UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

FOR THE QUARTERLY PERIOD ENDED DECEMBER 29, 2002

 

or

 

 

FOR THE TRANSITION PERIOD FROM          to         

 

Commission file number 0-26829

 

 

Tully’s Coffee Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

 

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 and (2) has been subject to such filing requirements for the past 90 days. Yes ý  No o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

TULLY’S COFFEE CORPORATION

Form 10-Q

For the Quarterly Period Ended December 29, 2002

 

Index

 

	STATEMENTS ABOUT FORWARD-LOOKING STATEMENTS
PART I	FINANCIAL INFORMATION
Item 1	Financial Statements
	Condensed Consolidated Balance Sheets at December 29, 2002 and March 31, 2002
	Condensed Consolidated Statements of Operations for the Thirteen and Thirty-nine Week Periods Ended December 29, 2002 and December 30, 2001
	Condensed Consolidated Statements of Cash Flows for the Thirty-nine Week Periods Ended December 29, 2002 and December 30, 2001
	Notes to Condensed Consolidated Financial Statements
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3	Quantitative and Qualitative Disclosures about Market Risk
Item 4	Controls and Procedures
PART II	OTHER INFORMATION
Item 4	Submission of Matters to a Vote of Security Holders
Item 6	Exhibits and Reports on Form 8-K
	SIGNATURES AND CERTIFICATIONS

 

2

 

Unless the context requires otherwise, as used in this report “Tully’s”, “Company”, “we”, “our” and “us” means Tully’s Coffee Corporation.

 

Statement About Forward-Looking Statements

 

We make forward–looking statements in this report that are subject to risks and uncertainties. These forward–looking statements include information about possible or assumed future results and performance of the Company and its plans and objectives. Additionally, when we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward–looking statements. Many possible events or factors could affect our future financial results and performance. The forward-looking statements are not guarantees of future performance and actual results or performance may differ materially from those expressed in our forward–looking statements.  Information regarding factors that could cause our actual results to differ materially from our expectations are included this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Factors That May Affect Our Future Results.”

 

You should not place undue reliance on these forward–looking statements.  Except to the extent required by the federal securities laws, we do not intend to update or revise the forward-looking statements contained in this report.

 

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PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

TULLY’S COFFEE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

 

		December 29, 2002			March 31, 2002
		(unaudited)
Assets
Current assets
Cash and cash equivalents		$	208		$	1,684
Short-term investments		—			1,705
Accounts receivable, net of allowance for doubtful accounts of $139 and $349, respectively		1,599			1,071
Inventories		2,620			2,258
Prepaid expenses and other current assets		895			710
Total current assets		5,322			7,428
Property and equipment, net		18,811			20,297
Goodwill, net		554			3,572
Other intangible assets, net		1,038			1,120
Other assets		716			723
Total assets		$	26,441		$	33,140
Liabilities And Stockholders’ (Deficit) Equity
Current liabilities
Current portion of long-term debt		$	265		$	308
Current portion of capital lease obligations		182			—
Line of credit		1,272			—
Accounts payable		2,095			2,259
Accrued liabilities		3,080			3,018
Current portion of deferred licensing revenue		2,112			2,112
Total current liabilities		9,006			7,697
Long-term debt, net of current portion		890			26
Capital lease obligations		398			127
Deferred lease costs		1,370			2,225
Convertible promissory note, net of discount		2,788			2,703
Deferred licensing revenue, net of current portion		12,355			13,945
Total liabilities		26,807			26,723
Commitments and contingencies
Stockholders’ equity
Series A convertible preferred stock, no par value; 17,500,000 shares authorized, 15,378,264 issued and outstanding, stated value of $2.50 per share and a liquidation preference of $38,446		34,483			34,483
Series B convertible preferred stock, no par value; 8,000,000 shares authorized; 4,990,709 issued and outstanding, stated value of $2.50 per share and a liquidation preference of $12,477		11,066			11,066
Common stock, no par value; 120,000,000 shares authorized; 16,409,188 and 16,320,613 shares issued and outstanding at December 29, 2002 and March 31, 2002, respectively		9,272			9,265
Deferred stock compensation		(163		)	—
Additional paid-in capital		27,315			27,093
Accumulated other comprehensive loss		—			(110		)
Accumulated deficit		(82,339		)	(75,380		)
Total stockholders’ (deficit) equity		(366		)	6,417
Total liabilities and stockholders’ (deficit) equity		$	26,441		$	33,140

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4

 

TULLY’S COFFEE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(dollars in thousands, except per share data)

 

 

		Thirteen-Week Periods Ended							Thirty-nine Week Periods Ended
		December 29, 2002				December 30, 2001			December 29, 2002				December 30, 2001
		(unaudited)							(unaudited)
Net sales		$	13,037			$	13,244		$	38,927			$	39,255
Cost of goods sold and related occupancy expenses		5,990				6,772			18,034				20,107
Store operating expenses		4,216				4,411			12,943				13,420
Other operating expenses		533				679			1,390				1,458
Marketing, general and administrative costs		2,244				2,387			7,457				7,763
Depreciation and amortization		884				1,153			2,991				3,645
Store closure and lease termination costs		—				226			—				1,085
Operating loss		(830			)	(2,384		)	(3,888			)	(8,223		)
Other income (expense)
Interest expense		(191			)	(165		)	(536			)	(654		)
Gain on sale of investments		—				2,589			14				2,589
Interest and other income		7				2			521				108
Loan guarantee fee expense		(29			)	—			(29			)	(216		)
Total other income (expense)		(213			)	2,426			(30			)	1,827
Income (loss) before income taxes and cumulative effect of change in accounting principle		(1,043			)	42			(3,918			)	(6,396		)
Income taxes		(1			)	—			(23			)	(2		)
Income (loss) before cumulative effect of change in accounting principle		(1,044			)	42			(3,941			)	(6,398		)
Cumulative effect of change in accounting principle		—				—			(3,018			)	—
Net income (loss)		$	(1,044		)	$	42		$	(6,959		)	$	(6,398	)
Net income (loss) per share - basic and diluted
Income (loss) before cumulative effect of change in accounting principle		$	(0.06		)	$		*	$	(0.24		)	$	(0.39	)
Cumulative effect of change in accounting principle		—				—			(0.18			)	—
Net income (loss) per share - basic and diluted		$	(0.06		)	$		*	$	(0.42		)	$	(0.39	)
Weighted average shares used in computing basic and diluted net income (loss) per share		16,409				16,309			16,367				16,248

 

* Less than $0.01

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

5

 

TULLY’S COFFEE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

 

		Thirty-nine Week Periods Ended
		December 29, 2002			December 30, 2001
		(unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(6,959	)	$	(6,398	)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
Cumulative effect of change in accounting principle		3,018			—
Depreciation and amortization		2,991			3,645
Store closure and lease termination costs		—			835
Non-cash interest expense		329			424
Employee stock option compensation expense		59			179
Provision for doubtful accounts		75			—
Loan guarantee fee expense		29			209
Gain on sale of investments		(14		)	(2,589		)
Changes in assets and liabilities:
Accounts receivable		(603		)	(361		)
Inventories		(363		)	2,144
Prepaid expenses and other assets		(156		)	94
Accounts payable		(164		)	(4,145		)
Accrued liabilities		(2		)	(1,299		)
Deferred lease costs		35			126
Deferred licensing revenue		(1,533		)	14,487
Net cash (used in) provided by operating activities		(3,258		)	7,351
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(702		)	(3,141		)
Additions to intangible assets		—			(12		)
Proceeds from sale of investments		1,829			2,709
Related party notes receivable		100			—
Payment received on related party notes receivable		(100		)	—
Net cash provided by (used in) investing activities		1,127			(444		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings (payments) under line of credit		1,272			(5,500		)
Payments on long-term debt and capital lease obligations		(625		)	(525		)
Proceeds from related party notes payable		—			900
Payments on related party notes payable		—			(1,250		)
Note receivable from stockholder		—			601
Proceeds from exercise of common stock options		1			3
Proceeds from exercise of common stock warrants		7			—
Net cash provided (used in) financing activities		655			(5,771		)
Net (decrease) increase in cash and cash equivalents		(1,476		)	1,136
Cash and cash equivalents at beginning of period		1,684			408
Cash and cash equivalents at end of period		$	208		$	1,544
SUPPLEMENTAL CASH FLOW INFORMATION:
Non-cash investing and financing activities:
Purchase of property and equipment through capital leases		$	748		$	—
Issuance of common stock in payment of liability		—			280
Available-for-sale securities received for deferred licensing revenue					1,771
Equipment purchased through accounts payable		—			2,390
Insurance premiums financed through note payable		289			304

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

6

 

TULLY’S COFFEE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.                   Basis of Presentation

 

The condensed consolidated financial statements include the accounts of Tully’s Coffee Corporation (“Tully’s” or the “Company”) and its wholly owned subsidiary, Spinelli Coffee Company, after elimination of all significant intercompany items and transactions.

 

The Company’s fiscal year ends on the Sunday closest to March 31. The fiscal year ending March 30, 2003 (“Fiscal 2003”) will include 52 weeks.  The fiscal years ending March 31, 2002 (“Fiscal 2002”) and April 1, 2001 (“Fiscal 2001”) both included 52 weeks.  The fiscal year ending March 29, 2004 (“Fiscal 2004”) will have 52 weeks.

 

The accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments that, in the opinion of management, are necessary to present fairly the financial information set forth therein.  Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Results of operations for the thirteen and thirty-nine week periods ended December 29, 2002, and December 30, 2001, respectively, are not necessarily indicative of future financial results.

 

Investors should read these interim statements in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto for Fiscal 2002 included in our annual report on Form 10-K, as amended, SEC File No. 0-26829, for the fiscal year ended March 31, 2002.

 

Recently Issued Accounting Standards

 

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123” (SFAS 148).  This Statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation.  It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation.  The provisions of SFAS 148 will be effective for fiscal years ending after December 15, 2002.  The Company is currently evaluating the implications of adoption of SFAS 148.

 

Adoption of Accounting Standard

 

Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”  (“SFAS 142”), was issued by the FASB in June 2001.  The statement changes the accounting for goodwill from an amortization method to an impairment only approach, and Tully’s was required to adopt it for Fiscal 2003.  Prior to the adoption of SFAS 142, the Company amortized goodwill using the straight-line method over the estimated life of fifteen years.  Upon adoption of SFAS 142, the Company ceased amortization of goodwill thereby eliminating approximately $89,000 and $266,000 in amortization expense for the thirteen-week period ended December 29, 2002 (“Third Quarter 2003”) and thirty-nine week period ended December 29, 2002 compared to the same periods in Fiscal 2002, respectively.

 

SFAS 142 requires that companies perform periodic evaluations of potential impairment of goodwill, with the initial assessment to be completed during the first six months of the year in which SFAS 142 is first applied.  During the thirteen-week period ended September 29, 2002 (“Second Quarter 2003”), Tully’s completed an impairment evaluation of its goodwill as of April 1, 2002, and determined that a non-cash impairment charge of $3,018,000 should be recorded.  As provided in SFAS 142, this impairment charge has been retroactively recorded as the cumulative effect of a change in accounting principle as of April 1, 2002 (see Note 5).

 

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Reclassifications

 

Reclassifications of prior year balances have been made to conform to the current year classifications and have no impact on net loss or financial position.

 

 

2.                   Liquidity

 

For Third Quarter 2003 and the thirty-nine week period ended December 29, 2002, the Company had a loss (before the cumulative effect of change in accounting principle, discussed in Note 5) of $1,044,000 and $3,941,000, respectively, as compared with a profit of $42,000 and a loss of $6,398,000 for the comparable periods in Fiscal 2002.  The impairment charge recorded as the cumulative effect of change in accounting for goodwill did not affect the Company’s cash flow or liquidity.

 

The Company’s cash operating activities used $1,350,000 of cash during Third Quarter 2003, and used $3,258,000 of cash during the thirty-nine week period ended December 29, 2002.  The Company ended Third Quarter 2003 with $208,000 in cash and cash equivalents.  Working capital deficit increased at December 29, 2002 to $3,684,000 as compared to a working capital deficit of $269,000 at March 31, 2002.  Cash and cash equivalents decreased by $1,476,000 during the thirty-nine week period ended December 29, 2002.  Because the Company principally operates as a “cash business,” it generally does not require a significant investment in working capital.  Further, Company management has placed increased emphasis on management of the Company’s investment in inventory and accounts receivable.  As a result, the Company typically has operated with current liabilities in excess of its current assets (excluding cash and cash equivalents).  Tully’s expects that its investment in accounts receivable will grow in proportion to sales growth in its Wholesale and International divisions, and inventory levels typically increase during the spring due to coffee crop seasonality and to a lesser degree during the autumn due to holiday seasonal merchandise.  Operation with minimal or deficit working capital has reduced the Company’s historical requirements for capital, but provides the Company with limited immediately available resources to deal with its short-term needs and unanticipated business developments and increases the Company’s dependence upon additional financing activities.

 

During the thirty-nine week period ended December 29, 2002 the Company closed four stores that did not meet the Company’s performance criteria, and is continuing to evaluate store locations and operations to determine if closure, downsizing or relocation of certain stores that do not meet performance objectives is necessary.  The Company is taking other actions to reduce negative cash flow from operations, including implementing programs to improve sales through new product offerings and retail marketing programs, revising operational procedures and the expansion of its Wholesale division.

 

On November 1, 2002, the Company entered into a new credit facility with the lessor of its headquarters, roasting plant and distribution facility, Kent Central LLC (“KCL”), which is secured by substantially all of the Company’s assets and guaranteed by certain directors and stockholders of the Company (the “financial backers” or “guarantors”), as described in Note 8.  The KCL credit facility allows the Company to borrow up to $2,000,000 through October 31, 2003.  The terms of the credit facility, and a related agreement among the Company and the guarantors, include provisions that, among other things, restrict the Company’s ability to incur additional secured debt or liens and to sell, lease or transfer assets.  Other provisions of these agreements would require accelerated repayment of the borrowed amounts in certain circumstances, including the issuance of new equity, certain mergers and changes in control, certain sales of assets, and upon certain changes or events relating to the guarantors.  The KCL credit facility does permit the Company to enter into an additional borrowing facility of up to $1.0 million with another lender, subject to KCL’s reasonable consent, and the Company would need to obtain the consent of the guarantors for this additional facility.  The additional facility may be secured by the Company’s accounts receivable and inventory, and KCL would have a subordinated interest in that collateral.   The Company is evaluating possible lenders for this additional secured borrowing and expects to enter into such a facility as part of its Fiscal 2003 financing strategy.

 

The Company believes that the combination of cash and cash equivalents at December 29, 2002, proceeds from the KCL credit facility, and the $1.0 million additional secured borrowing that the Company expects to obtain will be sufficient to fund ongoing operations of the Company through Fiscal 2003.  In order to fund unanticipated operating requirements in excess of the Company’s Fiscal 2003 operating plan and future capital expenditures, the Company would require additional capital.  The Company expects that additional sources of funding will be required

 

8

 

in subsequent periods to meet operating requirements, fund capital expenditures, and fund repayment of debt and other long-term obligations.  The Company has historically funded its capital requirements principally through the issuance of equity and debt securities, through borrowings and lease financing, and through cash provided under its international licensing relationships.  Additional sources of funding are expected to include debt or equity financings, and the Company is currently evaluating alternatives for raising additional capital, but the Company has not identified or obtained specific sources of long-term funding.  The inability of the Company to secure additional capital on reasonable terms, if at all, during the remainder of Fiscal 2003 or subsequent periods could adversely affect our business, operating results and financial condition.

 

If the Company is unable to secure the additional secured borrowing or other sources of capital are unavailable, or are available only on a limited basis or under unsatisfactory terms, then the Company would be required to substantially reduce operating, marketing, general and administrative costs related to its continuing operations, and to reduce or discontinue its investments in store improvements, new customers and new products.  In addition, the Company might be required to sell individual or groups of stores or other assets (such as wholesale territories or international contract interests) and might be unable to take advantage of business opportunities or respond to competitive pressures.  Store sales would involve the assignment or sub-lease of the store location (which may require the lessor’s consent) and the sale of the store equipment, leasehold improvements and related assets.  The Company has previously disposed of only underperforming store locations, but might be required to dispose of its better-performing locations in order to obtain a significant amount of sales proceeds.  The proceeds received from the sale of stores or other assets might not be in amounts or timing satisfactory to the Company, and the sale of better-performing locations or other income-producing assets could adversely affect the Company’s future operating results and cash flows.  The Company’s articles of incorporation provide that its Series A Preferred Stock is senior to the common stock for liquidation preferences, and the Series B Preferred stock is junior to the Series A Preferred Stock and to a stated dollar amount of liquidation preference for the holders of common stock.  If the Company were to sell all or a substantial portion of its assets in order to meet its operating needs and satisfy its obligations or were to be liquidated, the amounts available for distribution to shareholders might be less than the aggregate liquidation preferences of the more senior shareholders, and no amounts might be available for distribution to the more junior shareholders.

 

3.                   Inventories

 

Inventories consist of the following (dollars in thousands):

 

		December 29, 2002			March 31, 2002
		(unaudited)
Coffee
Unroasted coffee		$	1,138		$	531
Roasted coffee		446			657
Other goods held for sale		512			568
Packaging and other		524			502
Total		$	2,620		$	2,258

 

As of December 29, 2002, the Company had approximately $762,000 in fixed–price purchase commitments for green coffee.  Additionally, the Company is negotiating contracts for delivery in Fiscal 2004 expected to total approximately $2,700,000.

 

4.                   Short-term Investments

 

Short-term investments at March 31, 2002 consisted of shares of FOODX GLOBE Co., Ltd. (“FOODX”) (formerly known as Tully’s Coffee Japan) common stock.  During the thirteen-week period ended December 30, 2001, Tully’s sold 540 shares of FOODX stock for net proceeds of $2,709,000 and realized a gain of $2,589,000 on these sales.  During the thirteen-week period ended June 30, 2002 (“First Quarter 2003”), the Company sold 493 shares of FOODX stock for net proceeds of $1,813,000 and a realized gain of $27,000.  During Second Quarter 2003, the Company sold its remaining 5 shares of FOODX common stock for net proceeds of $16,000 and a realized loss of $13,000 (See Notes 7 and 12).

 

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5.                   Goodwill

 

During the Second Quarter 2003, the Company adopted the full provisions of SFAS 142.  SFAS 142 requires that companies perform periodic evaluations of potential impairment of goodwill, with the initial assessment to be completed during the first six months of the year in which SFAS 142 is first applied.  During Second Quarter 2003, Tully’s performed an evaluation of its goodwill, and determined that an impairment of $3,018,000 should be recorded as of April 1, 2002 related to the Company’s Retail division operations in California and Oregon.  As provided in SFAS 142, this impairment charge has been retroactively recorded as the cumulative effect of a change in accounting principle as of the beginning of Fiscal 2003.  The change in carrying amount of goodwill as of April 1, 2002 is as follows (in thousands):

 

 

Under SFAS 142, goodwill is no longer amortized.  In accordance with SFAS 142, the effect of this accounting change is reflected prospectively, and Tully’s ceased amortization of goodwill in Fiscal 2003.  Supplemental comparative disclosure, as if this change had been retroactively applied to the prior year periods, is as follows:

 

		Thirteen-Week Periods Ended						Thirty-nine-Week Periods Ended
		December 29, 2002			December 30, 2001			December 29, 2002			December 30, 2001
		(unaudited)
		(dollars in thousands, except per share data)
Net income (loss):
Reported net income (loss)		$	(1,044	)	$	42		$	(6,959	)	$	(6,398	)
Add back goodwill amortization		—			62			—			185
Adjusted net income (loss)		$	(1,044	)	$	104		$	(6,959	)	$	(6,213	)
Basic and diluted income (loss) per share:
Reported income (loss) per share		$	(0.06	)	$		**	$	(0.43	)	$	(0.39	)
Goodwill amortization		—					**	—			0.01
Adjusted basic and diluted income (loss) per share		$	(0.06	)	$		**	$	(0.43	)	$	(0.38	)

 

**          Amounts are less than $0.01.

 

Amortizable intangible assets at December 29, 2002 totaled $1,038,000 net of accumulated amortization of $414,000.  Amortization expense for the Third Quarter 2003 and thirty-nine week periods ended December 29, 2002, was approximately $30,000 and $83,000, respectively.

 

6.                   Related Party Notes Receivable

 

In May 2002, the Company loaned an aggregate of $100,000 to its newly hired chief executive officer under non-interest bearing notes in accordance with the terms of his employment agreement.  The notes were repaid in full during December 2002 pursuant to an amendment to the employment agreement.

 

7.                   International Licenses and Deferred Licensing Revenue

 

In April 2001, the Company granted Ueshima Coffee Company, LTD (“UCC”) an exclusive, perpetual license to use Tully’s business names, trademarks and other intellectual property rights to develop and operate specialty coffee stores throughout Asia, except for Japan, and received a $12,000,000 license fee.  The Company

 

10

 

has accounted for this payment as deferred licensing revenue and is amortizing this amount into income on a straight-line basis over seven years, the term of the prepaid royalties under the agreement.  Commencing in April 2009, UCC is required to pay the Company a royalty and service fee based upon the aggregate net revenues of the stores that UCC is then operating under the Tully’s business name, and all other sales of products or services made under the Tully’s business names and trademarks in Asia (other than Japan).  Under this agreement, the Company has granted a security interest in certain of its intellectual property rights and certain proceeds related thereto solely as the same relate to stores located in the territories described in the License Agreement.  The $12,000,000 license fee payment was the net payment after applicable Japanese tax withholdings paid by UCC that are subject to refund by Tully’s to UCC in the event Tully’s receives a tax credit for such taxes.

 

The Company has license and supply agreements with FOODX Globe Co. Ltd. (“FOODX”), previously known as Tully’s Coffee Japan.  During August 2002, Tully’s Coffee Japan changed its name as part of a strategy to operate multiple restaurant strategies, including Tully’s Coffee stores in Japan.  Under the license agreement, as amended in Fiscal 2002, FOODX has the right to use the Tully’s trademark, brand name and products in Japan in operating and franchising retail stores and engaging in wholesale coffee sales.  FOODX is required to pay licensing fees to the Company based upon the franchised store revenues.  The supply agreement, as amended during Fiscal 2002, allows FOODX to roast Tully’s coffee in Japan and to purchase other supplies and materials from sources other than the Company, subject to quality and pricing requirements.  FOODX is required to pay a fee to the Company based upon the volume of coffee roasted in Japan.  FOODX commenced coffee roasting in Japan during First Quarter 2003.

 

In consideration, and in connection with the formation of FOODX, the Company received 824 shares of FOODX stock.  On October 1, 2001, the Company received $4,200,000 in cash and 300 additional shares of FOODX common stock (valued at $1,771,000 on that date) in connection with the amendment of its supply agreement with FOODX.  The Company accounted for the October 1, 2001 payment as deferred licensing revenue and is amortizing this amount into income on a straight-line basis over fifteen years, the estimated life of the agreement.

 

In Second Quarter 2003, the Company assigned its intellectual property rights outside of the United States relating to its Spinelli brand, including the trademarks and related goodwill, to Spinelli Pte. Ltd. (“SPL”), the licensee of the Company’s Spinelli brand in Singapore and Taiwan.  Under the agreement, SPL agreed to pay $500,000 to the Company.  The Company received $250,000 from SPL during Second Quarter 2003, and expects to receive the balance of the purchase price in March 2003.  The Company retains certain rights with respect to the use of the Spinelli brand and related intellectual property in the United States and Japan.  The $500,000 purchase price, less approximately $40,000 of costs, was reported as “other income” in Second Quarter 2003.

 

8.                   Line of Credit and Long-term Debt

 

On November 1, 2002, the Company entered into a new credit facility secured by substantially all of the Company’s assets and guaranteed by certain directors and shareholders of the Company).  The lender, KCL, is also lessor of the building that houses the Company’s headquarters, roasting plant and distribution facility, under a ten-year lease which expires in May 2010.  The parties agreed to amend this lease in connection with the establishment of the new credit facility.  When the Company first occupied this facility in Fiscal 2001, the lessor funded $1,000,000 of tenant improvements to the facility, and the lease was amended at that time to reimburse the lessor for the improvement allowance through increased lease payments.  As a result, in Fiscal 2001 the Company recorded this $1,000,000 amount as a deferred lease cost liability, and has been amortizing this liability as rent was paid.  Under the provisions of the new KCL credit facility and the lease amendment, the parties agreed to add the unamortized tenant improvement allowance of $890,037 to the borrowed principal amount under the credit facility and to reduce the monthly rental for the remainder of the lease term by approximately $16,000 per month.  In addition, the amended lease provides that the lessor may, at its option, terminate the lease prior to the expiration of its term by giving the Company 150 days written notice of termination.  Although the lessor has listed the property for sale or lease, the Company is not aware of any current intention by the lessor to terminate the lease and the Company expects to continue its tenancy under the terms of the amended lease.  However, if the lessor were to terminate the lease prior to the expiration of its term, the recoverability of the Company’s leasehold improvements at the facility would be impaired; such leasehold improvements had a net book value of $1,342,000 at December 29, 2002.

 

11

 

Borrowings under the new KCL credit facility bear interest at prime less ½%, and a 3% loan fee is to be paid annually.  This new credit facility allows the Company to borrow up to $2,000,000 through October 31, 2003, in addition to the $890,037 unamortized tenant improvement allowance that was transferred to the credit facility from the lease and which is due on April 29, 2005.  The terms of the new credit facility, and a related agreement among the Company and the guarantors, include provisions that, among other things, restrict the Company’s ability to incur additional secured debt or liens and to sell, lease or transfer assets.  Other provisions of these agreements would require accelerated repayment of the borrowed amounts in certain circumstances, including the issuance of new equity, certain mergers and changes in control, certain sales of assets, and upon certain changes or events relating to the guarantors.

 

In consideration for providing the guaranties, the Company will issue warrants to the guarantors to purchase 30.86 shares of common stock, at an exercise price of $0.05 per share, for each $1,000 of debt guaranteed during a month.  If the Company were to fully borrow to the limit of the guaranties, the Company would issue warrants exercisable for an aggregate of 740,640 shares of common stock annually.  The Company is recognizing these non-cash loan guaranty costs as a financing expense based upon the fair value at the date of grant of the warrants.  In January 2003, the Company issued warrants to purchase 104,924 shares of common stock to the guarantors in consideration for the guaranties during Third Quarter 2003.  The Company also has agreed to indemnify the guarantors in connection with the guaranties and has granted each of them a security interest in substantially all of the Company’s assets (subordinated to the security interest of KCL).

 

9.                   Stockholders’ (Deficit) Equity

 

Options

 

The Company records deferred compensation for the difference between the exercise price for the options and the estimated market price for its common stock at the time of grant as established by the Company’s board of directors, and is amortizing the deferred stock compensation over the three year vesting period of the options.  During Third Quarter 2003, the Company granted no options to purchase shares of common stock to employees.  Third Quarter 2003, deferred stock compensation is summarized as follows:

 

 

Warrants

 

The Company had warrants outstanding to purchase 7,586,047 and 7,825,676 shares of common stock as of December 29, 2002 and December 30, 2001, respectively, at exercise prices ranging from $0.01 to $0.33 per share.  The weighted average exercise price of these warrants is $0.28 per share.

 

10.            Segment Reporting

 

The Company presents segment information in accordance with Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” (“SFAS 131”), which established reporting and disclosure standards for an enterprise’s operating segments. Operating segments are defined as components of an enterprise for which separate financial information is available and regularly reviewed by the Company’s senior management.

 

12

 

During the fourth quarter of Fiscal 2002, the Company realigned into three business units: (1) its Retail division, which includes its domestic store operations, (2) its Wholesale division, which sells to domestic customers in the supermarket, food service, office coffee service, restaurant and institutional channels, and which also handles the Company’s mail order sales, and (3) its International division, which sells products and materials to the Company’s international licensees and manages the international licensing of the Tully’s brand and the related royalty programs.  The previously reported amounts for the thirteen-week period ended December 30, 2001 (“Third Quarter 2002”) and the thirty-nine week period ended December 30, 2001 have been reclassified to reflect this realignment.

 

The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies in Note 1 to the Company’s annual consolidated financial statements in the Fiscal 2002 Form 10-K, as amended.  The tables below present information by operating segment:

 

		Thirteen-Week Periods Ended						Thirty-nine-Week Periods Ended
		December 29, 2002			December 30, 2001			December 29, 2002			December 30, 2001
		(unaudited) (dollars in thousands)
Net sales
Retail division		$	10,283		$	10,544		$	30,605		$	31,839
Wholesale division		1,608			1,371			4,400			3,983
International division		1,146			1,329			3,922			3,433
Total net sales		$	13,037		$	13,244		$	38,927		$	39,255
Operating income/(loss)
Retail division (1)		$	610		$	(169	)	$	1,278		$	(1,138	)
Wholesale division		243			(71		)	648			99
International division		774			740			2,380			1,889
Corporate and other expenses		(2,457		)	(2,915		)	(8,194		)	(8,954		)
Interest and other, net (2)		(213		)	2,457			(30		)	1,708
Income (loss) before income taxes and cumulative effect of change in accounting principle		$	(1,043	)	$	42		$	(3,918	)	$	(6,396	)
Depreciation and amortization
Retail division		$	637		$	831		$	2,141		$	2,478
Wholesale division		36			52			112			214
International division				**			**			**			**
Corporate and other expenses		211			270			738			953
Total depreciation and amortization		$	884		$	1,153		$	2,991		$	3,645

 

**          Amounts are less than $1,000.

 

(1)          For the Third Quarter 2002 and thirty-nine week periods ended December 30, 2001, the Retail division includes $226,000 and $1,085,000, respectively, for costs related to the closure of stores and termination of store leases.

 

(2)          Amounts include gains on sales of FOODX stock of $2,589,000 and $2,532,000 for the Third Quarter 2002 and thirty-nine week periods ended December 30, 2001, respectively, and $14,000 for the thirty-nine week period ended December 29, 2002.

 

11.            Net Loss Per Common Share

 

Basic net loss per share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period.  Diluted net loss per share is computed by dividing net loss by the sum of the

 

13

 

weighted average number of common shares and the effect of dilutive common share equivalents.

 

The Company has granted options and warrants to purchase common stock, and issued preferred stock and debt convertible into common stock.  These instruments may have a dilutive effect on the calculation of earnings or loss per share.  As of December 29, 2002 and December 30, 2001, there were outstanding shares of convertible stock, convertible debt, and options and warrants convertible into or exercisable for an aggregate of 33,069,608 and 31,698,836 shares of common stock, respectively.  All such instruments were excluded from the computation of diluted loss per share for Third Quarter 2003 and the thirty-nine-week periods ending December 29, 2002 and December 30, 2001, because the effect of these instruments on the calculation would have been antidilutive.  The effect of these instruments on the computation of diluted income per share for Third Quarter 2002 was less than one cent per share.

 

12.            Comprehensive Loss

 

Other comprehensive loss consists of the unrealized gains and losses, net of applicable taxes, on available-for-sale securities.

 

		Thirteen-Week Periods Ended						Thirty-nine Week Periods Ended
		December 29, 2002			December 30, 2001			December 29, 2002			December 30, 2001
		(unaudited)
		(dollars in thousands)
Net income (loss)		$	(1,044	)	$	42		$	(6,959	)	$	(6,398	)
Other comprehensive income (loss):
Unrealized holding (losses) gains on available-for-sale securities arising during the period		—			—			124			—
Reclassification adjustment for net losses (gains) realized in earnings		—			—			(14		)	—
		—			—			110			—
Total comprehensive income (loss)		$	(1,044	)	$	42		$	(6,849	)	$	(6,398	)

 

Because of the Company’s net operating losses, no tax expense (benefit) has been allocated to other comprehensive income (loss).

 

14

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Litigation Reform Act of 1995

 

We believe that certain statements herein, including those related to anticipated store openings, planned capital expenditures, and trends in or expectations regarding the Company’s operations, liquidity and capital resources, constitute “forward–looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based on currently available operating, financial and competitive information, and are subject to risks and uncertainties. Actual future results and trends may differ materially depending on a variety of factors, including, but not limited to, coffee and other raw material prices and availability, successful execution of strategies and plans, the impact of competition, general economic conditions, the popularity of specialty coffee due to consumer trends, health factors or other issues, as well as other risk factors as described more fully below in “Factors That May Affect Our Future Results.” The cautionary statements made in this section and elsewhere in this report should be read as being applicable to all related forward-looking statements wherever they appear in this report.

 

The following information should be read in conjunction with the condensed consolidated financial statements and accompanying notes and other financial data included elsewhere in this report, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes included in the Company’s Fiscal 2002 Annual Report on Form 10-K, as amended.  This analysis is provided pursuant to applicable SEC regulations and is not intended to serve as a basis for projections of future events.

 

OVERVIEW

 

Tully’s fiscal year ends on the Sunday closest to March 31. The Company records its sales and expenses on a 52-53 week period.  The fiscal years ending April 1, 2001 (“Fiscal 2001”), March 31, 2002 (“Fiscal 2002”) and March 30, 2003 (“Fiscal 2003”) have 52 weeks.  The fiscal year ending March 29, 2004 (“Fiscal 2004”) will have 52 weeks.  The third quarter in Fiscal 2003 was a thirteen-week period ending December 29, 2002 (“Third Quarter 2003”) and the corresponding period in Fiscal 2002 was a thirteen-week period ending December 30, 2001 (“Third Quarter 2002”).

 

Tully’s derives its net sales from (1) its Retail division, which operates retail stores in Washington, Oregon, California and Idaho, (2) its Wholesale division, which sells Tully’s-branded products to domestic supermarkets, food service distributors, restaurants, institutions, and office coffee services, and through direct mail order sales, and (3) its International division, which sells Tully’s-branded products to its international licensees and receives royalty and licensing fees from those international licensees.  For Third Quarter 2003, Tully’s derived approximately 78.9% of net sales from its Retail division as compared to 79.6% of total net sales for Third Quarter 2002.

 

During Fiscal 2003, the Company will continue to focus primarily on (i) improving the operations of its existing retail stores, including expansion of the merchandise offered in the stores, (ii) expanding its Wholesale division sales and International division licensee opportunities, and (iii) managing its costs more effectively.  In the thirty-nine week period ended December 29, 2002, the Company introduced Tully’s Premium Softened Ice Cream^TM into 63 Tully’s stores.  This product line features premium soft-serve vanilla bean and Tully’s espresso flavor ice cream, and supports an expanded menu including cones, sundaes, cold beverages and other items.  Tully’s also believes that customers will be receptive to improved value, variety and convenience through broader distribution, and it seeks expanded market share through its Wholesale division in the supermarket, food service, and institutional channels.  It is the Company’s belief that expanded product mix and broader distribution will help Tully’s reach prospective customers that do not currently buy the Company’s products, and increase the frequency and size of customer purchases.

 

15

 

Comparable store sales started to decline during the first half of Fiscal 2002 and this continued into Fiscal 2003 (comparable stores are stores open for the full period in both the current and comparative prior year periods).  Management believes that the comparable store sale decrease was caused by (i) the weak economy, exacerbated by consumer uncertainty following the events of September 11, 2001, (ii) competition from other specialty coffee and treat destination retail stores, (iii) customers purchasing Tully’s ground coffee through supermarkets instead of Tully’s retail stores as the result of expanded Tully’s presence in the supermarket segment, (iv) an increased operational emphasis on improving gross profits, rather than sales growth and (v) limited product innovation and marketing during Fiscal 2002 and early 2003.  Although management believes that the weak economy and continuing focus on gross profits are continuing to adversely affect sales, the Company has started to reemphasize product innovation (including the introduction of Tully’s Premium Softened Ice Cream) and consumer-oriented marketing.  Management believes that this new emphasis is beginning to deliver positive trends in comparable store sales as demonstrated by the comparable store sales percentages during the past 21 months set forth in the following graph:

 

 

The Company opened a new store on January 31, 2003, but does not expect any other new stores in Fiscal 2003.  The Company regularly reviews the operating results of its stores, and from time to time will identify stores that do not meet its financial expectations.  Such stores are evaluated for possible closure, downsizing or relocation.  The Company closed one such store in First Quarter 2003, two stores during Second Quarter 2003 and another in Third Quarter 2003, for a fiscal year-to-date total of four as of December 29, 2002.

 

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RESULTS OF OPERATIONS

 

Thirteen-Week Period Ended December 29, 2002 Compared With The Thirteen-Week Period Ended December 30, 2001

 

The following table sets forth, for the periods indicated, selected statement of operations data expressed as a percentage of sales.

 

		Thirteen-Week Periods Ended
		December 29, 2002		December 30, 2001
Net sales		100.0	%	100.0	%
Cost of goods sold and related occupancy expenses		45.9	%	51.1	%
Store operating expenses		32.3	%	33.3	%
Other operating expenses		4.1	%	5.2	%
Marketing, general and administrative costs		17.2	%	18.0	%
Depreciation and amortization		6.8	%	8.7	%
Store closure and lease termination costs			**	1.7	%
Operating loss		(6.4	)%	(18.0	)%
Other income (expense)
Interest expense		(1.5	)%	(1.2	)%
(Loss) gain on sale of investments and assets			**	19.5	%
Interest and other income		0.1	%		**
Loan guarantee fee expense		(0.2	)%		**
Total other income (expense)		(1.6	)%	18.3	%
Income (loss) before income taxes		(8.0	)%	0.3	%
Income taxes			**		**
Net income (loss)		(8.0	)%	0.3	%

 

**                                  Less than 0.1%

 

Net Sales

 

Total net sales for Third Quarter 2003 decreased 1.6% to $13,037,000 from $13,244,000 for the prior year period.  Retail sales decreased 2.5% to $10,283,000 from $10,544,000 due primarily to operating fewer retail stores during Third Quarter 2003.  Comparable store sales increased 0.4% for Third Quarter 2003 compared to the prior year period, reflecting the factors previously described above.  The Company ended the period with 100 Company–operated stores in the United States compared to 107 at December 30, 2001.

 

Wholesale division net sales increased $237,000 or 17.3% to $1,608,000 for Third Quarter 2003 from $1,371,000 for Third Quarter 2002.  The increase was due primarily to increased supermarket and food service sales.  The Wholesale division accounted for 12.3% of net sales for Third Quarter 2003 compared to 10.4% in Third Quarter 2002.

 

Net sales for the International division decreased 13.8% to $1,146,000 for the Third Quarter 2003, compared to $1,329,000 for the prior year period.  The increase in license and royalty revenue of $91,000 was offset by a $274,000 decrease in sales of coffee, equipment and supplies by the Company to FOODX as a consequence of the licensee sourcing more items in Japan.  International division sales accounted for 8.8% of net sales for Third Quarter 2003 compared to 10.0% in Third Quarter 2002.

 

17

 

Cost of Goods Sold and Operating Expenses

 

As a percentage of net sales, cost of goods sold and related occupancy expenses decreased to 45.9% for the Third Quarter 2003 from 51.1% for Third Quarter 2002.  This decrease in cost of goods sold and the corresponding improvement in gross margins were primarily due to (a) changes in the sales mix, including a higher proportion of the sales revenue growth higher-margin International division royalties and licensing fees but less international product sales and (b) lower retail division cost of goods sold and related occupancy expenses to sales from (i) the consolidation of the Company’s vendors and negotiations for improved quality and lower costs, (ii) reduced costs of green coffee from improved buying practices and lower market price levels (iii) improved inventory controls including better management of perishable inventories and supplies, and (iv) the elimination of occupancy costs on under performing stores closed during the previous twelve months.  Cost of goods sold and related occupancy expenses for Third Quarter 2003 decreased 11.5% to $5,990,000 from $6,772,000 for the comparable prior year period.

 

Store operating expenses for the Third Quarter 2003 decreased 4.4% to $4,216,000 from $4,411,000 for the prior year period. This decrease was primarily due to operating seven fewer stores during the entire Third Quarter 2003 than during Third Quarter 2002, partially offset by increased labor and other expenses from operating stores during the Third Quarter 2003.  As a percentage of net sales, store operating expenses decreased to 32.3% for the Third Quarter 2003 compared to 33.3% for Third Quarter 2002.

 

Other operating expenses (expenses associated with all operations other than Company-owned retail stores) decreased to $533,000 for the Third Quarter 2003 from $679,000 for the prior year period.  This was due to decreased costs in the International Division, and decreased labor expenses in the Wholesale Division.

 

Marketing, general and administrative costs and related non-cash stock option compensation expense for the Third Quarter 2003 decreased by 6.0% to $2,244,000 compared to $2,387,000 for the prior year period, reflecting efforts to reduce such costs.  As a percent of sales, marketing, general and administrative costs and related non-cash stock option compensation expense for Third Quarter 2003 decreased to 17.2% compared to 18.0% for the prior year period.

 

Depreciation and amortization for the Third Quarter 2003 was $884,000 compared to $1,153,000 for the prior year period.  This decrease in the current period is due to operating fewer stores during Third Quarter 2003, the reduction in depreciation for stores for which depreciable assets were reduced in Fiscal 2002 under the provisions of SFAS 121, and the effects of adopting SFAS 142, resulting in no goodwill amortization compared to amortization of $62,000 in Third Quarter 2002.

 

There were no significant store closure and lease termination costs during the Third Quarter 2003.  This compares to $226,000 recognized in Third Quarter 2002 when a decision was made to close a group of stores.

 

Other Income and Expense

 

During Third Quarter 2003, the Company commenced borrowing under its new credit line, as described in Note 8 to the Condensed Consolidated Financial Statements.  Interest on this debt and interest on new capital lease obligations established during Fiscal 2003, offset by interest savings from debt repaid in the previous fifteen months, resulted in a $26,000 increase in interest expense for Third Quarter 2003 compared to the same period in the previous year.  Non-cash loan guarantee fees of $29,000 were also incurred in Third Quarter 2003 as a consequence of the new credit line.   During Third Quarter 2002, the Company sold a portion of its FOODX stock and realized gains of $2,589,000 as described in Note 4 to the Condensed Consolidated Financial Statements.  No such sale of stock occurred in Third Quarter 2003.

 

Net Loss

 

As a consequence of the aforementioned improvements in the relative amounts of cost of goods sold, occupancy expense and operating expenses, offset partially by the effects from the decline in sales, the Company’s operating loss decreased by 65.2% to $(830,000) for Third Quarter 2003 as compared to $(2,384,000) in Third Quarter 2002, an improvement of $1,554,000.  The improved operating results were more than offset by the higher interest and loan guarantee costs in Third Quarter 2003 and no realized gains from investment sales in Third Quarter 2003 compared to a gain of $2,589,000 on FOODX stock sold in Third Quarter 2002.  As a result,

 

18

 

that the Company had a net loss of $(1,044,000) for Third Quarter 2003 compared to net income of $42,000 in Third Quarter 2002.  Because of the Company’s net operating losses, no tax benefit has been recognized in either period.

 

Thirty-nine Week Period Ended December 29, 2002 Compared With The Thirty-nine Week Period Ended December 30, 2001

 

The following table sets forth, for the periods indicated, selected statement of operations data expressed as a percentage of sales.

 

		Thirty-nine Week Periods Ended
		December 29, 2002		December 30, 2001
Net sales		100.0	%	100.0	%
Cost of goods sold and related occupancy expense		46.3	%	51.2	%
Store operating expenses		33.2	%	34.2	%
Other operating expenses		3.6	%	3.7	%
Marketing, general and administrative costs		19.2	%	19.7	%
Depreciation and amortization		7.7	%	9.3	%
Store closure and lease termination costs		—		2.8	%
Operating loss		(10.0	)%	(20.9	)%
Other income (expense)
Interest expense		(1.4	)%	(1.7	)%
Gain on sale of investments			**	6.6	%
Interest and other income		1.3	%	0.3	%
Loan guarantee fee expense		(0.1	)%	(0.6	)%
Total other income (expense)		(0.1	)%	4.6	%
Loss before income taxes and cumulative effect of change in accounting principle		(10.1	)%	(16.3	)%
Income taxes			**		**
Cumulative effect of change in accounting principle		(7.8	)%		**
Net loss		(17.9	)%	(16.3	)%

 

**                                  Less than 0.1%

 

Net Sales

 

Total net sales for the thirty-nine week period ended December 29, 2002 decreased 0.8% to $38,927,000 from $39,255,000 for the comparable prior year period.  Retail sales decreased 3.9% to $30,605,000 from $31,839,000 due primarily to operating fewer retail stores during entire thirty-nine week period ended December 29, 2002, and a comparable store sales decrease of 1.2% for the thirty-nine week period ended December 29, 2002 compared to the prior year period resulting from the factors described above.

 

Wholesale division net sales increased $417,000 or 10.5% to $4,400,000 for the thirty-nine week period ended December 29, 2002 from $3,983,000 for the period ended December 30, 2001.  The increase was due primarily to new supermarket and food service accounts, partially offset by declines in office coffee service sales.  Wholesale division sales channel accounted for 11.3% of net sales for thirty-nine week period ended December 29, 2002 compared to 10.1% for the comparable period ended December 30, 2001.

 

Net sales for the International division increased 14.2% to $3,922,000 for the thirty-nine week period ended December 29, 2002, compared to $3,433,000 for the prior year period.  Growth of license royalties from FOODX and roasting fees accounted for $246,000 of the increase.  International licensing fees, on an amortized basis, accounted for another $243,000 of the increase and resulted from the timing of the inception of these agreements in Fiscal 2002.  International division sales accounted for 10.1% of net s ales for the thirty-nine week period ended December 29, 2002 compared to 8.7% for the comparable period ended December 30, 2001.

 

19

 

Cost of Goods Sold and Operating Expenses

 

As a percentage of net sales, cost of goods sold and related occupancy expenses decreased to 46.3% for the thirty-nine week period ended December 29, 2002 from 51.2% for the same period ended December 30, 2001.  This decrease was primarily due to the greater relative sales revenue growth from higher-margin International division royalties and licensing fees as compared to the Wholesale and Retail divisions and the continued results from (i) the consolidation of the Company’s vendors and negotiations for improved quality and lower costs, (ii) reduced costs of green coffee from improved buying practices and lower market price levels and (iii) improved inventory controls including better management of perishable inventories and supplies.  As a result of this improvement in gross margin, and partly due to the reduction in occupancy costs after the closure of under performing stores, costs of goods sold and related occupancy expenses for the thirty-nine week period ended December 29, 2002 decreased 10.3% to $18,034,000 from $20,107,000 for the prior year period.

 

Store operating expenses for the thirty-nine week period ended December 29, 2002 decreased 3.6% to $12,943,000 from $13,420,000 for the prior year period. This decrease was primarily due to operating fewer stores during the thirty-nine week period ended December 29, 2002 compared to the same period ended December 30, 2001, partially offset by increased labor and other expenses from operating stores during the current period (due in part to increased costs associated with the introduction of new products.)  As a percentage of net sales, store operating expenses decreased to 33.2% for the thirty-nine week period ended December 29, 2002 compared to 34.2% for the comparable period ended December 30, 2001.

 

Other operating expenses (expenses associated with all operations other than Company-owned retail stores) decreased to $1,390,000 for the thirty-nine week period ended December 29, 2002 from $1,458,000 for the prior year period.  As a percentage of net sales, other operating expenses remained consistent at 3.6% for the thirty-nine week period ended December 29, 2002 compared to 3.7% for the comparable period ended December 30, 2001.

 

Marketing, general and administrative costs and related non-cash stock option compensation expense for the thirty-nine week period ended December 29, 2002 decreased 3.9% to $7,457,000 from $7,763,000 for the prior year period.  As a percentage of net sales, marketing, general and administrative costs decreased to 19.2% for the thirty-nine week period ended December 29, 2002 compared to 19.7% for the same period ended December 30, 2001, due primarily to the amendment to the terms of the sponsorship agreement and the decrease in non-cash stock option compensation expense.

 

Depreciation and amortization for the thirty-nine week period ended December 29, 2002 was $2,991,000 compared to $3,645,000 for the prior year period.  This decrease in the current period is due to operating fewer stores during the thirty-nine week period ended December 29, 2002, the reduction in depreciation for stores for which depreciable assets were reduced in Fiscal 2002 under the provisions of SFAS 121, and the effects of adopting SFAS 142, resulting in no goodwill amortization compared to amortization of $189,000 in the thirty-nine week period ended December 30, 2001.

 

During the thirty-nine week period ended December 29, 2002, the Company closed four stores, but there were no significant store closure or lease termination costs incurred in Fiscal 2003 related to the closure of these four stores.  During the thirty-nine week period ended December 30, 2001, store closure and lease termination costs of $1,085,000 were recognized as the consequence of a decision to close a group of stores in Fiscal 2002.

 

Other Income and Expense

 

Interest expense under the new KCL credit line and interest under new capital lease obligations established during Fiscal 2003 were less than the interest incurred under other debt that was repaid during Fiscal 2002 so that there was a $118,000 decrease in interest expense for the thirty-nine week period ended December 29, 2002 compared to the same period in the previous year.  Non-cash loan guarantee fees related to the new credit line were less than the guarantee fees associated with the borrowing facilities repaid in Fiscal 2002, so that loan guarantee fee expense declined by $187,000 for the thirty-nine week period ended December 29, 2002 compared to the same period in the previous year.  As the result of the agreement with Spinelli Pte. Ltd (see Note 7 to the Condensed Consolidated Financial Statements), the Company recognized a net gain of $460,000 that is included in other income for the thirty-nine week period ended December 29, 2002 without a comparable gain in the same period of the prior year.

 

20

 

During the thirty-nine week period ended December 29, 2002 the Company sold the remainder of its investment in FOODX stock and realized a gain of $14,000 compared to the $2,589,000 gain from such investment sales during the thirty-nine week period ended December 30, 2001 (see Note 4 to the Condensed Consolidated Financial Statements).

 

Cumulative Effect of Change in Accounting Principle

 

During the thirty-nine week period ended December 29, 2002, the Company adopted the full provisions of SFAS 142.  During Second Quarter 2003, Tully’s performed an evaluation of its goodwill as of April 1, 2002, and determined that an impairment charge of $3,018,000 should be recorded related to the Company’s Retail division operations in California and Oregon.  As provided in SFAS 142, this impairment charge has been retroactively recorded as the cumulative effect of a change in accounting principle as of the beginning of Fiscal 2003, and therefore is included in the results for the fiscal year to date.  See Note 5 to the Condensed Consolidated Financial Statements.

 

Net Loss

 

As a consequence of the aforementioned improvements in the relative amounts of cost of goods sold, occupancy expense and operating expenses and the decrease in store closure and lease termination costs, offset partially by the effects from the decline in sales, the Company’s operating loss decreased by 53% to $(3,888,000) for the thirty-nine week period ended December 29, 2002 as compared to $(8,223,000) in the thirty-nine week period ended December 30, 2001, which represents an improvement of $4,335,000.

 

This improvement in operating loss, lower interest expense and loan guarantee costs, and the gain from the Spinelli Pte. Ltd transaction, were more than offset by the $2,575,000 reduction in the realized gain from sales of FOODX stock for the thirty-nine week period ended December 29, 2002 compared to the prior year period and the $3,018,000 non-cash impairment charge for the cumulative effect of a change in accounting for goodwill under SFAS 142 recognized in the thirty-nine week period ended December 29, 2002.  As a result, the Company had a net loss of $(6,959,000) for the thirty-nine week period ended December 29, 2002 compared to a net loss of $(6,398,000) for the thirty-nine week period ended December 30, 2001.  Because of the Company’s net operating losses, no tax benefit has been recognized in either period.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The Company ended the period at December 29, 2002 with $208,000 in cash and cash equivalents. Working capital deficit increased at December 29, 2002 to $3,684,000 as compared to a working capital deficit of $269,000 at March 31, 2002.  Cash and cash equivalents decreased by $1,476,000 during the thirty-nine week period ended December 29, 2002.  Because the company principally operates as a “cash business” it generally does not require a significant investment in working capital.   Further, Company management has placed increased emphasis on management of the Company’s investment in inventory and accounts receivables.  As a result, the Company typically has operated with current liabilities in excess of its current assets (excluding cash and cash equivalents).  Tully’s expects that its investment in accounts receivable will grow in proportion to sales growth in its Wholesale and International divisions, and inventory levels typically increase during the spring due to coffee crop seasonality and to a lesser degree during the autumn due to holiday seasonal merchandise.  Operation with minimal or deficit working capital has reduced the Company’s historical requirements for capital, but provides the Company with less immediately available resources to deal with its short-term needs and unanticipated business developments, and increases the Company’s dependence upon ongoing financing activities.

 

Cash used in operating activities for the thirty-nine week period ended December 29, 2002 was $3,258,000 compared to $7,351,000 cash provided by operating activities in the thirty-nine week period ended December 30, 2001 (which included $16,200,000 cash provided by its international licensees as described in Note 7 to the Condensed Consolidated Financial Statements).  The Company’s cash used in operating activities during the thirty-nine week period ended December 29, 2002 includes seasonal inventory increases of $363,000 and an increase in accounts receivable balances of $603,000 (including $250,000 from the Spinelli agreement; see Note 7 to the Condensed Consolidated Financial Statements).

 

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Cash provided by investing activities for the thirty-nine week period ended December 29, 2002 totaled $1,127,000.  This includes net cash proceeds of approximately $1,829,000 from the sale of the Company’s remaining shares of stock of its Japanese licensee, and were partially offset by cash capital expenditures of $702,000 for property and equipment during the thirty-nine week period ended December 29, 2002.

 

Cash provided by financing activities for the thirty-nine week period ended December 29, 2002 totaled $655,000.  These activities included repayment of $625,000 on long-term debt and capital leases.  These repayments were offset by net borrowings of $1,272,000 under the new credit facility, and $8,000 received from the exercise of stock options and warrants.

 

The Company has fixed-price purchase commitments with certain of its vendors to maintain the supply of green coffee and stabilize its costs of goods sold.  As of December 29, 2002, the Company had fixed price inventory purchase commitments for green coffee remaining for delivery in Fiscal 2003 totaling approximately $762,000, and was negotiating contracts for delivery in Fiscal 2004 expected to total approximately $2,700,000.  The Company believes that the risk of non-delivery on these purchase commitments is low.

 

The Company has sponsorship agreements with the San Francisco Giants for PacBell Stadium in San Francisco and the Seattle Mariners involving Safeco Field in Seattle that provide for certain advertising and marketing rights in exchange for annual fees.  The Safeco Field agreement expires December 31, 2003 and provides for fees of approximately $505,000 in Fiscal 2003 and $520,000 in Fiscal 2004 (with additional charges for any tickets, food service and other incidentals provided to Tully’s).  The PacBell Stadium agreement was to expire on October 31, 2002 and provided for fees of $950,000 for Fiscal 2003.  During August 2002, the parties extended the term of the agreement through October 31, 2003 with an aggregate fee of $1,100,000 for the two years ($825,000 payable in Fiscal 2003 and $275,000 payable in Fiscal 2004), and with a reduced level of marketing benefits during Fiscal 2004.  Based upon the provisions of the amended PacBell Stadium agreement, the charge to expense will be $675,000 for Fiscal 2003 and $425,000 for Fiscal 2004.

 

Cash requirements for the remainder of Fiscal 2003, other than normal operating expenses and the commitments described above, are expected to consist primarily of capital expenditures for fixtures and equipment related to the introduction of new products into Tully’s stores, equipment and accounts receivable related to sales growth of the Wholesale division, roasting plant equipment, limited remodeling of current stores, and the development of one new store that opened January 31, 2003.  Management expects total Fiscal 2003 capital expenditures will be approximately $1,100,000 in addition to approximately $1,200,000 of roasting plant and store fixtures and equipment that are expected to be provided through operating or capital leases.  During the thirty-nine week period ended December 29, 2002, the Company has entered into capital leases totaling approximately $723,000 for equipment related to the introduction of Tully’s Premium Softened Ice Cream.

 

On November 1, 2002, the Company entered into a new credit facility with the lessor of the facility that houses the Company’s headquarters, roasting plant and distribution facility, Kent Central LLC (“KCL”), which is secured by substantially all of the Company’s assets and guaranteed by certain directors and stockholders of the Company.  See Note 8 to the Condensed Consolidated Financial Statements.  The KCL credit facility allows the Company to borrow up to $2,000,000 through October 31, 2003.  The terms of the credit facility, and a related agreement among the Company and the guarantors, include provisions that, among other things, restrict the Company’s ability to incur additional secured debt or liens and to sell, lease or transfer assets.  Other provisions of these agreements would require accelerated repayment of the borrowed amounts in certain circumstances, including the issuance of new equity, certain mergers and changes in control, certain sales of assets, and upon certain changes or events relating to the guarantors.  The KCL credit facility does permit the Company to enter into an additional borrowing facility of up to $1.0 million with another lender, subject to KCL’s reasonable consent, and the Company would need to obtain the consent of the guarantors for this additional facility.  The additional facility may be secured by the Company’s accounts receivable and inventory, and KCL would have a subordinated interest in that collateral.   The Company is evaluating possible lenders for this additional secured borrowing and expects to enter into such a facility as part of its Fiscal 2003 financing strategy.

 

The Company believes that the combination of cash and cash equivalents at December 29, 2002, proceeds from the KCL credit facility, and the $1.0 million additional secured borrowing that the Company expects to obtain will be sufficient to fund ongoing operations of the Company through Fiscal 2003.  In order to fund unanticipated

 

22

 

operating requirements in excess of the Company’s Fiscal 2003 operating plan and future capital expenditures, the Company would require additional capital.  The Company has historically funded its capital requirements principally through the issuance of equity and debt securities, through borrowings and lease financing, and through cash provided under its international licensing relationships.  The Company expects that additional sources of funding will be required for years beyond Fiscal 2003, in order to meet its operating requirements, fund its capital expenditures, and fund its payment of debt and other long-term obligations.  The inability of the Company to secure additional capital on reasonable terms, if at all, during Fiscal 2003 and subsequent years could adversely affect our business, operating results and financial condition.  Additional sources of funding are expected to include debt or equity financings, and the Company is currently evaluating alternatives for raising additional capital, but the Company has not identified or obtained specific sources of long-term funding.

 

If the Company is unable to secure the additional secured borrowing or other sources of capital are unavailable, or are available only on a limited basis or under unsatisfactory terms, then the Company would be required to substantially reduce operating, marketing, general and administrative costs related to its continuing operations, and to reduce or discontinue its investments in store improvements, new customers and new products.  In addition, the Company might be required to sell individual or groups of stores or other assets (such as wholesale territories or international contract interests) and might be unable to take advantage of business opportunities or respond to competitive pressures.  Store sales would involve the assignment or sub-lease of the store location (which may require the lessor’s consent) and the sale of the store equipment, leasehold improvements and related assets.  The Company has previously disposed of only underperforming store locations, but might be required to dispose of its better-performing locations in order to obtain a significant amount of sales proceeds.  The proceeds received from the sale of stores or other assets might not be in amounts or timing satisfactory to the Company, and the sale of better-performing locations or other income-producing assets could adversely affect the Company’s future operating results and cash flows.  The Company’s articles of incorporation provide that its Series A Preferred Stock is senior to the common stock for liquidation preferences, and the Series B Preferred stock is junior to both the Series A Preferred Stock and a stated dollar amount of liquidation preference for the holders of common stock.  If the Company were to sell all or a substantial portion of its assets in order to meet its operating needs and satisfy its obligations or were to be liquidated, the amounts available for distribution to shareholders might be less than the aggregate liquidation preferences of the more senior shareholders, and no amounts might be available for distribution to the more junior shareholders.

 

SEASONALITY

 

Tully’s business is subject to seasonal fluctuations. Significant portions of Tully’s net sales and profits are realized during the third quarter of its fiscal year. This period includes the Thanksgiving through New Year’s holiday season. In addition, quarterly results are affected by the timing of the opening of new stores or the closing of stores.  Growth in one or more divisions may obscure the impact of other seasonal influences. Conversely, seasonal fluctuations may obscure growth or declines in one or more divisions.  Because of the these business factors, the Company’s results for any quarter are not necessarily indicative of the results that may be achieved for another quarter or for the full fiscal year.

 

RECENTLY ISSUED ACCOUNTING STANDARDS

 

Recently issued accounting standards are described in Note 1 to the Condensed Consolidated Financial Statements.

 

FACTORS THAT MAY AFFECT OUR FUTURE RESULTS

 

The following factors may affect our future results and financial condition and should be considered in evaluating our business, operations and prospects.

 

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Company Risks

 

Our history of losses may continue in the future and this could have an adverse affect on our ability to grow.

 

To date, we have not made a profit from operations.  We expect to continue to incur losses in Fiscal 2003 and cannot assure you that we will ever become or remain profitable.

 

Rapid growth in some of our divisions may make it difficult to effectively allocate our resources and manage our business.

 

During Fiscal 2000 and 2001, the Company greatly expanded its retail store base, which placed strain on our management, production, financial and other resources.  In Fiscal 2001 and 2002, both the Wholesale and International divisions grew substantially.  Tully’s expects to continue to grow its Wholesale and International divisions in Fiscal 2003 and beyond. Although Retail division operations will focus primarily on improving operating results in existing stores in Fiscal 2003 rather than opening new stores, we expect to open or acquire new stores in future years.  We cannot assure you that we will be able to manage any future growth effectively.  Continued growth could further strain our management, production, information systems, financial and other resources.  To manage our growth effectively, we must:

 

•                    improve the sales and productivity of the average retail store and lower the average capital investment required to establish a new store,

 

•                    evolve the retail concept to be more differentiated from our competition, without losing the key elements of the Tully’s specialty coffee concept,

 

•                    provide consumer-focused initiatives to improve the movement of our products through the food service and supermarket sectors,

 

•                    efficiently increase the volume of product that we roast, package, and distribute while maintaining high levels of quality,

 

•                    continue to enhance our operational, financial and management systems, and

 

•                    successfully attract, train, manage and retain our employees.

 

Any failure to manage our growth effectively could have an adverse effect on our business, financial condition and results of operations.

 

Our operating flexibility and ability to raise additional capital is restricted by our new credit facility.  If we were to default under the facility, the lender, the guarantors, or both would have a right to seize our assets.

 

On November 1, 2002, the Company entered into a new credit facility.  See Note 8 to the Condensed Consolidated Financial Statements.  The terms of the new credit facility, and a related agreement among the Company and certain directors and shareholders who are guarantors of the debt, include provisions that, among other things, restrict the Company’s ability to incur additional secured debt or liens and to sell, lease or transfer assets.  These agreements also provide the lender and the guarantors with a security interest in substantially all of the Company’s assets.  Other provisions of these agreements would require accelerated repayment of the borrowed amounts in certain circumstances, including the issuance of new equity, certain mergers and changes in control, certain sales of assets, and upon certain changes or events relating to the guarantors.  These provisions could limit the Company’s ability to raise additional capital when needed, and a default by the Company under these agreements could result in the lender or guarantors taking actions that might be detrimental to the interests of other creditors and investors in the Company.

 

We may not be able to obtain additional capital when needed.

 

To date, we have not generated sufficient cash to fully fund operations and typically operate with minimal or deficit working capital.  We historically have financed this cash shortfall through the issuance of debt and equity securities, through borrowings, and through cash provided under our international licensing relationships.  We will

 

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need to raise additional capital in the near future to fund operations and planned growth.  Any equity or debt financing may not be available on favorable terms, if at all.  Such a financing might provide lenders with a security interest in Company assets or other liens that could be senior in position to current investors and creditors.  If financing is unavailable to us or is available only on a limited basis, we may be unable to take advantage of business opportunities or respond to competitive pressures, which could have an adverse effect on our business, operating results and financial condition.  In such event, the Company would need to modify or discontinue its growth plans and its investments in store improvements, new customers and new products, and substantially reduce operating, marketing, general and administrative costs related to its continuing operations, and might be required to sell stores or other assets (such as wholesale territories or international contract interests).  Store sales would involve the assignment or sub-lease of the store location (which may require the lessor’s consent) and the sale of the store equipment, leasehold improvements and related assets.  The Company has previously disposed of only underperforming store locations, but might be required to dispose of its better-performing locations in order to obtain a significant amount of sales proceeds.  The proceeds received from the sale of stores or other assets might not be in amounts or timing satisfactory to the Company, and the sale of better-performing locations or other income-producing assets could adversely affect the Company’s future operating results and cash flows.  The Company’s articles of incorporation provide that its Series A Preferred Stock is senior to the common stock for liquidation preferences, and the Series B Preferred stock is junior to both the Series A Preferred Stock and a stated dollar amount of liquidation preference for the holders of common stock.  If the Company were to sell all or a substantial portion of its assets in order to meet its operating needs and satisfy its obligations or were to be liquidated, the amounts available for distribution to shareholders might be less than the aggregate liquidation preferences of the more senior shareholders, and no amounts might be available for distribution to the more junior shareholders.

 

New senior management has only recently joined the Company

 

In February 2002, Tully’s hired a new CFO and in May 2002 the new CEO joined the Company.  These new executives may implement changes in Company strategies. Further, even if they pursue our existing strategies, their unfamiliarity with the Company could cause delays in implementing our strategies, which could cause our business and results of operations to suffer.

 

Our international licensees may not be successful in their operations and growth.

 

The Company has significant relationships with its licensees in Asia, FOODX and Ueshima Coffee Company.  If these licensees experience business difficulties or modify their business strategies, Tully’s results of operations could suffer.  During August 2002, FOODX changed its name from Tully’s Coffee Japan as part of a strategy to enable FOODX to operate multiple restaurant strategies, including Tully’s Coffee stores.  If this strategy results in a reduced allocation of FOODX resources or its management toward the Tully’s Coffee portion of the FOODX business, this might cause Tully’s results of operations to suffer.  Because these licensees are located outside of the United States, the factors that contribute to their success may be different than those affecting companies in the United States.  This makes it more difficult for the Company to predict the prospects for continued growth in its revenues and profits from these relationships.

 

If we are unable to successfully integrate business acquisitions, our business could be negatively impacted.

 

Integrating newly–acquired businesses is expensive and time-consuming.  Due to capital limitations, Tully’s has not yet fully conformed all of the Coffee Station and Marsee Baking stores (acquired in Fiscal 2001) to the Tully’s standards.  Failure to integrate the Coffee Station and Marsee Baking stores to the Tully’s Coffee retail concept may negatively impact the profitability of these stores and adversely impact Tully’s ability to compete in the Los Angeles and Portland markets.  We may consider future strategic acquisitions as part of our growth strategy.  If we do not manage future integration efforts successfully, our business and results of operations could suffer.

 

One supplier presently provides our entire new ice cream product base.

 

In Fiscal 2003 we have introduced Tully’s Premium Softened Ice Cream into 63 Tully’s stores.  A single supplier presently manufactures the ice cream product base for Tully’s.  If that supplier is unable to provide product to meet the requirements of the Company, or if the relationship between Tully’s and this supplier is otherwise interrupted, Tully’s may experience interruptions in the availability of this product and our results of operations could suffer.

 

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We have limited supplier choices providing our bakery category products.

 

We use local bakeries to supply our stores with a multitude of bakery items.  Most of these bakeries are independently owned with limited capital resources to fund growth.  If one (or more) of these suppliers is unable to provide high quality products to meet the requirements of the Company, or if the relationship between Tully’s and the supplier(s) is otherwise interrupted, Tully’s may experience interruptions in the product availability and our results of operations could suffer.

 

If we are required to relocate our offices and roasting plant, our business could be negatively impacted.

 

The Company and the lessor for the Company’s roasting plant and warehouse and administrative and executive office facility have agreed that the lessor may, at its option, terminate the lease upon 150 days notice, and the Company would be required to relocate its operations.  The lessor has listed the property for sale or lease.  If we were required to relocate, we might experience an interruption to our business, or incur extra costs related to the relocation or to the replacement facility.  In the event of such an early lease termination, the recoverability of the Company’s leasehold improvements at the facility would be impaired; such leasehold improvements had a net book value of $1,342,000 at December 29, 2002.

 

Our two largest stockholders have significant influence over matters subject to stockholder vote and may support corporate actions that conflict with other stockholders’ interests.

 

As of December 29, 2002, Mr. Tom T. O’Keefe, our founder and chairman, beneficially owned approximately 32% of our common stock and the Estate of Mr. Keith McCaw, a former director, beneficially owned approximately 23% of our common stock.  This ownership position gives Mr. O’Keefe and Mr. McCaw’s estate individually, and on a combined basis if acting in unison, the ability to significantly influence the election of our directors and other matters brought before the stockholders for a vote, including any potential sale or merger of our Company.  This voting power could prevent or significantly delay another company from acquiring or merging with us, even if the acquisition or merger was in the best interests of our stockholders.

 

Industry Risks

 

We cannot be certain that the specialty coffee industry will be accepted in new markets. Failure to achieve market acceptance will adversely affect our revenues.

 

Although the specialty coffee industry has gained substantial market acceptance throughout the United States over the last several years through the operation of a variety of specialty coffee shops, there is a risk that our brand or products may not be accepted in new markets. Consumer tastes and brand loyalties vary from one location or region of the country to another. Consumers in areas other than the Pacific Northwest, San Francisco, Los Angeles and Japanese markets may not embrace specialty coffee or the Tully’s brand if Tully’s were to expand its domestic or international operations into new geographic areas.

 

We cannot be certain that expanded product variety will be accepted in current or new markets. Failure to achieve market acceptance for new product offerings will adversely affect our revenues.

 

Tully’s retail store operations, and to a lesser extent, its Wholesale and International divisions, sell various foodstuffs and products other than coffee and coffee beverages.  The Company believes that growth of these complementary product categories is important to the growth of the Company’s revenues from existing stores, and for growth in total net revenues and profits.  Customers may not embrace these complementary product offerings, or may substitute them for products currently purchased from Tully’s.

 

We compete with a number of companies for customers. The success of these companies could have an adverse effect us.

 

Our Retail store division and our Wholesale division operate in highly competitive markets in the Pacific Northwest, San Francisco and Los Angeles.  Our specialty coffees compete directly against all restaurant and beverage outlets that serve coffee and the large number of independent espresso stands, carts and stores.

 

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Companies that compete directly with us in the retail and wholesale channels include, among others, Starbucks Corporation, Coffee Bean and Tea Leaf, Diedrich Coffee, Inc., Peet’s Coffee and Tea, Kraft Foods, Inc., The Proctor & Gamble Company, Nestle, Inc., and Seattle’s Best Coffee.  Some of these companies compete with our International division and we also face competition from companies local to those international markets that may better understand those markets, or be better established in those markets.  We must spend significant resources to differentiate our product from the products offered by these companies, but our competitors still may be successful in attracting our Retail, Wholesale and International customers.  Our failure to compete successfully against current or future competitors would have an adverse effect on our business, including loss of customers, declining revenues and loss of market share.

 

Our whole bean coffee sales must compete with supermarkets and warehouse clubs, and with other companies selling through those channels.

 

Supermarkets and warehouse clubs pose both an opportunity and a competitive challenge in the whole bean coffee market.  A number of global coffee suppliers, such as Starbucks Corporation, Kraft Foods, Inc., The Procter & Gamble Company, and Nestle Inc., distribute premium coffee products in supermarkets and warehouse clubs that may serve as substitutes for our whole bean coffees, and compete with the Tully’s whole bean and ground coffees sold in our stores and through our supermarket customers.

 

Changes in economic climates could adversely affect our revenues.

 

Our business is not diversified. Our revenues are derived predominantly from the sale of coffee, coffee beverages, baked goods and pastries and coffee–related accessories and equipment.  Given that many of these items are discretionary items in our customers’ budgets, our business depends upon a healthy economic climate for the coffee industry as well as the economy generally.  The Company believes that the weak economy during Fiscal 2002 and Fiscal 2003 has adversely impacted its revenues.  If the economic climate does not improve, or if it worsens, there could be further adverse impact on the Company’s revenues.

 

Competition for store locations and qualified workers could adversely affect our growth plans.

 

We face intense competition from both restaurants and other specialty retailers for suitable sites for new stores and for qualified personnel to operate both new and existing stores.  We may not be able to continue to secure adequate sites at acceptable rent levels or attract a sufficient number of qualified workers.  These factors could impact our plans for expansion and our ability to operate existing stores.  Similar factors could impact our Wholesale customers and our International customers, limiting the amount of products they need from us and adversely impacting our plans to grow revenues from those customers.

 

A shortage in the supply or an increase in price of coffee beans could adversely affect our revenues.

 

Our future success depends to a large extent upon the availability of premium quality unroasted, or green, coffee beans at reasonable prices.  The world coffee bean market is largely a commodity market, although purchases of premium Arabica coffee beans are typically negotiated on a per sale basis with growers.  Natural or political events, or disruption of shipping and port channels could interrupt the supply of these premium beans, or impact the cost.  In addition, green coffee bean prices have been affected in the past, and could be affected in the future, by the actions of organizations such as the International Coffee Organization and the Association of Coffee Producing Countries, which have attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee supplies worldwide.  Price increases for whole bean coffee result in increases in the costs of coffee beverages served in our stores. These cost increases may force us to increase the retail and wholesale prices for our coffee products, which could adversely affect our revenues.

 

Investment Risks

 

We may need additional capital, which if raised, could dilute your interest in our Company.

 

If we raise additional funds through the issuance of equity, convertible debt or other securities, current stockholders may experience dilution and the securities issued to the new investors may have rights or preferences senior to those of common stock.

 

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In addition, prior to October 1999, holders of our capital stock were entitled to preemptive rights pursuant to our Articles of Incorporation and the Washington Business Corporation Act.  As a result, some of our shareholders may be entitled to purchase shares of our common stock and Series A preferred stock at the respective purchase prices at which they were originally offered.  At some time the Company may be required to either satisfy these preemptive rights (through the sale of shares to these shareholders in exchange for the applicable cash consideration) or seek waivers of these preemptive rights from such shareholders, but it has not yet undertaken any efforts to do so.  The Company estimates the maximum number of shares that may be issuable upon exercise of preemptive rights to which certain shareholders may be entitled is be as follows:

 

 

The willingness of shareholders who may have a right to purchase additional shares to either purchase additional shares or waive such rights would depend upon a number of factors including the difference between the value of the Company’s shares at that time and the purchase price applicable to such shares.  Any additional issuances of our capital stock pursuant to the exercise of a shareholder’s preemptive rights could further dilute other existing shareholders.

 

The lack of a public market for Tully’s capital stock and restrictions on transfer substantially limit the liquidity of an investment in our capital stock.

 

There is currently no public market for our common stock or our preferred stock, and consequently liquidity of an investment in our capital stock currently is limited.  Whether Tully’s would ever “go public” and if so the timing and particulars of such a transaction, will be determined by our evaluation of the market conditions, strategic opportunities and other important factors at the time, based on the judgment of our management, board of directors and professional advisors.  Therefore, there can be no assurance that such a public market will ever become available for our common or preferred stock.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company is exposed to market risk related to changes in available-for sale security prices and foreign currency exchange rates on foreign investments.

 

The Company historically has had no foreign currency exchange rate exposure related to its international licensing arrangements with FOODX and UCC because all sales of merchandise and supplies have been denominated in U.S. dollars.  However, its licensing agreements provide for royalties on licensee sales that are denominated in foreign currencies.  Although the agreements provide for the payments to be made relatively soon after the sales occur, Tully’s is subject to foreign currency risk on these sales royalties and anticipates that this risk will increase as these royalties grow in the future.  At the present time, the Company does not hedge foreign currency risk, but may hedge known transaction exposure in the future.

 

The supply and price of green coffee beans are subject to significant volatility and can be affected by multiple factors in producing countries, including weather, political and economic conditions. In addition, green coffee bean prices have been affected in the past, any may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee bean supplies worldwide. In order to limit the cost exposure of green coffee beans, the main commodity used in the Company’s business, the Company

 

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enters into U.S. dollar-denominated fixed-price purchase commitments. This allows the Company to secure an adequate supply of quality green coffee beans and fix its cost of green coffee beans. As of December 29, 2002, the Company had fixed price inventory purchase commitments for green coffee totaling approximately $762,000, and was negotiating contracts for delivery in Fiscal 2004 expected to total approximately $2,700,000. The Company believes, based on relationships established with its suppliers, that the risk of loss on nondelivery on such purchase commitments is low. Such commitments are short-term in nature.

 

Under the new KCL credit facility described in Note 8 to the Condensed Consolidated Financial Statements, the Company borrows at an interest rate that is based upon the prime borrowing rate.  From time to time, the Company has other transactions and agreements that include provisions for interest at a variable rate.  Accordingly, the Company expects to be subject to fluctuating interest rates in the normal course of business during Fiscal 2003 and subsequent periods.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

We have established and maintain disclosure controls and procedures and conclude these controls and procedures are effective based upon our evaluation as of a date within ninety days prior to the filing date of this Form 10-Q Quarterly Report.  It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.  There were no significant changes in our internal controls or in other factors that could significantly affect our internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

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PART II. OTHER INFORMATION

 

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

 

(a)          Our 2002 Annual Meeting of Shareholders was held on December 19, 2002.

 

(b)         Shareholders elected, by a plurality of the votes cast, seven members to the Board of Directors to serve until the next Annual Meeting of the Shareholders or until their respective successors shall be elected and qualify.  The members elected (all of whom were already serving as the directors of Tully’s) and the votes for and withheld were as follows:

 

		FOR		WITHHELD
Arthur Buerk		20,714,646		180,391
Larry A. Culver		20,723,646		171,391
Marc Evanger		20,747,146		147,891
Tony Gioia		20,748,246		146,791
Lawrence L Hood		20,702,446		192,591
George Hubman		20,747,246		147,791
Tom T. O’Keefe		20,614,920		280,117

 

(c)          Shareholders ratified the selection of the auditors, PricewaterhouseCoopers LLP:

 

		VOTE
For		19,245,593
Against		113,610
Abstain		153,270

 

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ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

(a)  Exhibits

 

(a)                                  The exhibits listed below are filed as part of this Quarterly Report on Form 10-Q.

 

10.1		Promissory Note in favor of Kent Central, LLC, dated November 1, 2002 (1)
10.2		General Security Agreement dated November 1, 2002 between Tully’s Coffee Corporation and Kent Central, LLC (1)
10.3		Form of Guarantee for Guarantors under the Promissory Note and General Security Agreement dated November 1, 2002 (1)
10.4		Agreement dated November 1, 2002 between Tully’s Coffee Corporation and Guarantors re Kent Central Financing (1)
10.5		Fifth Lease Amendment between Kent Central, LLC and Tully’s Coffee Corporation (1)
10.6*		Amendment to Employment Agreement between Anthony J. Gioia and Tully’s Coffee Corporation, dated May 13, 2002.
99.1*		Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002
99.2*		Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002

 

*                                                                                         Filed herewith

 

(1)                                  Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 29, 2002, as filed with the Commission on November 13, 2002.

 

(b)  Current Reports on Form 8-K

 

Form 8-K, dated October 24, 2002 – Item 9 – Regulation FD Disclosure.  The Company issued a letter to its stockholders that provided an update on recent business activities.

 

Form 8-K, dated December 19, 2002 – Item 9 - Regulation FD Disclosure.  The Company released comparable store sales for the quarter to date period through December 15, 2002 at its annual shareholders meeting.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized, in Seattle, Washington on February 12, 2003.

 

	TULLY’S COFFEE CORPORATION
	By:	/s/ KRISTOPHER S. GALVIN
		Kristopher S. Galvin
		CHIEF FINANCIAL OFFICER
		Signing on behalf of the Registrant and as principal financial officer

 

CERTIFICATIONS PURSUANT TO18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 APPEAR ON THE FOLLOWING TWO PAGES

 

32

 

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

 

CERTIFICATIONS

 

I, Anthony J. Gioia, certify that:

 

1.                                     I have reviewed this quarterly report on Form 10-Q of Tully’s Coffee Corporation;

 

2.                                     Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

 

3.                                     Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

 

4.                                     The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

 

b)                                   evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c)                                    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

 

5.                                     The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

 

a)                                    all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

 

b)                                   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

 

6.                                     The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

Date:  February 12, 2003

 

/s/  Anthony J. Gioia
Anthony J. Gioia
President and Chief Executive Officer

 

33

 

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

 

CERTIFICATIONS

 

I, Kristopher S. Galvin, certify that:

 

1.                                     I have reviewed this quarterly report on Form 10-Q of Tully’s Coffee Corporation;

 

2.                                     Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

 

3.                                     Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

 

4.                                     The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

 

b)                                   evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c)                                    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

 

5.                                     The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

 

a)                                    all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

 

b)                                     any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

 

6.                                     The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

Date:  February 12, 2003

 

/s/ Kristopher S. Galvin
Kristopher S. Galvin
Chief Financial and Accounting Officer

 

34