUED)
A summary of the status of the Company's stock options as of December 31,
1997, 1998 and 1999 and the changes during the years ended on those dates is
presented below:
OPTIONS OUTSTANDING
---------------------------
WEIGHTED AVERAGE
EXERCISE PRICES
SHARES PER SHARE
--------- ----------------
BALANCE, January 1, 1997........................................... 594,964 $ 9.13
Granted (weighted average fair value of $6.81 per share)......... 200,500 15.08
Exercised........................................................ (57,201) 8.50
Forfeited........................................................ (85,799) 9.88
Expired.......................................................... -- --
---------
BALANCE, December 31, 1997......................................... 652,464 11.19
Granted (weighted average fair value of $8.30 per share)......... 628,700 18.66
Exercised........................................................ (44,239) 8.88
Forfeited........................................................ (147,216) 17.10
Expired.......................................................... (25,300) 15.50
---------
BALANCE, December 31, 1998......................................... 1,064,409 14.56
Granted (weighted average fair value of $4.77 per share) ........ 88,000 10.32
Exercised........................................................ (5,825) 9.09
Forfeited........................................................ (63,205) 10.66
---------
BALANCE, December 31, 1999......................................... 1,083,379 15.52
=========
Exercisable at December 31, 1997................................... 362,178 9.19
Exercisable at December 31, 1998................................... 491,972 9.54
Exercisable at December 31, 1999................................... 894,826 15.16
The fair value of each stock option granted in 1997, 1998 and 1999 is
estimated on the date of grant using the Black-Scholes option-pricing model
with the following weighted-average assumptions: no dividend yield; risk-free
interest rate of 6.17% for 1997, 5.28% for 1998, and 5.14% for 1999; expected
lives of the options of six years; and volatility of 32.50% for 1997, 48.97%
for 1998, and 38.95% for 1999.
The following table summarizes information about stock options
outstanding at December 31, 1999:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- ------------------------
NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED
OUTSTANDING AT AVERAGE AVERAGE EXERCISABLE AT AVERAGE
RANGE OF DECEMBER 31, REMAINING EXERCISE DECEMBER 31, EXERCISE
EXERCISE PRICES 1999 CONTRACT LIFE PRICE 1999 PRICE
------------------------------- -------------- ------------- -------- -------------- --------
$5.60 to $11.00................ 444,081 6.10 $ 8.46 330,414 $ 8.19
$11.09 to $14.97............... 226,798 7.48 $ 12.40 151,912 $ 12.34
$17.69 to $23.94............... 412,500 8.12 $ 21.79 412,500 $ 21.79
-------------- ------------- -------- -------------- --------
Total.......................... 1,083,379 7.29 $ 14.36 894,826 $ 15.16
F-24
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCK-BASED COMPENSATION PLANS - (CONTINUED)
EMPLOYEE STOCK PURCHASE PLAN
During 1998 the Company adopted the Schlotzsky's, Inc. Employee Stock
Purchase Plan (the "Stock Purchase Plan") and authorized 250,000 shares of
stock to be sold to employees through the Stock Purchase Plan. Under the
terms of the Stock Purchase Plan, employees may elect to contribute up to 15%
of compensation through payroll deductions for the purchase of Company stock
at 85% of the lesser of the market price at the beginning or the end of the
offering period. An offering period begins on January 1st and July 1st of
each year and expires in six months.
During 1998, 49 participants purchased 9,396 shares of stock through the
Stock Purchase Plan for $8.39 per share. During 1999, 62 participants
purchased 10,551 shares of stock through the Stock Purchase Plan for $8.39
per share. Under APB Opinion No. 25, the Stock Purchase Plan is considered
noncompensatory (the shares are purchased with after tax dollars). Therefore,
no compensation expense has been recognized for shares sold under this plan.
The fair value of stock purchase rights granted in 1998 and 1999 were
$6.55 and $3.39 per share respectively, or a total of $61,543 or $35,726
respectively. The fair value of each stock purchase right was determined
using an expected term of 6 months in 1998 and 1999, a volatility of 48.97%
and 38.95%, respectively, and a risk-free interest rate of 5.30% and 6.03%
respectively.
PRO FORMA NET INCOME AND NET INCOME PER COMMON SHARE
During 1997, 1998 and 1999, the Company did not incur any compensation
costs for the Option Plan under APB No. 25. Had the compensation cost for the
Company's Plan been determined consistent with SFAS No. 123, the Company's
net income and net income per common share for 1997, 1998 and 1999 would
approximate the pro forma amounts below:
DECEMBER 31, 1997 DECEMBER 31, 1998 DECEMBER 31, 1999
---------------------- ---------------------- -----------------------
AS REPORTED PRO FORMA AS REPORTED PRO FORMA AS REPORTED PRO FORMA
----------- --------- ----------- --------- ----------- ----------
Income before cumulative effect of
change in accounting principle......... $ 4,449,415 $4,201,878 $6,206,465 $4,673,829 $4,346,029 $2,992,156
Net income per common share - basic.... $ 0.74 $ 0.70 $ 0.84 $ 0.63 $ 0.59 $ 0.40
Net income per common share - diluted.. $ 0.71 $ 0.67 $ 0.82 $ 0.62 $ 0.58 $ 0.40
The effects of applying SFAS No. 123 in this pro forma disclosure are
not indicative of future amounts. SFAS No. 123 does not apply to awards
prior to 1995 and the Company anticipates making awards in the future under
its Plan. As the Company's options typically vest over three to five years,
the full impact of the pro forma disclosure requirements will not be
reflected until 2000.
F-25
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for interest during the years ended December 31, 1997, 1998
and 1999 was approximately $297,000, $248,000 and $2,086,000, respectively.
Cash paid for income taxes during the years ended December 31, 1997,
1998 and 1999 was approximately $2,404,000, $2,515,000 and $3,250,000,
respectively.
Noncash investing and financing activities:
1997
Notes totaling approximately $272,000 were received as payment for
nonrefundable Area Developer, Master Licensee, Territorial and other
fees.
Notes totaling approximately $1,400,000 were received as proceeds of
for sales of Turnkey Program properties.
Notes totaling approximately $525,000 were issued for acquisition of
developer rights.
1998
Notes totaling approximately $2,250,000 were received as payment for
nonrefundable Area Developer, Master Licensee, Territorial and other
fees.
Notes totaling approximately $21,334,000 were received as payment
for investment in Turnkey Projects.
1999
Notes totaling approximately $5,016,000 were received as payment of
nonrefundable Area Developer fees.
Notes totaling approximately $42,749,000 were received as payment
for sale of, or investment in, Turnkey projects.
Notes totaling approximately $4,311,000 were issued for acquisition
of developer rights.
15. RELATED PARTY TRANSACTIONS
Franchisees contribute 1% of gross sales to Schlotzsky's N.A.M.F., Inc.
("NAMF") to be used solely for the production of programs and materials for
marketing and advertising. The Company charges NAMF an amount equal to
certain cost allocations and salaries for administering NAMF. Advances to
/(from) NAMF totaled approximately $11,000 and $(189,000) at December 31,
1998 and 1999, respectively, and are included in other receivables in the
accompanying consolidated balance sheets.
Franchises contribute 1.75% of gross sales to Schlotzsky's NAA to be
used solely for media placement. At December 31, 1999, Schlotzsky's Inc.
advanced approximately $5.2 million to NAA for the purchase of network
television advertising.
One or more principal stockholders of the Company is guarantor of debt
of the Company, totaling approximately $1,383,000 and $1,185,000 at December
31, 1998 and 1999, respectively.
F-26
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. RELATED PARTY TRANSACTIONS - (CONTINUED)
At December 31, 1998 and 1999 the Company holds combined notes in the
amount of $455,000 from Sino Carribbean development for the right to obtain a
master license for certain territories in the Pacific Rim and the assumption
of a promissory note in the amount of $275,000. An officer of the Company
held 60% of Sino's outstanding common stock at December 31, 1996. In 1997,
Sino issued shares of common stock to third parties which reduced the
officer's interest to less than 30%.
During 1996, the Company paid $300,000 to Bonner Carrington Corporation
European Market ("BCCE") and agreed to serve as guarantor for additional
financing not to exceed $400,000. In return, the Company received: (i)
preferred stock representing 7.5% of the total outstanding shares of BCCE;
(ii) an option to buy additional preferred stock representing an additional
10% of the total outstanding shares of BCCE; and (iii) options to purchase
BCCE and its respective territories at predetermined prices effective during
the period covering December 1999 through December 2011. In February 1999,
the Company took assignment of the note from the bank in favor of Bonner
Carrington European Market ("BCCE") and has stepped into the lender position
for the $400,000.
During 1998, the Company paid $100,000 earnest money toward the
reacquisition of a master license territory from Java Rim, a wholly-owned
subsidiary of Bonner Carrington Corporation ("BCC").
The Company and Third & Colorado 19, L.L.C. ("T&C 19"), a limited
liability company owned by two stockholders of the Company, entered into a
lease agreement effective March 21, 1997, under which the Company leases from
T&C 19 approximately 29,410 square feet of office space and 11,948 square
feet of storage space, in Austin, Texas for the Company's corporate
headquarters. Under the terms of the lease, the Company pays annual net
rental of $12.95 per square foot for the office space and up to $2.50 per
square foot for the storage space for a term of 10 years beginning November
1997.
During 1997, an organization whose managing director is also a member of
the Company's Board of Directors became the successor to the Company's
international development licensing rights for Belgium, Luxemburg and The
Netherlands held by Euro American Development B.V. During 1998, the Company
re-acquired these rights from the related entity for $290,000 (in the form of
$125,000 cash and the remainder through cancellation of indebtedness).
16. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases office facilities and certain land, buildings and
equipment. Rent expense for the years ended December 31, 1997, 1998 and 1999,
was approximately $814,000, $1,195,000 and $2,078,000, respectively. Future
minimum rental payments under operating leases that have initial or remaining
noncancelable lease terms in excess of one year as of December 31, 1999 are
as follows:
YEAR ENDING
DECEMBER 31,
------------
2000.......................................................... $ 1,611,802
2001.......................................................... 1,636,541
2002.......................................................... 1,629,165
2003.......................................................... 1,598,228
2004.......................................................... 1,576,361
Thereafter.................................................... 18,470,750
-----------
$26,522,847
===========
F-27
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
16. COMMITMENTS AND CONTINGENCIES - (CONTINUED)
GUARANTIES ON FRANCHISE OPERATING LEASES AND OTHER OBLIGATIONS
The Company, and in some cases certain stockholders, guaranty certain real
estate and equipment leases and other obligations of its franchisees. Under
the Turnkey Program, the Company has typically provided a credit enhancement
in the form of a guaranty on the franchisee's lease assigned to a third-party
investor. These guaranties typically cover lease payments and various other
obligations of the franchisee for a period ranging from 18 months to five
years, and is effective throughout the term of the 20 year lease. At December
31, 1999, the Company was contingently liable for approximately $6.2 million
under these guaranties. Additionally, at December 31, 1999, the Company was
contingently liable for approximately $28 million under guaranties of other
franchisee real estate and equipment leases and various obligations.
LITIGATION
The Company is a defendant in various lawsuits arising in the ordinary
course of business. Management is of the opinion that all such matters are
without merit or are of such kind, or involve such amounts, as would not have
a significant effect on the consolidated financial position, results of
operations or cash flows of the Company if disposed unfavorably.
On February 8, 1999, the Lone Star Ladies Investment Club, et al., filed
a consolidated amended class action lawsuit in the Western District of Texas
against the Company and four of its officers and directors (Monica Gill,
Executive Vice President and Chief Financial Officer; John M. Rosillo,
director; Jeffrey J. Wooley, Senior Vice President and director; and John C.
Wooley, President and Chairman of the Board of Directors). The complaint,
alleges securities fraud arising from a change in the timing of recognition
of revenue from the sale of real estate properties in connection with which
the Company provided limited guaranties on franchisees leases of the
properties. In April 1998, Registrant announced that 1997 earnings would be
lower than previously announced because it would defer revenue received in
the fourth quarter from such real estate transactions rather than recognizing
it during the period in which the transaction occurred, as previously
contemplated. Plaintiffs seek monetary damages in an unspecified amount. The
Company believes that the allegations are without merit and intends to
vigorously defend against the suit.
17. CONCENTRATION OF CREDIT RISK
The Company's financial instruments that are exposed to concentrations
of credit risk consist primarily of cash and cash equivalents, mortgage notes
receivable from franchisees, notes receivable from Area Developers and Master
Licensees and notes receivable from affiliates. The Company places its cash
and cash equivalents with high credit quality financial institutions, which,
at times, may exceed federally insured limits. The Company has not
experienced any losses in such accounts.
The Company grants notes receivable to individuals and licensees who
have, in the opinion of the Company, adequate reserves to repay the notes
independent of the franchise rights. Although the Company has extended the
terms maturities of certain of the notes, it has not experienced significant
credit losses to date.
18. SEGMENTS
The Company and its subsidiaries are principally engaged in franchising
quick service restaurants that feature salads, made-to-order sandwiches with
unique sourdough buns and pizzas. At December 31, 1999 the Schlotzsky's
system included Company owned and franchised stores in 37 states, the
District of Columbia and 13 foreign countries.
F-28
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
18. SEGMENTS - (CONTINUED)
The Company identifies segments based on management responsibility within
the corporate structure. The Turnkey Development segment includes the
development of freestanding stores with high visibility and easy access. The
Restaurant Operations includes the operation of a limited number of
Company-owned restaurants for the purpose of product development, concept
refinement, prototype testing and training and to build brand awareness. The
Franchise Operations segment encompasses the franchising of stores in order to
achieve optimal success with owner-operated stores. The Company measures
segment profit as operating profit, which is defined as income before interest
and income taxes. The accounting policies of the Segments are the same as
those described in the summary of significant accounting policies (Note 1).
Segment information and a reconciliation to income, before interest and income
taxes are as follows:
TURNKEY RESTAURANT FRANCHISE
YEAR ENDED DECEMBER 31, 1999 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
--------------------------------------------- ------------- ------------- ------------- --------------
Revenue from external customers........... $ 1,687,155 $ 14,815,504 $ 31,435,757 $ 47,938,416
Depreciation and amortization............. 336,608 941,007 1,578,032 2,855,647
Operating income (loss) .................. (3,813,349) 630,200 9,190,811 6,007,662
Significant noncash items-fees financed... -- -- 5,016,250 5,016,250
Capital expenditures...................... 3,254,150 3,768,921 645,363 7,668,434
Total assets.............................. $ 40,575,066 $ 25,851,163 $ 66,333,152 $132,759,381
TURNKEY RESTAURANT FRANCHISE
YEAR ENDED DECEMBER 31, 1998 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
--------------------------------------------- ------------- ------------- ------------- --------------
Revenue from external customers........... $ 8,314,426 $ 7,720,432 $ 25,813,054 $ 41,847,912
Depreciation and amortization............. 446,962 609,265 828,627 1,884,854
Operating income (loss) .................. 3,061,365 (774,999) 5,590,446 7,876,812
Significant noncash items-fees financed... -- -- 2,250,000 2,250,000
Capital expenditures...................... 5,150,880 9,102,579 2,991,726 17,245,185
Total assets.............................. $ 42,902,095 $ 20,782,048 $ 41,137,611 $ 104,821,754
TURNKEY RESTAURANT FRANCHISE
YEAR ENDED DECEMBER 31, 1997 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
--------------------------------------------- ------------- ------------- ------------- --------------
Revenue from external customers........... $ 1,138,610 $ 6,364,042 $ 20,466,484 $ 27,969,136
Depreciation and amortization............. 178,953 434,698 541,949 1,155,600
Operating income (loss) .................. 592,001 (193,371) 5,716,424 6,115,054
Significant noncash items-fees financed... -- -- 272,003 272,003
Capital expenditures...................... 168,160 4,169,162 3,098,681 7,436,003
Total assets.............................. $ 18,740,459 $ 8,992,965 $ 51,787,162 $ 79,520,586
F-29
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
19. EARNINGS PER SHARE
Basic and diluted EPS computation for the years ended December 31, 1997,
1998 and 1999 are as follows:
FOR THE YEARS ENDED
DECEMBER 31,
----------------------------------------
1997 1998 1999
----------- ----------- -----------
BASIC EPS
Net income before cumulative effect of change in
accounting principle............................. $ 4,449,415 $ 6,206,465 $4,346,029
Cumulative effect of change in accounting principle,
net of tax....................................... -- -- (3,819,592)
----------- ----------- -----------
Net income......................................... 4,449,415 6,026,465 526,437
=========== =========== ===========
Weighted average common shares outstanding......... 5,994,403 7,382,983 7,409,496
=========== =========== ===========
Basic EPS before cumulative effect of change in
accounting principle............................. $ 0.74 $ 0.84 $ 0.59
Cumulative effect of change in accounting principle -- -- (0.52)
----------- ----------- -----------
Basic EPS.......................................... $ 0.74 $ 0.84 $ 0.07
=========== =========== ===========
DILUTED EPS
Net income before cumulative effect of change in
accounting principle............................. $ 4,449,415 $ 6,206,465 $4,346,029
Cumulative effect of change in accounting principle,
net of tax...................................... -- -- (3,819,592)
----------- ----------- -----------
Net income........................................ 4,449,415 6,026,465 526,437
=========== =========== ===========
Weighted average common shares outstanding......... 5,994,403 7,382,983 7,409,496
Assumed conversion of common shares issuable
under stock option plan and exercise of warrants.. 234,966 194,424 66,703
----------- ----------- -----------
Weighted average common shares outstanding -
assuming dilution................................. 6,229,369 7,577,407 7,476,199
=========== =========== ===========
Diluted EPS before cumulative effect of change in
accounting principle............................. $ 0.71 $ 0.82 $ 0.58
Cumulative effect of change in accounting principle -- -- (0.51)
----------- ----------- -----------
Diluted EPS.......................................... $ 0.71 $ 0.82 0.07
=========== =========== ===========
Outstanding options that were not included in the diluted calculation
because their effect would be anti-dilutive totaled 123,500, 571,000 and 748,000
in 1997, 1998 and 1999, respectively.
F-30
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors
Schlotzsky's, Inc. and Subsidiaries
In connection with our audit of the consolidated financial statements of
Schlotzsky's, Inc. and Subsidiaries referred to in our report dated March 2,
2000, which is included in Part IV of this Form 10-K, we have also audited
Schedule II for each of the three years in the period ended December 31,
1999. In our opinion, this schedule presents fairly, in all material
respects, the information required to be set forth therein.
GRANT THORNTON LLP
Dallas, Texas
March 2, 2000
S-1
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999
COL. A COL. B COL. C COL. D COL. E.
- -------------------------------------------- ------------- -------------------------------- ------------ ---------------
ADDITIONS
--------------------------------
BALANCE
AT CHARGE TO CHARGE TO BALANCE AT
BEGINNING COSTS AND OTHER END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTION PERIOD
- -------------------------------------------- ------------- --------------- ---------------- ------------ ---------------
Valuation allowance for notes receivable,
interest receivable, and other receivable:
Year ended December 31, 1999.............. $ (1,415,498) $ (1,246,401) $ -- $ 823,497 $ (1,838,402)
============= =============== ================ ============ ===============
Year ended December 31, 1998 ............. (442,774) (972,724) -- -- (1,415,498)
============= =============== ================ ============ ===============
Year ended December 31, 1997.............. (342,774) (100,000) -- -- (442,774)
============= =============== ================ ============ ===============
S-2