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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-27008
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SCHLOTZSKY'S, INC.
(Exact name of registrant as specified in its charter)
TEXAS 74-2654208
(State or other Jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
203 COLORADO STREET, AUSTIN, TEXAS 78701
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (512) 236-3600
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Name of each exchange
Title of each class on which registered
COMMON STOCK, NO PAR VALUE NASDAQ NATIONAL MARKET
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
PREFERRED STOCK PURCHASE RIGHTS
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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
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ ].
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 19, 1999 was approximately $60,849,000 based upon the
last sales price on March 19, 1999 on the NASDAQ National Market System for the
Company's common stock. For purposes of this computation, all officers,
directors and 10% beneficial owners of the registrant are deemed to be
affiliates. Such determination should not be deemed an admission that such
officers, directors or 10% beneficial owners are, in fact, affiliates of the
Registrant. Registrant had 7,401,338 shares of Common Stock outstanding on
March 19, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement to be filed with
the Securities and Exchange Commission not later than 120 days after the close
of the registrant's fiscal year are incorporated by reference into Part III of
this Form 10-K.
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SCHLOTZSKY'S, INC.
INDEX TO FORM 10-K
YEAR ENDED DECEMBER 31, 1998
PAGE NO.
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PART I
Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters . . . 17
Item 6. Selected Consolidated Financial Data. . . . . . . . . . . . . . . . . . . . 18
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 7A. Quantitative and Qualitative Disclosures About Market Risk. . . . . . . . . 28
Item 8. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . 29
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . 29
PART III
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . 30
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 12. Security Ownership of Certain Beneficial Owners and Management . . . . . . 30
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . 30
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. . . . . . 30
PART I
ITEM 1. BUSINESS
Schlotzsky's, Inc. (the "Company") was formed effective January 1, 1993,
when Schlotzsky's Franchising Limited Partnership, Schlotzsky's-Houston, Ltd.,
Schlotzsky's-San Antonio, Ltd., Schlotzsky's Restaurant Management Corporation,
and Schlotzsky's, Inc. (collectively, the "Predecessor Entities") were merged
into the Company and its two wholly-owned subsidiaries, Schlotzsky's
Restaurants, Inc. and Schlotzsky's Real Estate, Inc. (the "1993 Merger"). In
June 1993, the Company raised $5 million through the sale of Class A Preferred
Stock and used the proceeds to redeem the preferred stock issued in the 1993
Merger to the investors in the Predecessor Entities other than John C. Wooley
and Jeffrey J. Wooley. The Company's other subsidiaries, which are wholly-owned,
are Schlotzsky's Brands, Inc., Schlotzsky's Equipment Corporation, DFW
Restaurant Transfer Corp., 56th and 6th, Inc., and SREI Turnkey Development,
L.L.C. The Company and its subsidiaries are Texas corporations, and references
to the "Company" include its predecessors, and its and their subsidiaries,
unless the context otherwise requires.
The Company's principal executive offices are located at 203 Colorado
Street, Austin, Texas 78701, and its telephone number is (512) 236-3600.
GENERAL
The Company is a franchisor of quick service restaurants that feature
made-to-order sandwiches with unique sourdough buns. At December 31, 1998, the
Schlotzsky's system included eight Company-owned stores and 742 franchised
stores located in 38 states, the District of Columbia and 13 foreign countries.
System-wide sales were approximately $270.4 million for 1997 and $348.5 million
for 1998. Weighted average annual unit volumes were $455,000 in 1997 and
$503,000 for 1998.
STRATEGY
John C. Wooley and Jeffrey J. Wooley acquired the Company in 1981. They
were attracted to the Company by the unique characteristics of The Schlotzsky's
Original sandwich, the only sandwich sold at Schlotzsky's restaurants at that
time, and the strong brand loyalty that had developed for this sandwich in the
Company's markets. From 1981 to 1991, management tested different strategies to
expand the Company's business, including the development of Company-owned stores
and expanded store menus.
In 1991, the Company began implementing a strategy to achieve its objective
of becoming a leader in the specialty sandwich segment of the restaurant
industry in the United States. The key elements of this strategy are to: offer
an expanded menu of consistent, high quality foods featuring the Company's
proprietary bread recipes, complemented by excellent customer service; use the
Turnkey Program to develop new stores in high visibility, free-standing
locations; utilize area developers to decentralize certain labor intensive
aspects of franchisee recruiting and support; develop a strong network of
motivated owner-operator franchisees; and increase awareness of the Schlotzsky's
brand through enhanced marketing and private label products. Recently, the
Company revised its strategy to include the acquisition and development of a
limited number of Company-owned stores, principally for concept development.
The Company anticipates that it will initiate national network television
advertising in the Spring of 1999.
MENU OF DISTINCTIVE, HIGH QUALITY PRODUCTS. Schlotzsky's Deli restaurants
offer an expanded menu of consistent, high quality foods featuring the Company's
proprietary bread recipes, complemented by excellent customer service. The menu
features made-to-order sandwiches with bread that is baked fresh from scratch
every day for every restaurant. The Schlotzsky's Original sandwich, which was
introduced in 1971, is a variation of the muffaletta sandwich made with three
meats (lean ham, Genoa salami and cotto salami), three cheeses (mozzarella,
cheddar and parmesan), garlic butter, mustard, marinated black olives, onion,
lettuce and tomato on a toasted sourdough bun. The Schlotzsky's Original
sandwich continues to be the most popular item on the Schlotzsky's menu.
Schlotzsky's Deli restaurants now offer an expanded menu with 15 sandwiches on
four types of bread, 10 sourdough crust pizzas, five salads, soups, chips and
other side items, fresh baked cookies and other desserts, and
1
beverages. At most locations, sandwiches range in price from $3.00 to $4.75
($7.00 for an oversized Original), and eight-inch gourmet pizzas are priced
between $3.50 and $4.50.
TURNKEY PROGRAM; HIGH VISIBILITY STORES. The Company and its area
developers encourage franchisees to develop free-standing stores with high
visibility and easy access. The Company believes the location of a store is as
important to its success as the efforts of the franchisee, and works with area
developers to assist franchisees in identifying and acquiring superior store
locations. The Company implemented its Turnkey Program as a means of
accelerating the development of high visibility stores and capitalizing on the
Company's experience in evaluating store sites by providing a variety of
services from securing the site, to development and construction of the store.
The Turnkey Program also enhances the quality and consistency of the
free-standing stores developed for franchisees by the Company because of its
experience building prototype stores and its purchasing power with suppliers and
contractors.
AREA DEVELOPERS. The Company has 32 area developers trained to assist the
Company in achieving its expansion goals in the United States. Area developers
provide the following services: they recruit and qualify franchisees; they
assist franchisees in site selection, training, financing, building and opening
stores; they provide ongoing operational support; they monitor product and
service quality; and they help coordinate local advertising. Prior to 1991,
these functions were performed by Company personnel. By utilizing its area
developer network, the Company believes that it can effectively support a
growing number of franchised stores while controlling its overhead costs. Area
developers receive a portion of franchise fees and royalties from each store in
their territories and are motivated to develop their markets and monitor
operating performance. Generally, area developers have been required to meet
specific store opening schedules under their agreements with the Company in
order to maintain their development rights. The Company recently contracted
with several area developers to buy down their portion of franchise fees and
royalties in return for cash or the combination of cash and a note. As a result
of these contracts, it is contemplated that store opening schedules for these
area developers will be eliminated.
MOTIVATED OWNER-OPERATOR FRANCHISEES. The Company is developing a strong
network of owner-operator franchisees. The Company believes that a motivated
owner-operator is an essential key to the success of a store. The Schlotzsky's
system consists almost exclusively of franchised stores, owned and managed by
entrepreneurial franchisees. The Company seeks franchisees who are committed to
providing on-site supervision of store operations and prefers to limit
franchisees to three or four locations in relatively close proximity. As of
December 31, 1998, out of 458 franchisees with stores, 9 franchisees have more
than five stores each and, in the aggregate, account for approximately 8.8% of
the stores in the system.
INCREASED BRAND AWARENESS. The Company seeks to increase awareness of the
Schlotzsky's brand through enhanced marketing and private label products. The
Company is directing its franchising efforts to establish a sufficient number of
stores in larger markets to allow expanded cooperative advertising through
newspaper, radio and television. The Company has developed a complete line of
private label products to increase Schlotzsky's brand awareness. Private label
products are used by franchisees in preparing foods and are displayed at stores
as part of the standard decor package. Some private label products are sold by
franchisees for home consumption. In 1999, Schlotzsky's brand chips became
available for retail purchase outside of the restaurant system for the first
time in the domestic superstores of one of the world's largest retailers. The
Company expects to continue to explore alternative channels for retail
distribution of some of its private label products.
COMPANY-OWNED STORES. The Company's flagship store in Austin, Texas opened
in 1995, and two stores were acquired from franchisees by the Company in 1996,
one in New York City (Manhattan) and one in Houston. In addition, in 1997, the
Company developed or acquired and began operating another store in Houston, one
in Illinois, one in Mississippi, and one in Georgia. In 1998, the Company
completed the relocation of two additional units in Austin, Texas, acquired two
stores in College Station, Texas and opened a store in Cedar Park, Texas. Also
during 1998, the stores in Houston, Illinois and Mississippi were reclassified
as "held for sale" and so were not considered to be part of the portfolio of
Company-owned units at the end of the year. The operating results of the units
held for sale are considered an operating cost of the Turnkey Program and are
reported in Turnkey Program cost. Results from restaurants the Company intends
to own and operate on a longer term basis are reflected in restaurant operations
figures. The Company anticipates opening or acquiring additional stores in Texas
during 1999. The Company operates these stores primarily for product
development, concept refinement, prototype testing and training, and to build
brand awareness. The Company may acquire or develop a limited number of other
Company-owned stores in the future for these purposes and may acquire or develop
others from time to time with the intent of transferring them to franchisees.
2
EXPANSION
At December 31, 1998, the Schlotzsky's system consisted of 750 stores in 38
states, the District of Columbia, and 13 foreign countries. At December 31, 1996
and 1997, the system included 573 and 673 stores, respectively.
STORE LOCATIONS AS OF DECEMBER 31, 1998
NUMBER
LOCATION OF STORES
-------- ---------
UNITED STATES:
Texas. . . . . . . . . . 219
Arizona. . . . . . . . . 40
Georgia. . . . . . . . . 36
Tennessee. . . . . . . . 35
Florida. . . . . . . . . 31
Illinois . . . . . . . . 29
Indiana. . . . . . . . . 25
Michigan . . . . . . . . 23
California . . . . . . . 22
North Carolina . . . . . 21
Wisconsin. . . . . . . . 20
Colorado . . . . . . . . 20
Oklahoma . . . . . . . . 18
Alabama. . . . . . . . . 18
South Carolina . . . . . 17
Ohio . . . . . . . . . . 16
New Mexico . . . . . . . 15
Missouri . . . . . . . . 12
Kansas . . . . . . . . . 12
Nebraska . . . . . . . . 11
Louisiana. . . . . . . . 10
Utah . . . . . . . . . . 10
Minnesota. . . . . . . . 9
Arkansas . . . . . . . . 7
Nevada . . . . . . . . . 7
Virginia . . . . . . . . 6
Oregon . . . . . . . . . 6
Mississippi. . . . . . . 5
Idaho. . . . . . . . . . 5
Washington . . . . . . . 4
Iowa . . . . . . . . . . 3
West Virginia. . . . . . 3
North Dakota . . . . . . 3
Kentucky . . . . . . . . 3
South Dakota . . . . . . 2
Hawaii . . . . . . . . . 2
Pennsylvania . . . . . . 2
New York . . . . . . . . 2
District of Columbia . . 1
---
TOTAL U.S. . . . . . . . 730
3
INTERNATIONAL:
Argentina. . . . . . . . 3
Japan. . . . . . . . . . 3
Turkey . . . . . . . . . 3
Malaysia . . . . . . . . 2
Canada . . . . . . . . . 1
China. . . . . . . . . . 1
Germany. . . . . . . . . 1
Guatemala. . . . . . . . 1
Lebanon. . . . . . . . . 1
Mexico . . . . . . . . . 1
Morocco. . . . . . . . . 1
Saudi Arabia . . . . . . 1
United Kingdom . . . . . 1
---
TOTAL INTERNATIONAL: . . 20
---
TOTAL STORES:. . . . . . 750
---
---
TURNKEY PROGRAM
The Company instituted the Turnkey Program to further assist franchisees in
obtaining superior sites and to achieve more rapid penetration in those selected
major markets where the Company believes there is strong demand by franchisees
for good locations. The Company believes that the Turnkey Program enhances the
Company's ability to recruit qualified franchisees by securing and developing
high profile sites and achieving critical mass for advertising purposes more
quickly in selected markets. Under the Turnkey Program, the Company works
independently or with an area developer to identify superior store sites within
a territory. The Company will typically perform various services including, but
not limited to, site selection, feasibility analysis, environmental studies,
site work, permitting and construction management, receiving a fee and
recognizing revenue upon the completion of these services. The Company may
assign its earnest money contract on a site to a franchisee, or a third-party
investor, who then assumes responsibility for developing the store. The Company
may also purchase or lease a selected site, design and construct a Schlotzsky's
Deli restaurant on the site and sell, lease or sublease the completed store to a
franchisee. Where the Company does not sell the property to a franchisee, the
Company sells the improved property, or, in the case of a leased property,
assigns the lease and any sublease, to an investor.
From inception of the Turnkey Program through 1997, the Company
typically provided credit enhancement in the form of limited guaranties on
the franchisees' leases for leased locations sold to investors. The Company
obtained agreements from the franchisees to indemnify the Company in case the
guaranties are called upon. Upon sale of the leased site or assignment of
its earnest money contract, the Company has deferred revenue generated (even
though proceeds were received in cash) and allocable costs incurred in
connection with the property. When a lease guaranty is terminated, or the
Company's exposure to loss under the guaranty has passed, the Company
recognizes the revenue and allocable costs related to the site. Generally,
if no credit enhancement is provided in connection with such transactions,
the Company recognizes the revenue and allocable expenses in the periods in
which the transactions occur. During 1998, the Company began emphasizing
ownership of the real estate by franchisees through a program which entails
acquiring the rights to a superior site and reselling the property, or its
rights (with any improvements), to a franchisee whose permanent mortgage loan
will be financed by a third party financial institution. The Company
provides credit enhancement for the franchisee in the form of a limited
guaranty in favor of the lender. These guarantees are usually for loan
payments required to be made during the first two to five years and are
limited to 15% to 25% of the principal amount of the loan. Generally, in
those cases, the Company recognizes the revenue and allocable expenses in the
period in which the transaction occurs. The Company will often interim
finance land and building costs in anticipation of permanent financing by a
financial institution. In addition, the Company charges a fee when it is
requested to manage construction of a store on property owned by a franchisee
or an investor. This construction management fee is recognized when the store
is completed. The Company anticipates that the total investment in each
developed free-standing location will be approximately $1,200,000 to
$2,000,000 (less for leased locations).
4
MENU
The Schlotzsky's Deli menu provides customers with popular food items which
the Company believes are fresher, more flavorful and of greater variety than
those offered by competitors. The key menu groups are made-to-order sandwiches
and pizzas, salads, soups, cookies and other desserts, and beverages. Sandwiches
and pizzas are made with delicatessen-style meats, grilled chicken and specialty
cheeses, all of which are purchased ready for use from approved suppliers. The
Company's distinctive sandwich buns and pizza crusts are baked daily from
scratch, rather than with pre-mixed or frozen dough, to ensure the highest
quality and freshness.
FRANCHISING
The Company has adopted a strategy of franchising, rather than owning
stores. The Company believes that franchisees who own and operate stores are
more highly motivated and manage stores more efficiently than typical
manager-employees. Moreover, franchising allows the Company to expand the number
of stores and penetrate markets more quickly and with less capital than
developing Company-owned stores. Area developers play a role in the Company's
franchising program by recruiting qualified franchisees and by monitoring and
providing support to franchised stores.
AREA DEVELOPERS. The Company's 32 area developers recruit and qualify
franchisees according to criteria developed by the Company. Once a franchisee is
approved by the Company, the area developer works with the Company to assist the
franchisee in site selection, training, store design and layout, construction
and financing. The area developer provides store opening assistance, monitors
store performance and compliance with product and service quality standards
established by the Company and helps to coordinate cooperative advertising
within his territory. The Company pays area developers 50% of all franchise fees
paid by franchisees in their territories, although some area developers have
received up to 100% of certain franchise fees as an inducement to develop their
territories more quickly. In addition, the Company also pays area developers
approximately 42% of the royalties received under franchise agreements
providing for 6% royalties and 12.5% to 25% of royalties received under
franchise agreements providing for 4% royalties, in each case with respect to
franchisees in their territories.
It is contemplated that the percentage of franchise fees and royalties
payable to certain area developers could be reduced to approximately 33% and
21%, respectively, if proposed transactions are consummated. There can be no
assurance that such transactions will be completed. Area developers are not
required to own or operate stores, although some of the Company's area
developers are also franchisees, or have investments in franchisees, under
separate franchise agreements. Area developers are granted exclusive rights to
one or more television markets in the United States, typically for a term of 50
years. Each area developer pays the Company a nonrefundable fee for the
exclusive development rights for a market. The Company typically receives 25% to
50% of the area developer fee when the area development agreement is signed with
the balance payable with interest over an 18 to 36-month period under a
promissory note from the area developer.
Area development agreements are nonassignable without the prior written
consent of the Company, and consents have been granted from time to time. The
Company retains rights of first refusal with respect to any proposed sale by the
area developer. Area developers are not permitted to compete with the Company.
Area developers typically commit to a store opening schedule for each territory.
The Company has agreed to extend or waive store opening schedules for certain
area developers under certain conditions, and may eliminate the schedules for
those whose royalties are bought down. If an area developer fails to meet its
obligations, the Company can terminate or repurchase its territory.
FRANCHISEES. The Company believes the involvement of owners in daily store
operations is critical to the success of a franchise. The Company prefers
franchisees who will operate no more than three or four stores, located within a
single market. Franchisees are selected on the basis of various factors,
including business background, experience and financial resources. Because the
cost of building and equipping a Schlotzsky's Deli restaurant is somewhat higher
than for some other specialty sandwich franchise operations, the Company's
franchisees must make certain minimum investments into their stores and
typically must have substantial cash resources or a relatively high net worth to
obtain financing to build and equip stores. While area developers identify and
recruit potential franchisees, all franchisees must be approved by the Company.
5
FRANCHISE AGREEMENTS. The Company enters into one or more agreements with
each franchisee granting the franchisee the right to develop one or more stores
within a territory over a defined period of time. Once a site for a store has
been selected by the franchisee and accepted by the Company, additional
documentation specifying that site is signed. Under the Company's current
standard franchise agreement, the franchisee is required to pay a franchise fee
of $30,000 for the franchisee's first store and $20,000 for any additional
store. The franchise fee is payable at the time of signing the agreement. The
current standard franchise agreement provides for a term of 20 years (with one
ten-year renewal option) and payment of a royalty of 6% of sales. As of December
31, 1998, 98 stores operated under franchise agreements entered into prior to
1991 were paying a royalty of 4% of sales.
The Company has the right to terminate any franchise agreement for certain
specific reasons, including a franchisee's failure to make payments when due or
failure to adhere to the Company's policies and standards. Many state franchise
laws, however, limit the ability of a franchisor to terminate or refuse to renew
a franchise. See "Government Regulation."
FRANCHISEE TRAINING AND SUPPORT. Each franchisee is required to have a
principal operator approved by the Company who satisfactorily completes the
Company's training program and who devotes full business time and efforts to the
operation of the franchisee's stores. Franchisees may also enroll each store
manager in the Company's training program. The Company provides training at
operating Schlotzsky's Deli restaurants in various locations. In November 1995,
the Company opened its new flagship Schlotzsky's Deli restaurant in Austin,
Texas, which includes training facilities. Most franchisee training is being
conducted at that location. Franchisees are required to pass a minimum skills
test before they can begin operating their first store. An on-site training crew
is provided by the Company or an area developer for three days before and two
days after the opening of a franchisee's first store. Company management and
area developers maintain ongoing communication with franchisees, exchanging
operating and marketing information.
FRANCHISE OPERATIONS. All franchisees are required to operate their stores
in compliance with the Company's policies, standards and specifications,
including matters such as menu items, ingredients, materials, supplies,
services, fixtures, furnishings, decor and signs. Food preparation is
standardized and is limited to baking bread, slicing pre-cooked meats, cheese
and produce, melting cheese and heating sandwiches. Because they usually operate
no more than three stores, franchisees are expected to be actively involved in
monitoring operations at each store. Each franchisee has full discretion to
determine the prices to be charged to its customers. Franchise stores are
periodically inspected by area developers and the Company's field service
representatives. The Company's field service representatives and area developers
monitor compliance with the Company's standards and specifications as set forth
in the franchise agreement and the Company's manuals.
REPORTING. Most Schlotzsky's Deli restaurant franchisees are required to
report weekly sales and other data to the Company. Other franchisees are
required to report monthly. Generally, 6% royalties are payable weekly by
automatic bank drafts and 4% royalties are payable monthly by check. The Company
is evaluating software for use by franchisees to record and report sales and
other operating information and anticipates that franchisees may be able to
license this software beginning at some point in 1999. Although the Company has
the right to audit franchisees, it relies primarily on voluntary compliance by
franchisees to accurately report sales and remit royalties. The Company expects
to begin auditing some franchise locations during 1999.
INTERNATIONAL MASTER LICENSEES. In addition to the Company's expansion in
the United States, the Company has granted nonassignable rights to develop
stores in international markets to master licensees. A master licensee is
typically licensed for 50 years to use the Schlotzsky's trademarks in designated
foreign territories and may grant area development rights and franchises in
those territories. Unlike area developers, master licensees contract directly
with franchisees, and the Company delegates the selection of franchisees and
approval of sites to the master licensees. When a master license is granted, the
master licensee pays the Company a negotiated, nonrefundable license fee. In
some instances, the Company will negotiate a territorial agreement pursuant to
which a foreign territory is reserved and the principal economic terms of the
master license agreement are agreed upon in return for a nonrefundable fee to be
applied toward the master license fee. The Company normally receives 15% to 35%
of the master license fee in cash when the master license or territorial
agreement is signed, with the balance payable with interest over a term of up to
48 months under a promissory note from the master licensee. Typically, the
Company also receives one-third to one-half of any sublicense and franchise fees
and one-third of any royalties received by
6
the master licensee. All amounts payable to the Company by the master
licensees must be paid in U.S. dollars. As of December 31, 1998, the Company
had executed master licenses or territorial agreements covering 49 foreign
countries. As with area developers, if master licensees fail to meet their
obligations, the Company can terminate their rights or repurchase their
territories. Master licensees are subject to various laws and regulations
regarding franchising and licensing in their territories and are responsible
for complying with these laws and regulations.
SITE SELECTION
The Company and its area developers often assist franchisees in selecting
their sites and developing their stores. Each franchisee is responsible for
selecting store locations acceptable to the Company. Site selection criteria are
based on accessibility and visibility of the site and selected demographic
factors, including population, residential and commercial density, income, age
and traffic patterns. The Company prefers that franchisees select sites for
free-standing stores to maximize store visibility and sales potential. As the
table below indicates, the mix of store sites has changed since the Company
adopted a new strategy in 1991 focusing on higher visibility stores.
STORES OPENED BETWEEN
AS OF AS OF JANUARY 1, 1992 AND
STORE SITE DECEMBER 31, 1991 DECEMBER 31, 1998 DECEMBER 31, 1998
---------- ----------------- ----------------- ---------------------
Free-Standing . . . . . . . 24% 52% 57%
End-Cap . . . . . . . . . . 31 27 24
In-Line . . . . . . . . . . 28 11 7
Other . . . . . . . . . . . 17 10 12
--- --- ---
Total . . . . . . . . . . . 100% 100% 100%
--- --- ---
--- --- ---
The Company has developed a series of prototype store designs and
specifications for free-standing and end-cap stores which it makes available for
use by franchisees. These specifications may be adapted to existing restaurants
and other retail spaces.
UNIT ECONOMICS
The Company believes that the Schlotzsky's Deli restaurant concept offers
attractive unit economics. The cost to a franchisee of developing and opening a
prototype Schlotzsky's Deli restaurant (excluding restaurants like the Company's
flagship store) in leased space has recently ranged from approximately $300,000
to $500,000, including leasehold improvements, equipment, fixtures and initial
working capital. While the initial cost of owning a free-standing, prototype
restaurant ranges from $1,200,000 to $2,000,000, the monthly payments at
interest rates in effect at December 31, 1998 were favorable compared to monthly
rent at comparable leased locations. During the twelve months ended December 31,
1998, the weighted average store sales for Schlotzsky's Deli restaurants was
approximately $503,000, although store revenue varies significantly depending
upon the type, size and location of the store. The Company believes that food
and paper costs for the Schlotzsky's Deli menu items are relatively low as a
percentage of gross store sales as compared to many quick service restaurant
concepts.
FINANCING
With respect to non-Turnkey Program stores, the Company usually does not,
and is not obligated to, provide financing to franchisees for the costs of
developing and opening stores. Both the Company and area developers assist
franchisees in obtaining financing by identifying third party financing sources.
Certain financial institutions have designed equipment leasing programs
specifically for Schlotzsky's franchisees and have developed guidelines for sale
and leaseback financing for Schlotzsky's stores. The Company has also identified
Small Business Administration lenders which have made loans to Schlotzsky's
franchisees. These lenders are not committed to provide any financing to
franchisees and there can be no assurance that franchisees will be able to
finance their costs of opening stores on suitable terms.
7
The Company has negotiated with certain financial institutions to provide
mortgage loans to qualified franchisees with stores developed through the
Turnkey Program. These loans typically would involve a limited guaranty by the
Company. In certain cases, the Company acquires the right to the land and, in
connection with the sale of the land to a franchisee (or another buyer who plans
to subsequently sell the property to a franchisee), provides interim financing
in anticipation of permanent financing by a financial institution. These loans
may be in the form of construction draw notes or mortgages. The Company had
loaned an aggregate of approximately $7.3 million to various franchisees through
this program, which had not been assigned to a financial institution as of
December 31, 1998. There can be no assurance that financial institutions will
agree to accept assignments of these or future loans made by the Company on
acceptable terms, if at all.
The Company from time to time agrees to guaranty its franchisees'
obligations to equipment and real property lessors or subordinates all or a
portion of its royalties to the obligations of franchisees on such leases. These
guaranties provide for a limited number of payments or limited time period for
which the Company may be required to perform on its guaranty.
As of December 31, 1998, the Company had guarantied an aggregate of
approximately $26.4 million which is principally comprised of real estate leases
and mortgages, as well as equipment leases and other obligations of its
franchisees.
PURCHASING; PRIVATE LABELING
Franchisees are required to purchase equipment, furniture, smallwares,
merchandising displays and food from suppliers approved by the Company.
Approximately 80-85% of overall purchases of goods used in daily operations by
the Company's franchised stores are from International Multifoods Corporation,
which provides volume discounts to franchisees based upon system-wide purchases.
The Company believes that comparable goods are available at competitive prices
from numerous other suppliers.
The Company has licensed certain manufacturers to sell Schlotzsky's private
label meats, cheeses, potato chips and other products. The Company receives
licensing fees from these manufacturers based on their sales of private label
products to franchisees. While franchisees are not required to purchase private
label products, other than the Company's proprietary flour mixes, the Company
believes that most franchisees prefer them because they are of equal or superior
quality compared to other brand name products and generally are less expensive
than the supplies available from other approved sources. In addition, some
private label products can be sold separately at stores for home consumption,
enhancing brand awareness and providing franchisees with additional sales and
profit opportunities.
MARKETING
Franchised stores contribute 1% of gross sales to Schlotzsky's N.A.M.F.,
Inc. ("NAMF"), a non-profit corporation administered by the Company. NAMF funds
are used principally to develop and produce radio and television commercials and
print advertising for use in local markets, in-store graphics and displays, and
promotions, but such funds may also be used to pay for media space or time. NAMF
has developed advertising campaigns for use by franchisees centered around
different slogans, such as FUNNY NAME. SERIOUS SANDWICH.-Registered Trademark-;
ACCEPT NO SUBSTITUTESKY'S-Registered Trademark-; BEST BUNS IN TOWN-Registered
Trademark-; and ORIGINAL TASTE EVERY DAY. NAMF'S field marketing representatives
coordinate advertising campaigns and promotions for area developers and
franchisees.
Franchisees are required by the terms of their franchise agreements to
spend at least 3% of gross sales on advertising. Effective January 1, 1999, the
Company began collecting 1.75% of the 3% for network television advertising. The
Company anticipates that network advertising will be initiated during the Spring
of 1999. The Company has requested franchisees to form local advertising groups
to pool the remainder of the 3% in order to maximize the benefits of local
advertising for members.
COMPETITION
8
The food service industry is intensely competitive with respect to concept,
price, location, food quality and service. There are many well established
competitors with substantially greater financial and other resources than the
Company. Such competitors include a large number of national, regional and local
food service companies, including fast food and quick-service restaurants,
casual full-service restaurants, delicatessens, pizza restaurants and other
convenience dining establishments. Some of the Company's competitors have been
in existence longer than the Company and are better established in markets where
Schlotzsky's stores are or may be located. The Company believes that it competes
for franchisees with franchisors of other restaurants and various concepts.
Schlotzsky's stores compete primarily on the basis of distinctive, high
quality food and convenience, rather than price. The Company believes that
Schlotzsky's stores provide the quick service and convenience of fast food
restaurants while offering more distinctive, higher quality products. Pricing is
designed so that customers perceive good value (high quality food at reasonable
prices), even though Schlotzsky's menu prices are typically higher than certain
competitors' prices.
Competition in the food service business is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company and its area developers attempt to assist
franchisees in managing or adapting to these factors, but no assurance can be
given that some or all of these factors will not adversely affect some or all of
the franchisees.
TRADEMARKS, SERVICE MARKS AND TRADE SECRETS
The Company owns a number of trademarks and service marks registered with
the United States Patent and Trademark Office. The Company has also registered
or made application to register trademarks in foreign countries where master
licenses have been granted. The flour and bread making recipes and techniques
currently used in Schlotzsky's stores are based on a modification of the
Company's original recipe developed jointly by the Company and Pillsbury
Company. The recipes and techniques are protected by the Company and its
suppliers as trade secrets. The Company has not sought patent protection for
these recipes, and it is possible that competitors could develop flour recipes
and baking procedures that duplicate or closely resemble the Company's. The
Company considers its trademarks, service marks and trade secrets to be critical
to the business and actively defends and enforces them.
GOVERNMENT REGULATION
The Company must comply with regulations adopted by the Federal Trade
Commission (the "FTC") and with several state laws that regulate the offer and
sale of franchises. The Company also must comply with a number of state laws
that regulate certain substantive aspects of the franchisor-franchisee
relationship. The FTC's Trade Regulation Rule on Franchising (the "FTC Rule")
requires that the Company furnish prospective franchisees with a franchise
offering circular containing information prescribed by the FTC Rule.
State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees, by regulating discrimination among franchisees
with regard to charges, royalties or fees, and by restricting the development of
other restaurants within certain proscribed distances from existing franchised
restaurants. Those laws also restrict a franchisor's rights with regard to the
termination of a franchise agreement (for example, by requiring "good cause" to
exist as a basis for the termination), by requiring the franchisor to give
advance notice to the franchisee of the termination and give the franchisee an
opportunity to cure any default, and by requiring the franchisor to repurchase
the franchisee's inventory or provide other compensation. To date, those laws
have not precluded the Company from seeking franchisees in any given area and
have not had a material adverse effect on the Company's operations.
Each Schlotzsky's store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties or failures
in obtaining the required licenses or approvals can delay and sometimes prevent
the opening of a new store.
Schlotzsky's stores must comply with federal and state environmental
regulations, such as those promulgated under the Federal Water Pollution Act,
Federal Clean Water Act of 1977 and the Federal Resource and
9
Conservation Recovery Act of 1976, but the Company believes that those
regulations have not had a material effect on their operations. More
stringent and varied requirements of local governmental bodies with respect
to zoning, land use, and environmental factors can delay and sometimes
prevent development of new stores in particular locations.
The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters, such as minimum wages,
overtime and other working conditions. Significant numbers of the food service
personnel in Schlotzsky's stores receive compensation at rates related to the
federal minimum wage and, accordingly, increases in the minimum wage increase
labor costs at those locations.
The Company and its franchisees also must comply with the provisions of the
Americans with Disabilities Act, which requires that employers provide
reasonable accommodation for employees with disabilities and that restaurants be
accessible to customers with disabilities.
EMPLOYEES
As of December 31, 1998, the Company employed 159 persons at its corporate
headquarters. None of the Company's employees is covered by a collective
bargaining agreement or is represented by any labor union. The Company believes
its relationship with its employees is good.
RISK FACTORS
In addition to the other information contained in this report, the
following factors should be considered carefully in evaluating the Company:
FORWARD LOOKING STATEMENTS. This report contains statements that
constitute "forward-looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended (the "Securities Act" and Section 21E of the
Securities Exchange Act of 1934, as amended (the "Exchange Act")). The words
"expect," "estimate," "anticipate," "contemplate," "predict," "believe,"
"intend," "plan," "project" and similar expressions and variations thereof are
intended to identify forward-looking statements. Such statements appear in a
number of places in this Report and include statements regarding the intent,
belief or current expectations of the Company, its directors or its officers
with respect to, among other things: (i) trends affecting the Company's
financial condition or results of operations; (ii) the Company's financing
plans; (iii) the Company's business and growth strategies, including strategies
related to the Company's Turnkey Program and plans concerning the Company's
relationship with its area developers; and (iv) the declaration and payment of
dividends. Shareholders and prospective investors are cautioned that any such
forward-looking statements are not guaranties of future performance and involve
risks and uncertainties, and that actual results may differ materially from
those projected in the forward-looking statements as a result of various
factors. The accompanying information contained in this Report including,
without limitation, the information set forth under the headings "Management's
Discussion and Analysis of Financial Condition and Results of Operations," and
"Business," as well as information contained in the Company's other filings with
the Securities and Exchange Commission (the "Commission"), identify important
factors that could cause such differences.
RAPID GROWTH STRATEGY. During 1998, 107 new Schlotzsky's stores were
opened. During 1996 and 1997, the Company and its franchisees opened 135 and
120 stores, respectively. This level of store openings is significantly greater
than that experienced by the Company prior to 1995. The Company will rely
primarily upon its franchisees, area developers, the Turnkey Program, and new
geographic markets to maintain this level of expansion. The number of openings
and the performance of new stores will depend on various factors, including: (i)
the availability of suitable sites for new stores; (ii) the ability to recruit
qualified franchisees; (iii) the ability of franchisees to negotiate acceptable
lease or purchase terms for new locations, obtain capital required to construct,
build-out and operate new stores, meet construction schedules, and hire and
train qualified store personnel; (iv) the establishment of brand awareness in
new markets; and (v) the ability of the Company to manage this anticipated
expansion. Not all of these factors are within the control of the Company, and
there can be no assurance that the Company will be able to maintain or
accelerate its growth or that the Company will be able to manage its expanding
operations effectively. See "Business -- Strategy."
10
TURNKEY PROGRAM. As of December 31, 1998, the Company had developed 128
stores under the Turnkey Program, 39 of which were developed during 1998. The
Company expects that the Turnkey Program will continue to produce approximately
30% to 40% of new store development. The Company has limited experience in
implementing this program, which has evolved significantly since its
inception. There can be no assurance that results experienced to date are
indicative of future performance under the program. The Company may be unable
to sell properties acquired under the Turnkey Program at a profit or at its
cost, and the Company could be required to sell properties at a loss or hold
properties indefinitely, diminishing the capital available to reinvest in the
Turnkey Program. The Company may also be unable to obtain permanent third
party financing for interim loans made to the Company's franchisees, which
would further diminish capital available for the Turkey Program. See "--
Credit Risk and Contingencies," "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources" and "Business -- Turnkey Program."
RELIANCE ON AREA DEVELOPERS. The Company relies on certain area developers
to find qualified franchisees in their areas. Area developers are independent
contractors, and are not employees of the Company. Through 1998, most area
developer agreements specified a schedule for opening stores in the territory
covered by the agreement. It is contemplated that in 1999, the Company will
eliminate the development schedule for several area developers in connection
with the buy down of their rights to receive future franchise fees and
royalties. In addition, the Company has agreed in the past to extend or waive
development schedules for certain area developers. There can be no assurance
that area developers will be able to meet their contractual development
schedules. These schedules are a significant factor in the Company's
expectations regarding the number and timing of new store openings. Delays in
store openings could adversely affect the future operations of the Company.
From time to time, the Company relies extensively on certain area
developers, many of whom do not have experience operating restaurants. In those
instances, the Company has less direct involvement in recruiting franchisees and
in monitoring the quality of franchised stores. The Company provides training
and support to area developers, but the quality of store operations and the
ability of area developers to meet development schedules may be diminished by
their lack of experience. It may be difficult for the Company to enforce its
area development agreements or to terminate the area development rights of area
developers who fail to meet development schedules or other standards and
requirements imposed by the Company, limiting the ability of the Company to
develop the territories of such area developers. See "Business -- Franchising."
Between January 1, 1996 and December 31, 1998, 123 of the 362 new stores
opened were within territories controlled by only two area developers. As of
December 31, 1998, these two area developers controlled 14 territories having a
total of 308 stores. As these territories mature, system-wide growth will depend
upon more activity in other territories. Because of its plans to buy down the
percentages of franchise fees and royalties payable to certain area developers,
the Company will be primarily responsible for recruiting franchisees and will
receive limited assistance with openings from many of its area developers. The
Company believes that the concentration of store openings among a relatively few
area developers is due primarily to the longer tenure of these area developers
with the Company and the size and maturity of the territories covered by their
agreements.
DEPENDENCE ON FRANCHISING CONCEPT. Because royalties from franchisees'
sales are a principal component of the Company's revenue base, the Company's
performance depends upon the ability of its franchisees to promote and
capitalize upon the Schlotzsky's concept and its reputation for quality and
value. The Company believes that the cost to a franchisee of opening a
Schlotzsky's Deli restaurant is higher than the store opening costs incurred by
franchisees of many of the Company's competitors for franchisees. This
necessarily limits the number of persons who are qualified to be franchisees of
the Company. The Company has established criteria to use in evaluating
prospective franchisees, but there can be no assurance that it, or its area
developers, will recruit franchisees who have the level of business abilities or
financial resources necessary to open Schlotzsky's stores on schedule or that
franchisees will conduct operations in a manner consistent with the Company's
concepts and standards. See "Business -- Franchising."
The Company is subject to various state and federal laws relating to the
franchisor-franchisee relationship. The failure by the Company to comply with
these laws could subject the Company to liability to franchisees and to fines
or other penalties imposed by governmental authorities. The Company believes
that the franchising industry is experiencing an increasing trend of
franchisees filing complaints with state and federal governmental authorities
and instituting lawsuits against franchisors claiming that they have engaged
in unlawful or unfair trade practices or violated express or implied
agreements with franchisees.
11
While the Company's experience is consistent with the trends in the industry,
the Company believes that it is in material compliance with these laws and
regulations and its agreements with franchisees, and that its relations with
its franchisees are generally good. See "Business --Government Regulation"
and "-- Litigation."
IMPORTANCE OF LICENSING FEES. During the past three years, the Company's
revenue from private label licensing fees (brand contribution) has increased
significantly as the volume of system sales has increased, terms with certain
major suppliers have been renegotiated, and franchisees have increased their
participation in the Company's purchasing programs. This revenue is largely
dependent upon the voluntary participation of the franchisees. In 1999, the
Company anticipates renegotiating the terms of the contracts with some of its
suppliers and will explore other alternative retail channels of distribution for
some of its private label products.
The Company believes its purchasing programs provide franchisees with
significant cost savings and other advantages. There can be no assurance that
the Company's suppliers will not increase prices to franchisees or that
franchisees will not negotiate more favorable terms from other approved
suppliers. Some franchisees may also object to these fees as a source of revenue
to the Company. Any of these developments could result in reduced purchases by
franchisees of private label products and declining private label licensing
revenue to the Company. This could have a material adverse effect on the
financial condition and results of operations of the Company. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Results of Operations."
CREDIT RISK AND CONTINGENCIES. The Company guaranties certain real estate
obligations and equipment leases and other obligations of its franchisees. The
Company has entered into guaranties with respect to most of the leases between
its franchisees and the buyers of the sites developed under the Turnkey Program.
These guaranties typically cover lease payments or various other obligations of
the franchisee for a period ranging from 18 months to five years, and are
effective throughout the term of the 20 year lease. The Company guaranties a
limited portion of most of the mortgages of certain franchisees who purchase
Turnkey Program sites pursuant to the mortgage financing program which the
Company began implementing during 1998. See "Business -- Turnkey Program" and
"Business - Financing." At December 31, 1998, the Company was contingently
liable for approximately $26.4 million which is principally comprised of
guaranties on real estate leases and mortgages, equipment leases and other
obligations of its franchisees.
During 1998, the mortgage financing program substantially replaced the
lease transactions completed in the Turnkey Program during prior years. While
the Company provided financing for several mortgages which were sold or held for
sale to financial institutions, there can be no assurance that the financial
institutions will accept all or most of the mortgages that the Company expects
to assign. The principal amount of the loans outstanding under the mortgage
financing program as of December 31, 1998 was approximately $7.3 million. The
Company charges area developers and master licensees a fee ("developer fee") for
the rights to develop a defined territory. Typically, a portion of the developer
fee has been paid in cash and the balance paid with a promissory note from the
area developer or master licensee. The Company periodically evaluates the credit
risk and obtains annual valuations of these notes from an independent financial
services institution with expertise in valuing instruments of this sort. As of
December 31, 1998, the Company held notes receivable from area developers and
master licensees in an aggregate principal amount of approximately $5.2 million.
At December 31, 1998, the principal balance of these notes had been reserved on
the financial statements of the Company by approximately $593,000, reflecting
the fair market value of such notes based upon valuations from a third party
valuation service. The Company also holds notes receivable from certain
franchisees related to the sale of Company-owned stores and certain other
obligations. As of December 31, 1998, the outstanding principal amount of these
notes was approximately $8,092,000. While the Company considers it unlikely that
there will be defaults on a significant amount of the notes, such defaults could
adversely affect the Company's financial condition. Parties controlled by or
related to directors, officers and principal shareholders of the Company have
provided financing to certain area developers and master licensees and have
guarantied obligations of certain area developers and master licensees to the
Company. See "Certain Transactions -- Master License and Area Development
Agreements" and "Business -- Franchising -- International Master Licensees."
A wholly owned subsidiary of the Company is the general partner of a
limited partnership that developed a retail shopping center in the Austin area.
The Company and its subsidiary have guarantied the repayment of a loan for this
project in the principal amount of $1.1 million due in April 2001. The Company
does not exercise control over the partnership and does not consider its
investment in the retail shopping center to represent a separate line of
12
business. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources."
LIMITED OPERATING HISTORY OF PROTOTYPES. Over the past several years, the
Company has refined its store prototypes and currently encourages franchisees to
develop larger, free-standing stores with higher visibility. This has increased
the costs to franchisees of opening and operating stores. The Company and
franchisees have a limited history of operating these prototype stores, and
results achieved to date may not be indicative of future results. There can be
no assurance that, on a sustained basis, the Company will be able to attract and
retain franchisees qualified to assume the increased debt and the management
responsibility associated with the larger operations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements of the Company and the Notes thereto.
GEOGRAPHIC CONCENTRATION. Of the 750 stores in the system at December 31,
1998, 219 were located in Texas. A downturn in the regional economy or other
significant adverse events in Texas could have a material adverse effect on the
Company's financial condition and results of operations.
CERTAIN FACTORS AFFECTING THE RESTAURANT INDUSTRY. The Company and its
franchisees may be affected by risks inherent in the restaurant industry,
including: adverse changes in national, regional or local economic or market
conditions; increased costs of labor (including increases in the minimum wage);
increased costs of food products; management problems; increases in the number
and density of competitors; limited alternative uses for properties and
equipment; changing consumer tastes, habits and spending priorities; changing
demographics; the cost and availability of insurance coverage; uninsured losses;
changes in government regulation; changing traffic patterns; weather conditions;
and local, regional or national health and safety matters. The Company and its
franchisees may be the subject of litigation based on discrimination, personal
injury or other claims, including claims which may be based upon legislation
that imposes liability on restaurants or their employees for injuries or damages
caused by the negligent service of alcoholic beverages to an intoxicated person
or to a minor. The Company can be adversely affected by publicity resulting from
food quality, illness, injury or other health concerns or operating issues
resulting from one restaurant or a limited number of restaurants in the
Schlotzsky's system. None of these factors can be predicted with any degree of
certainty, and any one or more of these factors could have a material adverse
effect on the Company's financial condition and results of operations.
COMPETITION. The food service industry is intensely competitive with
respect to concept, price, location, food quality and service. There are many
well-established competitors with substantially greater financial and other
resources than the Company. These competitors include a large number of
national, regional and local food service companies, including fast food and
quick service restaurants, casual full-service restaurants, delicatessens, pizza
restaurants and other convenience dining establishments. Some of the Company's
competitors have been in existence longer than the Company and may be better
established in markets where Schlotzsky's stores are or may be located. The
Company believes that it competes for franchisees against franchisors of other
restaurants and various other concepts.
Competition in the food service industry is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company and its area developers assist
franchisees in managing or adapting to these factors, but no assurance can be
given that some or all of these factors will not adversely affect some or all of
the franchisees. See "Business -- Competition."
CONTROL BY PRINCIPAL SHAREHOLDERS. As of December 31, 1998, John C. Wooley
and Jeffrey J. Wooley beneficially owned an aggregate of approximately 13.9% of
the outstanding Common Stock. Additionally, Greenfield Capital Partners B.V. and
NethCorp Investments VI B.V., entities of which Floor Mouthaan, a director of
the Company is the managing director, beneficially owned an aggregate of 5.6% of
the outstanding Common Stock, and Getov Holding B.V., an entity of which John M.
Rosillo, a director of the Company, is the managing director, beneficially owned
1.7% of the outstanding Common Stock at December 31, 1998. As a result, these
shareholders, if they were to act in concert, would have the ability to
influence the outcome of any issue submitted to a vote of the shareholders.
There are no agreements or understandings among these shareholders regarding the
voting of their shares, but to date they have voted consistently on matters
submitted to a vote of the shareholders.
13
DEPENDENCE ON MANAGEMENT AND KEY PERSONNEL. The Company's success is
highly dependent upon the efforts of its management and key personnel, including
its Chairman of the Board and President, John C. Wooley. The Company has
employment agreements with John C. Wooley, Jeffrey J. Wooley, Kelly R. Arnold
and Karl D. Martin, each of which includes certain noncompetition provisions
that survive the termination of employment. The employment agreements with John
C. Wooley and Jeffrey J. Wooley were entered into effective February 1998 and
will expire in February 2001. The Company also has obtained certain
noncompetition agreements from several other members of management and key
personnel who are not subject to employment agreements. However, there can be no
assurance such noncompetition agreements will be enforceable. The loss of the
services of John C. Wooley or other management or key personnel could have a
material adverse effect on the Company. The Company does not carry key man life
insurance on any of its officers. See "Management."
GOVERNMENT REGULATION. The restaurant industry is subject to numerous
federal, state and local governmental regulations, including those relating to
the preparation and sale of food and zoning and building requirements. The
Company and its area developers and franchisees are also subject to laws
governing their relationships with employees, including wage and hour laws, and
laws and regulations relating to working and safety conditions and citizenship
or immigration status. The Company's franchise operations are subject to
regulation by the United States Federal Trade Commission and the Company must
also comply with state laws relating to the offer, sale and termination of
franchises and the refusal to renew franchises. The failure to obtain or
maintain approvals to sell franchises could adversely affect the Company.
Increases in the minimum wage rate, employee benefit costs or other costs
associated with employees, could adversely affect the Company and its area
developers and franchisees. See "Business -- Government Regulation."
ABSENCE OF DIVIDENDS. The Company has never paid cash dividends on its
Common Stock and does not anticipate paying any cash dividends in the
foreseeable future.
POTENTIAL VOLATILITY OF STOCK PRICE. There have been periods of
significant volatility in the market price and trading volume of the Common
Stock, which in many cases were unrelated to the operating performance of, or
announcements concerning, the Company. General market price declines or market
volatility in the future could adversely affect the price of the Common Stock.
In addition, the trading price of the Common Stock has been and is likely to
continue to be subject to significant fluctuations in response to variations in
quarterly operating results, the results of the Turnkey Program, changes in
management, competitive factors, regulatory changes, general trends in the
industry, recommendations by securities industry analysts and other events or
factors. This volatility has been exacerbated by the lack of a significant
public float in the Common Stock. There can be no assurance that an adequate
trading market can be maintained for the Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE. As of December 31, 1998, the Company had
7,391,942 shares of Common Stock outstanding. A substantial number of shares
will 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 the
Common Stock. Sales of substantial amounts of Common Stock in the public market,
or the perception that such sales could occur, could adversely affect the
prevailing market price for the Common Stock and could impair the Company's
ability to raise capital through a public offering of equity securities.
ANTI-TAKEOVER PROVISIONS. The Texas Business Combination Law, which became
effective September 1, 1997, restricts certain transactions between a public
corporation and affiliated shareholders. The statute, which is applicable to the
Company, may have the effect of inhibiting a non-negotiated merger or other
business combinations involving the Company.
The Company's Articles of Incorporation and Bylaws include certain
provisions that may have the effect of discouraging or delaying a change in
control of the Company. Directors are elected for staggered three-year terms,
which has the effect of delaying the ability of shareholders to replace specific
directors or effect a change in a majority of the Board of Directors. The
Bylaws were amended in 1998 to provide that a director may only be removed for
cause by vote of the holders of at least two-thirds of the shares present in
person or by proxy at a meeting of shareholders called expressly for that
purpose. All shareholder action must be effected at a duly called annual or
special meeting of shareholders and shareholders must follow an advance
notification procedure for certain shareholder proposals and nominations of
candidates for election to the Board of Directors.
14
The Board of Directors has the authority, without further action by the
shareholders, to issue up to 1,000,000 shares of Preferred Stock in one or more
series and to fix the rights, preferences, privileges and restrictions thereof,
and to issue authorized unissued shares of Common Stock. The issuance of
Preferred Stock or additional shares of Common Stock could adversely affect the
voting power of the Common Stockholders and could have the effect of delaying,
deferring or preventing a change in control of the Company. The issuance of
Preferred Stock also could adversely affect other rights of Common Stockholders,
including creation of a preference upon liquidation or upon the payment of
dividends in favor of the holders of Preferred Stock.
In December 1998, the Company announced that the Board of Directors had
adopted a Shareholder's Rights Plan and approved a dividend of one Right for
each share of Company Common Stock outstanding. Under the plan, each shareholder
of record receives one Right for each share of Common Stock held. Initially, the
Rights are not exercisable and automatically trade with the Common Stock. There
are no separate Rights certificates at this time. Each Right entitles the holder
to purchase one one-hundredth of a share of Company Class C Series A Junior
Participating Preferred Stock for $75.00 (the "Exercise Price").
The Rights separate and become exercisable upon the occurrence of certain
events, such as an announcement that an "acquiring person" (which may be a group
of affiliated persons) beneficially owns, or has acquired the rights to own,
20% or more of the outstanding Common Stock, or upon the commencement of a
tender offer or exchange offer that would result in an acquiring person
obtaining 20% or more of the outstanding shares of Common Stock.
Upon becoming exercisable, the Rights entitle the holder to purchase
Common Stock with a value of $150 for $75. Accordingly, assuming the Common
Stock had a per share value of $75 at the time, the holder of a right could
purchase two shares for $75. Alternatively, the Company may permit a holder to
surrender a Right in exchange for stock or cash equivalent to one share of
Common Stock (with a value of $75) without the payment of any additional
consideration. In certain circumstances, the holders have the right to acquire
common stock of an acquiring company having a value equal to two times the
Exercise Price of the Rights.
The Rights have certain anti-takeover effects. The Rights will cause
substantial dilution to an acquiring person. Accordingly, the existence of the
Rights may deter certain acquirers from making takeover proposals or tender
offers.
ITEM 2. PROPERTIES
In March 1997, the Company entered into a lease with a limited liability
company owned by John C. Wooley and Jeffrey J. Wooley for a new corporate
headquarters facility in Austin. This lease will expire in 2007. The facility
consists of approximately 41,000 square feet of office and storage space. The
Company moved to this new facility in November 1997. The former corporate
headquarters facility, consisting of approximately 11,000 square feet of office
space in Austin, was sold by the Company in December 1997. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Results of Operations."
The Company leases approximately 10,000 square feet of space for the
flagship Schlotzsky's Deli restaurant and training facility in Austin and
approximately 7,100 square feet for a store opened in Austin in February 1998.
The Company has a ground lease for an additional 2,700 square foot store which
opened in Austin in February 1998, and owns the real estate for a 3,200 square
foot store opened in Austin in December 1998. The Company leases approximately
3,000 square feet each for two stores which it operates in Houston. The Company
leases two stores in College Station, Texas with an aggregate of 5,400 square
feet of space. The Company also owns the sites of two stores in North Lake,
Illinois and Pearl, Mississippi and leases approximately 1,800 square feet for
its store in New York City. It is contemplated that the Houston stores, the
Pearl, Mississippi store and the North Lake, Illinois store will be sold.
As of December 31, 1998, the Company had 86 store sites in various stages
of development under the Turnkey Program. Development was completed on 71 sites
and these sites are operating and under lease or mortgage. Four of the sites in
development are in various stages of construction and 82 sites remain in the
pre-development stage. The Company also owns five sites, which it contemplates
remarketing. It is contemplated that sites acquired under the
15
Turnkey Program will be sold to franchisees and investors at various stages
of development or after completion. See "Business -- Turnkey Program."
Schlotzsky's Real Estate, Inc., a wholly-owned subsidiary of the Company,
is the general partner and the Company is a limited partner of a limited
partnership which owns a 17,600 square foot shopping center in suburban Austin.
Schlotzsky's Real Estate, Inc. and the Company have a combined 40% interest in
the capital and profits of this limited partnership. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
ITEM 3. LEGAL PROCEEDINGS
The State of New Mexico Taxation and Revenue Department has assessed the
Company $131,000 for gross receipts taxes, penalties and interest for the years
1987 through 1993. The assessment imposes gross receipts taxes on franchise fees
and royalties received by the Company from New Mexico franchisees and NAMF
contributions by those franchisees. The Company filed a protest with the New
Mexico Taxation and Revenue Department claiming that the assessment violates the
Commerce Clause of the United States Constitution because the Company does not
have any physical presence in or substantial nexus with New Mexico. The Company
has reserved a liability for taxes and attorneys' fees in respect of this
assessment. If other state taxing authorities attempt to impose taxes on
receipts derived by the Company from franchisees in those states, the Company's
financial condition and results of operations could be materially adversely
affected.
On February 8, 1999, the Lone Star Ladies Investment Club, et al., filed a
consolidated amended class action lawsuit in the Western District of Texas
against the Company and four of its officers and directors (Monica Gill,
Executive Vice President and Chief Financial Officer; John M. Rosillo, director;
Jeffrey J. Wooley, Senior Vice President and director; and John C. Wooley,
President and Chairman of the Board of Directors). The complaint, alleges
securities fraud arising from a change in the timing of recognition of revenue
from the sale of real estate properties in connection with which the Company
provided limited guaranties on franchisees leases of the properties. In April
1998, Registrant announced that 1997 earnings would be lower than previously
announced because it would defer revenue received in the fourth quarter from
such real estate transactions rather than recognizing it during the period in
which the transaction occurred, as previously contemplated. Plaintiffs seek
monetary damages in an unspecified amount. The Company believes that the
allegations are without merit and intends to vigorously defend against the suit.
The Company is subject to routine litigation in the ordinary course of
business, including contract, franchisee, area developer and employment-related
litigation. In the course of enforcing its rights under existing and former
franchise agreements and area developer agreements, the Company is subject to
complaints and letters threatening litigation concerning the interpretation and
application of these agreements, for example, in cases of administration of the
NAMF advertising funds, default or termination of franchisees or area
developers, requirements or payments relating to products used in the stores
(such as private label licensing), and the Turnkey Program. The Company
endeavors to treat its franchisees and area developers reasonably and fairly and
in compliance with applicable contractual provisions with due regard for the
protection of the Company's trademarks, service marks and goodwill. None of
these routine matters, individually or in the aggregate, are believed by the
Company to be material to its business or financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The authorized capital stock of the Company consists of 30,000,000 shares
of Common Stock, no par value, and 1,000,000 shares of Class C Preferred Stock,
no par value. The Company's Common Stock is traded on the National Market of
the National Association of Securities Dealers Automated Quotation System
("NASDAQ") under the Symbol "BUNZ". Trading began on December 15, 1995 in
connection with the Company's initial public offering. No public market existed
for the Common Stock prior to that time. As of March 19, 1999, 7,401,338 shares
of outstanding Common Stock were owned by approximately 6,000 beneficial owners
constituting 283 shareholders of record.
The high and low bid prices as reported by NASDAQ for the period from
January 1, 1997 to December 31, 1998 are set forth below:
HIGH LOW
------ ------
FISCAL 1997:
First Quarter . . . . . . . . . . . 12 1/4 9 5/8
Second Quarter . . . . . . . . . . . 14 1/4 10 3/4
Third Quarter . . . . . . . . . . . 20 3/8 13 1/4
Fourth Quarter . . . . . . . . . . . 20 1/4 14 1/2
FISCAL 1998
First Quarter . . . . . . . . . . . 23 3/8 14 3/4
Second Quarter . . . . . . . . . . . 22 5/8 13 3/16
Third Quarter . . . . . . . . . . . 18 1/2 9 1/8
Fourth Quarter . . . . . . . . . . . 11 1/4 9 1/4
These quotations may reflect inter-dealer prices, without retail mark-up,
mark-down or commissions and may not necessarily represent actual transactions.
The Company has never paid and has no current plans to pay cash dividends on its
Common Stock. The Company currently intends to retain earnings for use in the
operation and expansion of the Company's business and does not anticipate paying
cash dividends in the foreseeable future. The declaration and payment of future
dividends will be at the sole discretion of the Board of Directors and will
depend on the Company's profitability, financial condition, capital needs,
future prospects and other factors deemed relevant by the Board of Directors.
On December 18, 1998, the Board of Directors adopted resolutions regarding
the designation, preferences, and rights of Class C Series A Junior
Participating Preferred Stock in connection with the adoption of a Shareholders'
Rights Plan. See "Risk Factors - Anti Takeover Provisions."
The Transfer Agent and Registrar for the Company's Common Stock is Harris
Trust and Savings Bank of Chicago, Illinois.
17
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data for the
Company for the periods and the dates indicated. The historical consolidated
financial data as of and for the years ended December 31, 1996, 1997 and
1998 have been derived from the audited consolidated financial statements of the
Company and its predecessor entities, included elsewhere herein. The balance
sheet data and statement of operations data as of and for the years ended
December 31, 1994, and 1995 has been derived from the Company's audited
financial statements not included or incorporated herein. The selected
financial data should be read in conjunction with, and are qualified in their
entirety by, the Consolidated Financial Statements of the Company and related
Notes and other financial information included elsewhere in this report.
FISCAL YEARS ENDED DECEMBER 31,
----------------------------------------------------------
1994 1995 1996 1997 1998
------ ------ ------ ------ ------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF Operations Data:
Revenue:
Royalties . . . . . . . . . . . . . . . . . . . . . . . . $4,657 $7,425 $10,747 $14,561 $18,885
Franchise fees. . . . . . . . . . . . . . . . . . . . . . 1,019 1,494 1,775 1,555 1,365
Developer fees. . . . . . . . . . . . . . . . . . . . . . 2,793 2,666 1,993 325 270
Restaurant sales. . . . . . . . . . . . . . . . . . . . . 428 505 3,610 6,364 7,720
Brand contribution. . . . . . . . . . . . . . . . . . . . 150 397 1,295 2,915 4,003
Turnkey development . . . . . . . . . . . . . . . . . . . -- 41 726 1,139 8,314
Other fees and revenue. . . . . . . . . . . . . . . . . . 256 324 568 1,110 1,291
------- ------- ------- ------- -------
Total revenue. . . . . . . . . . . . . . . . . . . . 9,303 12,852 20,714 27,969 41,848
Costs and expenses:
Service costs:
Royalties. . . . . . . . . . . . . . . . . . . . . . . 1,122 2,405 3,791 5,373 7,225
Franchise fees . . . . . . . . . . . . . . . . . . . . 661 767 959 813 697
Restaurant operations:
Cost of sales. . . . . . . . . . . . . . . . . . . . . 188 189 1,183 2,014 2,513
Labor costs. . . . . . . . . . . . . . . . . . . . . . 154 408 1,424 2,493 3,205
Operating expenses . . . . . . . . . . . . . . . . . . 260 251 1,040 1,952 2,168
Turnkey development costs . . . . . . . . . . . . . . . . 16 332 519 368 4,806
General and administrative. . . . . . . . . . . . . . . . 4,183 5,419 6,509 7,686 11,472
Depreciation and amortization . . . . . . . . . . . . . . 372 458 779 1,155 1,885
------- ------- ------- ------- -------
Total costs and expenses . . . . . . . . . . . . . . 6,956 10,229 16,204 21,854 33,971
------- ------- ------- ------- -------
Income from operations . . . . . . . . . . . . . . . . 2,347 2,623 4,510 6,115 7,877
Other:
Interest income (expense) . . . . . . . . . . . . . . . . (201) (149) 455 753 2,058
Other income. . . . . . . . . . . . . . . . . . . . . . . 226 138 132 195 --
------- ------- ------- ------- -------
Total other income (expense) . . . . . . . . . . . . 25 (11) 587 948 2,058
------- ------- ------- ------- -------
Income before income taxes and
Extraordinary gain . . . . . . . . . . . . . . . . . . 2,372 2,612 5,097 7,063 9,935
Provision for income taxes. . . . . . . . . . . . . . . . 927 1,017 1,902 2,614 3,729
Gain on extinguishment of debt, net of tax. . . . . . . . 40 38 -- -- --
------- ------- ------- ------- -------
Net income. . . . . . . . . . . . . . . . . . . . . . . . $1,485 $1,633 $3,195 $4,449 $6,206
------- ------- ------- ------- -------
------- ------- ------- ------- -------
Net income per share - basic(1) . . . . . . . . . . . . . $0.47 $0.47 $0.58 $0.74 $0.84
Net income per share - diluted(1) . . . . . . . . . . . . $0.44 $0.42 $0.57 $0.71 $0.82
Working capital . . . . . . . . . . . . . . . . . . . . . $1,909 $18,750 $13,515 $42,563 $26,224
Total assets. . . . . . . . . . . . . . . . . . . . . . . 16,481 36,708 40,979 79,521 104,228
Long-term debt, less current maturities(2). . . . . . . . 10,452 3,029 3,129 1,936 9,219
Stockholders' equity. . . . . . . . . . . . . . . . . . . 1,614 28,974 32,312 66,991 73,963
- - ------------
(1) Earnings per share reflects retroactive application of statement of
financial accounting standards ("SFAS") no. 128, "Earning Per Share."
(2) For 1994, long-term debt includes $8,000,000 for redeemable preferred
stock.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The Company derives its revenue from several sources: royalties, franchise
fees, developer fees (consisting of area developer and master licensee fees),
Company-owned restaurant sales, Turnkey development, brand contribution (private
label licensing fees), and other franchise-related activities. Between 1991 and
1994, developer fees grew to represent a significant portion of total revenue as
the Company sold development rights for most of the television markets in the
United States and certain international territories. Franchise fees, Turnkey
development and brand contribution increased following this period as the rate
at which stores opened increased. Since the Company has sold developer rights
for virtually all of the United States, developer fees derived from these
non-recurring transactions have declined as a percentage of total revenue, while
typically brand contributions, franchise fees and royalties based on franchise
store sales and revenue from the Turnkey Program have increased.
Royalties are based on a percentage of franchisees' net sales and are
recognized by the Company in the same period that the franchise store sales
occur. Generally, royalties are earned at the rate of 6% of sales for stores
opened after 1991 and 4% of sales for stores opened before that time.
Royalties are paid by means of weekly automatic drafts by the Company on
franchisee bank accounts for 6% royalty stores. As of December 31, 1998, 98
franchised stores were paying royalties on a monthly basis at the rate of 4%.
This number of stores will decline as older franchise agreements expire (the
majority of which will expire after 1999). A portion of the royalties
received by the Company are paid to its area developers as royalty service
costs for providing on-going services to franchisees in their territories.
See "Business -- Franchising --Area Developers." Royalties have increased
since 1992 due not only to the growth in the number of stores, but also to
increases in average weekly sales. The increase in average weekly sales is
due primarily to the conversion of older franchise stores to the Schlotzsky's
Deli restaurant concept, as well as the selection of more free-standing
locations for newer stores, which have better visibility and generally
experience higher sales than the smaller "in-line" stores located in strip
shopping centers which are characteristic of stores opened prior to 1992.
Franchise fees are payments received by the Company from franchisees and
are typically recognized into revenue as stores open. The franchise fee for a
franchisee's initial store is currently $30,000. The franchise fee for each
additional store committed to and opened by a franchisee is $20,000. Expenses
associated with franchise fees are shown as franchise fee service costs and
include the portion of the franchise fee paid to area developers. The Company
generally pays area developers approximately one-half of the franchise fees
collected from franchisees in their development areas. As the Company
reacquires a limited number of territories and buys down the percentage of
participation by certain area developers, the Company expects that franchise
fee service costs will decrease as a percentage of franchise fees to less
than 50%.
Restaurant sales are reported from Company-owned stores, and declined
between 1991 and 1994 as a result of the Company's strategy adopted in 1991
to develop only franchised stores. The number of Company-owned stores
declined from 22 to two stores between 1990 and 1994. Restaurant sales
increased significantly in 1996 because the Company's flagship restaurant in
Austin, Texas was in operation the entire year and because two additional
stores were acquired from franchisees during 1996. Currently, Company stores
are operated primarily for product development, concept refinement and
training franchisees. Management does not believe that the operating cost of
sales for Company-owned stores is indicative of costs for franchised stores
on a system-wide basis. Restaurant sales should increase as the Company
continues to acquire or open a limited number of additional Company-owned
stores. See "Business -- Strategy -- Company-Owned Stores."
The Company charges developers a nonrefundable fee for the exclusive
rights to develop a defined territory for a specified term. Typically, a
portion of the developer fee is paid in cash and the balance is paid with a
promissory note. See "Business -- Franchising -- Area Developers" and "--
International Master Licensees." When the Company has fulfilled substantially
all of its contractual responsibilities and obligations, such as training,
providing manuals, and, in the case of master licensees, reasonable efforts
to obtain trademark registration, the Company recognizes as revenue the cash
portion of the fee and the value of the promissory note, as determined by an
independent third party valuation. These fees have declined in the last three
years as most of the remaining domestic territories have
19
been sold and fees from the licensing of international territories, which are
not aggressively marketed by management, remain sporadic.
Revenue is also generated from brand contribution (private label
licensing fees) and the Turnkey Program. The Company has licensed
manufacturers to produce Schlotzsky's private label products and began
receiving licensing fees from sales of private label foods to franchisees in
late 1994. This revenue has increased significantly to $1,295,000 for 1996,
$2,915,000 for 1997 and $4,003,000 for 1998. The Company believes that
private label licensing fees will increase as a greater portion of the
systems' menu ingredients are covered by the program, system-wide sales grow
and terms with various suppliers are renegotiated. See "Business --
Purchasing; Private Labeling" and "Risk Factors -- Importance of Licensing
Fees."
The Company instituted the Turnkey Program to further assist franchisees
in obtaining superior sites and to achieve more rapid penetration in those
selected major markets where the Company believes there is strong demand by
franchisees for good locations. Under the Turnkey Program, the Company works
independently or with an area developer to identify superior store sites
within a territory. The Company will typically perform various consulting
services including, but not limited to, site selection, feasibility analysis,
environmental studies, site work, permitting and construction management,
receiving a fee and recognizing revenue upon the completion of these
services. The Company may assign its earnest money contract on a site to a
franchisee, or a third-party investor, who then assumes responsibility for
developing the store. The Company may also purchase or lease a selected site,
design and construct a Schlotzsky's Deli restaurant on the site and sell,
lease or sublease the completed store to a franchisee. Where the Company does
not sell the property to a franchisee, the Company sells the improved
property, or, in the case of a leased property, assigns the lease and any
sublease, to an investor.
The Company anticipates that the total investment in each developed
free-standing location will be approximately $1,200,000 to $2,000,000 (less for
leased locations). From inception of the Turnkey Program through 1997, the
Company typically provided a credit enhancement in the form of a limited
guaranty on the franchisee's lease for leased locations. Upon sale of the
leased site or assignment of its earnest money contract, the Company has
deferred revenue generated (even though proceeds were received in cash) and
allocable costs incurred in connection with the property. When a lease guaranty
is terminated, or the Company's exposure to loss under the guaranty has passed,
the Company recognizes the revenue and allocable costs related to the site.
Generally, if no credit enhancement is provided in connection with such
transactions, the Company may recognize the revenue and allocable expenses in
the periods in which the transactions occur. During 1998, the Company began
emphasizing ownership of the real estate by franchisees through a program which
entails acquiring the rights to a superior site and reselling the property, or
its rights (with any improvements), to a franchisee whose mortgage loan is
financed by a third party financial institution. The Company provides credit
enhancement for the franchisee in the form of a limited guaranty in favor of the
lender. Generally, in those cases, the Company recognizes the revenue and
allocable expenses in the period in which the transaction occurs. In some
cases, the Company may interim finance land and building costs in anticipation
of permanent financing by a financial institution. The Company believes that
the Turnkey Program enhances the Company's ability to recruit qualified
franchisees by securing and developing high profile sites and achieving critical
mass for advertising purposes more quickly in selected markets. In addition, the
Company charges a fee when it is requested to manage construction of a store on
property owned by a franchisee or an investor. This construction management fee
is recognized when the store is completed.
20
The following table sets forth (i) the percentage relationship to total
revenue of the listed items included in the Company's consolidated statements of
operations, except as otherwise indicated, and (ii) selected store data.
FISCAL YEARS ENDED DECEMBER 31,
---------------------------------------
1996 1997 1998
--------- --------- ---------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Royalties. . . . . . . . . . . . . . . . . . . . . . . . . 51.9% 52.1% 45.1%
Franchise fees . . . . . . . . . . . . . . . . . . . . . . 8.6 5.6 3.3
Developer fees . . . . . . . . . . . . . . . . . . . . . . 9.6 1.2 0.6
Restaurant sales . . . . . . . . . . . . . . . . . . . . . 17.4 22.7 18.4
Brand contribution . . . . . . . . . . . . . . . . . . . . 6.3 10.4 9.6
Turnkey development. . . . . . . . . . . . . . . . . . . . 3.5 4.1 19.9
Other fees and revenue . . . . . . . . . . . . . . . . . . 2.7 3.9 3.1
--------- --------- ---------
Total revenue. . . . . . . . . . . . . . . . . . . . . 100.0 100.0 100.0
Costs and expenses:
Service costs:
Royalties(1). . . . . . . . . . . . . . . . . . . . . . . 35.3 36.9 38.3
Franchise fees(2) . . . . . . . . . . . . . . . . . . . . 54.0 52.3 51.1
Restaurant operations:
Cost of sales(3). . . . . . . . . . . . . . . . . . . . . 32.8 31.6 32.6
Labor costs(3). . . . . . . . . . . . . . . . . . . . . . 39.5 39.2 41.5
Operating expenses(3) . . . . . . . . . . . . . . . . . . 28.8 30.7 28.1
Turnkey development costs (4) . . . . . . . . . . . . . . 71.5 32.3 57.8
General and administrative . . . . . . . . . . . . . . . . 31.4 27.5 27.4
Depreciation and amortization. . . . . . . . . . . . . . . 3.8 4.1 4.5
Total costs and expenses . . . . . . . . . . . . . . . 78.2 78.1 81.2
--------- --------- ---------
Income from operations. . . . . . . . . . . . . . . . . . 21.8 21.9 18.8
Other:
Interest income . . . . . . . . . . . . . . . . . . . . . 2.2 2.7 4.9
Other income. . . . . . . . . . . . . . . . . . . . . . . 0.6 0.7 0.0
--------- --------- ---------
Total other income . . . . . . . . . . . . . . . . . . 2.8 3.4 4.9
--------- --------- ---------
Income before income taxes. . . . . . . . . . . . . . . . 24.6 25.3 23.7
Provision for income taxes. . . . . . . . . . . . . . . . 9.2 9.3 8.9
--------- --------- ---------
Net income. . . . . . . . . . . . . . . . . . . . . . . . 15.4% 15.9% 14.8%
--------- --------- ---------
--------- --------- ---------
STORE DATA:
System-wide sales(5). . . . . . . . . . . . . . . . . . . $202,400 $270,400 $348,500
Change in same store sales(6) . . . . . . . . . . . . . . 3.3% 3.4% 3.1%
Weighted average annual store sales(7). . . . . . . . . . $410,000 $455,000 $503,000
Weighted average weekly store sales(7). . . . . . . . . . $ 7,867 $ 8,753 $ 9,671
Change in average weighted weekly store sales(8) . . . . 11.0% 11.3% 10.5%
Number of stores opened during period . . . . . . . . . . 135 120 107
Number of stores closed during period . . . . . . . . . . 25 20 30
Number of stores in operation at end of period. . . . . . 573 673 750
- - ---------------------------------
(1) Expressed as a percentage of royalties.
(2) Expressed as a percentage of franchise fees.
(3) Expressed as a percentage of restaurant sales.
(4) Expressed as a percentage of Turnkey development.
(5) In thousands. Includes sales for all stores, as reported by
franchisees or derived by the Company from other data reported by
franchisees.
(6) Same store sales are based upon stores which were open for the entire
period indicated and for at least 18 months as of the end of the
corresponding prior period, including stores which were temporarily
closed and reopened within 6 months.
(7) In actual dollars (rounded in the case of average annual store sales).
(8) Percentage change in weighted average weekly store sales from previous
fiscal year.
21
RESULTS OF OPERATIONS
FISCAL YEAR 1998 COMPARED TO 1997
REVENUE. Total revenue increased 49.6% from $27,969,000 to $41,848,000.
Royalties increased 29.7% from $14,561,000 to $18,885,000. This increase
was due to the full year impact of stores opened in 1997 and the addition of 107
restaurants opened during the period from January 1, 1998 to December 31, 1998.
Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, a 10.5% increase in average weekly
sales and a 3.1% increase in same store sales.
Franchise fees decreased 12.2% from $1,555,000 to $1,365,000. This decrease
was a result of 13 fewer openings during 1998, as compared to 1997. The fewer
number of openings is principally the result of the Company's increasing
emphasis on superior site selection for larger freestanding stores with higher
visibility and on more highly qualified and better capitalized franchisees.
Developer fees decreased 16.9% from $325,000 to $270,000. This decrease was
primarily the result of less emphasis on these transactional fees and the fact
that the development rights to most domestic markets have been sold. The Company
anticipates that developer fees received in the future will primarily result
from re-marketing development rights it has acquired.
Restaurant sales increased 21.3% from $6,364,000 to $7,720,000. This
increase was attributable to a 6.2% increase in sales volume at the Company's
flagship store and the relocation and reopening of two Company-owned stores
during 1998. In the future, it is contemplated that several more Company-owned
stores will be developed, operated and maintained by the Company in certain key
markets.
Private label licensing fees (brand contributions) increased 37.3% from
$2,915,000 to $4,003,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well as
the increasing volume of system-wide sales and greater franchisee participation
in the Company's purchasing programs. During 1999, the Company expects
additional products will be added to its private label program and alternative
retail channels of distribution of its products may become available, resulting
in the potential for further increases in licensing fees.
Turnkey development revenue increased from $1,139,000 to $8,314,000. In
contrast with 1997 when 33 of 40 Turnkey Program transactions involved the
Company's credit enhancement on franchisee leases, only five of the 69 Turnkey
Program transactions involved such lease guaranties in 1998. Of the $8,314,000,
$2,102,000 was related to transactions completed during 1997 involving the
Company's lease guaranties, which were terminated during 1998. The remainder of
the transactions in 1998 involved sales of rights to real estate to franchisees
or investors (who acquired with the objective of selling developed properties to
franchisees). Revenue in 1998 also included approximately $258,000 of rental
revenue from sites completed and under lease. The Company anticipates that
Turnkey development revenue may be reduced in the future as a greater emphasis
is placed on lowering the cost to franchisees of each project.
Other fees and revenues increased 16.1% from $1,110,000 to $1,289,000. This
change was primarily due to the increased level of supplier contributions to the
Company's annual convention held in July 1998.
COSTS AND EXPENSES. Royalty service costs increased 34.5% from $5,373,000
to $7,225,000. This increase was a direct result of the increase in royalty
revenue for 1998, as compared to 1997. Royalty service costs as a percentage of
royalties grew from 36.9% to 38.3%. This increase reflects the growing
percentage of restaurants serviced by the area developer system and whose area
developers receive approximately 42% of the royalties from the stores in their
territories. During 1999, the Company expects developer service costs as a
percentage of royalty revenue to decrease as the Company intends to buy-down the
rights and obligations of several of its area developers and to re-acquire the
rights to a limited number of territories.
Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 24.8% from $2,014,000 to $2,513,000, and as a percentage of restaurant
sales increased from 31.6% to 32.6%. Also, restaurant labor costs
22
increased 28.6% from $2,493,000 to $3,205,000, and as a percentage of
restaurant sales increased from 39.2% to 41.5% for the same period in 1997.
These percentage increases were primarily due to operational inefficiencies
experienced in re-opening two Company-owned stores. Restaurant operating
expenses have increased 11.1% from $1,952,000 to $2,168,000, but as a
percentage of restaurant sales decreased from 30.7% to 28.1% for 1998, as
compared to 1997. This decrease is due to the increasing sales outpacing the
increased costs associated with operating the new stores.
Turnkey development costs increased from $368,000 to $4,806,000 and as a
percentage of Turnkey development revenue increased from 32.3% to 57.8%. These
increases are primarily the result of $1,063,000 of costs deferred in 1997 being
recognized in 1998, the addition of staff to the Turnkey Program in late 1997
and during 1998 and certain costs being recognized for sites no longer being
pursued.
General and administrative expenses increased 49.3% from $7,686,000 to
$11,471,000, and as a percentage of total revenue remained relatively stable at
27.4%.
Depreciation and amortization increased 63.1% from $1,156,000 to
$1,885,000, and as a percentage of revenue increased from 4.1 to 4.5%. This
dollar increase was principally due to amortization of goodwill and other
intangibles acquired in 1997 and 1998, and depreciation related to the
additional stores the Company was operating during the year.
OTHER. Net interest income increased 173.3% from $753,000 to $2,058,000.
This increase was a result of funds being loaned for Turnkey mortgages and
interim construction financing under the Turnkey Development Program.
INCOME TAX EXPENSE. Income tax expense reflects a combined federal and
state effective tax rate of 37.5% for 1998, which is slightly higher than the
effective combined tax rate for the comparable period in 1997. Based on
projections of taxable income, the Company anticipates that its effective
combined rate for federal and state taxes will remain fairly stable.
FISCAL YEAR 1997 COMPARED TO 1996
REVENUE. Total revenue increased 35.0% from $20,714,000 to $27,969,000.
Royalties increased 35.5% from $10,747,000 to $14,561,000. This increase
was due to the full year impact of stores opened in 1996 and the addition of 120
restaurants opened during the period from January 1, 1997 to December 31, 1997.
Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, an 11.3% increase in average weekly
sales and a 3.4% increase in same store sales.
Franchise fees decreased 12.4% from $1,775,000 to $1,555,000. This decrease
was a result of 15 fewer openings during 1997, as compared to 1996. The fewer
number of openings was principally the result of the Company's increasing
emphasis on superior site selection for larger freestanding stores with higher
visibility and on more highly qualified and better capitalized franchisees.
Developer fees decreased 83.7% from $1,993,000 to $325,000. This decrease
was primarily the result of less emphasis on these transactional fees and the
fact that the development rights to most domestic markets have been sold.
Restaurant sales increased 76.3% from $3,610,000 to $6,364,000. This
increase was attributable to a 17.4% increase in sales volume at the Company's
flagship store and the opening of two additional Company-owned stores in 1997.
Private label licensing fees (brand contributions) increased 125.1% from
$1,295,000 to $2,915,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well as
the increasing volume of system-wide sales and greater franchisee participation
in the Company's purchasing programs.
23
Turnkey development revenue increased 56.9% from $726,000 to $1,139,000.
Cash received in excess of costs allocable to 1997 Turnkey Program transactions
in which the Company provided credit enhancement on franchisees' leases was
treated as deferred revenue, and accordingly, did not impact the 1997 revenue or
net income. Revenue in 1997 included approximately $303,000 of rental revenue
from sites completed and under lease. Forty sites developed under the Turnkey
Program were sold during 1997, seven of which had no credit enhancement
associated with the transaction and the revenues from that activity comprise the
balance of Turnkey development revenue generated during 1997.
Other fees and revenues increased 95.4% from $568,000 to $1,110,000. This
change was primarily due to the increased level of supplier contributions to the
Company's annual convention held in July 1997.
COSTS AND EXPENSES. Royalty service costs increased 41.7% from $3,791,000
to $5,373,000. This increase was a direct result of the increase in royalty
revenue for 1997, as compared to 1996. Royalty service costs as a percentage of
royalties grew from 35.3% to 36.9%. This increase reflected the growing
percentage of restaurants serviced by the area developer system and whose area
developers receive approximately 42% of the royalties from the stores in their
territories.
Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 70.3% from $1,183,000 to $2,014,000, but as a percentage of restaurant
sales decreased from 32.8% to 31.6%. Also, restaurant labor costs increased
75.1% from $1,424,000 to $2,493,000, but as a percentage of restaurant sales
decreased from 39.5% to 39.2% for the same period in 1996. These percentage
decreases were primarily due to the improving operational efficiencies attained
in the various Company-owned stores. Restaurant operating expenses increased
87.7% from $1,040,000 to $1,952,000, and as a percentage of restaurant sales
increased from 28.8% to 30.7% for 1997, as compared to 1996. The increase in
operating expenses is due to the additional facility costs for the additional
stores the Company operates.
Turnkey development costs decreased 29.1% from $519,000 to $368,000, and as
a percentage of Turnkey development revenue decreases from 71.5% to 32.3%.
These increases were primarily attributable to the deferral of costs associated
with stores developed, or developed and sold with a lease guaranty, during 1997.
General and administrative expenses increased 18.1% from $6,508,000 to
$7,686,000, but as a percentage of total revenue decreased from 31.4% to 27.5%.
The dollar increase was principally the result of additional personnel at the
corporate office, including certain one-time expenses related to the hiring and
relocation of the individuals. The percentage decrease is the result of revenue
increasing at a greater rate than these expenses for 1997.
Depreciation and amortization increased 48.4% from $779,000 to $1,156,000,
and as a percentage of revenue increased from 3.8 to 4.1%. This dollar increase
was principally due to amortization of goodwill and other intangibles acquired
in 1996 and 1997, and depreciation related to the additional stores the Company
was operating during the year.
OTHER. Net interest income increased 65.5% from $455,000 to $753,000. This
increase was a result of a higher level of funds invested during the more recent
period because of the secondary offering.
INCOME TAX EXPENSE. Income tax expense reflects a combined federal and
state effective tax rate of 37.0% for 1997, which is slightly lower than the
effective combined tax rate for the comparable period in 1996.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $6,516,000 for 1998. Accounts
payable and accrued liabilities increased $7,124,000, primarily because of
construction costs incurred during the fourth quarter that were due subsequent
to the end of the year. Net cash of $20,945,000 was used in investing activities
primarily consisting of expenditures of $17,245,000 on the completion of two
Company-owned stores, the acquisition of two additional Company-owned stores and
three future sites for additional Company-ownedstores. The Company used
$19,918,000 of cash primarily for establishing its construction and mortgage
program for the Turnkey Program. The Company used $8,713,000 to re-acquire the
development rights to several domestic
24
territories and re-acquire franchise rights in some selected markets. During
1998, financing activities provided cash of approximately $11,592,000 due
primarily to the issuance of debt.
Net cash provided by operating activities was $5,608,000 for 1997. Also
during 1997, net cash of $8,798,000 was used in investing activities primarily
consisting of expenditures of $7,436,000 on the completion of Company-owned
stores, three future sites of additional Company stores and the construction of
its new corporate headquarters. As a result of the sale of the Company's former
headquarters and a Company-owned store, sale of equipment generated $1,655,000
of cash flow. Also, the Company used $2,722,000 to re-acquire the development
rights to several domestic territories and re-acquired franchise rights in some
selected markets. During 1997, financing activities provided cash of
approximately $28,805,000 due primarily to the issuance of 1,731,825 shares of
common stock in the Company's secondary public offering. The Company used
proceeds from the offering to retire approximately $2,537,000 of debt during the
year.
At December 31, 1998, the Company had approximately $14,601,000 of debt
outstanding. During 1998, the Company borrowed approximately $5,000,000 in
connection with the re-acquisition of certain domestic development rights and
drew on its line of credit to fund Turnkey development activities. During 1997,
the Company borrowed $1,113,000 primarily in connection with the re-acquisition
of certain domestic development rights. These notes bear interest at rates
ranging from the lender's prime interest rate to 10.6% and all mature by the end
of 2001. The Company guaranties certain real estate leases, equipment leases and
other obligations of franchisees. At December 31, 1998, these contingent
liabilities totaled approximately $26,438,000. Included in this amount is a
construction loan for a limited partnership in which the Company and its
subsidiary, Schlotzsky's Real Estate, Inc., own a combined 40% interest in
capital and profits. The loan, for which the Company is liable for the full
amount, had a balance of $1,093,000 at December 31, 1998, bears interest at
prime plus 1.25% and matures April 2001. Monthly payments are being made by the
limited partnership.
The Company plans to develop additional Company-owned stores in the next
18 months in the Austin market and certain selected other markets. Funds of
approximately $10,000,000 are estimated to be required for the development of
these Company-owned stores. Two stores opened in the first quarter of 1998
and the Company completed the construction of its new Company headquarters in
the fourth quarter of 1997. Proceeds from the secondary public offering were
used to complete these construction projects.
The Company continues to expand and refine its Turnkey Program and expects
that it will have 50 to 100 sites under contract or at various stages of
development at any given time. The Company has used the net proceeds from its
public offerings and the proceeds from sites sold and contracts assigned to
finance the activity of the Turnkey Program. With the anticipated activity in
the Turnkey Program, the capital required to finance the Turnkey Program will
be significant. The tables below provide a summary of Turnkey Program
activity since its inception and a summary of the status of the Turnkey
Program at December 31, 1998.
Turnkey Program revenue consists of the following:
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------------------
1996 1997 1998
------------ ------------ ------------
Sales to investors and franchisees . . . . . . . . . . $6,638,150 $31,361,869 $29,596,310
Development and construction management fees . . . . . 174,979 190,000 176,562
------------ ------------ ------------
Gross Turnkey Program revenue . . . . . . . . . . . 6,813,129 31,551,869 29,772,872
Turnkey Program development costs. . . . . . . . . . . (6,455,618) (28,829,065) (23,382,340)
------------ ------------ ------------
Net revenue from Turnkey Program projects . . . . . 357,511 2,722,804 6,390,532
Rental income. . . . . . . . . . . . . . . . . . . . . 368,402 303,091 258,187
Interim construction interest. . . . . . . . . . . . . -- 1,270 238,888
Deferred revenue recognized. . . . . . . . . . . . . . -- -- 1,426,819
Revenue deferred . . . . . . . . . . . . . . . . . . . -- (1,888,555) --
------------ ------------ ------------
Total Turnkey Program revenue . . . . . . . . . . . $ 725,913 $ 1,138,610 $ 8,314,426
------------ ------------ ------------
------------ ------------ ------------
25
The following table reflects system performance of the Turnkey Program
for the years ended December 31, 1997 and 1998.
NUMBER OF UNITS
--------------------
1997 1998
------ ------
Sites in process at beginning of year. . . . . . . . . . . . . . . . . 30 78
Sites beginning development during the year. . . . . . . . . . . . . . 90 83
Sites inventoried as Company-owned stores. . . . . . . . . . . . . . . (1) (3)
Sites inventoried as real estate or restaurants held for sale. . . . . -- (2)
Sites sold - revenue recognized. . . . . . . . . . . . . . . . . . . . (7) (69)
Sites sold - revenue deferred. . . . . . . . . . . . . . . . . . . . . (33) --
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) (1)
------ ------
Sites in process at end of year. . . . . . . . . . . . . . . . . . . . 78 86
------ ------
------ ------
INVESTED AT
DECEMBER 31,
1998
-----------
Sites under development or to be sold. . . . . . . . . . . . . . . . . 5 4 4,431,000
Predevelopment Site (prequalification) . . . . . . . . . . . . . . . . 73 82 1,494,000
------ ------ -----------
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 86 $ 5,925,000
------ ------ -----------
------ ------ -----------
The Company currently has a line of credit available from a financial
institution to finance Turnkey Program capital requirements. In December 1998,
the line of credit was increased to allow the Company to draw up to $15,000,000,
and bears interest at the bank's prime lending rate and expires December 2001.
As of December 31, 1998, the Company had drawn approximately $6,360,000 on this
line of credit and had allowed certain Area Developers and Franchisees to borrow
$7,147,000 under this credit facility.
The Company believes that cash flow from operations, together with the
proceeds of the Turnkey Program, collections from notes receivable and
borrowings under existing credit facilities described above will be sufficient
to meet the Company's anticipated operating cash needs for the foreseeable
future. If net proceeds from the Turnkey Program, credit facilities, and cash
flow from operations are insufficient to finance the Company's future expansion
plans, including continuing investment in Turnkey Program properties and the
buydowns of percentages of participation by certain Area Developers, the Company
intends to seek additional funds for this purpose from future debt financings or
additional offerings of equity securities, although there can be no assurance of
the availability of such funds on acceptable terms in the future.
YEAR 2000 COMPLIANCE
The year 2000 issue is a result of many computer programs being written
using two digits, e.g. "99", to define a year. Date-sensitive software may
recognize the year "00" as the year 1900 rather than the year 2000. This
would result in errors and miscalculations or even system failure causing
disruptions in business activities and transactions.
The Company's computer software programs utilize four digits to define
the applicable calendar year and therefore the Company believes that it has
no material internal risk concerning the Year 2000 issue. The Company has
received preliminary responses from many of its major restaurant equipment
suppliers indicating that they and the products they sell to the Company's
restaurant system also have no material internal risk from the Year 2000
issue. To date, none of the Company's major suppliers have indicated that
they anticipate material internal risks. The Company is continuing a process
of in-depth inquiry concerning the readiness of its major suppliers and those
of the restaurant system. The Company will assess and, where practicable,
attempt to mitigate its risks with respect to the failure of these entities
to be Year 2000 compliant. The Company plans to continue to educate its
franchise system during 1999 to prepare them to anticipate Year 2000 issues
which could affect them locally. The Company does not anticipate that its
costs associated with monitoring readiness and mitigating risks concerning
the Year 2000 issue will be material. However, even if favorable responses
are received, there can be no assurance that third parties will be Year 2000
compliant.
26
The impact on the Company's operations, if any, from the inability of any of its
suppliers and franchisees to become Year 2000 compliant is not reasonably
estimable (except that if there is a national or regional crisis in the
financial, transportation or utility infrastructure, it would likely adversely
affect most commercial enterprises, including the Company.)
QUARTERLY COMPARISONS
Since the adoption of the Schlotzsky's Deli restaurant concept in 1991, the
Company has experienced growth in royalties and franchise fees. Store openings
typically mark the recognition of franchise fees and the beginning of the
royalty stream to the Company. Accordingly, a large number of store openings has
a significant impact on the amount and timing of revenue. The timing of store
openings can also affect the same store sales and other period-to-period
comparisons. There were 135 store openings in 1996, 120 in 1997 and 107 in 1998.
At July 1, 1995, the initial franchise fee was increased from $17,500 to $20,000
and was further increased to $30,000 effective August 1, 1998. The net
profitability from developer fees is substantially higher than that derived from
royalties and franchise fees because of the relatively lower costs associated
with developer fees. Therefore, quarters in which the Company derived a high
percentage of total revenue from developer fees reflect substantially higher
margins. While developer fees were a significant portion of revenue in past
years , it is anticipated that they will not be material in the future because
most of the attractive developer territories in the United States have been
sold. Moreover, the Company anticipates that royalty and other revenue will
continue to increase so that developer fees will decline as a percentage of
total revenue, resulting in more normalized margins. Also, the Company believes
restaurant sales and private label licensing fees (brand contributions) will
continue to increase as a percentage of revenue.
In 1997, the Company recorded a significant fourth quarter adjustment
related to activities within the Turnkey Program. The adjustment included the
deferral of approximately $1,889,000, representing the excess of proceeds
received of approximately $24,268,000 over the related development costs of
approximately $22,380,000, in connection with the transfer of title or
assignment of earnest money contracts on 33 Turnkey Program properties to
various third-party investors. Revenue is deferred only in those Turnkey
Program transactions for which the Company provides a credit enhancement to
the third-party investor in the form of a guaranty on the franchisee lease
assigned at the same time that the sale or assignment of the property occurs.
The Company also deferred certain costs of approximately $894,000 associated
with the acquisition, development and, in some instances, construction of the
Turnkey Program properties. The applicable tax effect of the adjustments was
approximately $368,000. During 1998, only five of the 69 Turnkey Program
transactions involved the Company's guaranty on franchisees' leases with third
party investors who acquired properties from the Company. Accordingly, most
of the revenue from Turnkey Program transactions during 1998 was recognized
in the period in which the transactions occurred.
27
Management believes that the Company experiences only moderate seasonality.
The Company attempts to make store sales less seasonal by offering a variety of
products which tend to sell better during various seasons.
The following table presents unaudited quarterly results of operations
for the 1996, 1997 and 1998 fiscal years.
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
PRESENTATION OF QUARTERLY FIGURES
1996 1997
---------------------------------- ----------------------------------
1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH
REVENUES: (Dollars in thousands, except per share data)
Royalties $2,245 $2,675 $2,875 $2,953 $3,278 $3,606 $3,820 $3,858
Franchise fees 348 475 400 553 353 240 411 551
Developer fees 595 416 325 657 -- 125 -- 200
Restaurant sales 566 810 1,061 1,173 1,324 1,439 1,636 1,965
Brands contribution 121 238 511 424 535 807 791 783
Turnkey development 39 80 143 463 685 762 1,374 (1,683)
Other fees and revenue 168 214 123 63 160 361 312 276
---------------------------------- ----------------------------------
Total revenues 4,082 4,908 5,438 6,286 6,335 7,340 8,344 5,950
COSTS & EXPENSES 3,261 3,945 4,240 4,758 4,969 5,575 6,405 4,906
---------------------------------- ----------------------------------
OPERATING INCOME 821 963 1,198 1,528 1,366 1,765 1,939 1,044
NET INCOME $ 629 $ 714 $ 798 $1,053 $ 889 $1,162 $1,234 $1,164
---------------------------------- ----------------------------------
---------------------------------- ----------------------------------
Earnings per share - basic(1) $0.11 $0.13 $0.14 $0.20 $0.16 $0.21 $0.22 $0.16
Earnings per share - diluted(1) $0.11 $0.13 $0.14 $0.19 $0.16 $0.20 $0.21 $0.15
Store Openings 28 33 31 43 29 21 28 42
1998
----------------------------------
1ST 2ND 3RD 4TH
REVENUES:
Royalties $4,259 $4,720 $4,875 $5,032
Franchise fees 340 380 340 305
Developer fees -- -- -- 270
Restaurant sales 1,616 1,885 1,745 2,475
Brands contribution 860 1,006 1,052 1,085
Turnkey development 1,125 1,732 2,845 2,612
Other fees and revenue 254 590 207 238
----------------------------------
Total revenues 8,454 10,313 11,064 12,017
COSTS & EXPENSES 6,812 8,216 9,052 9,890
----------------------------------
OPERATING INCOME 1,642 2,097 2,012 2,127
NET INCOME $1,342 $1,571 $1,582 $1,712
----------------------------------
----------------------------------
Earnings per share - basic(1) $0.18 $0.21 $0.21 $0.23
Earnings per share - diluted(1) $0.18 $0.21 $0.21 $0.23
Store Openings 30 31 24 22
- - -------------
(1) Earnings per share reflects retroactive application of Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share."
IMPACT OF INFLATION
The Company believes that inflation did not have a material impact on
its operations for the periods reported. Significant increases in labor,
employee benefits, food costs and other operating expenses could have a
material adverse effect on franchisees' store operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Changes in short-term interest rates on loans from financial
institutions could materially affect the Company's earnings because the
underlying obligations are either variable, or fixed for such a short period
of time as to effectively become variable.
At December 31, 1998 a hypothetical 100 basis point increase in interest
rates would result in a reduction of approximately $114,000 in annual pre-tax
earnings. The estimated reduction is based upon the increased interest
expense of our variable rate debt and assumes no change in the volume or
composition of debt at December 31, 1998. The fair values of the Company's
bank loans are not significantly affected by changes in market interest rates.
28
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the financial statements referred to in the index
on page F-1 setting forth the Consolidated Financial Statements of
Schlotzsky's, Inc. and Subsidiaries, together with the report of Grant
Thornton LLP dated February 26, 1999.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On May 8, 1998, the Company reported on Form 8-K that Coopers & Lybrand
L.L.P., the Company's auditors for fiscal years 1994 through 1997, resigned
effective May 4, 1998. Their reports on the financial statements never
contained an adverse opinion, disclaimer of opinion, and were never qualified or
modified as to uncertainty, audit scope or accounting principles.
The Company has never been advised by Coopers & Lybrand that (1) internal
controls necessary for the Company to develop reliable financial statements did
not exist; (2) Coopers & Lybrand would no longer be able to rely on management's
representations or that it was unwilling to be associated with the financial
statements prepared by management; (3) Coopers & Lybrand needed to expand
significantly the scope of its audit; (4) Coopers & Lybrand had received
information which did or which might, if further investigated, impact the
fairness or reliability of a report or financial statement previously issued or
to be issued or which did or might cause Coopers & Lybrand to be unwilling to
rely on management's representations or be associated with the Company's
financial statements; or (5) Coopers & Lybrand did not conduct such further
investigation or expanded audit, or was not able to resolve its concerns about
the Company, because of its pending resignation as the Company's accountant or
any other reason.
On April 28, 1998, Coopers & Lybrand informed the Company that there was a
disagreement with management concerning the timing of the recognition of revenue
from certain of the Company's Turnkey Program transactions. The transactions at
issue were fiscal year 1997 sales of real estate with leases to franchisees
guarantied by the Company. The issue was resolved to Coopers & Lybrand's
satisfaction before the filing of the Company's Annual Report on Form 10-K. The
issue was discussed with the Audit Committee of the Board of Directors, and the
Company authorized Coopers & Lybrand to discuss the issue with the Company's
successor accountants. A letter from Coopers & Lybrand L.L.P. expressing
agreement with the Company's statements in such report on Form 8-K was included
as an exhibit to such report.
On June 19, 1998, the Company reported on Form 8-K that on June 18, 1998,
Grant Thornton LLP was engaged by the Company's Board of Directors as the new
independent accountant of the Company to replace Coopers & Lybrand L.L.P.
During the two fiscal years, and any interim period, preceding June 18, 1998,
neither the Company nor anyone on its behalf consulted Grant Thornton LLP on
accounting principles, audit opinions or financial reporting matters.
The Company requested Grant Thornton LLP to review the disclosures
required in the report on Form 8-K before it was filed with the Commission and
provided them with the opportunity to furnish the Company with a letter
addressed to the Commission containing any new information, or any clarification
of the Company's views or statements by Grant Thornton LLP that it did not agree
with the statements made in the report. Grant Thornton LLP informed the Company
that it reviewed the disclosures and did not intend to furnish the Company with
such a letter.
29
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with regard to directors and executive officers and their
business experience is set forth under "Election of Directors" in the
Registrant's definitive Proxy Statement for the Annual Meeting of
Shareholders to be held on May 28, 1999, and is incorporated herein by
reference.
ITEM 11. EXECUTIVE COMPENSATION
Information with regard to executive compensation and pension or similar
plans is set forth under "Compensation of Directors" and "Compensation of
Executive Officers" in the Registrant's definitive Proxy Statement for the
Annual Meeting of Shareholders to be held on May 28, 1999, and is
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with regard to security ownership of certain beneficial
owners and management is set forth under "Security Ownership of Certain
Beneficial Owners and Management" in the Registrant's definitive Proxy
Statement for the Annual Meeting of Shareholders to be held on May 28, 1999,
and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with regard to certain relationships and related
transactions is set forth under "Election of Directors; Certain Relationships
and Related Transactions," in the Registrant's definitive Proxy Statement for
the Annual Meeting of Shareholders to be held on May 28, 1999, and is
incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS. Reference is made to the index on page F-1 for
a list of all financial statements filed as part of this Report.
(a)(2) FINANCIAL STATEMENTS SCHEDULES. Reference is made to the index on
page F-1 for a list of all financial statement schedules filed as part of this
Report.
(a)(3) EXHIBITS
3.1 -- Articles of Incorporation of the Registrant, as amended. (1)
3.2 -- Statement of Resolutions Regarding the Designation,
Preferences and Rights of Class C Series A Junior Participating
Preferred Stock of the Registrant. (2)
3.3 -- Bylaws of the Registrant, as amended.(3)
4.1 -- Specimen stock certificate evidencing the Common Stock. (1)
4.2 -- Schlotzsky's, Inc. Employee Stock Purchase Plan. (4)
4.3 -- Rights Agreement by and between Schlotzsky's, Inc. and
Harris Trust and Savings Bank dated December 18, 1998. (2)
10.1 -- Form of Unit Franchise Agreement entered into by the
Registrant and franchisees.(1)
10.2 -- Form of Unit Development Agreement entered into by the
Registrant and franchisees.(1)
10.3 -- Form of Area Developer Agreement entered into by the
Registrant and area developers.(1)
10.4 -- Form of Master License Agreement entered into by the
Registrant and area master licensees.(1)
10.5(a) -- Form of Territorial Agreement entered into by the
Registrant and master licensees.(1)
10.5(b) -- Form of Master Development Agreement entered into by the
Registrant and master licensees.(1)
30
10.6 -- Preferred Stock Repurchase Agreement, dated October 1993, among
the Company, John C. Wooley, Jeffrey J. Wooley, and the purchasers
of Class A Preferred Stock.(1)
10.7 -- Preferred Stock Purchase Agreement, dated July 20, 1994, among the
Registrant and the purchasers.(1)
10.8 -- Registration Rights Agreement, dated July 20, 1994, by and between
the Registrant and the shareholders named therein.(1)
10.9 -- Second Amended Agreement among Shareholders, dated July 20, 1994,
by and among the Registrant and the Shareholders described
therein.(1)
10.10 -- Loan/Compromise and Settlement Agreement, dated April 7, 1994,
between the Federal Deposit Insurance Corporation as Receiver of
Bank of the Hills, Austin, Texas, and the Registrant.(1)
10.11 -- Promissory Note, dated May 18, 1993, of the Registrant to First
State Bank, Austin, Texas in the original principal amount of
$381,249.99.(1)
10.12(a) -- Promissory Note, dated April 15, 1993, of the Registrant to Janet
P. Newberger and Lester Baum, as trustees of the 1992 Newberger
Family Trust, in the original principal amount of $750,000.(1)
10.12(b) -- Promissory Note, dated March 31, 1994, by and between the
Registrant and Janet P. Newberger and Lester Baum, co-trustees of
the 1992 Newberger Family Trust.(1)
10.12(c) -- Second Modification Agreement, dated effective December 31, 1994,
by and between the Registrant and Janet P. Newberger and Lester
Baum, as trustees of the 1992 Newberger Family Trust.(1)
10.12(d) -- Promissory Note, dated September 6, 1995, of the Registrant to
JanMor Corporation, in the original principal amount of
$400,000.(1)
10.13 -- Promissory Note, dated February 1, 1995, of the Registrant to
Liberty National Bank, Austin, Texas in the original principal
amount $220,000, Security Agreement, dated February 1, 1995 and
Guaranty, dated February 1, 1995, by and between John C. Wooley
and Liberty National Bank.(1)
10.14 -- Real Estate Lien Note and Deed of Trust, Security Agreement and
Financing Statement, dated March 31, 1995, of the Registrant to
Texas Bank, N.A. in the original principal amount of $500,000.(1)
10.15 -- Promissory Note, dated April 14, 1995, between the Registrant and
First State Bank in the original principal amount of
$2,000,000.(1)
10.16 -- Promissory Note and Security Agreement, dated July 15, 1993, of
the Registrant to R. M. Wilkin, Inc. in the original principal
amount of $450,000.(1)
10.17 -- Commitment Letter, dated July 7, 1995, by and between AT&T
Commercial Finance Corporation and the Registrant in an amount not
to exceed $1,100,000.(1)
10.18 -- Term Sheet, dated July 19, 1995 by and between BeneVent-Noro and
the Registrant.(1)
10.19 -- Promissory Note, dated December 1, 1994, by and between Bee
Cave/Westbank, Ltd. and Liberty National Bank in the original
principal amount of $1,150,000.(1)
10.20 -- Loan Commitment, dated July 18, 1995, by and between Manns Capital
Corporation and Bee Cave/Westbank, Ltd., and Letter Amendment to
Permanent Loan Commitment, dated July 28, 1995.(1)
10.21 -- Promissory Note, dated August 18, 1995, by and between the
Registrant and First State Bank in the original principal amount
of $850,000.(1)
10.22 -- Operating Lease for 218 South Lamar, dated May 27, 1994, by and
between William C. Pfluger, et al. and Schlotzsky's Restaurants,
Inc.(1)
10.23 -- Lease Agreement, September 8, 1995, by and between the Registrant
and Austin CBD 29, Inc.(1)
10.24 -- Deed of Trust and Real Estate Lien Note, dated December 31, 1993,
by and between Schlotzsky's Real Estate, Inc. and Austin CBD Block
29, Ltd.(1)
10.25(a) -- Franchise Financing Program Procedures for Qualified Franchisees,
dated April 15, 1994, by and between Captec Financial Group, Inc.
and the Registrant.(1)
10.25(b) -- Ultimate Net Loss Agreement, dated April 15, 1994, by and between
the Registrant and Captec Financial Group, Inc.(1)
10.25(c) -- Amendment to Ultimate Net Loss Agreement, dated March 30, 1995.(1)
10.26(a) -- Franchise finance letter of understanding, dated February 21,
1994, by and between Stephens Franchisee Finance and the
Registrant.(1)
10.26(b) -- Franchisee Financing Agreement, dated September 1, 1994, between
the Registrant and Stephens Diversified Leasing, Inc.(1)
31
10.27 -- Agreement, dated July 1, 1994, by and among Thomas Development
Corporation, Micardo, Inc. and the Registrant.(1)
10.28 -- Earnest Money Contract, dated May 20, 1994, among Schlotzsky's
Real Estate, Inc., William C. Pfluger, et al., Schlotzsky's
Restaurants, Inc., the Registrant and John C. Wooley.(1)
10.29 -- Unsecured Promissory Note, dated June 29, 1993, from John C.
Wooley payable to the Registrant in the original principal amount
of $280,000.(1)
10.30 -- Unsecured Promissory Note, dated June 29, 1993, from Jeffrey J.
Wooley payable to the Registrant in the original principal amount
of $150,000.(1)
10.31 -- Unsecured Promissory Note, dated January 1, 1993, from John C.
Wooley payable to the Registrant in the original principal amount
of $319,712.45.(1)
10.32 -- Unsecured Promissory Note, dated January 1, 1993, from Jeffrey J.
Wooley payable to the Registrant in the original principal amount
of $76,540.93.(1)
10.33 -- Unsecured Promissory Note, dated February 6, 1995, from John C.
Wooley payable to the Registrant in the original principal amount
of $131,000.(1)
10.34 -- Unsecured Promissory Note, dated February 6, 1995, from Jeffrey J.
Wooley payable to the Registrant in the original principal amount
of $6,000.(1)
10.35(a) -- Schlotzsky's, Inc. 1993 Third Amended and Restated Stock Option
Plan of the Registrant. (5)
10.35(b) -- Amendments to 1993 Third Amended and Restated Stock Option
Plan. (4)
10.36(a) -- Employment Agreement, dated as of March 1, 1998, by and between
the Registrant and John C. Wooley. (6)
10.36(b) -- Employment Agreement, dated as of March 1, 1998, by and between
the Registrant and Jeffrey J. Wooley. (6)
10.36(c) -- Employment Agreement, dated January 1, 1994, by and between the
Registrant and Kelly R. Arnold.(1)
10.36(d) -- Employment Agreement, dated January 1, 1994, by and between the
Registrant and Karl D. Martin.(1)
10.37(a) -- Indemnity Agreement, dated June 30, 1993, by and between the
Registrant and John C. Wooley.(1)
10.37(b) -- Indemnity Agreement, dated June 30, 1993, by and between the
Registrant and Jeffrey J. Wooley.(1)
10.38 -- Form of Indemnification Agreement for Directors and Officers of
the Registrant.(1)
10.39 -- Schlotzsky's 1995 Nonemployee Directors Stock Option Plan, and
form of Stock Option Agreement.(1)
10.40 -- Warrant Certificate, dated March 31, 1994, of the Registrant to
William C. Pfluger for 75,000 warrants.(1)
10.41 -- Confidentiality Agreement, dated December 8, 1989, by and between
Bunge Foods Corporation and Schlotzsky's Franchising Limited
Partnership.(1)
10.42 -- Real Estate Lien Note dated December 31, 1993, from CBD Block 29,
Ltd. to Schlotzsky's Real Estate, Inc. in the original principal
amount of $302,209.12.(1)
10.43 -- Promissory Note, dated October 4, 1995, from the Registrant to
First State Bank, Austin, Texas in the original principal amount
of $576,000.(1)
10.44 -- Promissory Note dated October 25, 1995, from the Registrant to
United Bank & Trust in the original principal amount of
$500,000.(1)
10.45 -- Promissory Note dated November 1995 from Registrant and
Schlotzsky's Restaurants, Inc. to AT&T Commercial Finance
Corporation in the original principal amount of $1,100,000.(1)
10.46 -- Promissory Note dated November 17, 1995 from Registrant to
Comerica Bank -- Texas in the original principal amount of
$245,000.(1)
10.47 -- Form of Guaranty between Schlotzsky's, Inc. and landlord with
respect to Turnkey restaurants. (7)
10.48 -- Form of Tenant Acknowledgment with Indemnification between
Schlotzsky's Real Estate, Inc. and Franchisee concerning Turnkey
restaurants. (7)
10.49* -- Form of Promissory Note from franchisee/borrower to Schlotzsky's
Real Estate, Inc.
10.50* -- Form of Loan Agreement between franchisee/borrower and
Schlotzsky's Real Estate, Inc.
10.51* -- Form of Assignment of Note and Lien from Schlotzsky's Real Estate,
Inc. to mortgage lender.
10.52* -- Form of Limited Guaranty between Schlotzsky's, Inc. and mortgage
lender with respect to Turnkey restaurants.
32
10.53* -- Credit Agreement, as amended, with Wells Fargo.
22.1* -- List of subsidiaries of the Registrant.
24.1* -- Consent of Grant Thornton LLP.
27.1* -- Financial Data Schedule - fiscal year ending 1998.
- - -------------
* Filed herewith.
(1) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-1 (File No. 33-98004) filed with the Securities and Exchange
Commission on October 12, 1995, as amended, and incorporated herein by
reference.
(2) Previously filed as a Exhibit to the Registrant's Registration of certain
Classes of Securities on Form 8-A filed with the Securities and Exchange
Commission on December 18, 1998 and incorporated herein by reference.
(3) Previously filed as an Exhibit to the Registrant's Report on Form 8-K filed
December 18, 1998 and incorporated herein by reference.
(4) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-8 (File No. 333-57077) filed with the Securities and Exchange
Commission on June 17, 1998, as amended, and incorporated herein by
reference.
(5) Previously filed as an Exhibit to the Registrant's Registration Statement
on Form S-1 (File No. 333-34921) filed with the Securities and Exchange
Commission on September 4, 1997, as amended, and incorporated herein by
reference.
(6) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form
10-Q filed with the Securities and Exchange Commission on November 16, 1998
and incorporated herein by reference.
(7) Previously filed as an Exhibit to the Registrant's Annual Report on Form
10-K filed with the Securities and Exchange Commission on April 14, 1998,
as amended, and incorporated herein by reference.
(b) REPORTS ON FORM 8-K
The following is the date and description of the events reported on Form
8-K covering events in the fourth quarter of fiscal year 1998: On December
18, 1998 the Registrant issued a press release announcing the adoption of the
Shareholder's Rights Plan.
33
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange
Act of 1934 as amended, the Registrant has duly caused this Report to be
signed on its behalf by the undersigned, thereunto duly authorized.
SCHLOTZSKY'S, INC.
By: /s/ John C. Wooley
-------------------------------------------------
John C. Wooley,
Chairman of the Board and Chief Executive Officer
Date: March 29, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Signature Capacity Date
--------- -------- ----
/s/ John C. Wooley
- - ------------------------
John C. Wooley Chairman of the Board and March 29, 1999
Chief Executive Officer
(Principal Executive Officer)
/s/
- - ------------------------
Monica L. Gill Chief Financial Officer, Treasurer March 29, 1999
Executive Vice President
(Principal Financial Officer and
Principal Accounting Officer)
/s/
- - ------------------------
Jeffrey J. Wooley Senior Vice President and March 29, 1999
Secretary
/s/
- - ------------------------
Joseph K. Pruett Controller of Financial Reporting March 29, 1999
/s/
- - ------------------------
John L. Hill, Jr. Director March 29, 1999
/s/
- - ------------------------
Azie Taylor Morton Director March 29, 1999
- - ------------------------
John M. Rosillo Director
/s/
- - ------------------------
Raymond A. Rodriguez Director March 29, 1999
/s/
- - ------------------------
Floor Mouthaan Director March 29, 1999
34
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Consolidated Financial Statements:
Report of Independent Accountants. . . . . . . . . . . . . . . . . . F-2
Consolidated Balance Sheets at December 31, 1997 and 1998. . . . . . F-3
Consolidated Statements of Income for the years ended
December 31, 1996, 1997 and 1998. . . . . . . . . . . . . . . . . F-4
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1996, 1997 and 1998. . . . . . . . . . . F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1997 and 1998. . . . . . . . . . . . . . . . . F-6
Notes to Consolidated Financial Statements . . . . . . . . . . . . . F-7
Financial Statement Schedule:
Report of Independent Accountants. . . . . . . . . . . . . . . . . . S-1
Schedule II -- Valuation and Qualifying Accounts . . . . . . . . . . S-2
All other schedules are omitted as the required information is not applicable
or the information is presented in the consolidated financial statements,
related notes or other schedules.
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
Schlotzsky's, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of
Scholotzsky's, Inc. (a Texas corporation) and Subsidiaries as of December 31,
1998 and 1997, and the related consolidated statements of income, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Schlotzsky's,
Inc. and Subsidiaries as of December 31, 1998 and 1997, and the consolidated
results of their operations and their consolidated cash flows for each of the
three years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
Grant Thornton LLP
February 26, 1999
F-2
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
DECEMBER 31,
---------------------------
1997 1998
------------ ------------
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . $31,254,048 $15,384,991
Temporary cash investments . . . . . . . . . . . . . . . . . . . . . . 18,000 1,439,077
Receivables from Turnkey Program development . . . . . . . . . . . . . 6,054,337 1,229,468
Royalties receivable . . . . . . . . . . . . . . . . . . . . . . . . . 809,125 762,141
Turnkey notes and other receivables, current portion . . . . . . . . . -- 13,326,956
Other receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,055,760 3,086,065
Prepaid expenses and other assets. . . . . . . . . . . . . . . . . . . 584,510 572,996
Turnkey Program development. . . . . . . . . . . . . . . . . . . . . . 6,950,595 5,924,562
Notes receivable, current portion. . . . . . . . . . . . . . . . . . . 2,574,588 4,246,574
------------ ------------
Total current assets . . . . . . . . . . . . . . . . . . . . 50,300,963 45,972,830
Property, equipment and leasehold improvements, net. . . . . . . . . . 9,998,630 18,529,746
Real estate and restaurants held for sale. . . . . . . . . . . . . . . 1,063,592 9,215,485
Notes receivable, less current portion . . . . . . . . . . . . . . . . 1,972,470 6,875,915
Notes receivable from related parties, less current portion. . . . . . 2,565,399 2,609,775
Turnkey notes and other receivables, less current portion. . . . . . . -- 2,185,429
Investments and advances . . . . . . . . . . . . . . . . . . . . . . . 1,456,790 1,530,947
Deferred federal income tax asset. . . . . . . . . . . . . . . . . . . 580,460 23,885
Intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . 11,113,213 16,815,059
Other noncurrent assets. . . . . . . . . . . . . . . . . . . . . . . . 469,069 469,069
------------ ------------
Total assets . . . . . . . . . . . . . . . . . . . . . . . . $79,520,586 $104,228,140
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable -- trade. . . . . . . . . . . . . . . . . . . . . . . $6,002,920 $4,752,369
Current maturities of long-term debt . . . . . . . . . . . . . . . . . 250,625 5,382,585
Accrued liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . 1,484,715 9,613,593
------------ ------------
Total current liabilities. . . . . . . . . . . . . . . . . . 7,738,260 19,748,547
Deferred revenue, net. . . . . . . . . . . . . . . . . . . . . . . . . 2,855,380 1,298,486
Long-term debt, less current maturities. . . . . . . . . . . . . . . . 1,936,387 9,218,515
------------ ------------
Total liabilities. . . . . . . . . . . . . . . . . . . . . . 12,530,027 30,265,548
Commitments and contingencies
Stockholders' equity:
Preferred stock:
Class C--no par value
Authorized--1,000,000 shares; issued--none . . . . . . . . . . . -- --
Common stock, no par value, 30,000,000 shares authorized, 7,334,416
and 7,401,942 issued at December 31, 1997 and 1998,
respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . 62,202 62,877
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . 56,664,104 57,533,997
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . 10,264,253 16,470,718
Treasury stock (10,000 shares) . . . . . . . . . . . . . . . . . . . -- (105,000)
------------ ------------
Total stockholders' equity . . . . . . . . . . . . . . . . . 66,990,559 73,962,592
------------ ------------
Total liabilities and stockholders' equity . . . . . . . . . $79,520,586 $104,228,140
------------ ------------
------------ ------------
The accompanying notes are an integral part of the
consolidated financial statements.
F-3
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
------------------------------------------
1996 1997 1998
------------ ------------ ------------
Revenue:
Royalties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,747,238 $14,561,377 $18,885,390
Franchise fees . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,775,000 1,554,585 1,365,000
Developer fees . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,992,750 325,000 270,380
Restaurant sales . . . . . . . . . . . . . . . . . . . . . . . . . . 3,610,199 6,364,042 7,720,432
Brand contribution . . . . . . . . . . . . . . . . . . . . . . . . . 1,294,982 2,915,233 4,003,247
Turnkey Program development. . . . . . . . . . . . . . . . . . . . . 725,913 1,138,610 8,314,426
Other fees and revenue . . . . . . . . . . . . . . . . . . . . . . . 568,250 1,110,289 1,289,037
------------ ------------ ------------
Total revenues . . . . . . . . . . . . . . . . . . . . . . . 20,714,332 27,969,136 41,847,912
Expenses:
Service costs:
Royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,791,384 5,373,151 7,225,320
Franchise fees. . . . . . . . . . . . . . . . . . . . . . . . . . 958,500 812,625 697,250
Restaurant operations:
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . 1,183,361 2,014,096 2,513,156
Labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,424,434 2,493,478 3,205,225
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . 1,039,591 1,951,618 2,167,784
Turnkey development costs. . . . . . . . . . . . . . . . . . . . . . 519,328 367,656 4,806,099
General and administrative . . . . . . . . . . . . . . . . . . . . . 6,507,930 7,685,858 11,471,412
Depreciation and amortization. . . . . . . . . . . . . . . . . . . . 779,284 1,155,600 1,884,854
------------ ------------ ------------
Total expenses . . . . . . . . . . . . . . . . . . . . . . . 16,203,812 21,854,082 33,971,100
------------ ------------ ------------
Income from operations . . . . . . . . . . . . . . . . . . . 4,510,520 6,115,054 7,876,812
Other:
Interest income, net . . . . . . . . . . . . . . . . . . . . . . . . 454,670 752,960 2,058,262
Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,075 195,661 --
------------ ------------ ------------
Income before income taxes . . . . . . . . . . . . . . . . . 5,097,265 7,063,675 9,935,074
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . 1,902,290 2,614,260 3,728,609
------------ ------------ ------------
Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,194,975 $ 4,449,415 $ 6,206,465
------------ ------------ ------------
------------ ------------ ------------
Income per common share - basic:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.58 $ 0.74 $ 0.84
------------ ------------ ------------
------------ ------------ ------------
Weighted average shares outstanding. . . . . . . . . . . . . . . . . 5,525,902 5,994,403 7,382,983
------------ ------------ ------------
------------ ------------ ------------
Income per common share - diluted:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.57 $ 0.71 $ 0.82
------------ ------------ ------------
------------ ------------ ------------
Weighted average shares outstanding. . . . . . . . . . . . . . . . . 5,639,225 6,229,369 7,577,407
------------ ------------ ------------
------------ ------------ ------------
The accompanying notes are an integral part of the
consolidated financial statements.
F-4
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
COMMON STOCK
ADDITIONAL TOTAL
NUMBER OF STATED CAPITAL PAID-IN RETAINED TREASURY STOCKHOLDERS'
SHARES AMOUNT CAPITAL EARNINGS STOCK EQUITY
-------------- -------------- -------------- -------------- -------------- --------------
Balance, January 1, 1996 . . . . . 5,509,998 $ 43,958 $ 26,238,964 $ 2,691,443 -- $28,974,365
Options exercised. . . . . . . . . 29,924 299 254,201 (111,819) -- 142,681
Net income . . . . . . . . . . . . -- -- -- 3,194,975 -- 3,194,975
-------------- -------------- -------------- -------------- -------------- --------------
Balance, December 31, 1996 . . . . 5,539,922 44,257 26,493,165 5,774,599 -- 32,312,021
Public sale of stock . . . . . . . 1,731,825 17,318 29,615,201 -- -- 29,632,519
Options exercised. . . . . . . . . 57,201 572 485,802 40,239 -- 526,613
Warrants exercised . . . . . . . . 5,468 55 69,936 -- -- 69,991
Net income . . . . . . . . . . . . -- -- -- 4,449,415 -- 4,449,415
-------------- -------------- -------------- -------------- -------------- --------------
Balance, December 31, 1997 . . . . 7,334,416 62,202 56,664,104 10,264,253 -- 66,990,559
Options exercised. . . . . . . . . 44,089 441 399,175 -- -- 399,616
Warrants exercised . . . . . . . . 23,437 234 224,761 -- -- 224,995
Treasury stock purchase
(10,000 shares). . . . . . . . . -- -- -- -- (105,000) (105,000)
Tax benefit from employee stock
transactions . . . . . . . . . . -- -- 245,957 -- -- 245,957
Net income . . . . . . . . . . . . -- -- -- 6,206,465 -- 6,206,465
-------------- -------------- -------------- -------------- -------------- --------------
Balance, December 31, 1998 . . . . 7,401,942 $ 62,877 $ 57,533,997 $ 16,470,718 $ (105,000) $ 73,962,592
-------------- -------------- -------------- -------------- -------------- --------------
-------------- -------------- -------------- -------------- -------------- --------------
The accompanying notes are an integral part of the
consolidated financial statements.
F-5
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
-----------------------------------------
1996 1997 1998
----------- ----------- -----------
Cash flows from operating activities:
Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 3,194,975 $ 4,449,415 $ 6,206,465
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization. . . . . . . . . . . . . . 779,284 1,155,600 1,884,854
Bad debt expense . . . . . . . . . . . . . . . . . . . . 187,774 100,000 972,724
Gain on sale of assets . . . . . . . . . . . . . . . . . -- (308,632) (268,813)
Equity in losses of investment in partnership. . . . . . -- -- 93,260
Financed fees. . . . . . . . . . . . . . . . . . . . . . (1,860,796) (272,003) (2,250,000)
Payments received on financed fees . . . . . . . . . . . 829,590 743,534 409,150
Non-recurring expense relating to the
issuance of stock to a non-employee. . . . . . . . . . 103,791 -- --
Changes in assets and liabilities:
Royalties and other receivables. . . . . . . . . . . . (971,614) (6,995,423) 218,880
Prepaid expenses and other assets. . . . . . . . . . . 45,118 (336,748) 11,514
Turnkey program development. . . . . . . . . . . . . . (5,384,025) 1,621,773 (19,918,229)
Other noncurrent assets. . . . . . . . . . . . . . . . (280,154) (188,915) --
Deferred revenue . . . . . . . . . . . . . . . . . . . 91,440 1,191,615 (1,556,894)
Deferred federal income tax asset. . . . . . . . . . . (75,578) 26,988 556,575
Accounts payable and accrued liabilities . . . . . . . 1,172,539 4,420,923 7,124,284
----------- ----------- -----------
Net cash provided by (used in) operating activities. (2,167,656) 5,608,127 (6,516,230)
----------- ----------- -----------
Cash flows from investing activities:
Expenditures for property and equipment. . . . . . . . . . (1,664,363) (7,436,003) (17,245,185)
Sale of property and equipment . . . . . . . . . . . . . . -- 1,655,123 146,861
Acquisition of investments and intangible assets . . . . . (2,227,297) (2,721,814) (8,712,762)
Redemption of restricted certificates of deposit . . . . . 60,983 -- --
Advances on notes receivable . . . . . . . . . . . . . . . (603,121) (693,100) (5,838,021)
Collections on notes receivable. . . . . . . . . . . . . . 235,933 627,032 12,313,822
Acquisition of investments . . . . . . . . . . . . . . . . (83,147) (190,928) (1,421,077)
Advances to limited partnership, stockholders
and affiliates . . . . . . . . . . . . . . . . . . . . . (45,014) (37,940) (188,431)
Distributions and collections from limited
partnership, stockholders and affiliates . . . . . . . . 79,958 -- --
----------- ----------- -----------
Net cash used in investing activities. . . . . . . . (4,246,068) (8,797,630) (20,944,793)
----------- ----------- -----------
Cash flows from financing activities:
Sale of stock. . . . . . . . . . . . . . . . . . . . . . . -- 30,073,141 --
Repurchase of stock. . . . . . . . . . . . . . . . . . . . -- -- (105,000)
Stock issue costs. . . . . . . . . . . . . . . . . . . . . (51,180) (440,622) --
Options and warrants exercised . . . . . . . . . . . . . . 90,070 596,604 624,611
Proceeds from issuance of notes payable and
long-term debt . . . . . . . . . . . . . . . . . . . . . 583,774 1,112,709 16,060,000
Principal payments on notes payable and
long-term debt . . . . . . . . . . . . . . . . . . . . . (914,664) (2,537,239) (4,987,645)
----------- ----------- -----------
Net cash provided by (used in) financing activities. (292,000) 28,804,593 11,591,966
----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents . . . . (6,705,724) 25,615,090 (15,869,057)
Cash and cash equivalents at beginning of year . . . . . . . 12,344,682 5,638,958 31,254,048
----------- ----------- -----------
Cash and cash equivalents at end of year . . . . . . . . . . $ 5,638,958 $31,254,048 $15,384,991
----------- ----------- -----------
----------- ----------- -----------
The accompanying notes are an integral part of the
consolidated financial statements.
F-6
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Schlotzsky's, Inc. and Subsidiaries (the "Company") is a franchisor of
quick service restaurants ("Schlotzsky's Deli") that feature made-to-order
sandwiches, which has 750 stores located in 38 states, the District of Columbia,
Argentina, Canada, China, Germany, Guatemala, Japan, Lebanon, Malaysia,
Mexico, Morocco, Saudi Arabia, Turkey and the United Kingdom. Approximately 29%
of franchised stores are located in Texas. In addition, the Company had granted
territorial rights to Area Developers located in all 50 states and to Master
Licensees in 49 foreign countries for a fee which is typically payable in cash
and promissory notes receivable generally collateralized by the related
territorial rights.
The Company also operates a Turnkey Development Program (the "Turnkey
Program") to further assist franchisees in obtaining store sites.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of
Schlotzsky's, Inc., a Texas corporation, and its wholly-owned subsidiaries. All
significant intercompany balances and transactions are eliminated in
consolidation.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH EQUIVALENTS
Cash equivalents include unrestricted highly liquid investments purchased
with an original maturity date of three months or less. At December 31, 1997 and
1998, cash equivalents totaling approximately $27,053,000 and $11,232,000,
respectively, consisted primarily of money market accounts and overnight
repurchase agreements.
TEMPORARY CASH INVESTMENTS
Temporary cash investments include amounts invested in certificates of
deposit with an original maturity date of greater than three months.
RECEIVABLES FROM TURNKEY PROGRAM DEVELOPMENT
Receivables from Turnkey Program development are comprised of amounts held
in escrow on behalf of the Company at title companies or institutional investors
at year end.
TURNKEY NOTES AND OTHER RECEIVABLES
Turnkey notes receivable consist of mortgage, draw notes and construction
receivables relating to the sale of Turnkey sites and funding of construction of
Turnkey units, respectively.
F-7
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
NOTES RECEIVABLE
Notes receivable consist of Area Developer and Master Licensee promissory
notes. As of December 31, 1997 and 1998, the Company has recorded a valuation
allowance of approximately $443,000 and $593,000, respectively, based upon a
third party valuation.
PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements are stated at cost, net of
accumulated depreciation and amortization. Expenditures for normal maintenance
of property and equipment are charged against income as incurred. Expenditures
which significantly extend the useful lives of the assets are capitalized. The
costs of assets retired or otherwise disposed of and the related accumulated
depreciation and amortization balances are removed from the accounts and any
resulting gain or loss is included in income. Depreciation and amortization is
calculated using the straight-line method over the estimated useful lives of the
assets, or lease term for leasehold improvements, if less.
REAL ESTATE AND RESTAURANTS HELD FOR SALE
Real estate and restaurants held for sale consist of properties owned by
the Company which it intends to remarket. The operating results of these
restaurants are considered a part of the Turnkey Program and are included in
Turnkey development costs in the consolidated income statement. These
properties are stated at the lower of cost or net realizable value.
INVESTMENTS
Investments are stated at the lower of cost or market. Limited partnership
investments are accounted for under the equity method, and accordingly, the
Company's investment is adjusted for allocated profits, losses and
distributions.
TURNKEY PROGRAM
Under the Turnkey Program, the Company works independently or with an area
developer to identify superior store sites within a territory. The Company will
typically perform various services including, but not limited to, site
selection, feasibility analysis, environmental studies, site work, permitting
and construction management, receiving a fee and recognizing revenue upon the
completion of these services. The Company may assign its earnest money contract
on a site to a franchisee, or a third-party investor, who then assumes the
responsibility for developing the store. The Company also may purchase or lease
a selected site, design and construct a Schlotzsky's Deli restaurant on the site
and sell, lease or sublease the completed store to a franchisee. Where the
Company does not sell the property to a franchisee, the Company sells the
improved property, or, in the case of a leased property, assigns the lease and
any sublease, to an investor. From inception of the Turnkey Program through
1997, the Company typically provided credit enhancement in the form of limited
guaranties on the franchisees' leases for leased locations sold to investors.
The Company obtained agreements from the franchisees to indemnify the Company in
case the guaranties are called upon. Upon sale of the leased site or assignment
of its earnest money contract, the Company has deferred revenue generated (even
though proceeds were received in cash) and allocable costs incurred in
connection with the property. When a lease guaranty is terminated, or the
Company's exposure to loss under the guaranty has passed, the Company recognizes
the revenue and allocable costs related to the site. Generally, if no credit
enhancement is provided in connection with such transactions, the Company
recognizes the revenue and allocable expenses in the periods in which the
transactions occur.
F-8
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
TURNKEY PROGRAM, CONTINUED
During 1998, the Company began emphasizing ownership of the real estate
by franchisees through a program which entails acquiring the rights to a
superior site and reselling the property, or its rights (with any
improvements), to a franchisee whose permanent mortgage loan will be financed
by a third party financial institution. The Company provides credit
enhancement for the franchisee in the form of a limited guaranty in favor of
the lender. These guarantees are usually for loan payments required to be
made during the first two to five years and are limited to 15% to 25% of the
principal amount of the loan. Generally, in those cases, the Company
recognizes the revenue and allocable expenses in the period in which the
transaction occurs. The Company will often interim finance land and building
costs in anticipation of permanent financing by a financial institution. In
addition, the Company charges a fee when it is requested to manage
construction of a store on property owned by a franchisee or an investor.
This construction management fee is recognized when the store is completed.
Turnkey Program development is stated at the lower of cost or estimated net
realizable value. Land, site development, building and equipment costs,
including capitalized carrying costs (primarily interest incurred and property
taxes until the property is ready for sale), are accumulated and accounted for
on a site specific basis.
Turnkey Program revenue consists of the following:
FOR THE YEAR ENDED
DECEMBER 31,
----------------------------------------------
1996 1997 1998
----------- ----------- -----------
Sales to investors and franchisees . . . . . . . . . . . . . $ 6,638,150 $31,361,869 $29,596,310
Development and construction management fees . . . . . . . . 174,979 190,000 176,562
----------- ----------- -----------
Gross Turnkey Program revenue. . . . . . . . . . . . . . 6,813,129 31,551,869 29,772,872
Turnkey Program development costs. . . . . . . . . . . . . . (6,455,618) (28,829,065) (23,382,340)
----------- ----------- -----------
Net revenue from Turnkey Program projects. . . . . . . . 357,511 2,722,804 6,390,532
Rental income. . . . . . . . . . . . . . . . . . . . . . . . 368,402 303,091 258,187
Interim construction interest. . . . . . . . . . . . . . . . -- 1,270 238,888
Deferred revenue recognized. . . . . . . . . . . . . . . . . -- -- 1,426,819
Revenue deferred . . . . . . . . . . . . . . . . . . . . . . -- (1,888,555) --
----------- ----------- -----------
Total Turnkey Program revenue. . . . . . . . . . . . . . $ 725,913 $ 1,138,610 $ 8,314,426
----------- ----------- -----------
----------- ----------- -----------
F-9
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
The following table reflects system performance of the Turnkey Program for
the years ended December 31, 1997 and 1998.
NUMBER OF UNITS
----------------------------
1997 1998
------------ ------------
Sites in process at beginning of year. . . . . . . . . . . . . . . . 30 78
Sites beginning development during the year. . . . . . . . . . . . . 90 83
Sites inventoried as Company-owned stores. . . . . . . . . . . . . . (1) (3)
Sites inventoried as real estate or restaurants held for sale. . . . -- (2)
Sites sold - revenue recognized. . . . . . . . . . . . . . . . . . . (7) (69)
Sites sold - revenue deferred. . . . . . . . . . . . . . . . . . . . (33) --
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) (1)
------------ ------------
Sites in process at end of year. . . . . . . . . . . . . . . . . . . 78 86
------------ ------------
------------ ------------
INVESTED AT
DECEMBER 31,
1998
------------
Sites under development or to be sold. . . . . . . . . . . . . . . . 5 4 4,431,000
Predevelopment sites (prequalification). . . . . . . . . . . . . . . 73 82 1,494,000
------------ ------------ ------------
Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 86 $ 5,925,000
------------ ------------ ------------
------------ ------------ ------------
Turnkey Program sites in process at end of year are classified as current
assets as management expects to complete and sell such sites within the next
year.
F-10
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
INTANGIBLE ASSETS
Intangible assets consist primarily of the Company's original franchise
rights, royalty values and goodwill, and developer and franchise rights related
to the Company's reacquiring of franchises and developer rights. Intangible
assets are amortized over their estimated useful lives ranging from four to 40
years.
The Company evaluates the propriety of the carrying amount of its
intangible assets, as well as the amortization period for each intangible when
conditions warrant. If an indicator of impairment is present, the Company
compares the projected undiscounted cash flows for the related business with the
unamortized balance of the related intangible asset. If the undiscounted cash
flows are less than the carrying value, management estimates the fair value of
the intangible asset based on future operating cash flows for the next 10 years,
discounted at the Company's primary borrowing rate. The excess of the
unamortized balance of the intangible asset over the fair value, as determined,
is charged to impairment loss. The Company believes that no impairment of its
intangibles has occurred and that no reduction of the carrying amounts or
estimated useful lives is warranted.
REVENUE RECOGNITION
Royalties:
Royalties are paid to the Company by franchisees at 4% to 6% of gross
franchise sales. Royalties are recognized in the period of the related gross
franchise sales are earned.
Franchise Fees:
Proceeds from the awarding of a franchise are recognized as revenue when
the Company has performed substantially all services for the franchisee as
stipulated in the franchise agreement, typically at store opening. Franchise
fees collected but not yet recognized are recorded, net of deferred direct
incremental expenses, as deferred revenue in the accompanying consolidated
financial statements.
Developer Fees:
The Company will convey rights to certain persons, under agreements ("Area
Developer Agreements") to act as an area developer within a specific development
area for a specified term. Developers within the United States ("Area
Developers") locate prospective new franchisees, perform site selection duties
and provide services to the franchisees subsequent to the store opening. The
Company charges the Area Developers a nonrefundable fee for the rights conveyed.
The Company typically collects a portion of the fee in cash at closing of the
Area Developer Agreements, and extends terms on the remainder.
International developers ("Master Licensees") have the exclusive right to
develop and license the development and operation of Schlotzsky's Deli
restaurants using the Company's system and trademarks within the development
area. The rights to develop and sublicense the development and operation of
Schlotzsky's Deli restaurants in the foreign territory are granted pursuant to
the terms and conditions under an agreement with a Master Licensee ("Master
License Agreement").
F-11
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
The Company has also entered into Master Development Agreements or
Territorial Agreements (collectively the "Territorial Agreements") which, for a
nonrefundable reservation fee, grants the right to negotiate exclusive
territorial rights to develop Schlotzsky's Deli restaurants in the territory,
subject to and in accordance with terms and conditions of a Master License
Agreement; however, the right to develop, operate and sublicense the development
and operation of Schlotzsky's Deli restaurants in the territory is not granted
until the execution of the Master License Agreement. The Territorial Agreement
specifies the desired economic terms and basic form of the Master License
Agreement. The Company requires the Master Licensee to obtain clauses, covenants
and agreements to comply with and conform to the business practices or laws of
the respective territory. The cost of conforming the contract of the Master
License Agreement is the responsibility of the Master Licensee. If the Company
cannot reasonably satisfy itself of the enforceability of such clauses,
covenants and agreements within the territory, the Company will not be obligated
to grant a Master License Agreement and any rights granted under the Territorial
Agreements will terminate immediately upon notice by the Company.
The Company ordinarily collects approximately 15% to 35% of cash at closing
of either a Territorial Agreement or Master License Agreement, with the
remainder financed typically over a term typically not exceeding four years,
depending on the creditworthiness of the maker and guarantor of the note.
With respect to Area Developers and Master Licensees, the Company
recognizes as revenue the nonrefundable fees received in cash and the fair value
of the financed portion as established by an independent third party and any
incentive fees due, upon fulfillment of substantially all of its contractual
responsibilities and obligations to the Area Developers and Master Licensees.
For Area Developers, this includes providing manuals and sales offering
materials, which typically coincides with the execution of the Area Developer
Agreement and the receipt of cash and a promissory note. With respect to Master
Licensees, the Company's duties to the Master Licensees include providing
manuals, initial training if requested, and reasonable efforts to obtain
registration of the Company's trademarks in the applicable foreign territories.
Completion of the Company's duties typically coincides with the execution of a
Territorial Agreement or Master License Agreement and the receipt of cash and a
promissory note.
Area Developers and Master Licensees are required to meet certain
performance requirements under their agreements which include minimum store
opening schedules, performance standards and compliance with the terms of their
notes to the Company, if any. Failure to meet these requirements could result in
the Company terminating their agreements.
In general, the Area Developers and Master Licensees receive a fee for
recruitment and development, including advertising, soliciting, qualifying and
closing sales as well as consultation and advice in establishment, construction,
financing and opening of restaurants in their territory. The Area Developers
portion of the fee, in general, is equal to one-half of franchise fee paid by
franchisees to the Company. Master Licensees collect the initial sublicense and
developer fees and then remit a portion of these fees back to the Company. The
Company expects to receive approximately one-third to one-half of these fees
from the Master Licensee.
In addition, Area Developers and Master Licensees receive a portion of the
ongoing royalties from the franchised restaurants for providing service and
support to the franchisees in their development area. Area Developers typically
receive 2.5% out of the 6% ongoing royalties, and Master Licensees typically
retain two-thirds of ongoing royalties, remitting one-third to the Company.
F-12
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
EXPENSE RECOGNITION
Royalty Service Costs:
Royalty service costs include the portion of the royalty stream paid to
Area Developers.
Franchise Fee Development Costs:
In accordance with the Area Developer Agreements, the Company pays Area
Developers approximately one-half of the initial franchise fees collected from
franchise sales in a specified development area. These costs are recognized as
expenses when the related franchisee fee is recognized. Franchise fee
development costs paid, but not yet recognized, are recorded as a reduction of
gross deferred revenue in the accompanying consolidated financial statements.
Turnkey Development Costs:
In providing the Turnkey program, the Company has certain personnel and
overhead costs that are a direct result of Turnkey activities. Certain costs are
allocated to specific Turnkey projects and deferred until the site is sold, or
no longer pursued, and its related gain or loss is recognized.
Income Taxes:
The Company recognizes deferred tax assets or liabilities computed based on
the difference between the financial statement and income tax basis of assets
and liabilities using the enacted marginal tax rate. Deferred income tax
expenses or credits are based on the changes in the asset or liability from
period to period.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments include cash and cash equivalents,
certificates of deposit, receivables, notes receivable, accounts payable,
accrued liabilities and debt. The carrying value of financial instruments
approximates fair value at December 31, 1997 and 1998.
F-13
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -
(CONTINUED)
FISCAL YEAR
The Company utilizes a "4-4-5 week" quarterly reporting schedule for
royalties, restaurant operations and royalty service costs. As a result of this
reporting schedule, the fiscal year will include 53 weeks of activity for these
line items once every 5-6 years. The financial statements for 1996 and 1997
reflect 52 weeks of operations for these items, while 1998 includes 53 weeks.
Further, the fourth quarter of 1998 contained 14 weeks. In years having a 14
week fourth quarter, royalty revenue, restaurant sales, royalty service costs,
restaurant operating expenses and net income in the fourth quarter are not
comparable to results in each of the first three quarters, and can be expected
to decline in the following quarter. For all other areas of the financial
statements, the Company reports all fiscal quarters as ending on March 31, June
30, September 30 and December 31.
RECLASSIFICATIONS
Certain reclassifications were made to previously reported amounts in the
accompanying consolidated financial statements and notes to make them consistent
with the current presentation format.
2. NOTES RECEIVABLE
Notes receivable consist of the following:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Notes receivable from Area Developers (under Area Development
Agreements) and Master Licensees (under Master License and
Territorial Agreements), collateralized by their respective
territories, net of valuation allowance of $443,000 and $593,000,
respectively, bearing interest ranging from 6% to 9%
due through in installments December 2003 . . . . . . . . . . . . . . . . . . $1,386,252 $2,828,977
Notes receivable from franchisees, Area Developers, and Master
Licensees bearing interest at 8% to 8.9%, some notes collateralized
by their restaurants, others uncollateralized, net of valuation
allowance of $100,000 in 1998, due in installments through
January 2023 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,814,981 821,245
Notes receivable from franchisees bearing interest ranging from
8.5% to 10%, collateralized by franchisees' property
and equipment due in installments through October 2003. . . . . . . . . . . . 324,405 7,270,096
Notes receivable bearing interest at 8%, collateralized by real estate,
principal and interest due October 1998 . . . . . . . . . . . . . . . . . . . 846,000 --
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,420 202,171
---------- ----------
4,547,058 11,122,489
Current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,574,588) (4,246,574)
---------- ----------
Notes receivable, less current portion. . . . . . . . . . . . . . . . . . . . . $1,972,470 $6,875,915
---------- ----------
---------- ----------
F-14
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. NOTES RECEIVABLE FROM RELATED PARTIES
Notes receivable from related parties consist of the following:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Note receivable from Master Licensee, an organization of which a
member of the Company's Board of Directors is Managing Director,
bearing interest at 9%, due in installments through December 1999 . . . . . . $275,000 $275,000
Notes receivable from certain stockholders of the Company, bearing
interest at 7.5%, due in installments through 2001. . . . . . . . . . . . . . 237,618 292,619
Notes receivable from related entities controlled by stockholders
of the Company, bearing interest at 9%, collateralized by real
estate, due in installments through 2001. . . . . . . . . . . . . . . . . . . 579,466 530,688
Note receivable from Master Licensee, an organization of which
a member of the Company's management is a shareholder, bearing
interest at 8%, due in installments through December 2006. . . . . . . . . . . 455,000 455,000
Notes receivable from Master Licensee, an organization of which
the Company is a preferred shareholder, bearing interest at 9%,
due in installments through December 2007.. . . . . . . . . . . . . . . . . . 1,068,315 1,098,316
---------- ----------
2,615,399 2,651,623
Current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (50,000) (41,848)
---------- ----------
Notes from related parties receivable, less current portion . . . . . . . . . . $2,565,399 $2,609,775
---------- ----------
---------- ----------
From time to time, the Company makes advances to certain stockholders,
related partnerships and affiliates (see notes on "Investments and Advances"
and "Related Party Transactions").
4. TURNKEY NOTES AND OTHER RECEIVABLES
Notes and other receivables related to Turnkey projects consist of the
following:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Draw notes and other receivables from franchisees, bearing interest
ranging from 8.5% to 10.0% collateratized by real estate, due in
December 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ -- $6,539,353
Mortgage notes receivable from franchisees, bearing interest ranging
from 7.6% to 10.0% collateralized by real estate, due in installments
through October 2008. . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 7,336,345
Other receivables from franchisees, due by December 1999. . . . . . . . . . . . -- 1,636,687
---------- ----------
-- 15,512,385
Current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (13,326,956)
---------- ----------
Turnkey notes and other receivables, less current portion . . . . . . . . . . . $ -- $2,185,428
---------- ----------
---------- ----------
F-15
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements consist of the following:
DEPRECIABLE DECEMBER 31,
DEPRECIATION LIFE ---------------------------
METHOD (Years) 1997 1998
------------- ----------- ----------- -----------
Building . . . . . . . . . . . . . . . . . . Straight Line 32 $ -- $6,417,164
Furniture, fixtures and
Equipment. . . . . . . . . . . . . . . . . Straight Line 3 to 7 3,520,805 6,223,498
Leasehold improvements . . . . . . . . . . . Straight Line 13 to 32 7,229,286 5,733,128
----------- -----------
10,750,091 18,373,790
Accumulated depreciation and amortization. . . . . . . . . . . . . . . . . . . . . (1,163,265) (2,158,523)
----------- -----------
9,586,826 16,215,267
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411,804 2,314,479
----------- -----------
Property, equipment and leasehold improvements, net. . . . . . . . . . . . . . . . $9,998,630 $18,529,746
----------- -----------
----------- -----------
During 1998, the Company purchased land, buildings, leasehold improvements
and furniture, fixtures and equipment in connection with their expansion of the
Company-owned restaurants in the amounts of $2,314,000, $2,014,000, $3,304,000,
and $1,470,000, respectively.
Depreciation and amortization of property, equipment and leasehold
improvements totaled approximately $363,000, $566,000 and $1,060,000 for the
years ended December 31, 1996, 1997 and 1998, respectively.
6. INVESTMENTS AND ADVANCES
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Limited partnership:
Investment . . . . . . . . . . . . . . . . . . . . . . . . . . $ 189,798 $ 96,538
Advances . . . . . . . . . . . . . . . . . . . . . . . . . . . 507,046 774,463
---------- ----------
696,844 871,001
Building art . . . . . . . . . . . . . . . . . . . . . . . . . . 263,071 263,071
Investments in Master Licensees (net of $100,000 reserve). . . . 496,875 396,875
---------- ----------
Investments and advances . . . . . . . . . . . . . . . . . . . . $1,456,790 $1,530,947
---------- ----------
---------- ----------
LIMITED PARTNERSHIP
The Company owns a 40% general and limited partnership interest in an
entity engaged in the acquisition, development and construction of certain
commercial real estate. The partnership has the following assets, liabilities
and partners' capital:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Assets . . . . . . . . . . . . . . $2,289,572 $2,239,960
Liabilities. . . . . . . . . . . . 1,634,384 1,933,276
Partners' Capital. . . . . . . . . 655,188 306,684
F-16
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. INVESTMENTS AND ADVANCES - (CONTINUED)
The partnership's net profits, losses and distributions are allocated based
upon methods set forth in the partnership agreement. The Company is allocated
25% of distributions and like amount of net profits until the other limited
partner has received an aggregate amount equal to its aggregate contribution.
Thereafter, remaining net profits and all losses are allocated 40% to the
Company.
The Company is the guarantor of all partnership indebtedness which consists
of borrowings under a $1,150,000 bank line of credit with approximately
$1,117,000 and $1,093,000 outstanding at December 31, 1997 and 1998,
respectively. The indebtedness is collateralized by project real estate, and
related leases and rents.
INVESTMENTS IN MASTER LICENSEES
In November 1996, the Company paid $300,000 to acquire a 7.5% interest in a
Master Licensee and also agreed to serve as guarantor of additional financing
not to exceed $400,000. At December 31, 1997 and 1998, the outstanding balance
on the additional financing guarantied by the Company was $400,000. See note on
"Related Party Transactions." During 1997, the Company made an investment of
approximately $197,000 in a Master Licensee.
7. INTANGIBLE ASSETS
Intangible assets consist of the following:
AMORTIZATION DECEMBER 31,
PERIOD --------------------------
(YEARS) 1997 1998
------------ ----------- -----------
Original franchise rights. . . . . . . . . . . . 40 $ 5,688,892 $ 5,688,892
Royalty value and goodwill . . . . . . . . . . . 20 2,222,938 3,122,117
Developer and franchise rights acquired. . . . . 20 to 40 4,668,200 9,789,263
Debt issue costs . . . . . . . . . . . . . . . . 5 to 25 98,964 65,136
Organization costs . . . . . . . . . . . . . . . 4 to 10 29,021 --
Other intangible assets. . . . . . . . . . . . . 5 345,037 318,449
----------- -----------
13,053,052 18,983,857
Less accumulated amortization. . . . . . . . . . (1,939,839) (2,168,798)
----------- -----------
Intangible assets, net . . . . . . . . . . . . . $11,113,213 $16,815,059
----------- -----------
----------- -----------
F-17
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. INTANGIBLE ASSETS - (CONTINUED)
In 1997, the Company reacquired the developer rights in Connecticut,
Maryland, Virginia and various western territories. The aggregate purchase price
of these developer rights was approximately $1,734,000. Also, the Company
reacquired franchise rights in Houston and Austin, Texas for approximately
$1,018,000.
In 1998, the Company re-acquired certain developer and franchise rights in
Georgia, Michigan, and certain portions of Ohio, Texas and various western
territories. In addition, the Company re-acquired the international licensing
rights to Belgium, Luxemburg, and The Netherlands.
The developer rights acquired under these transactions are being
amortized on a straight-line basis over 40 years. Amortization of intangible
assets totaled approximately $340,000, $502,000 and $747,000 for the years
ended December 31, 1996, 1997 and 1998, respectively.
8. ACCRUED LIABILITIES
Accrued liabilities consist of the following:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Accrued taxes . . . . . . . . . . . . . . . . $ 252,116 $1,216,954
Accrued legal and professional. . . . . . . . 212,012 392,277
Developer service costs . . . . . . . . . . . 742,541 910,848
Repurchase of development territories . . . . -- 6,550,000
Other accrued liabilities . . . . . . . . . . 278,046 543,514
---------- ----------
$1,484,715 $9,613,593
---------- ----------
---------- ----------
9. DEFERRED REVENUE
Franchise fees, developer fees and revenue from the Turnkey Program,
collected but not yet recognized into income less related direct incremental
costs paid but not yet charged to expense are as follows:
Deferred revenue consists of the following:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Deferred franchise and developer fees. . . . . . . . . . . . . . $2,037,500 $1,687,500
Deferred direct incremental costs:
Deferred franchise fee development service costs. . . . . . . (1,034,375) (838,750)
Deferred commissions. . . . . . . . . . . . . . . . . . . . . (13,750) (6,500)
Other deferred costs. . . . . . . . . . . . . . . . . . . . . (22,550) (5,500)
Deferred revenue, net -- Turnkey Program . . . . . . . . . . . . 1,888,555 461,736
---------- ----------
$2,855,380 $1,298,486
---------- ----------
---------- ----------
F-18
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. LONG-TERM DEBT
In June 1997, the Company secured an additional line of credit of up to
$15,000,000 from a financial institution. This line of credit bears interest at
the bank's prime lending rate and expires December 2001, with approximately
$6,360,000 outstanding at December 31, 1998 and approximately $7,147,000 which
had been loaned to various franchisees and area developers for which the Company
has provided a guaranty.
Long-term debt consists of the following:
DECEMBER 31,
-------------------------
1997 1998
---------- ----------
Capitalized lease, bearing an effective interest rate of 11.24%,
collateralized by real property; monthly principal and interest
installments of $12,615 through 2020 . . . . . . . . . . . . . . . . . . . . . $1,238,170 $1,225,298
Various notes payable to individuals and corporations, bearing
interest at 6% to 9% per annum, due in periodic principal and
interest installments through 2004, and collateralized by
equipment and assignment of royalties from certain franchisees . . . . . . . . 791,607 545,439
Capitalized lease bearing an effective interest rate of 13.67%,
collateralized by real property; monthly principal and interest
installments of $6,312 due through 2017. . . . . . . . . . . . . . . . . . . . -- 534,937
Capitalized lease bearing an effective interest rate of 12.85%,
collateralized by real property; monthly principal and interest
installments of $5,361 due through 2027. . . . . . . . . . . . . . . . . . . . -- 513,359
Note payable to a financial institution bearing interest at the
lesser of LIBOR + 1.75% or the bank's prime lending rate,
collateralized by the Company's receivables and intangibles,
with the principal due March, 1999. . . . . . . . . . . . . . . . . . . . . . -- 5,000,000
Note payable to a financial institution bearing interest at the
lesser of LIBOR + 1.75% or the bank's prime lending rate,
collateralized by the Company's receivables and intangibles,
with the principal due December, 2001. . . . . . . . . . . . . . . . . . . . . -- 6,360,000
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157,235 422,067
---------- ----------
2,187,012 14,601,100
Current maturities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (250,625) (5,382,585)
---------- ----------
Long-term debt, less current maturities . . . . . . . . . . . . . . . . . . . . $1,936,387 $9,218,515
---------- ----------
---------- ----------
F-19
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. LONG-TERM DEBT - (CONTINUED)
The aggregate annual maturities of long-term debt at December 31, 1998 are
as follows:
YEAR ENDED
DECEMBER 31,
-------------
1999. . . . . . . . . . . . . . . . . . . . . . . . . $5,382,585
2000. . . . . . . . . . . . . . . . . . . . . . . . . 258,439
2001. . . . . . . . . . . . . . . . . . . . . . . . . 6,415,949
2002. . . . . . . . . . . . . . . . . . . . . . . . . 62,481
2003. . . . . . . . . . . . . . . . . . . . . . . . . 69,798
Thereafter. . . . . . . . . . . . . . . . . . . . . . 2,411,848
------------
$14,601,100
------------
------------
Interest expense, totaled approximately $331,000, $297,000 and $248,000 for
the years ended December 31, 1996, 1997 and 1998, respectively. All of the
interest in 1997 and 1998 was capitalized.
11. INCOME TAXES
The provision for federal and state income taxes consists of the following:
FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------------
1996 1997 1998
----------- ----------- -----------
Federal:
Current . . . . . . . . . . . . . . . . . . . . . . 1,886,719 $2,416,124 $2,813,396
Deferred . . . . . . . . . . . . . . . . . . . . . (75,578) 26,988 556,575
---------- ---------- ----------
Total federal . . . . . . . . . . . . . . . . . . 1,811,141 2,443,112 3,369,971
State . . . . . . . . . . . . . . . . . . . . . . . . 91,149 171,148 358,638
---------- ---------- ----------
Total provision for income taxes. . . . . . . . . . . 1,902,290 $2,614,260 $3,728,609
---------- ---------- ----------
---------- ---------- ----------
The differences between the income tax expense and the amount that would result
if the statutory rates were applied to the pretax financial income were as
follows:
FOR THE YEARS ENDED
DECEMBER 31,
-------------------------------------------------
1996 1997 1998
------------ ------------ ------------
Expense at statutory rate of 34% . . . . . . . . . . . . . $1,733,070 $2,401,650 $3,377,925
Nondeductible items, including
amortization . . . . . . . . . . . . . . . . . . . . . . 86,915 99,653 69,922
State income taxes, net. . . . . . . . . . . . . . . . . . 60,158 112,957 236,701
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . 22,147 -- 44,061
------------ ------------ ------------
1,902,290 $2,614,260 $3,728,609
------------ ------------ ------------
------------ ------------ ------------
F-20
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
11. INCOME TAXES - (CONTINUED)
Deferred taxes are provided for the temporary differences between the
financial reporting bases and the tax bases of the Company's assets and
liabilities. The temporary differences that give rise to the deferred tax
assets or liabilities are as follows:
DECEMBER 31,
-----------------------------
1997 1998
------------ ------------
Deferred Tax Assets:
Receivables. . . . . . . . . . . . . . . . . . . $ -- $ 265,167
Deferred revenue . . . . . . . . . . . . . . . . 666,842 307,004
Accrued liabilities. . . . . . . . . . . . . . . 21,809 117,753
Other. . . . . . . . . . . . . . . . . . . . . . 35,028 36,563
------------ ------------
Gross deferred tax assets. . . . . . . . . . . . 723,679 726,487
------------ ------------
------------ ------------
Deferred Tax Liabilities:
Property, equipment and intangibles. . . . . . . 143,219 593,614
Installment sale . . . . . . . . . . . . . . . -- 99,202
Other. . . . . . . . . . . . . . . . . . . . . . -- 9,786
------------ ------------
Gross deferred tax liabilities. . . . . . . . . . . 143,219 702,602
------------ ------------
Net deferred tax asset. . . . . . . . . . . $ 580,460 $ 23,885
------------ ------------
------------ ------------
12. STOCKHOLDERS' EQUITY
WARRANTS
During 1994, the Company issued a warrant to purchase 23,437 shares of
common stock at an initial exercise price of $9.60 per share. The warrant was
exercised in March 1998.
SHAREHOLDERS' RIGHTS PLAN
In December 1998, the Company announced that the Board of Directors had
adopted a Shareholder's Rights Plan and approved a dividend of one Right for
each share of Company Common Stock outstanding. Under the plan, each shareholder
of record receives one Right for each share of Common Stock held. Initially, the
Rights are not exercisable and automatically trade with the Common Stock. There
are no separate Rights certificates at this time. Each Right entitles the holder
to purchase one one-hundredth of a share of Company Class C Series A Junior
Participating Preferred Stock for $75.00 (the "Exercise Price").
The Rights separate and become exercisable upon the occurrence of certain
events, such as an announcement that an "acquiring person" (which may be a group
of affiliated persons) beneficially owns, or has acquired the rights to own,
20% or more of the outstanding Common Stock, or upon the commencement of a
tender offer or exchange offer that would result in an acquiring person
obtaining 20% or more of the outstanding shares of Common Stock.
Upon becoming exercisable, the Rights entitle the holder to purchase
Common Stock with a value of $150 for $75. Accordingly, assuming the Common
Stock had a per share value of $75 at the time, the holder of a right could
purchase two shares for $75. Alternatively, the Company may permit a holder to
surrender a Right in exchange for stock or cash equivalent to one share of
Common Stock (with a value of $75) without the payment of any additional
consideration. In certain circumstances, the holders have the right to acquire
common stock of an acquiring company having a value equal to two times the
Exercise Price of the Rights.
F-21
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCK-BASED COMPENSATION PLANS
The Company sponsors the "Schlotzsky's, Inc. Third Amended and Restated
Stock Option Plan" (the "Plan"), which is a stock-based incentive compensation
plan, as described below. The Company applies APB Opinion No. 25 and related
Interpretations in accounting for the Plan. In 1995, the FASB issued SFAS No.
123 "Accounting for Stock-Based Compensation" which, if adopted by the Company,
would change the methods the Company applies in recognizing the cost of the
Plan. Adoption of the cost recognition provisions of SFAS No. 123 is optional
and the Company has decided not to elect these provisions of SFAS No. 123.
However, pro forma disclosures as if the Company adopted the cost recognition
provisions of SFAS No. 123 in 1995 are required by SFAS No. 123 and are
presented below.
THE STOCK OPTION PLAN
Under the Plan, the Company was originally authorized to issue 800,000
shares of common stock pursuant to "awards" granted in the form of incentive
stock options (qualified under Section 422 of the Internal Revenue Code of 1986,
as amended) and non-qualified stock options. Awards may be granted to key
employees of the Company. In February 1998, the Compensation Committee of the
Board of Directors amended the Plan to provide for an additional 150,000 shares
of common stock to be authorized for issuance as non-qualified stock options
under its provisions, and in May 1998, the shareholders approved amendments to
the Plan, including an additional 500,000 shares of common stock to be
authorized for issuance as either incentive stock options or non-qualified stock
options.
Options granted in 1998 generally vest ratably over three years. Options
granted before 1998 generally vest ratably over five years.
F-22
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCK-BASED COMPENSATION PLANS - (CONTINUED)
A summary of the status of the Company's stock options as of December 31,
1996, 1997 and 1998 and the changes during the years ended on those dates are
presented below:
OPTIONS OUTSTANDING
---------------------------------
WEIGHTED AVERAGE
EXERCISE PRICES
SHARES PER SHARE
------------ -----------------
BALANCE, January 1, 1996. . . . . . . . . . . . . . . . . . . . . . . 621,790 $ 8.70
Granted (weighted average fair value of $4.96 per share). . . . . . 82,850 10.50
Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (29,924) 6.75
Forfeited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (79,752) 8.05
Expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- --
---------
BALANCE, December 31, 1996. . . . . . . . . . . . . . . . . . . . . . 594,964 9.13
Granted (weighted average fair value of $6.81 per share). . . . . . 200,500 15.08
Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (57,201) 8.50
Forfeited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (85,799) 9.88
Expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- --
---------
BALANCE, December 31, 1997. . . . . . . . . . . . . . . . . . . . . . 652,464 11.19
Granted (weighted average fair value of $8.30 per share). . . . . . 628,700 18.66
Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44,239) 8.88
Forfeited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (147,216) 17.10
Expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (25,300) 15.50
---------
BALANCE, December 31, 1998. . . . . . . . . . . . . . . . . . . . . . 1,064,409 14.56
---------
---------
Exercisable at December 31, 1996. . . . . . . . . . . . . . . . . . . 339,981 8.75
Exercisable at December 31, 1997. . . . . . . . . . . . . . . . . . . 362,178 9.19
Exercisable at December 31, 1998. . . . . . . . . . . . . . . . . . . 491,972 9.54
The fair value of each stock option granted in 1996, 1997 and 1998 is
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions: no dividend yield; risk-free
interest rate of 6.37% for 1996, 6.17% for 1997, and 5.28% for 1998; expected
lives of the options of six years; and volatility of 37.01% for 1996, 32.50% for
1997, and 48.97% for 1998.
The following table summarizes information about stock options outstanding
at December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------ -----------------------------
NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED
OUTSTANDING AT AVERAGE AVERAGE EXERCISABLE AT AVERAGE
RANGE OF DECEMBER 31, REMAINING EXERCISE DECEMBER 31, EXERCISE
EXERCISE PRICES 1998 CONTRACT LIFE PRICE 1998 PRICE
- - ------------------------ -------------- -------------- -------- -------------- --------
$5.60 to $11.00. . . . . 413,930 6.56 $ 8.59 363,930 $ 8.35
$11.09 to $14.97 . . . . 237,079 8.53 $12.40 115,142 $12.27
$17.69 to $23.94 . . . . 413,400 9.12 $21.78 12,900 $18.73
-------------- --------------
Total. . . . . . . . . . 1,064,409 7.99 $14.56 491,972 $ 9.54
F-23
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCK-BASED COMPENSATION PLANS - (CONTINUED)
EMPLOYEE STOCK PURCHASE PLAN
During 1998 the Company adopted the Schlotzsky's, Inc. Employee Stock
Purchase Plan (the "Stock Purchase Plan") and authorized 250,000 shares of stock
to be sold to employees through the Stock Purchase Plan. Under the terms of the
Stock Purchase Plan, employees may elect to contribute up to 15% of compensation
through payroll deductions for the purchase of Company stock at 85% of the
lesser of the market price at the beginning or the end of the offering period.
An offering period begins on January 1st and July 1st of each year and expires
in six months.
During 1998, 49 participants purchased 9,396 shares of stock through the
Stock Purchase Plan for $8.39 per share. Under APB Opinion No. 25, the Stock
Purchase Plan is considered noncompensatory. Therefore, no compensation expense
has been recognized for shares sold under this plan.
The fair value of stock purchase rights granted in 1998 were $6.55 per
share or a total of $61,543. The fair value of each stock purchase right was
determined using an expected term of six months, a volatility of 48.97%, and a
risk-free interest rate of 5.30%.
PRO FORMA NET INCOME AND NET INCOME PER COMMON SHARE
During 1996, 1997 and 1998, the Company did not incur any compensation
costs for the Plan under APB No. 25. Had the compensation cost for the Company's
Plan been determined consistent with SFAS No. 123, the Company's net income and
net income per common share for 1996, 1997 and 1998 would approximate the pro
forma amounts below:
DECEMBER 31, 1996 DECEMBER 31, 1997 DECEMBER 31, 1998
-------------------------- -------------------------- -------------------------
AS PRO AS PRO AS PRO
REPORTED FORMA REPORTED FORMA REPORTED FORMA
------------ ------------ ------------ ------------ ------------ -----------
Net income . . . . . . . . . . . . . . . . $ 3,194,975 $ 3,085,016 $ 4,449,415 $ 4,201,878 $ 6,206,465 4,673,829
Net income per common share -- basic. . . . $ 0.58 $ 0.56 $ 0.74 $ 0.70 $ 0.84 $ 0.63
Net income per common share -- diluted . . $ 0.57 $ 0.55 $ 0.71 $ 0.67 $ 0.82 $ 0.62
The effects of applying SFAS No. 123 in this pro forma disclosure are not
indicative of future amounts. SFAS No. 123 does not apply to awards prior to
1995 and the Company anticipates making awards in the future under its Plan. As
the Company's options typically vest over three to five years, the full impact
of the pro forma disclosure requirements will not be reflected until 2000.
F-24
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for interest during the years ended December 31, 1996, 1997 and
1998 was approximately $313,000, $297,000 and $248,000, respectively.
Cash paid for taxes during the years ended December 31, 1996, 1997 and 1998
was approximately $2,614,000, $2,404,000 and $2,515,000, respectively.
Noncash investing and financing activities:
1996
Notes totaling approximately $1,861,000 were received as payment for
nonrefundable Area Developer, Master Licensee, Territorial and other fees.
1997
Notes totaling approximately $272,000 were received as payment for
nonrefundable Area Developer, Master Licensee, Territorial and other fees.
Notes totaling approximately $1,400,000 were received as proceeds of for
sales of Turnkey Program properties.
Notes totaling approximately $525,000 were issued for acquisition of
developer rights.
1998
Notes receivable totaling approximately $2,250,000 were received as
payment for nonrefundable Area Developer, Master Licensee, Territorial and
other fees.
Notes receivable totaling approximately $21,334,000 were received as
payment for investment in Turnkey Projects.
15. RELATED PARTY TRANSACTIONS
Franchisees contribute 1% of gross sales to Schlotzsky's N.A.M.F., Inc.
("NAMF") to be used solely for the production of programs and materials for
marketing and advertising. The Company charges NAMF an amount equal to certain
cost allocations and salaries for administering NAMF. Advances to NAMF totaled
approximately $40,000 and $11,000 at December 31, 1997 and 1998, respectively,
and are included in other receivables in the accompanying consolidated balance
sheets.
One or more principal stockholders of the Company is guarantor of debt of
the Company's, totaling approximately $1,460,000 and $1,383,000 at December 31,
1997 and 1998, respectively.
In 1996, the Company entered into a Territorial Agreement pursuant to which
Sino-Caribbean Development, Inc. ("Sino") paid $150,000 in cash and $600,000 by
a promissory note for the right to obtain a master license for certain
territories in the Pacific Rim. In addition, Sino agreed to assume a promissory
note in the amount of $275,000 in exchange for territorial rights under an
existing Master License Agreement. The outstanding balances on the combined
notes were $455,000 at December 31, 1997 and 1998. An officer of the Company
held 60% of Sino's outstanding common stock at December 31, 1996. In 1997, Sino
issued shares of common stock to third parties which reduced the officer's
interest to less than 30%.
F-25
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
During 1996, the Company paid $300,000 to Bonner Carrington Corporation
European Market ("BCCE") and agreed to serve as guarantor for additional
financing not to exceed $400,000. In return, the Company received: (i) preferred
stock representing 7.5% of the total outstanding shares of BCCE; (ii) an option
to buy additional preferred stock representing an additional 10% of the total
outstanding shares of BCCE; and (iii) options to purchase BCCE and its
respective territories at predetermined prices effective during the period
covering December 1999 through December 2011. In February 1999, the Company
acted on the guarantee of the $400,000. In a separate transaction in June 1996,
the Company entered into a Master License Agreement pursuant to which BCCE paid
the Company $25,000 in cash and $75,000 by promissory note. BCCE is a wholly
owned subsidiary of Bonner Carrington Corporation.
During 1998, the Company paid $100,000 earnest money toward the
reacquisition of a master license territory from Java Rim, a wholly-owned
subsidiary of Bonner Carrington Corporation ("BCC").
The Company and Third & Colorado 19, L.L.C. ("T&C 19"), a limited liability
company owned by two stockholders of the Company, entered into a lease agreement
effective March 21, 1997, under which the Company leases from T&C 19
approximately 29,410 square feet of office space and 11,948 square feet of
storage space, in Austin, Texas for the Company's corporate headquarters. Under
the terms of the lease, the Company pays annual net rental of $12.95 per square
foot for the office space and up to $2.50 per square foot for the storage space
for a term of 10 years beginning November 1997.
During 1997, an organization whose managing director is also a member
of the Company's Board of Directors became the successor to the Company's
International development licensing rights for Belgium, Luxemburg and The
Netherlands held by Euro American Development B.V. During 1998, the Company
re-acquired these rights from the related entity for $290,000 (in the form of
$125,000 cash and the remainder through cancellation of indebtedness).
16. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases office facilities, land, buildings and equipment for its
Company-owned stores. Rent expense for the years ended December 31, 1996, 1997
and 1998, was approximately $118,000, $814,000 and $1,195,000, respectively.
Future minimum rental payments under operating leases that have initial or
remaining noncancelable lease terms in excess of one year as of December 31,
1998 are as follows:
YEAR ENDING
DECEMBER 31,
-------------
1999 . . . . . . . . . . . . $ 1,353,839
2000 . . . . . . . . . . . . 1,374,725
2001 . . . . . . . . . . . . 1,387,205
2002 . . . . . . . . . . . . 1,378,732
2003 . . . . . . . . . . . . 1,414,603
Thereafter . . . . . . . . . 18,465,497
-----------
$25,374,601
-----------
-----------
GUARANTIES ON FRANCHISE OPERATING LEASES AND OTHER OBLIGATIONS
The Company, and in some cases certain stockholders, guaranty certain real
estate and equipment leases and other obligations of its franchisees. Under the
Turnkey Program, the Company has typically provided a credit enhancement in the
form of a guaranty on the franchisee's lease assigned to a third-party investor.
These guaranties typically cover lease payments and various other obligations of
the franchisee for a period ranging from 18 months to five years, and is
effective throughout the term of the 20 year lease. At December 31, 1998, the
Company was contingently liable for approximately $6.2 million under these
guaranties. Additionally, at December 31, 1998, the Company was contingently
liable for approximately $20.2 million under guaranties of other franchisee real
estate and equipment leases and various obligations.
F-26
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
16. COMMITMENTS AND CONTINGENCIES B (CONTINUED)
LITIGATION
The Company is a defendant in various lawsuits arising in the ordinary
course of business. Management is of the opinion that all such matters are
without merit or are of such kind, or involve such amounts, as would not have a
significant effect on the consolidated financial position, results of operations
or cash flows of the Company if disposed unfavorably.
On February 8, 1999, the Lone Star Ladies Investment Club, et al., filed a
consolidated amended class action lawsuit in the Western District of Texas
against the Company and four of its officers and directors (Monica Gill,
Executive Vice President and Chief Financial Officer; John M. Rosillo, director;
Jeffrey J. Wooley, Senior Vice President and director; and John C. Wooley,
President and Chairman of the Board of Directors). The complaint, alleges
securities fraud arising from a change in the timing of recognition of revenue
from the sale of real estate properties in connection with which the Company
provided limited guaranties on franchisees leases of the properties. In April
1998, Registrant announced that 1997 earnings would be lower than previously
announced because it would defer revenue received in the fourth quarter from
such real estate transactions rather than recognizing it during the period in
which the transaction occurred, as previously contemplated. Plaintiffs seek
monetary damages in an unspecified amount. The Company believes that the
allegations are without merit and intends to vigorously defend against the suit.
17. CONCENTRATION OF CREDIT RISK
The Company's financial instruments that are exposed to concentrations of
credit risk consist primarily of cash and cash equivalents, mortgage notes
receivable from franchisees, notes receivable from Area Developers and Master
Licensees and notes receivable from affiliates. The Company places its cash and
cash equivalents with high credit quality financial institutions, which, at
times, may exceed federally insured limits. The Company has not experienced any
losses in such accounts.
The Company grants notes receivable to individuals and licensees who have,
in the opinion of the Company, adequate reserves to repay the notes independent
of the franchise rights. Although the Company has extended the terms maturities
of certain of the notes, it has not experienced significant credit losses to
date.
18. SEGMENTS
The Company and its subsidiaries are principally engaged in franchising
quick service restaurants that feature salads, made-to-order sandwiches and
pizzas with unique sourdough buns. At December 31, 1998 the Schlotzsky's system
included Company owned and franchised stores in 38 states, the District of
Columbia and 13 foreign countries.
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement No. 131, "Disclosures about Segments of an Enterprise and Related
Information," which the Company has adopted in the current year.
F-27
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
18. SEGMENTS -- (CONTINUED)
The Company identifies such segments based on management responsibility
within the corporate structure. The Turnkey Development segment includes
the development of free-standing stores with high visibility and easy access.
The Restaurant Operations includes the operation of a limited number of
Company-owned restaurants for the purpose of product development, concept
refinement, prototype testing and training and to build brand awareness. The
Franchise Operations segment encompasses the franchising of stores in order
to achieve optimal success with owner-operated stores. The Company measures
segment profit as operating profit, which is defined as income before
interest and income taxes. Segment information and a reconciliation to
income, before interest and income taxes are as follows:
TURNKEY RESTAURANT FRANCHISE
YEAR ENDED DECEMBER 31, 1998 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- - -------------------------------------------------- ------------ ------------ ------------ ------------
Revenue from external customers. . . . . . . . . . $ 8,314,426 $ 7,720,432 $ 25,813,054 $ 41,847,912
Depreciation and amortization. . . . . . . . . . . 446,962 609,265 828,627 1,884,854
Operating income (loss) . . . . . . . . . . . . . 3,061,365 (774,999) 5,590,446 7,876,812
Significant noncash items - fees financed. . . . . -- -- 2,250,000 2,250,000
Capital expenditures . . . . . . . . . . . . . . . 5,150,880 9,102,579 2,991,726 17,245,185
Total assets . . . . . . . . . . . . . . . . . . . $ 42,902,095 $ 20,782,048 $ 40,543,997 $104,228,140
TURNKEY RESTAURANT FRANCHISE
YEAR ENDED DECEMBER 31, 1997 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- - -------------------------------------------------- ------------ ------------ ------------ ------------
Revenue from external customers. . . . . . . . . . $ 1,138,610 $ 6,364,042 $ 20,466,484 $ 27,969,136
Depreciation and amortization. . . . . . . . . . . 178,953 434,698 541,949 1,155,600
Operating income (loss) . . . . . . . . . . . . . 592,001 (193,371) 5,716,424 6,115,054
Significant noncash items - fees financed. . . . . -- -- 272,003 272,003
Capital expenditures . . . . . . . . . . . . . . . 168,160 4,169,162 3,098,681 7,436,003
Total assets . . . . . . . . . . . . . . . . . . . $ 18,740,459 $ 8,992,965 $ 51,787,162 $ 79,520,586
TURNKEY RESTAURANT FRANCHISE
YEAR ENDED DECEMBER 31, 1996 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- - -------------------------------------------------- ------------ ------------ ------------ ------------
Revenue from external customers. . . . . . . . . . $ 725,913 $ 3,610,199 $ 16,378,220 $ 20,714,332
Depreciation and amortization. . . . . . . . . . . 86,674 273,689 418,921 779,284
Operating income (loss) . . . . . . . . . . . . . 119,911 (310,876) 4,701,485 4,510,520
Significant noncash items - fees financed. . . . . -- -- 1,860,796 1,860,796
Capital expenditures . . . . . . . . . . . . . . . 21,424 1,234,537 408,402 1,664,363
Total assets . . . . . . . . . . . . . . . . . . . $ 15,533,211 $ 5,839,137 $ 19,606,764 $ 40,979,112
F-28
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
19. EARNINGS PER SHARE
Basic and diluted EPS computation for the years ended December 31, 1996,
1997 and 1998 are as follows:
FOR THE YEARS ENDED
DECEMBER 31,
------------------------------------
1996 1997 1998
---------- ---------- ----------
Basic EPS
- - ---------
Net income . . . . . . . . . . . . . . . . . . . . $3,194,975 $4,449,415 $6,206,465
---------- ---------- ----------
---------- ---------- ----------
Weighted average common shares outstanding . . . . 5,525,902 5,994,403 7,382,983
---------- ---------- ----------
---------- ---------- ----------
Basic EPS. . . . . . . . . . . . . . . . . . . . . $ 0.58 $ 0.74 $ 0.84
---------- ---------- ----------
---------- ---------- ----------
Diluted EPS
- - -----------
Net income . . . . . . . . . . . . . . . . . . . . $3,194,975 $4,449,415 $6,206,465
---------- ---------- ----------
---------- ---------- ----------
Weighted average common shares outstanding . . . . 5,525,902 5,994,403 7,382,983
Assumed conversion of common shares issuable
Under stock option plan and exercise of warrants 113,323 234,966 194,424
---------- ---------- ----------
Weighted average common shares outstanding --
assuming dilution. . . . . . . . . . . . . . . . . 5,639,225 6,229,369 7,577,407
---------- ---------- ----------
---------- ---------- ----------
Diluted EPS. . . . . . . . . . . . . . . . . . . . . $ 0.57 $ 0.71 $ 0.82
---------- ---------- ----------
---------- ---------- ----------
Outstanding options that were not included in the diluted calculation
because their effect would be anti-dilutive totaled 199,361, 123,500 and
571,000 in 1996, 1997 and 1998, respectively.
F-29
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
Schlotzsky's, Inc. and Subsidiaries
In connection with our audit of the consolidated financial statements of
Schlotzsky's, Inc. and Subsidiaries referred to in our report dated February 26,
1999, which is included in Part IV of this Form 10-K, we have also audited
Schedule II for each of the three years in the period ended December 31,
1998. In our opinion, this schedule presents fairly, in all material
respects, the information required to be set forth therein.
GRANT THORNTON LLP
Dallas, Texas
February 26, 1999
S-1
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
COL. A COL. B COL. C COL. D COL. E.
- - --------------------------------------------------- ------------- ----------------------------- ------------- -------------
ADDITIONS
BALANCE -----------------------------
AT CHARGE TO CHARGE TO BALANCE AT
BEGINNING COSTS AND OTHER END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTION PERIOD
- - --------------------------------------------------- ------------- ------------- ------------- ------------- -------------
Valuation allowance for
Notes Receivable:
December 31, 1998
Valuation Allowance . . . . . . . . . . . . . $(442,774) $(972,724) $ -- $ -- $(1,415,498)
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
December 31, 1997
Valuation Allowance. . . . . . . . . . . . . . (342,774) (100,000) -- -- (442,774)
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
December 31, 1996
Valuation Allowance. . . . . . . . . . . . . . (155,000) (187,774) -- -- (342,774)
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
S-2