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SCHLOTZSKY'S, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

Commission File Number 0-27008

Schlotzsky's, Inc.
(Exact name of registrant as specified in its charter)

        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 [X].

        The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2002, was approximately $26,805,000 based upon the last sales price on June 28, 2002, on the NASDAQ National Market System for the Company's common stock. Registrant had 7,319,887 shares of Common Stock outstanding on March 24, 2003.

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act. Yes [    ] No [X]

DOCUMENTS INCORPORATED BY REFERENCE

        None.

SCHLOTZSKY'S, INC.

Index to Form 10-K
Year Ended December 31, 2002

PART I

ITEM 1. BUSINESS

INTRODUCTION

        Schlotzsky's, Inc., is a franchisor and operator of restaurants in the fast casual sector under the Schlotzsky's® Deli brand. Schlotzsky's Deli restaurants offer a menu of distinctive, high quality foods featuring our proprietary breads, complemented by excellent customer service in a visually appealing setting. Our current menu includes upscale made-to-order hot sandwiches and pizzas served on our proprietary buns and crusts, wraps, chips, salads, soups, fresh baked cookies and other desserts, and beverages. At December 31, 2002, the system included 607 franchised restaurants and 36 Company-operated restaurants located in 37 states, the District of Columbia and six foreign countries.

        Our executive offices are located at 203 Colorado Street, Austin, Texas 78701, our telephone number is (512) 236-3600, and our website is www.schlotzskys.com. Our filings with the Securities and Exchange Commission and our Annual Reports to Shareholders are available on our website but are not incorporated into this Annual Report on Form 10-K.

        We generated our revenues of approximately $60.5 million for 2002 through two business segments:

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Franchise Operations. Our Franchise Operations segment is a key source of revenues through royalties we collect from our franchisees for the use of our trademarks and operating systems and license fees we receive from manufacturers and supply chain managers of Schlotzsky's Deli brand products. This segment encompasses franchising of restaurants, assisting franchisees and licensing the manufacture of Schlotzsky's Deli brand products. Several brand products, including chips, cheeses and meats, are available for retail sale in grocery and other retail stores.



2.

Restaurant Operations. Our Restaurant Operations segment includes 14 restaurants in our long-term portfolio that we intend to operate for the purposes of leadership of the franchise system and, in certain cases, to stimulate the redevelopment of certain markets. These stores also are used to demonstrate sales potential and key operating metrics, to build brand awareness, and to serve as laboratories for product development, concept refinement, product and process testing, and training. We also operate 22 restaurants that were developed for or acquired from franchisees and are being operated until they are re-franchised.

        See Note 16 to the Consolidated Financial Statements for financial information regarding our business segments.

        As used in this report, the terms "Company,""Schlotzsky's," "us," and "we" refer to Schlotzsky's, Inc. and its subsidiaries unless the context indicates otherwise.

SCHLOTZSKY'S DELI SYSTEM
Franchising

        Franchise Philosophy.    We have generally adopted the strategy of franchising, rather than owning, the majority of the system's restaurants. Franchising allows us to expand the number of restaurants and penetrate markets more quickly and with less capital than developing Company-operated restaurants. In general, franchisees have been on-premise operators; however, we may consider licensing multi-unit operators. Area developers play a role in our franchising program in certain territories by monitoring and providing support to franchised restaurants and in some territories by also recruiting qualified franchisees.

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        Franchise Agreements.    We enter into an agreement with each franchisee granting the franchisee the right to develop a restaurant within a defined local market area for a finite period of time. In most cases, we have reserved the right to license sales of sandwiches, pizzas and other products in alternative retail outlets within that market area. Under our current standard franchise agreement, the franchisee pays a fee of $30,000 for each restaurant. The current standard franchise agreement provides for a term of 20 years (with one ten-year renewal option), payment of a royalty of 6% of contractual restaurant sales, and advertising contributions of 4% of contractual restaurant sales. Contractual sales are based on the definitions in our franchise agreements and add to net sales any discounts for employee and manager meals at franchised restaurants, as well as Company-operated restaurants, and are a principal driver of our revenue because royalty revenue is based on the contractual sales of our franchised restaurants. About 10% of our franchisees signed older forms of franchise agreements that require them to pay a royalty of only 4% of contractual sales. The terms of our franchise agreements have changed in the past in response to new laws and the franchise market in general, and they may change in the future.

        Franchisee Training and Support.    We have approximately 360 franchisees for our 607 franchised restaurants. We provide on-the-job training at various restaurants and on-the-job and classroom training at our flagship restaurant and national training center, which we opened in Austin, Texas in 1995. Franchisees may enroll each of their restaurant managers in our training program. We, or an area developer, provide an on-site training crew before and after the opening of a franchisee's first restaurant, as well as providing ongoing service and support. We also provide updated operating and marketing information and maintain ongoing communication with franchisees, through conference calls, a call center and computer communications. Franchised restaurants receive ongoing service and support, and are periodically inspected by area developers and by our field service representatives to monitor compliance with our standards and specifications as set forth in the franchise agreement and our manuals.

        Area Developers.    Beginning in the early 1990s, we entered into a series of contracts for area developers who played a large role in franchise sales and franchisee services in particular markets. The area developer program has played an important part of our growth strategy, but over the past four years we have repurchased some of those area developer territories or modified the contracts to decrease their responsibilities and their compensation. We may enter into similar transactions with existing area developers, but there can be no assurance that such transactions will occur. In August 2002, we acquired the territorial rights of our largest area developer. We do not intend to expand the area developer program beyond our existing markets.

        In exchange for a non-refundable fee, generally paid by cash and a note, area developers were granted exclusive rights to one or more development territories in the United States, typically for a term of 50 years. We retain a right of first refusal with respect to any proposed sale of rights by an area developer. If an area developer fails to meet its obligations, we can terminate the contract or repurchase its territory.

        We typically pay compensation to area developers who retained their original sales and service obligations based on 50% of all franchise fees paid by franchisees in their territories. In addition, we also pay these area developers compensation generally based on 2.5% of franchisees' restaurant contractual sales, constituting approximately 42% of the royalties received under franchise agreements providing for 6% royalties. Compensation payable to those area developers with reduced responsibilities has been reduced to approximately 1.25% of franchisees' restaurant sales, or approximately 21% of royalties.

        International Master Licensees.    We have granted non-assignable rights to master licensees to develop restaurants in certain foreign countries. A master licensee is typically licensed for 50 years to use our trademarks in a designated territory and may grant area development rights and franchises in

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that territory. Unlike area developers, master licensees serve as sub-franchisors in their respective territories. When a master license is granted, the master licensee pays us a negotiated, nonrefundable license fee.

Restaurant Development

        Location and Design.    We often assist franchisees in identifying restaurant sites, although franchisees are responsible for selecting restaurant locations acceptable to us. Site selection criteria are based on several factors, such as accessibility and visibility of the site and selected demographic factors, including population, residential and commercial density, income, age and traffic patterns.

        We also assist owners of older restaurants in finding economically feasible ways to upgrade or remodel their restaurants to maintain consistency with our brand image and competitiveness in their markets. We have developed a variety of standard restaurant designs and specifications for freestanding and shopping center restaurants that can be adapted to a variety of real estate layouts. These designs may be adapted to existing restaurants and other retail spaces with our approval, such as rehabilitating or renovating buildings that were originally designed for completely different concepts.

        Restaurant Cost.    Capital requirements incurred by a franchisee to open a restaurant vary depending on the location and size of the restaurant, whether the restaurant is free-standing or in a shopping center, development or rehabilitation costs, whether the restaurant is owned or leased, and the specific terms of any related loan or lease agreement. Shopping center restaurants are currently estimated to cost approximately $450,000 to $650,000 and vary based on size and the level of landlord contribution to construction costs. Leased freestanding buildings have a similar cost depending on the size of the building and the terms and conditions of the lease. If a franchisee were to purchase the land and own and develop the land and building instead of leasing, then the total investment would be approximately $1,650,000 to $1,850,000, with the largest variables being cost of land and land development. In addition, the franchisee will need adequate working capital to support their business start-up and pay us all required initial fees.

        Prior Restaurant Development Services.    From 1995 until 2000, while franchisees were primarily responsible for their own restaurant development, we developed a number of restaurants in which we were involved in acquiring sites, building restaurants for franchisees and sometimes guaranteeing franchisee debts or leases related to the restaurant, under what we referred to as our Turnkey program. Under this program, we would typically perform or oversee various restaurant development services and entered into guarantees for lease agreements or mortgage loans in exchange for a fee. We sometimes provided interim financing to the franchisee to purchase a restaurant built under the Turnkey program or to purchase land and construct the building for a new restaurant. The interim loan was typically either sold to, or refinanced by, an institutional lender. We typically provided credit enhancement for the franchisee in the form of a limited guaranty in favor of the lender. We sometimes also made a long-term loan to the franchisee for a portion of the cost of the restaurant. These loans were usually subordinated to the institutional lenders. During this period from 1995 until 2000, the majority of restaurants built were developed outside of the Turnkey program. In 2000, the Turnkey program was cancelled. Despite the program's cancellation, we expect that we may be required to perform on guarantees or, in certain limited instances, provide guarantees, subordinated loans or take on an equity interest for franchisees, particularly those who purchase restaurants available for sale from us. As of December 31, 2002, we had guaranteed an aggregate of approximately $22.0 million of franchisee obligations, which is principally comprised of real estate and equipment leases and mortgages.

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Schlotzsky's Deli Restaurant Locations

        At December 31, 2002, the Schlotzsky's Deli system consisted of 643 restaurants open and operating in 37 states, the District of Columbia, and six foreign countries. At December 31, 2001 and 2000, the system included 674 and 711 restaurants open and operating, respectively.

RESTAURANT LOCATIONS AS OF DECEMBER 31, 2002

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Brand Products

        We have licensed certain manufacturers to produce Schlotzsky's Deli brand meats, cheeses, potato chips and other products. We receive licensing fees from these manufacturers and supply chain managers based on their sales of brand products to distributors, who in turn sell to our restaurants. While franchisees are not required to purchase brand products, other than our proprietary flour mixes and paper products, we believe that most franchisees prefer them because they are of equal or superior quality compared to other brand name products.

        Since 1999, we have also licensed certain brand products for sale outside of the restaurant system. Schlotzsky's Deli brand meats, cheeses and potato chips are available for retail sale in certain grocery chains and other retail outlets in selected markets. We are continuing to seek distribution in additional retail outlets and markets and are exploring additional products for inclusion in this program.

        We do not manufacture, warehouse or distribute Schlotzsky's Deli brand products. We continually strive to improve the supply chain for our franchisees and our Company-operated restaurants. We have worked with a variety of different food distributors, but currently one national food distribution company distributes substantially all of the brand products needed to operate one of our restaurants.

Restaurant Operations

        We opened our Marketplace restaurant and national training center in Austin, Texas, in 1995, and have continued to expand our portfolio of Company-operated locations, particularly since the 1999 acquisition of certain restaurants in Austin, Texas, and the re-acquisition of the Austin development territory. Three of the 14 restaurants in our long-term restaurant portfolio (two in Austin and one in Houston) are Marketplace restaurants, which are operated for research and development and training and, along with a Schlotzsky's Deli, include a full bakery producing pastries, muffins and other baked goods for sale in the Marketplace restaurant and in the coffee bar section of certain other Company-operated restaurants. We expect to open additional Company-operated restaurants for market leadership purposes, beginning with key markets in our home state of Texas.

        We also operate 22 other restaurants developed for or acquired from franchisees on a purchase or lease basis. We intend to re-franchise these restaurants and do not consider these restaurants to be part of our long-term portfolio of Company-operated units, but classify them as "Restaurants Available for Sale." In the interim, these restaurants serve as a base of operations for Company personnel in their respective markets and, as such, are an important part of the franchising infrastructure.

MARKETING AND ADVERTISING

        We seek to become a well-known national brand. Schlotzsky's N.A.M.F., Inc. ("NAMF"), a Texas not-for-profit corporation, along with Schlotzsky's National Advertising Association, Inc. ("NAA"), also

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a Texas not-for-profit corporation that was merged into NAMF as of December 30, 2002, is responsible for funding the marketing and advertising for our system. NAMF utilizes national, regional, local and cable television advertising, as well as radio, freestanding inserts and direct mail to present advertising messages to consumers. The allocation between national, regional and local advertising will vary from time to time depending on pricing and other factors.

        Franchisees are required by the terms of their franchise agreements to spend at least 4% of their restaurant's contractual sales on advertising and we encourage them to spend more than the minimum. Effective January 1, 2001, we began collecting three quarters of that 4% contribution for advertising through NAMF and NAA. The remainder of the 4% was spent locally by individual franchisees or by local advertising groups formed in order to maximize the benefits of local advertising for members. Effective February 2003, 4% of contractual sales will be collected on a national basis and will be used for national, regional and local advertising and marketing, managed on a centralized basis. Company-operated restaurants contribute to advertising funds on the same basis as franchised restaurants. NAMF reimburses us for personnel and other costs that we incur related to the marketing and advertising for our system.

COMPETITION

        The food service industry is intensely and increasingly competitive with respect to concept, price, location, food quality and service. There are many well-established competitors with substantially greater financial strength, market share, media presence, points of distribution and other resources than us. Such competitors include a large number of national and regional food service companies, including fast food and quick-service restaurants, fast casual dining restaurants, casual dining restaurants, delicatessens, pizza restaurants and other dining establishments. There are also new and growing competitors in the fast casual upscale sandwich category in which the Company primarily operates. Some of our competitors have been in business longer than we have and are better established in markets where our restaurants are or may be located. We believe that we compete for franchisees with franchisors of other restaurants and various concepts.

        Competition in the food service business is affected by changes in consumer taste, economic conditions, demographic trends, traffic patterns, the cost and availability of real estate, qualified labor, product availability and local competitive factors. Our area developers and we 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 our restaurants.

TRADEMARKS AND TRADE SECRETS

        We own several trademarks that are protected under common law and/or are registered with the United States Patent and Trademark Office. Included among the marks that are registered with the Patent and Trademark Office is the name and mark "Schlotzsky's." We have also registered or applied to register many of our trademarks in various foreign countries. The potential duration of trademarks is generally unlimited, subject to continued use and registration renewals. We, and our suppliers, protect our recipes and techniques as trade secrets. We have not generally sought patent protection for these recipes or techniques, and it is theoretically possible that competitors could develop recipes and techniques that duplicate or closely resemble ours, including the recipe and techniques relating to our distinctive bread. We consider our trademarks and trade secrets to be materially important to our business and key to our strategy of differentiation. We seek to protect our trade secrets through various internal controls such as confidentiality agreements.

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GOVERNMENT REGULATION

        We must comply with regulations adopted by the Federal Trade Commission (the "FTC") and with several state laws that apply to the offer and sale of franchises, including those requiring that prospective franchisees receive a franchise offering circular containing certain prescribed information. We must also comply with several state laws that regulate certain substantive aspects of the franchisor-franchisee relationship, including those requiring the franchisor to deal with its franchisees in good faith; prohibiting interference with a right of free association among franchisees; regulating discrimination among franchisees with regard to charges; restricting the development of new restaurants within certain distances from existing franchised restaurants; or restricting a franchisor's rights to terminate a franchise agreement by requiring any of the following: "good cause," advance notice, an opportunity to cure defaults, or repurchase the franchisee's inventory or other compensation. To date, these laws have not precluded us from seeking franchisees in any state and have not had a material adverse effect on our franchise operations.

        We and our franchisees, in the operation of the restaurants, must comply with federal, state and local laws and regulations regarding health, sanitation, safety, fire, zoning, environment, wages, working hours, working conditions, disabilities, and alcoholic beverages (where applicable). Any failure to comply with such laws or to obtain or maintain applicable permits can adversely impact or prevent the opening or continued operation of a restaurant. To date, our business has not been materially affected by any such noncompliance. Many of our restaurant employees receive compensation at rates related to the federal minimum wage and, accordingly, increases in the minimum wage increase labor costs at those locations. Compliance with environmental and other laws and regulations has impacted the cost of new restaurants, but we believe it has not prevented development of new restaurants. Compliance with securities law regulations and new rules under the Sarbanes-Oxley Act is expected to impact our cost as a publicly traded company.

EMPLOYEES

        As of December 31, 2002, we employed 150 full-time equivalent personnel at our corporate headquarters or as field personnel and 825 personnel at Company-operated restaurants. None of our employees is covered by a collective bargaining agreement or represented by a labor union. We believe our relationship with our employees is good.

FORWARD-LOOKING STATEMENTS

        This report contains statements that are not historical information and are considered "forward-looking statements," as defined under the federal securities laws. Forward-looking statements may also be included from time to time in other written and oral communications by us or by our authorized representatives. Forward-looking statements include, but are not limited to, those related to: our business and growth strategies; the availability of financing for us and our franchisees; the impact of increased competition within the fast casual segment of the restaurant industry on restaurant sales; new restaurant development; continued viability of restaurants during weak economy; sales, costs and earnings projections; the sufficiency of operating cash flows, working capital and borrowings for our future liquidity and capital resource needs; the results of pending or threatened legal proceedings; the disposition of restaurants available for sale; future distribution of Schlotzsky's Deli brand products; the expected recruitment of multi-unit operators and franchisees; and the future declaration and payment of dividends. Although forward-looking statements reflect our expectations based on then-current information, shareholders and prospective investors are cautioned not to place undue reliance on such forward-looking statements. We undertake no obligation to update any forward-looking statements. There can be no assurance that forward-looking statements will actually be achieved. Actual future results may be materially different from the forward-looking statements because of various risks and

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uncertainties, including but not limited to those identified in this report under the heading "Risk Factors."

RISK FACTORS

        In addition to the other information contained in this report, the following factors should be considered carefully in evaluating the Company:

        New Restaurant and Restaurant Upgrade Strategy.    We have initiated several measures to stimulate the development of new Schlotzsky's Deli restaurants or renovation of existing restaurants by our franchisees, including updating shopping-center model restaurant designs, developing improved menu formats, increasing the number of employees devoted to franchisee development, and increasing advertising aimed at prospective franchisees. Although we believe these actions are appropriate, there can be no assurance they will result in the opening of more restaurants. Some franchisees may choose to close their restaurants rather than invest in remodels or upgrades as encouraged by us or required under the terms of their franchise agreements. During 2002, 2001 and 2000, our franchisees and we opened 13, 18 and 32 new Schlotzsky's Deli restaurants, respectively. The number of openings and the performance of new restaurants will depend on various factors, including: the availability of suitable sites for new restaurants; the ability to recruit financially and operationally qualified franchisees; the ability of franchisees to negotiate acceptable lease or purchase terms, obtain required capital, meet construction schedules, and hire and train qualified restaurant personnel; the establishment of brand awareness in new markets; our ability to manage anticipated growth; and our ability to implement restaurant renovations and upgrades. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Overview."

        Dependence on Franchising Concept.    Because royalties from franchised restaurants are a principal component of our revenue base, our performance depends upon the ability of our franchisees to capitalize on and properly execute the Schlotzsky's Deli concept. The operation of a Schlotzsky's Deli restaurant requires a franchisee's significant and continued effort in areas such as product quality, customer service, employee training, local marketing and cost controls. We believe that the costs for a franchisee to open a Schlotzsky's Deli restaurant, including the cost to purchase or lease real estate that meets our site selection criteria, are higher than the restaurant opening costs of certain competing concepts. This necessarily limits the number of persons who are qualified to be our franchisees. We have established criteria to use in evaluating prospective franchisees, as well as training programs to assist in franchisee restaurant operations, but there can be no assurance that franchisees will successfully open and operate Schlotzsky's Deli restaurants consistent with our expectations. In addition, franchisees set their own prices which will affect their sales. Poor restaurant operations, such as cleanliness, attentiveness of employees and quality control, will also affect each store's sales. Since franchisees are independent business owners, they make their own decisions regarding new restaurant openings and whether to close existing restaurants. There can be no assurance that franchisees will open additional restaurants or continue operations of existing restaurants. During 2002, 2001 and 2000 franchisees closed 53, 73 and 91 restaurants, respectively and we closed two Company-operated restaurants in 2002. See "Business."

        We are subject to various state and federal laws relating to the franchisor relationship. If we fail to comply with these laws, we could be subject to liability to certain penalties or damages to franchisees or by governmental authorities. We believe that we are in material compliance with these laws and regulations and our agreements with franchisees. There can be no assurance that such liability will not be imposed in the future. See "Business" and "Business—Government Regulation."

        Schlotzsky's Deli Brand Licensing Arrangements.    Our revenue from Schlotzsky's Deli brand licensing arrangements (brand contribution) is a significant portion of our overall revenue, and is based primarily on voluntary franchisee purchases of our brand products. There can be no assurance that

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franchisees will maintain their future voluntary purchases of Schlotzsky's Deli brand products. See "Business "and "Legal Proceedings."

        Availability of Appropriate Financing.    We will require additional financing to support Company operations and the intended growth in the number of Company-operated restaurants and to refinance certain debt with relatively short maturities. While we are working with potential lenders to develop appropriate credit facilities, there can be no assurance that we will obtain appropriate financing on acceptable terms to meet these needs. Failure to obtain such financing would require us to significantly modify our growth strategies for Company-operated restaurants and reduce our operating costs and capital expenditures. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources."

        Dependence on Suppliers and Distributors.    One national food distribution company currently distributes substantially all of our system's distribution needs (other than certain beverages and produce). If this company, or any other company significant to our system's supply chain, were to go out of business or be distracted from performing their functions, we could suffer adverse consequences while we move our business to another company. It would take time to find another distributor to provide the full range of services. See "Business."

        Operation of Company-operated Restaurants.    Our revenue from Company-operated restaurants has increased significantly over the past four years as we have increased the number of restaurants we operate. Restaurant operations have different financial characteristics, including higher capital requirements and lower operating margins, than our franchising operations. In addition, a majority of the restaurants operated by us were developed for or acquired from franchisees that, in many cases, did not operate these restaurants with consistent profitability. We expect to further increase the number of restaurants we operate, both in our long-term portfolio and in our available for sale portfolio. There can be no assurance that we will increase the number of Company-operated restaurants or achieve consistent profitability in our operation of restaurants that we have or will acquire from franchisees in the future. See "Business."

        Investments in Intangible Assets.    We have substantial investments in intangible assets with a carrying value of $68.3 million as of December 31, 2002. The carrying amount of such investments is dependent, in part, on projected cash flows for the related business activities. Such projected cash flows can be impacted by factors both within and without management's control and projection of cash flows requires the exercise of judgment. There can be no assurance that factors adversely impacting these projected cash flows will not occur or that management's judgments will not change in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies."

        Credit Risk and Contingencies.    We have charged our area developers and master licensees a fee ("developer fee") for the rights to develop a defined territory and have typically accepted a portion of the developer fee in the form of a promissory note. As of December 31, 2002, we held notes receivable from area developers and master licensees in an aggregate net carrrying value of approximately $1.4 million. We also hold notes receivable from certain franchisees related to their purchase of restaurants and certain other obligations. As of December 31, 2002, the aggregate net carrying value of these notes was approximately $6.1 million. Noncollection on the net notes receivable as described above could adversely affect our financial condition. See "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations—Off Balance Sheet Arrangements."

        We have guaranteed for the benefit of Schlotzsky's N.A.M.F., Inc., a bank term note, with an outstanding balance of approximately $1.9 million at December 31, 2002, and a $500,000 line of credit which has no outstanding balance at December 31, 2002. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Off Balance Sheet Arrangements."

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        We have guaranteed certain loans, leases and other obligations of certain franchisees. We entered into most of these guarantees prior to 2000 in connection with restaurants developed under the former Turnkey program. At December 31, 2002, the Company was contingently liable for approximately $22.0 million of franchisees' obligations, which was principally comprised of guarantees on real estate leases and mortgages, equipment leases, and loans of franchisees. We have, from time-to time, been called upon to perform under such guarantees and there can be no assurance that we will not be so called upon in the future. See "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations—Off Balance Sheet Arrangements."

        Directly and through a wholly owned subsidiary, we are the general partner and a limited partner in a limited partnership that owns a retail shopping center in the Austin, Texas, area. We have guaranteed, subject to certain conditions, the repayment of a loan for this project in the principal amount of approximately $2.0 million due in October 2009 (our subsidiary received the proceeds of the loan in repayment of its loan to the partnership). We do not consider our investment in the retail shopping center to represent a separate line of business. We have also guaranteed a loan, in the principal amount of approximately $2.1 million due in January 2016, of a limited liability company in which one of our subsidiaries owns a 50% interest (our subsidiary also received the proceeds of this loan in payment for the restaurant purchased by the limited liability company). See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Off Balance Sheet Arrangements."

        Litigation and Claims.    We are subject to various lawsuits and claims that arise from our business operations. We have obtained liability insurance to cover certain types of claims, subject to significant deductibles, retentions and other limitations. There can be no assurance that such insurance will be available to us in the future on acceptable terms or that the insurance obtained will be adequate to pay applicable claims. See "Legal Proceedings."

        Geographic Concentration.    Of the 643 restaurants in the Schlotzsky's Deli system at December 31, 2002, 189 were located in Texas. A downturn in the regional economy or other significant adverse events in Texas could have a material adverse effect on our financial condition and results of operations. See "Business—Schlotzsky's Deli Restaurant Locations."

        Factors Affecting the Restaurant Industry.    We and our franchisees may be affected by risks inherent in the restaurant industry as identified above, including but not limited to the following: adverse changes in national, regional or local economic conditions; weather conditions; availability and cost of labor (including increases in the minimum wage); health and safety concerns; increased costs of food products; limited alternative uses for properties and equipment; changing consumer tastes, habits and spending priorities; increased concern with nutrition and health issues; and changing demographics.. The restaurant industry is subject to numerous federal, state and local governmental regulations, including those relating to food preparation, employment, zoning and building requirements. We may also be adversely affected by publicity resulting from food quality, illness, injury or other health concerns or operating issues or allegations resulting from one restaurant or a limited number of restaurants in the Schlotzsky's Deli system or in other restaurant chains. If we implement changes to our menu, our recipes, or our pricing, there is a risk that the consumer market will respond negatively to those changes, which would negatively affect our sales. Our advertising and marketing strategy could be negatively impacted by an increase in advertising costs, especially in the television market, which could essentially price us out of the national network television market based on the funds available for advertising in NAMF. 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 our financial condition and results of operations. See "Business."

        Competition.    The food service industry is intensely and increasingly competitive with respect to concept, price, location, food quality and service. There are new competitors as well as many

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well-established competitors with substantially greater financial and other resources than us. These competitors include a large number of national, regional and local food service companies, including fast food and quick-service restaurants, fast casual dining restaurants, casual dining restaurants, delicatessens, pizza restaurants and other convenience dining establishments. Some of our competitors have been in business longer than us and may be better established in markets where Schlotzsky's Deli restaurants are or may be located. There are also new and growing competitors in the fast casual upscale sandwich category in which we primarily operate. Another restaurant could emulate our distinctive bread, recipes and store appearance. We provide training and other assistance to its franchisees in 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 Schlotzsky's Deli restaurants. We also believe that we compete for franchisees with franchisors of other restaurants and various concepts. See "Business."

        Reliance on Area Developers.    We rely on certain area developers along with our own staff to recruit qualified franchisees and to perform quality inspections of franchised restaurants and other services. Area developers are independent contractors, and are not our employees. Although most area developer agreements originally specified a schedule for opening restaurants in their territories, we eliminated the minimum development schedule for several area developers in exchange for a reduced commission from future franchise fees and royalties. We also, under certain limited circumstances, have agreed in the past to extend, amend or waive minimum development schedules for certain other area developers. We provide training and support to area developers, but the quality of restaurant operations in their territories may differ, based on the area developer's level of training and experience. We cannot guarantee that our area developers will be in full compliance with development schedules, inspection standards or other requirements, and there can be no assurance that restaurants in the territories of such area developers will conform to our standards. In the past four years, we have negotiated transactions with certain area developers to reacquire their territories or to reduce their responsibilities along with their compensation. As a result, our success in those territories increasingly depends on our ability to perform functions that we had previously relied upon or shared with area developers to perform. See "Business."

        Dependence on Management and Key Personnel.    Our success is very dependent upon the efforts of our management and key personnel, including our Chairman of the Board, President and Chief Executive Officer, John C. Wooley. We have employment agreements with John C. Wooley, Jeffrey J. Wooley, and Richard H. Valade, which include certain noncompetition provisions that survive the termination of employment. The Wooley employment agreements were amended and restated effective January 1, 2001, and will automatically extend for rolling four-year terms. The Valade agreement was dated August 15, 2000, and will extend automatically for one-year terms. However, there can be no assurance that such noncompetition agreements will be enforceable in any particular situation. The loss of the services of John C. Wooley or other management or key personnel could have a material adverse effect on us. We do not carry key man life insurance on any of our officers. See "Directors and Executive Officers of the Registrant."

        Volatility of Stock Price and Volume.    There have been periods of significant volatility in the market price and trading volume of our Common Stock, which in many cases were unrelated to the operating performance of, or announcements concerning, us. General market price declines or market volatility in the future could adversely affect the price of our 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 many factors including, but not limited to: variations in quarterly operating results, changes in management, competitive factors, regulatory changes, general trends in the industry, recommendations by securities industry analysts and other events or factors. The low volume of public trading to the Common Stock has exacerbated this volatility. There can be no assurance that an adequate trading market can be maintained for the Common Stock.

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        As of December 31, 2002, we had 7,496,778 shares of Common Stock issued, of which 189,525 shares were held in treasury, and we had outstanding an aggregate of 940,290 stock options and warrants that were exercisable. A substantial number of shares may become available for sale in the public market at various 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 our Common Stock. Sales of substantial amounts of Common Stock in the public market, or the perception that such sales may occur, could adversely affect the market price for the Common Stock and could impair our ability to raise capital through a public offering of equity securities. See "Market for Registrant's Common Equity and Related Stockholder Matters."

        Anti-Takeover Provisions.    The Texas Business Combination Law restricts certain transactions between a public corporation and affiliated shareholders. The statute may have the effect of inhibiting a non-negotiated merger or other business combination involving us.

        Our 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 to 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 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 other shareholder action must be effected at a duly called annual or special meeting and shareholders must follow an advance notification procedure for certain shareholder proposals and nominations 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 additional 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 could have other adverse effects on Common Stockholders, including creation of a preference upon liquidation or the payment of dividends in favor of the holders of Preferred Stock.

        The Board of Directors has adopted a Shareholders' Rights Plan, pursuant to which certain rights would become exercisable upon the occurrence of certain events, such as a purchase, tender offer, or exchange offer that would result in a person obtaining 20% or more of our outstanding shares of Common Stock. Upon becoming exercisable, the Rights may entitle the holder to purchase our Common Stock or an acquiring company's stock for less than market value or to receive cash. The Rights have certain anti-takeover effects, including the substantial dilution of value incurred by such a person who acquires 20% or more of our Common Stock. Accordingly, the existence of the Rights may deter certain persons from making takeover proposals or tender offers. Of the 1,000,000 shares of Preferred Stock that are authorized, 200,000 shares have been reserved for issuance under the Shareholders' Rights Plan as Class C Series A Junior Participating Preferred Stock.

        We have issued a promissory note payable to the seller of certain rights to an area developer territory with a principal amount outstanding of approximately $21.8 million as of December 31, 2002. The note is subject to acceleration by the payee 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.)

        Absence of Dividends.    We have never paid cash dividends on our Common Stock.

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        Stock Repurchase Program.    In January 2001, the Board of Directors increased the existing authorization to repurchase shares of our outstanding Common Stock to 1,000,000 shares. Since then, the Company repurchased 179,525 shares at a total cost of approximately $738,000.

ITEM 2. PROPERTIES

        We lease our corporate headquarters facility in Austin, Texas, from Third & Colorado, L.L.C., a company of which John C. Wooley and Jeffrey J. Wooley are controlling members. This lease will expire in 2007. The facility consists of approximately 41,000 square feet of office and storage space.

        We operate 36 restaurants in twelve states. Fourteen of these restaurants are in our portfolio of restaurants to be operated for the long term. Of these units, thirteen are in Texas and one is in Georgia. The remaining 22 restaurants are considered available for sale. Five of these restaurants are located in Georgia, three each in North Carolina and Texas, two each in Mississippi and Tennessee, and one each in Alabama, Arkansas, Arizona, Minnesota, New Mexico, New York and Utah. The properties consist of land, building, leasehold improvements, and restaurant equipment. The equipment is typically owned, and the land and building are either owned or leased. In addition, we have certain excess undeveloped or partially developed real estate held for sale.

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ITEM 3. LEGAL PROCEEDINGS

        Russell R. Kesterson and Steven P. Schmidt v. Schlotzsky's, Inc., Ron Lynch and Jane Doe Lynchy, John Does I—X, Jane Does I—X, ABC Corporations I—X, XYZ Companies I—X, (Case No. CV2002-021158) was filed on October 31, 2002, in the Superior Court of Maricopa County, Arizona. Plaintiffs were franchisees of the Company and owned and operated a Schlotzsky's Deli Restaurant in Phoenix, Arizona. The Complaint includes claims of breach of contract, interference with business expectancy, interference with business relationship, unfair competition and negligence. Plaintiffs allege that a "superstore" owned by Lynch and/or our affiliates encroached on their business and allege that we failed to collect royalties from the "superstore," creating unfair competition. Plaintiffs further state that they attempted to relocate their restaurant but that we failed to approve a proposed alternative location and that we induced their employee to work for a competing restaurant. Plaintiffs are seeking an unspecified amount of damages, including treble damages, attorney's fees, and costs. On December 3, 2002, we filed a petition styled Schlotzsky's, Inc., v. Russell R. Kesterson and Steven P. Schmidt, in the United States District Court for the Western District of Texas, Austin Division (Civil Action No. AO2CA 768SS) to compel Plaintiffs to arbitrate their claims in Austin, Texas. The federal court entered an order on December 20, 2002, granting our petition to compel arbitration in the manner provided in the franchise agreement and enjoined Kesterson and Schmidt from pursuing any of their claims in the lawsuit pending in Arizona. To date, we are unaware of any subsequent demand for arbitration filed by either Kesterson or Schmidt.

        Kimberly L.E. Garland v. Schlotzsky's, Inc., Schenck & Associates, John C. Wooley, Darrell W. Kolinek, Kelly R. Arnold, Joyce Cates, Brian Wieters, David B. Gerstner, and Jeffrey P. Noeldner, (Case No. 01-CV-2377), was filed on or about December 26, 2001 in the United States District Court for the District of Minnesota. Plaintiff is a principal and guarantor under a franchise agreement between the Company and Holy Buns, L.L.C., a former franchisee in Apple Valley, Minnesota ("Franchise Agreement"). Plaintiff alleges fraudulent and negligent misrepresentation and omission and violations of the Minnesota Franchise Act, Minnesota Uniform Deceptive Trade Practices Act, and the Texas Deceptive Trade Practices and Consumer Protection Act against the Company and five of its current and former employees (John Wooley, Darrell Kolinek, Kelly Arnold, Joyce Cates, and Brian Wieters), her Area Developer (Jeffrey Noeldner), her accountant (David Gerstner), and his accounting firm (Schenck & Associates). Plaintiff claims that the defendants engaged in a fraudulent scheme to sell her a Schlotzsky's franchise and Schlotzsky's Deli restaurant in Apple Valley, Minnesota (constructed through the Company's Turnkey Program) that they knew was not financially viable. Plaintiff seeks an unspecified amount of money damages plus attorneys' fees, costs, and interest. We have denied the allegations in our answer and filed a motion, which is still pending, to dismiss or stay the case pending arbitration in the manner provided in the Franchise Agreement. On March 11, 2003, the Court ordered the parties to appear for a settlement conference on April 29, 2003. The case is not yet set for trial.

        Robert Coshott v. Schlotzsky's, Inc., (Cause No. GN 1-02279), was filed on July 24, 2001, in the 200^th Judicial District Court of Travis County, Texas. Plaintiff is the Master Licensee for Australia and New Zealand, and he opened a Schlotzsky's Deli restaurant in Melbourne, Australia. Plaintiff brings causes of action for fraud and/or negligent misrepresentation. Plaintiff alleges that he experienced problems with certain equipment specified or approved by the Company, that the Company's system and equipment did not generate enough finished food product to service his potential customers; that the Company misrepresented the level of revenue the restaurant could reasonably be expected to achieve; that the Company delayed his ability to develop restaurants by failing to timely secure certain trademarks and trade names; and that the Company misrepresented whether it would allow Plaintiff to franchise Schlotzsky's Deli restaurants in certain gas station or convenience store locations in his territories. Plaintiff requests actual and punitive damages of $3.75 million plus lost profits and incidental and consequential damages of an unspecified amount. The case is not yet set for trial.

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        Dae Kim, DWK Enterprises, Inc., and Aecon International, Inc. v. John Wooley, Schlotzsky's, Inc., Schlotzsky's Franchising Limited Partnership, Schlotzsky's NAMF, Inc., Schlotzsky's National Advertising Association, Inc., and Schlotzsky's, Brands, Inc., Schlotzsky's Brand Products, L.P., Schlotzsky's Real Estate, Inc., and Schlotzsky's Restaurants, Inc., (Civil Action No. SA-03-CA-00362), was originally filed in the 73^rd Judicial District Court of Bexar County, Texas on or about September 25, 2001 (after a similar lawsuit was filed and later withdrawn in Harris County, Texas) against Schlotzsky's, Inc., John Wooley, Schlotzsky's Franchising Limited Partnership, and Schlotzsky's NAMF, Inc. (collectively, "Defendants"). Plaintiffs are, or claim to be, franchisees in Houston and San Antonio Texas, and Plaintiff Kim was an area developer for those markets. Plaintiffs bring causes of action for breach of contract, breach of fiduciary duty, breach of the duty of good faith and fair dealing, civil conspiracy, tortious interference with contract, tortious interference with prospective business relationship, violation of the Texas Deceptive Trade Practices and Consumer Protection Act, restraint of trade, detrimental reliance-fraud in the inducement, and defamation-business disparagement. They seek an unspecified amount of money damages plus exemplary damages, attorneys' fees, pre-judgment interest, costs, and a jury trial. Defendants, except for Mr. Wooley, who was previously dismissed from the case, answered and asserted counterclaims alleging breach of contract and that Plaintiffs' claim under the Texas Deceptive Trade Practices Act is groundless in fact or in law and brought in bad faith or for the purpose of harassment, and seeking money damages, costs of court, penalty fees, costs incurred in performing the accounting, attorneys' fees, and pre- and post-judgment interest. Defendants (except for Mr. Wooley) removed the case to federal court because they believed that plaintiffs had alleged a cause of action under the federal antitrust laws for the first time in their fourth amended complaint. Plaintiffs filed a motion to remand the case to state court, and defendants (except for Mr. Wooley) filed a memorandum in opposition to this motion. The Court has not yet ruled on the motion to remand.

        U.S. Restaurant Properties Operating L.P. v. Schlotzsky's, Inc. was filed on February 27, 2003, in the District Court of Dallas County, B-44^th Judicial District (Cause No. 03-01758) and we were served on March 7, 2003. Plaintiff is a real estate investment company that owns certain Schlotzsky's Deli restaurants, and leases them to franchisees. It alleges that in 1997 and 1998 we entered into several written guaranty agreements where we agreed to guarantee certain lease agreements. Plaintiff states that in 1998 the Parties entered into an agreement whereby Plaintiff agreed to release Schlotzsky's from its guaranty obligations pertaining to six properties in which the tenants had defaulted, in exchange for Schlotzsky's agreement to purchase seven other properties. One of the properties located in Texas was purchased by the Company. Plaintiffs are seeking an order requiring us to purchase the other six properties, two of which are in Texas, and one each in Arizona, Colorado, Indiana, and Tennessee, for a total purchase price of over $4.5 million. In the alternative, Plaintiff is seeking damages or an order reinstating the previously released guaranties. Plaintiff's claims include breach of contract and a request for attorneys' fees. The case is not yet set for trial.

        In addition to the matters discussed above, we are defendants in various other legal proceedings arising from our business. The ultimate outcome of these pending proceedings cannot be projected with certainty. However, based on our experience to date, we believe such proceedings will not have a material effect on our business or financial condition.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        Not applicable.

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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 (including 200,000 shares of Class C Series A Junior Participating Preferred Stock reserved for issuance under our Shareholders' Rights Plan). Our Common Stock is traded on the NASDAQ National Market under the symbol "BUNZ". As of March 4, 2003, 7,319,887 shares of outstanding Common Stock were owned by approximately 280 beneficial owners and 4,500 shareholders of record.

        The following table shows, for our Common Stock in each fiscal quarter in the last two years, the highest and lowest sales price (reflecting actual transactions reported by NASDAQ).

        We have never paid cash dividends on our Common Stock and, while we periodically evaluate this issue, we do not have current plans to do so. The declaration and payment of future dividends will be at the sole discretion of the Board of Directors and will depend on our profitability, financial condition, capital needs, future prospects, financing restrictions and other factors deemed relevant by the Board of Directors.

        The Transfer Agent and Registrar for our Common Stock is Computershare Investor Services, LLC.

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 consolidated balance sheet data as of December 31, 2002 and 2001 and the consolidated statement of operations data as of and for the years ended December 31, 2002, 2001 and 2000 have been derived from the audited consolidated financial statements of the Company, included elsewhere herein. The consolidated balance sheet data as of December 31, 2000, 1999 and 1998 and consolidated statement of operations data as of and for the years ended December 31, 1999 and 1998 have 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

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in their entirety by, the Consolidated Financial Statements of the Company and related Notes and other financial information included elsewhere in this report.

(1)

Effective January 1, 1999, the Company implemented a change in accounting principle regarding revenue recognition of developer fees.

(2)

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142. See "Notes to Consolidated Financial Statements."

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

        We derived approximately 97.4% of our revenue in 2002 from three recurring sources: royalties from franchisees, restaurant sales at Company-operated restaurants and brand contribution (license fees from the sales of Schlotzsky's Deli brand products to the restaurant system and in the retail sector). Royalties are generally reported and collected weekly. Net restaurant sales are generally for cash or credit card at the time of the sales transaction.

        We are in the process of enhancing and expanding the menu of the Schlotzsky's Deli system to increase the culinary sophistication of menu offerings and to improve nutritional value through increased offerings of lower calorie and reduced fat menu items. At the same time, restaurant designs are being updated to complement the new menu and to improve restaurant efficiency and the quality of the customers' dining experience. These changes are intended to increase restaurant sales volumes and improve gross margins and restaurant profitability. We expect to test the menu and format enhancements beginning with Company-operated restaurants in Austin, Texas, starting in the second quarter of 2003 and to introduce several of the successful enhancements throughout most of the Schlotzsky's Deli system in 2003 through 2005.

        We are also pursuing long-term financing to fund an expansion of Company-operated leadership restaurants in key markets in Texas and other states, to refinance certain shorter-term or higher-rate debt and to support operations. Potential financing alternatives include asset-backed financing, secured by intellectual property and related royalty rights and agreements, and conventional real estate mortgages. Failure to obtain such financing would require us to significantly modify our growth strategies for Company-operated restaurants and reduce operating costs and capital expenditures.

        During 2002, we repaid the remaining outstanding balances under our 1999 bank group credit agreement with the proceeds of real estate mortgages, and completed the acquisition of the territorial rights of our largest area developer, primarily through a seller-financed promissory note. This acquisition improves our ability to grow the Schlotzsky's Deli system, particularly Company-operated restaurants, in this territory, which includes the Dallas, Houston, and San Antonio markets, as well as all or parts of ten other states. Our revenues declined in 2002 due to factors such as economic difficulties in local economies and trade areas and increased competition. These economic difficulties continued to depress sales levels across the system to below 2001 levels, and also had a tempering effect on franchisee development and new restaurant openings. The termination of our former Turnkey program in 2000 (see below) has also impacted new restaurant development.

        We no longer build and develop restaurants for franchisees as we did from 1995 to 2000 through our Turnkey program. Franchisees must now do so themselves. While the Turnkey program was successful in increasing systemwide sales, restaurant count and average weekly unit sales, the program involved our undertaking significant real estate development and credit risks. As a result of the termination of the Turnkey program, a non-cash, pre-tax charge of approximately $5,340,000 was recorded in the second quarter of 2000.

CRITICAL ACCOUNTING POLICIES

        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, liabilities, revenues and expenses and related disclosure of contingent liabilities. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the

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circumstances. Estimates and assumptions are reviewed periodically. Actual results may vary from these estimates.

        We believe the following critical accounting policies require estimates about the effect of matters that are inherently uncertain and require subjective judgments. Changes in the estimates and judgments could significantly impact our results of operations and financial conditions in future periods.

•

Determination of the appropriate valuation allowances for accounts and notes receivable.
 


Our accounts and notes receivable are primarily from franchisees of the Schlotzsky's Deli system. We require personal guarantees for all franchise accounts and, for notes receivable, generally obtain a secondary secured interest in the related property and equipment or rights. Many of the notes receivable are fully subordinated to the franchisee's senior mortgage debt. In reviewing the adequacy of the valuation allowances for accounts and notes receivable, we consider factors such as historical collection experience, the value of personal guarantees and real property collateral, the franchisee's sales and operating trends, including potential for improvement in operations, and general economic conditions that may affect the franchisee's ability to pay. Actual realization of amounts receivable could differ materially from our estimates.

•

Determination of appropriate valuation allowances for real estate held for sale.
 


Our real estate held for sale consists primarily of pad sites. As these sites are being actively marketed, they are periodically assessed for estimated net realizable value. Factors considered in this assessment are offers and letters of intent received on properties, discussions with local real estate brokers, property tax and bank appraisals, sale prices of similar properties and level of activity and interest exhibited by potential buyers. Actual realizeability could differ materially from our estimates.

•

Determination of appropriate valuation allowance for intangible assets.
 


Amortizing intangible assets consist primarily of amounts paid to reacquire various developer and franchise rights. Annually, and whenever an event or circumstances indicate impairment may be present, we compare projected undiscounted cash flows to the carrying value of the related assets to determine if impairment has occurred. In estimating future cash flows, we consider such factors as current results, trends, future prospects, and other economic factors. Actual future cash flows could differ materially from our estimates.

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        The following tables set forth (i) the percentage relationship to total revenue of the listed items included in our consolidated statements of operations, except as otherwise indicated, and (ii) selected restaurant data.

(1)

Expressed as a percentage of royalties.

(2)

Expressed as a percentage of franchise fees.

(3)

Expressed as a percentage of restaurant sales.

(4)

Amounts may not sum due to rounding.

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(1)

Includes contractual sales for all restaurants, including Company-operated and franchised, as reported by franchisees or derived by us from other data.

(2)

Same store contractual sales are based on Company-operated and franchised restaurants that were open for the entire period indicated and for at least eighteen months as of the end of the corresponding prior period, including restaurants that were temporarily closed and reopened within six months.

(3)

In actual dollars (rounded in the case of average annual store sales).

(4)

Freestanding restaurants include all restaurants in freestanding buildings; shopping center restaurants are restaurants in a shopping center; other restaurants include downtown, airport and other locations.

(5)

Percentage change in weighted average weekly store contractual sales from previous fiscal year.

(6)

Systemwide contractual sales, same store contractual sales, and weighted average annual same store contractual sales, all based on contractual sales as defined in our franchise agreements, represent net sales under generally accepted accounting principles, plus the amounts of any discounts for employee or manager meals. Contractual sales are used in this chart and throughout this report, because these sales are the basis of our royalty income and contractual sales are the only sales amounts reported by the franchisees.

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RESULTS OF OPERATIONS

Fiscal Year 2002 Compared to 2001

        REVENUE. Total revenue decreased 2.1% from $61,851,000 to $60,546,000.

        ROYALTIES decreased 8.3% from $21,765,000 to $19,967,000. The decrease was due to a decrease in the average number of franchised restaurants operating during 2002 compared to 2001 and a decrease in same store contractual sales of 6.1%, partially offset by a continuing shift in restaurant mix towards larger, higher volume units.

        FRANCHISE FEES decreased 64.9% from $348,000 to $122,000. The decrease was principally the result of fewer openings of franchised restaurants as well as a decrease in average franchise fee recognized per opening during 2002 as compared to the prior year.

        DEVELOPER FEES decreased 49.2% from $455,000 to $231,000. The decrease is primarily attributed to the expiration of amortization on certain agreements, and an increase in income related to the recognition of deferred developer fees based upon the termination of one international master licensee in the third quarter of 2001.

        RESTAURANT SALES increased 6.1% from $29,906,000 to $31,723,000. The increase was primarily due to an increase in the average number of Company-operated restaurants during 2002 compared to 2001, partially offset by an 8.0% decrease in same store sales. As of December 31, 2002, there were 36 Company-operated restaurants, compared to 33 at December 31, 2001, of which 22 and 18, respectively, were available for sale. During 2002, we closed two restaurants, one in the Schlotzsky's Deli long-term portfolio and one available for sale restaurant. Also during 2002, we acquired an additional four restaurants from franchisees and reopened one restaurant, which was previously operated by a franchisee. In the normal course of business, we expect to acquire additional restaurants from franchisees. While it is our intention to re-franchise these restaurants, the restaurants serve as a base of operations for Company personnel in their respective markets and, as such, are an important part of the franchising infrastructure.

        SCHLOTZSKY'S DELI BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 1.2% from $7,397,000 to $7,309,000. The decrease was primarily due to by the effect of the decrease in systemwide contractual sales, partially offset by more favorable terms with certain major suppliers than the prior year period, the recognition of $151,000 in past due fees from a licensee during the second quarter of 2002, and an increase in sales through retail channels. Sales of Schlotzsky's Deli brand products through retail channels of distribution accounted for 6.5% of brand contribution in 2002, up from 4.8% in 2001.

        OTHER FEES AND REVENUE decreased 39.7% from $1,981,000 to $1,195,000. The decrease was due to reduced vendor contributions to conventions and franchisee meetings, a decrease in expired franchise fees and transfer fees, gains of approximately $330,000 on the sale of certain restaurants available for sale and restaurant equipment recognized in the prior year, and approximately $170,000 in real estate and transaction fees from the former Turnkey program recorded in the prior year.

        OPERATING EXPENSES. SERVICE COSTS decreased 17.7% from $4,894,000 to $4,028,000, and as a percentage of royalties and franchise fees decreased from 22.1% to 20.1%. This decrease was primarily due to our reacquisition of certain area developer territory rights during 2002 and 2001, a decrease in franchise fee costs due to fewer restaurant openings during 2002 as compared to the prior year, and a decrease in royalty and franchise fee revenue.

        RESTAURANT OPERATIONS EXPENSES increased 6.0% from $27,823,000 to $29,490,000. This increase was primarily due to the increase in restaurant sales. RESTAURANT COST OF SALES increased 6.8% from $8,363,000 to $8,935,000, and increased as a percentage of net restaurant sales from 28.0% to 28.2%.    RESTAURANT PERSONNEL AND BENEFITS COST increased 3.9% from

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$12,515,000 to $12,998,000, and decreased as a percentage of net restaurant sales from 41.8% to 41.0%. The decrease, as a percentage of net restaurant sales, was due to improved labor scheduling. RESTAURANT OPERATING EXPENSES increased 8.8% from $6,945,000 to $7,557,000, and increased as a percentage of net restaurant sales from 23.2% to 23.8%. The increase as a percentage of net restaurant sales was primarily due to fixed cost expense components related to acquired restaurants as well as a reduction in the leverage on fixed costs, due to the decrease in average sale volumes. All cost components were adversely impacted by training and pre-opening costs for Company-operated restaurants that will open in the future. The use of some Company-operated restaurants in the long-term portfolio for product, process and equipment testing and for systemwide training also adversely impacts their operating performance.

        EQUITY LOSS ON INVESTMENTS increased 78.0% from a loss of $109,000 to a loss of $194,000. The equity investment represents the Company's 50% interest in a limited liability company that operates a Schlotzsky's Deli restaurant which opened in 2000.

        GENERAL AND ADMINISTRATIVE EXPENSES increased 4.1% from $18,719,000 to $19,489,000, and increased from 30.3% to 32.2% as a percentage of total revenue. The increase was primarily due to increases in insurance costs, advertising and marketing and legal and professional fees, partially offset by reduced salaries and benefits, due to a reduced number of employees, reduced convention and franchisee meeting expenses, and property taxes.

        DEPRECIATION AND AMORTIZATION increased 18.8% from $4,224,000 to $5,020,000, and increased from 6.8% to 7.8% as a percentage of total revenue. The increase was primarily due to the amortization of reacquired area developer territory rights, depreciation related to an increase in the average number of Company-operated restaurants during 2002 as compared to the prior year, and a $300,000 impairment charge, related to restaurants, partially offset by a reduction of approximately $241,000 in intangible asset amortization expense related to the adoption of SFAS No. 142.

        INTEREST INCOME decreased 30.9% from $943,000 to $652,000. The decrease was due to the decrease in the amount of outstanding notes receivable, the non-recognition of interest income on certain subordinated or under-performing notes receivable and a decrease in average interest rate during 2002 as compared to the prior year, partially offset by the cash receipt of $77,000 in interest in 2002 on a non-accruing note receivable.

        INTEREST EXPENSE increased 8.9% from $2,822,000 to $3,073,000 due to debt incurred in conjunction with the reacquisition of our largest area developer territorial rights and an increase in the average number of Company-operated restaurants during 2002 as compared to the prior year, partially offset by lower average interest rates and a decrease of approximately $32,000 of interest capitalized on Company-operated restaurants under construction as compared to the prior year.

        PROVISION (CREDIT) FOR INCOME TAXES reflected a provision for 2002, even though there was a pretax loss and the effective combined tax benefit rate was 40.8% for 2001, due both to income levels and certain state taxes being based in part on factors other than income.

        NET INCOME decreased from $2,489,000 to a loss of $199,000, and earnings per share, both basic and diluted, were $(0.03) for the twelve months ended December 31, 2002, compared to $0.34 and $0.33, basic and diluted, respectively, in the prior year, due to the factors discussed above.

Supplemental Restaurant Operations Information—
Performance of Long-term Portfolio Deli Restaurants

        The following table is presented for the Schlotzsky's Deli restaurants in the Company's long-term portfolio for the twelve months ended December 31, 2002. As of December 31, 2002, this restaurant group included eight restaurants in the Austin area, two in College Station, Texas and one in suburban Atlanta, Georgia. This group includes ten recently constructed freestanding restaurants and one

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shopping center end cap restaurant. In accordance with our internal management reporting practices for consistent comparisons, line item categories have been expanded and percentages are calculated based on gross sales, instead of net sales as used elsewhere in this report. Facility costs vary by restaurant because some facilities are rented and some are owned. The table provides the average percentage results for each line item for the eleven Schlotzsky's Deli restaurants in the long-term portfolio group as a whole, as well as the best and worst percentage performance for each line item for any restaurant in the group.

*

Represents the actual best and worst percentage performance for a restaurant in the group. The best and worst performance on a composite basis would be 32.3% and 1.1%, respectively.

Fiscal Year 2001 Compared to 2000

        REVENUE. Total revenue increased 4.5% from $59,175,000 to $61,851,000.

        ROYALTIES decreased 3.2% from $22,478,000 to $21,765,000. The decrease was due to a decrease in the average number of franchised restaurants in 2001 compared to 2000, an increased percentage of systemwide sales generated by Company-operated restaurants, which do not pay royalties, and a decrease in same store contractual sales of 1.4%, partially offset by a continuing shift in restaurant mix towards larger, higher volume units.

        FRANCHISE FEES decreased 31.9% from $511,000 to $348,000. This decrease was a result of fewer restaurant openings during 2001, as compared to 2000. The reduced number of openings was principally the result of the discontinuation of the Turnkey program in 2000, as well as the Company's increased emphasis on superior site selection for new restaurants and on more highly qualified franchisees.

        DEVELOPER FEES decreased 38.5% from $740,000 to $455,000. The decrease reflected the termination of three international master licensees in the fourth quarter of 2000 which are therefore not included in 2001 revenue, as well as the deferral of amortization into income of deferred revenue

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for certain international master licensees and domestic area developers to the extent of uncollected notes receivable, partially offset by an increase in income related to the recognition of deferred developer fees based upon the termination of one international master licensee in the third quarter of 2001.

        RESTAURANT SALES increased 16.2% from $25,738,000 to $29,906,000. The increase was primarily due to an increase in the average number of Company-operated restaurants operated during 2001 compared to 2000, an increase in prices and a 2.2% increase in Company-operated restaurant same store sales. As of December 31, 2001, there were 33 Company-operated restaurants compared to 29 at December 31, 2000, of which 18 and 16, respectively, were available for sale.

        SCHLOTZSKY'S DELI BRAND LICENSING FEES (BRAND CONTRIBUTION) increased 3.6% from $7,142,000 to $7,397,000. The increase was a result of more favorable terms with certain major suppliers and an increase in the sales of Schlotzsky's Deli brand products through retail channels, partially offset by the effect of the decrease in systemwide contractual sales. Sales of Schlotzsky's Deli brand products through retail channels of distribution accounted for 4.8% of brand contribution in 2001, up 7% from 4.5% in 2000.

        OTHER FEES AND REVENUE decreased 22.8% from $2,566,000 to $1,981,000. This decrease was primarily due to the elimination of revenue generated by the former Turnkey program, which was cancelled in 2000, partially offset by gains of approximately $243,000 on the sale of available for sale property during 2001.

        OPERATING EXPENSES. SERVICE COSTS decreased 11.2% from $5,510,000 to $4,894,000, and as a percentage of royalties and franchise fees declined from 24.0% to 22.1%. This decrease was primarily due to the Company's reacquisition of certain area developer territory rights during 2001 and 2000, a decrease in franchise fee costs due to fewer restaurant openings during 2001 as compared to the prior year, and a decrease in royalty revenue.

        RESTAURANT OPERATIONS EXPENSES increased 17.4% from $23,707,000 to $27,823,000. This increase was primarily due to the increase in restaurant sales. RESTAURANT COST OF SALES increased 13.7% from $7,353,000 to $8,363,000, but decreased as a percentage of net restaurant sales from 28.6% to 28.0%. The decrease, as a percentage of net restaurant sales, was due to improved controls and price increases, which were partially offset by rising costs for meats and cheeses and increased discounts. RESTAURANT PERSONNEL AND BENEFITS COST increased 17.0% from $10,693,000 to $12,515,000, and increased as a percentage of net restaurant sales from 41.5% to 41.8%. The increase, as a percentage of net restaurant sales, was due to several additional managers in training for Company-operated restaurants under development and an increase in manager coverage at restaurants available for sale. RESTAURANT OPERATING EXPENSES increased 22.7% from $5,661,000 to $6,945,000, and increased as a percentage of net restaurant sales from 22.0% to 23.2%. The increase in operating costs, as a percentage of net restaurant sales, was due to higher voluntary contributions to the Austin advertising cooperative during 2001 as well as increased repair, maintenance, utility and facility costs, partially offset by operational efficiencies. All cost components were adversely impacted by training and pre-opening costs for Company-operated restaurants that will open in the future. The use of some Company-operated restaurants in the long-term portfolio for product, process and equipment testing and for systemwide training also adversely impacts their operating performance.

        EQUITY LOSS ON INVESTMENTS increased 98.2% from a loss of $55,000 to a loss of $109,000. The equity investment represents the Company's 50% interest in a limited liability company that operates a Schlotzsky's Deli restaurant which opened in 2000.

        GENERAL AND ADMINISTRATIVE EXPENSES decreased 32.8% from $27,865,000 to $18,719,000, and decreased from 47.1% to 30.3% as a percentage of total revenue. The decrease was

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primarily due to the termination of the Turnkey program during the second quarter of 2000, which resulted in a non-cash, pre-tax charge of approximately $5,340,000 in 2000. The decrease from the prior year was also impacted by reduced salaries and benefits, due to a reduced number of employees, reduced convention and franchisee meeting expenses, reduced legal and professional fees, reduced office supplies and reduced travel expenses, partially offset by increases in property taxes, insurance costs, and severance costs related to a reduction in force during the third quarter of 2001.

        DEPRECIATION AND AMORTIZATION increased 12.0% from $3,771,000 to $4,224,000, and increased from 6.4% to 6.8% as a percentage of total revenue. The increase was principally due to the amortization of reacquired area developer territory rights and depreciation related to an increase in the average number of Company-operated restaurants during the year.

        INTEREST INCOME decreased 58.4% from $2,265,000 to $943,000. The decrease was due to the decrease in the amount of outstanding notes receivable and the non-recognition of interest income on certain subordinated notes receivable.

        INTEREST EXPENSE decreased 21.3% from $3,586,000 to $2,822,000. This decrease was due to reduced debt levels, a lower weighted average interest rate, and bank waiver and amendment fees in the prior year.

        PROVISION (CREDIT) FOR INCOME TAXES reflected a combined federal and state effective tax rate of 40.8% for 2001, which was higher than the effective combined tax benefit rate of 24.4% for 2000 due to certain state taxes being based in part on factors other than income.

OFF-BALANCE SHEET ARRANGEMENTS

        We have outstanding guarantees of indebtedness of others, including related parties, of approximately $28.0 million as of December 31, 2002. These guarantees include approximately $5.3 million of lease guarantees for the benefit of franchisees, approximately $16.7 million of mortgage loan guarantees for the benefit of franchisees and approximately $6.0 million of loan guarantees for the benefit of related parties.

        The lease guarantees for the benefit of franchisees arose primarily through our former Turnkey program, in which we developed the restaurants, leased the restaurants to franchisees, and then sold them to a leasing company. The guarantees range from limited guarantees, either in dollar amount or term, to full guarantees for the life of the lease. The maximum guarantee for a single lease is approximately $1.3 million. Certain guarantees extend through 2018. We may be required by the lessor to make monthly rental payments or property tax and common area maintenance payments if the franchisee does not make the required payments in a timely manner. We have indemnification agreements with the franchisee under which the franchisee would be obligated to reimburse us for any amounts paid under such guarantees. As of December 31, 2002, we had accrued a liability of approximately $141,000 related to these guarantees. We also have net deferred gain related to the sale of these leases in the amount of approximately $142,000 as of December 31, 2002. (See "Note 7 to the Consolidated Financial Statements.")

        The mortgage loan guarantees for the benefit of franchisees also arose primarily through our former Turnkey program, in which we developed the related restaurants, sold the restaurant to a franchisee, and guaranteed all or a portion of the franchisee's mortgage loan. The guarantees range from limited guarantees, either in dollar amount or term, to full guarantees of the mortgage. The maximum amount of a single guarantee is approximately $1.1 million. Certain guarantees extend through 2016. We may be required by the lender to make monthly mortgage payments if the franchisee does not make the required payments in a timely manner, or we may be required to make up any deficiency, up to the amount of the guarantee, if the related restaurant is sold for net proceeds less than the amount of the outstanding mortgage. We have indemnification agreements with the

26

franchisees under which the franchisee would be obligated to reimburse us for any amount paid under such guarantees. In the event that we purchase the loan from the lender in the event of a default, we would succeed to the lender's security interest in the related property.

        The loan guarantees in favor of related parties primarily arose when we guaranteed certain debt of related parties for which the proceeds of the loans were used to repay outstanding debt to us. Two of the guarantees, for the benefit of our restaurant venture and our real estate venture, are of mortgage debt, totaling approximately $4.1 million. These guarantees extend through 2009 on one note and through 2016 on the other note. A third guarantee, in the amount of approximately $1.9 million, is for the benefit of the advertising entity of the Schlotzsky's Deli restaurant system, for which we received the net proceeds of the loan in repayment of outstanding debt to us. This guarantee expires in 2004.

        We have been called upon, from time to time, to make payments on obligations we have guaranteed. During 2002, we paid approximately $493,000 in various lease guarantees and approximately $100,000 under various loan guarantees, both for the benefit of franchisees. In addition, pursuant to a guarantee of a franchisee's debt obligation, we expect to purchase that obligation from a bank, in the amount of approximately $665,000, in August 2003.

LIQUIDITY AND CAPITAL RESOURCES

        Cash and cash equivalents decreased $1,889,000 in 2002, increased $1,404,000 in 2001, and decreased $3,749,000 in 2000. Cash flows are impacted by operating, investing and financing activities.

        Operating activities provided $6,669,000, $8,718,000, and $2,195,000 of cash in 2002, 2001, and 2000 respectively. The decrease in cash provided in 2002 as compared to 2001 was the net result of lower net income, lower provision for deferred taxes and uncollectible accounts and impairment of assets and a reduced use of cash for certain working capital accounts, partially offset by increased depreciation and amortization and lower amortization of deferred revenue. The increase in cash provided in 2001 as compared to 2000 was the net result of a return to profitability after a net loss in 2000, an increase in depreciation and amortization, and a reduced use of cash for certain working capital accounts, partially offset by decreased provisions for uncollectible accounts and impairment of assets.

        Investing activities used $4,055,000 of cash in 2002, $2,635,000 of cash in 2001, and provided $4,499,000 of cash in 2000. The increase in cash used in 2002 as compared to 2001 was the net result of a reduction in net repayments on notes receivable, partially offset by a reduction in expenditures for property and equipment and proceeds from the sale of property and equipment. The decrease in cash provided in 2001 compared to 2000 was the net result of an increase in expenditures for intangible assets, reduced net repayments of notes receivable, and a decrease in the amount of net proceeds received from the sale of property, equipment and real estate.

        Financing activities used $4,504,000 in 2002, $4,678,000 in 2001, and $10,443,000 of cash in 2000, respectively. The use of cash in 2002, 2001 and 2000 is due to the net repayment of debt. Additionally, we implemented a stock repurchase program in 2001.

        At December 31, 2002, we had approximately $53,505,000 of total debt outstanding. During 2002, we completely repaid all outstanding balances under our 1999 bank group credit agreement with the proceeds of mortgages on Company-operated restaurants and real estate. During 2002, we also exercised an option to acquire our largest area developer territory. This acquisition was primarily financed through a promissory note to the seller. The amount outstanding under this note was approximately $21,790,000 at December 31, 2002.

        Certain of our mortgage debt requires the maintenance of certain financial ratios, including debt-to-equity and working capital. While we are currently in compliance with these covenants, or have obtained waivers, any failure to comply in the future could have material adverse consequences to us.

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        The following tables present certain of our obligations and commitments to make future payments, excluding interest payments, under contracts and contingent commitments as of December 31, 2002.

        We plan to develop additional Company-operated restaurants. Two restaurants are under construction in the Austin area, and are expected to open in 2003. The Company has received a lending commitment for one of the restaurants. The Company has also acquired the building sites for two additional restaurants in the Austin area.    Sites for additional restaurants in Texas and in other markets are under consideration.

        We will require additional financing to execute our growth strategy for Company-operated restaurants and for other purposes. We are pursuing financing alternatives, including asset-backed financing secured by its intellectual property and related royalty rights and agreements, as well as real estate mortgages. There can be no assurance that such financing can be arranged in acceptable amounts and on acceptable terms. Failure to obtain such financing would require us to significantly modify our growth strategies for Company-operated restaurants and reduce our operating costs and capital expenditures.

        Our Board of Directors has authorized the repurchase of up to 1,000,000 shares of the Company's outstanding Common Stock. In 1998, 10,000 shares were repurchased for $105,000. In 2002 and 2001, we repurchased an additional 179,525 shares at a total cost of approximately $738,000.

QUARTERLY COMPARISONS

        We utilize a "4-4-5 week" quarterly reporting schedule for royalties, restaurant operations and royalty service costs. Fiscal years 2002 and 2001 included 52 weeks. For all other areas of the financial statements, we report all fiscal quarters as ending on March 31, June 30, September 30 and December 31.

        We believe that we experience only moderate seasonality, although first and fourth quarter systemwide contractual sales, which impact several revenue categories, are generally lower than the second and third quarter levels. We attempt to make restaurant sales less seasonal by offering a variety of products that tend to sell better during various seasons.

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SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONDENSED QUARTERLY RESULTS OF OPERATIONS
(UNAUDITED)

        The following tables present unaudited condensed quarterly results of operations and selected restaurant data for 2002 and 2001.