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SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

Commission File Number 0-27008

203 Colorado Street, Suite 600, Austin, Texas 78701

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ          

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

      The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2003, was approximately $13,092,600, based upon the last sales price on June 30, 2003 on the NASDAQ National Market System for the Company’s common stock. Registrant had 7,338,661 shares of Common Stock outstanding on March 26, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

      None.

Index to Form 10-K

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PART I

INTRODUCTION

      Schlotzsky’s, Inc., through its wholly-owned subsidiaries, is a franchisor and operator of restaurants in the fast casual sector under the Schlotzsky’s® brand. Schlotzsky’s® restaurants offer a menu of distinctive, high quality foods featuring our proprietary breads, complemented by excellent customer service in a visually appealing setting. Our current menu includes upscale made-to-order hot sandwiches and pizzas served on our proprietary buns and crusts, wraps, chips, salads, soups, fresh baked cookies and other desserts, and beverages. At December 31, 2003, the system included 524 franchised restaurants and 37 Company-operated restaurants located in 37 states, the District of Columbia and six foreign countries.

      Our executive offices are located at 203 Colorado Street, Suite 600, Austin, Texas 78701, our telephone number is (512) 236-3800, and our website is www.schlotzskys.com. Our filings with the Securities and Exchange Commission and our Annual Reports to Shareholders are available on our website but are not incorporated into this Annual Report on Form 10-K.

      We generated revenues of approximately $56.2 million for 2003 through two business segments:

	1. Franchise Operations. Our Franchise Operations segment is a key source of revenues through royalties we collect from our franchisees for the use of our trademarks and operating systems and license fees we receive from manufacturers and supply chain managers of Schlotzsky’s brand products. This segment encompasses franchising of restaurants, assisting franchisees and licensing the manufacture of Schlotzsky’s brand products. Several brand products, including chips, cheeses and meats, are available for retail sale in grocery and other retail stores.
	2. Restaurant Operations. Our Restaurant Operations segment includes 15 restaurants in our long-term portfolio that we intend to operate for the purposes of leadership of the franchise system and, in certain cases, to stimulate the redevelopment of certain markets. These stores also are used to demonstrate sales potential and key operating metrics, to build brand awareness, and to serve as laboratories for product development, concept refinement, product and process testing, and training. We also operate 22 restaurants that were developed for or acquired from franchisees and are being operated until they are re-franchised or otherwise divested, or until their current leases expire. Beginning in late 2003, we designated four of the 37 restaurants as training restaurants where franchisees can learn or refine their operating techniques.

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

      During the second quarter of 2003, Schlotzsky’s, Inc. formed new wholly-owned Delaware limited liability companies, including: Schlotzsky’s Franchisor, LLC (“Franchisor”); Schlotzsky’s Brand Products, LLC (“Brand Products”); and Schlotzsky’s Franchise Operations, LLC (“Franchise Operations”). On June 7, 2003, Schlotzsky’s contributed to Franchisor all of its intellectual property, including trademarks, and related economic interests in the payments to be received pursuant to the franchise agreements and brand licensing agreements for the Schlotzsky’s restaurant concept and brand. Franchisor thus became the franchisor of the Schlotzsky’s restaurant concept and licensor of the Schlotzsky’s brand. Franchisor concurrently contributed the brand licensing agreements to Brand Products. Franchisor and Brand Products entered into a management agreement with Franchise Operations to manage the intellectual property, administer the franchise and brand license agreements, and enter into additional franchise and brand agreements. As part of the corporate change, Schlotzsky’s, Inc. transferred certain personnel from several departments focused on franchise services to Franchise Operations.

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

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SCHLOTZSKY’S SYSTEM

Franchising

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

      Franchise Agreements. Our franchise agreements grant the franchisee the right to develop a restaurant within a defined local market area for a finite period of time. In most cases, we have reserved the right to license sales of sandwiches, pizzas and other products in alternative retail outlets or special event venues within that market area. Under our current standard franchise agreement, the franchisee pays a fee of $30,000 for each restaurant. The current standard franchise agreement for an owner-operator provides for a term of 20 years (with one ten-year renewal option), payment of a royalty of 6% of contractual restaurant sales, and advertising contributions of 4% of contractual restaurant sales. Contractual sales (as defined in our franchise agreements) add to net sales any discounts for employee and manager meals. Contractual sales are a principal driver of our royalty revenue because royalty revenue is based on the contractual sales of our franchised restaurants. Some of our earlier franchisees operate under older forms of franchise agreements that require franchisees to pay a royalty of only 4% of contractual sales.

      Franchisee Training and Support. We have approximately 320 franchisees for our 524 franchised restaurants. We will provide on-the-job training for new and existing franchisees at our designated Company-operated training restaurants. We also provide updated operating and marketing information and maintain ongoing communication with franchisees through conference calls, a call center and internet and e-mail communications. Franchised restaurants receive ongoing service and support, and are periodically inspected by area developers and by our field service representatives to monitor compliance with our standards and specifications as set forth in the franchise agreement and our manuals.

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

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

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

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

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Restaurant Development

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

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

      In 2003, we initiated a gradual evolution and transition of the concept from the “Schlotzsky’s Deli” version of Schlotzsky’s which was first implemented in 1991, to “Schlotzsky’s Sandwich Café & Bakery.” This Sandwich Café initiative, originally referred to as Concept 2005, was launched as our response to changing consumer tastes and increased competitive intrusion, particularly in the sandwich sector of the restaurant industry. This initiative involves an enhanced menu and design renovations that we believe will lead to a more sophisticated dining experience for our customers. We have enacted a phased development plan for our franchisees to meet the Sandwich Café standards in place of the standard remodel requirements under their franchise agreements. Although franchisees are responsible for the costs of remodeling, they have received funds from Schlotzsky’s NAMF, Inc., a Texas not-for-profit corporation, for new menus and wall banners. We believe that substantially all of the existing franchised restaurants will be converted to Sandwich Cafés by the third quarter of 2006. All new franchise licenses will be for Sandwich Cafés.

      Restaurant Cost. Capital requirements incurred by a franchisee to open a restaurant vary depending on the location and size of the restaurant, whether the restaurant is free-standing or in a shopping center, development or rehabilitation costs, whether the restaurant is owned or leased, and the specific terms of any related loan or lease agreement. Shopping center restaurants are currently estimated to cost approximately $300,000 to $650,000, and vary based on size and the level of landlord contribution to construction costs. Leased freestanding buildings have a similar cost depending on the size of the building and the terms and conditions of the lease. If a franchisee were to purchase the land and own and develop the land and building instead of leasing, then the total investment would vary greatly, with the largest variables being cost of land and land development. In addition, the franchisee will need adequate working capital to support their business start-up and pay us required initial fees.

Schlotzsky’s Restaurant Locations

      At December 31, 2003, the Schlotzsky’s system consisted of 561 restaurants open and operating in 37 states, the District of Columbia, and six foreign countries. At December 31, 2002 and 2001, the system included 643 and 674 restaurants open and operating, respectively.

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RESTAURANT LOCATIONS AS OF DECEMBER 31, 2003

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Brand Products

      We have licensed certain manufacturers to produce Schlotzsky’s brand meats, cheeses, potato chips and other products for use in the Schlotzsky’s restaurant system. We receive licensing fees from these manufacturers and supply chain managers based on their sales of brand products to distributors, who in turn sell to our restaurants. While franchisees are currently not required to purchase our brand products exclusively, other than our proprietary flour mixes, logoed paper products and certain special sauces, they are contractually required to purchase products that meet our quality standards and specifications.

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

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

Restaurant Operations

      Since the 1999 acquisition of certain restaurants in Austin and the re-acquisition of the Austin development territory, we have increased our commitment to restaurant operations. Three of the 15 restaurants in our long-term restaurant portfolio (all in Austin) are Sandwich Café restaurants, which include a full bakery producing pastries, muffins and other baked goods for sale in the restaurant and in the coffee bar section of certain other Company-operated restaurants. We intend to convert all long-term restaurants to the Sandwich Café format to the extent financing becomes available.

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

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MARKETING AND ADVERTISING

      We seek to become a well-known national brand. Schlotzsky’s N.A.M.F., Inc. (“NAMF”), a Texas not-for-profit corporation, is primarily responsible for developing, producing and funding the marketing and advertising for our system. NAMF utilizes national, regional, local and cable television advertising, as well as radio, freestanding inserts, direct mail, point of purchase materials and other forms of advertising to present advertising messages to consumers. The allocation between national, regional and local advertising will vary from time to time depending on pricing and other factors.

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

COMPETITION

      The food service industry, particularly the sandwich sector, is intensely and increasingly competitive with respect to concept, price, location, food quality and service. There are many competitors, both new and well established, with substantially greater financial strength, market share, media presence, points of distribution and other resources than us. Such competitors include a large number of national and regional food service companies, including fast food and quick-service restaurants, fast casual dining restaurants, casual dining restaurants, delicatessens, pizza restaurants and other dining establishments. We believe that we compete for franchisees with franchisors of other restaurants and various concepts.

TRADEMARKS AND TRADE SECRETS

      We own several trademarks that are protected under common law and/or are registered with the United States Patent and Trademark Office including the name and mark “Schlotzsky’s.” We have also registered or applied to register many of our trademarks in various foreign countries. We, and our suppliers, protect our recipes and techniques as trade secrets. We have not generally sought patent protection for these recipes or techniques, and it is possible that competitors could develop recipes and techniques that duplicate or closely resemble ours, including the recipe and techniques relating to our distinctive and proprietary breads and pizza crusts.

GOVERNMENT REGULATION

      We must comply with regulations adopted by the Federal Trade Commission (the “FTC”) and with several state laws that apply to and regulate the offer and sale of franchises, and impose registration and disclosure requirements on franchisors.

      All Schlotzsky’s restaurants must comply with federal, state and local laws and regulations regarding health, sanitation, safety, fire, zoning, environment, wages, working hours, working conditions, disabilities, and alcoholic beverages (where applicable). Compliance with environmental and other laws and regulations has impacted the cost of new restaurants, but we believe it has not prevented development of new restaurants. Compliance with securities law regulations and new rules under the Sarbanes-Oxley Act has had, and is expected to continue to have, an adverse impact on our operating costs.

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EMPLOYEES

      As of December 31, 2003, we employed 105 full-time equivalent personnel at our corporate headquarters or as field personnel and 982 personnel at Company-operated restaurants. None of our employees is covered by a collective bargaining agreement or represented by a labor union. We believe our relationship with our employees is good.

FORWARD-LOOKING STATEMENTS

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

RISK FACTORS

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

      New Restaurant and Restaurant Upgrade Strategy. We have initiated several measures to stimulate the development of new Schlotzsky’s restaurants or renovation of existing restaurants by our franchisees, including updating model restaurant designs, developing improved designs and menu formats, and increasing an overall effort to recruit prospective franchisees. Although we believe these actions are appropriate, there can be no assurance they will result in the opening of more restaurants. Some franchisees may choose to close their restaurants rather than invest in remodels or upgrades under the Sandwich Café transition as encouraged by us or required under the terms of their franchise agreements. During 2003, 2002 and 2001, our franchisees and we opened 7, 13 and 18 new Schlotzsky’s restaurants, respectively. The number of openings and the performance of new restaurants will depend on various factors, including: the availability of suitable sites for new restaurants; the ability to recruit financially and operationally qualified franchisees; the ability of franchisees to negotiate acceptable lease or purchase terms, obtain required capital, meet construction schedules, and hire and train qualified restaurant personnel; the establishment of brand awareness in new markets; overall economic conditions; and our ability to implement restaurant renovations and upgrades. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Overview.”

      Availability of Appropriate Financing and/or Renegotiation of Existing Debt. We will require additional financing to support Company operations and to refinance certain debt with relatively short maturities. While we are working with potential lenders to develop appropriate credit facilities, there can be no assurance that we will obtain appropriate financing on acceptable terms to meet these needs. We are also negotiating with certain creditors to modify the terms of the obligations and required payments. Failure to obtain such financing or modified terms with creditors would require us to significantly modify our growth strategies,

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

      Credit Risk and Contingencies. We have charged our area developers and master licensees a fee (“developer fee”) for the rights to develop a defined territory and have typically accepted a portion of the developer fee in the form of a promissory note. As of December 31, 2003, we held notes receivable from area developers and master licensees in an aggregate net carrying value of approximately $1.4 million. We also hold notes receivable from certain franchisees related to their purchase of restaurants and certain other obligations. As of December 31, 2003, the aggregate net carrying value of these notes was approximately $3.5 million. Noncollection on unreserved notes receivable as described above could adversely affect our financial condition. See “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Off Balance Sheet Arrangements.”

      We have guaranteed for the benefit of Schlotzsky’s NAMF Funding, LLC (a wholly-owned subsidiary of NAMF), a bank term note, with an outstanding balance of approximately $4.14 million at December 31, 2003. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Off Balance Sheet Arrangements.”

      We have guaranteed certain loans, leases and other obligations of certain franchisees. We entered into most of these guarantees prior to 2000 in connection with restaurants developed under the former Turnkey program. At December 31, 2003, the Company was contingently liable for approximately $18.0 million of franchisees’ obligations, which was principally comprised of guarantees on real estate leases and mortgages, equipment leases, and loans of franchisees. We have, from time to time, been called upon to perform under such guarantees and there can be no assurance that we will not be so called upon in the future. See “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Off Balance Sheet Arrangements.”

      Directly and through a wholly owned subsidiary, we are the general partner and a limited partner in a limited partnership that owns a retail shopping center in the Austin, Texas, area. We have guaranteed, subject to certain conditions, the repayment of a loan for this project in the principal amount of approximately $2.0 million due in October 2009 (our subsidiary received the proceeds of the loan in repayment of its loan to the partnership). We do not consider our investment in the retail shopping center to represent a separate line of business. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Off Balance Sheet Arrangements.”

      Factors Affecting the Restaurant Industry. We and our franchisees may be affected by risks inherent in the restaurant industry, including but not limited to the following: adverse changes in national, regional or local economic conditions; weather conditions; availability and cost of labor (including increases in the minimum wage); health and safety concerns; increased costs of food products; limited alternative uses for properties and equipment; changing consumer tastes, habits and spending priorities; increased concern with nutrition and health issues; and changing demographics. The restaurant industry is subject to numerous federal, state and local governmental regulations, including those relating to food preparation, employment, zoning and building requirements. If we implement changes to our menu, our recipes, or our pricing, there is a risk that the consumer market will respond negatively to those changes, which would negatively affect our

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      Competition. The food service industry is intensely and increasingly competitive with respect to concept, price, location, food quality and service. There are new competitors as well as many well-established competitors with substantially greater financial and other resources than us. These competitors include a large number of national, regional and local food service companies, including fast food and quick-service restaurants, fast casual dining restaurants, casual dining restaurants, delicatessens, pizza restaurants and other convenience dining establishments. Some of our competitors have been in business longer than us and may be better established in markets where Schlotzsky’s restaurants are or may be located. There are also new and growing competitors in the fast casual upscale sandwich sector in which we primarily operate. Another restaurant could emulate our distinctive bread, recipes and store appearance or allege we are doing the same. Competition in the food service business is affected by changes in consumer taste, economic conditions, demographic trends, traffic patterns, the cost and availability of real estate, availability of qualified labor, product availability and local competitive factors. We provide training and other assistance to our franchisees in adapting to these factors, but no assurance can be given that some or all of these factors will not adversely affect some or all of Schlotzsky’s restaurants. We also believe that we compete for franchisees with franchisors of other restaurants and various concepts. See “Business.”

      Dependence on Franchising Concept. Because royalties from franchised restaurants are a principal component of our revenue base, our performance depends upon the ability of our franchisees to capitalize on and properly execute the Schlotzsky’s concept. The operation of a Schlotzsky’s restaurant requires a franchisee’s significant and continued effort in areas such as product quality, customer service, employee training, local marketing and cost controls. We believe that the costs for a franchisee to open a Schlotzsky’s restaurant, including the cost to purchase or lease real estate that meets our site selection criteria, are higher than the restaurant opening costs of certain competing concepts. This necessarily limits the number of persons who are qualified to be our franchisees. We have established criteria to use in evaluating prospective franchisees, as well as training programs to assist in franchisee restaurant operations, but there can be no assurance that franchisees will successfully open and operate Schlotzsky’s restaurants consistent with our expectations. In addition, franchisees set their own prices which will affect their sales. Poor restaurant operations in areas such as cleanliness, attentiveness of employees and quality control, will also affect each store’s sales. Because franchisees are independent business owners, they make their own decisions regarding new restaurant openings and whether to close existing restaurants. There can be no assurance that franchisees will open additional restaurants or continue operations of existing restaurants. During 2003, 2002 and 2001 franchisees closed 95, 53 and 72 restaurants, respectively and we closed 5 Company-operated restaurants in 2001-03. See “Business.”

      We are subject to various state and federal laws relating to the franchisor relationship. If we fail to comply with these laws, we could be subject to certain penalties by governmental authorities or be liable for damages to franchisees. We believe that we are in material compliance with these laws and regulations and our agreements with franchisees. There can be no assurance that such liability will not be imposed in the future. We reserve the right to change the terms of our franchise agreements from time to time as we deem appropriate. See “Business” and “Business — Government Regulation.”

      Schlotzsky’s Brand Licensing Arrangements. Our revenue from Schlotzsky’s brand licensing arrangements (brand contribution) is a significant portion of our overall revenue, and is currently based primarily on franchisee purchases of our brand products. There can be no assurance that franchisees will maintain their future purchases of Schlotzsky’s brand products. There also can be no assurance that the Company’s future licensing revenue will not be reduced due to pricing considerations or market conditions. See “Business.”

      Dependence on Suppliers and Distributors. One national food distribution company currently meets substantially all of our system’s distribution needs (other than certain beverages and produce). If this company, or any other company significant to our system’s supply chain, were to go out of business or stop

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      Investments in Intangible Assets. We have substantial investments in intangible assets with a carrying value of $66.0 million as of December 31, 2003. The carrying amount of such investments is dependent, in part, on projected cash flows for the related business activities. Such projected cash flows can be impacted by factors both within and outside of management’s control and projection of cash flows requires the exercise of judgment. There can be no assurance that factors adversely impacting these projected cash flows will not occur or that management’s judgments will not change in the future. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies.”

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

      Food Quality and Safety. We may be adversely affected by publicity resulting from food quality, illness, injury or other health concerns or operating issues or allegations resulting from an occurrence at one restaurant or a limited number of restaurants in the Schlotzsky’s system or in other restaurant chains. We are impacted by both real and perceived deficiencies by the public in safety and health-related issues related to food production and distribution.

      Reliance on Area Developers. We rely on certain area developers along with our own staff to recruit qualified franchisees and to perform quality inspections of franchised restaurants and other services. Area developers are independent contractors, and are not our employees. We provide training and support to area developers, but the quality of restaurant operations in their territories may differ, based on the area developer’s level of training and experience. We cannot guarantee that our area developers will be in full compliance with inspection standards or other requirements, and there can be no assurance that restaurants in the territories of such area developers will conform to our standards. See “Business.”

      Geographic Concentration. Of the 561 restaurants in the Schlotzsky’s system at December 31, 2003, 176 were located in Texas. A downturn in the regional economy or other significant adverse events in Texas could have a material adverse effect on our financial condition and results of operations. See “Business — Schlotzsky’s Restaurant Locations.”

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

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

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      As of December 31, 2003, we had 7,521,524 shares of Common Stock issued, of which 189,525 shares were held in treasury, and we had outstanding an aggregate of 704,360 stock options and warrants that were exercisable. A substantial number of shares may become available for sale in the public market at various times. No predictions can be made as to the effect, if any, that market sales or the availability of shares for future sale will have on the market price of our Common Stock. Sales of substantial amounts of Common Stock in the public market, or the perception that such sales may occur, could adversely affect the market price for the Common Stock and could impair our ability to raise capital through a public offering of equity securities. See “Market for Registrant’s Common Equity and Related Stockholder Matters.”

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

      Our Articles of Incorporation and Bylaws include certain provisions that may have the effect of discouraging or delaying a change in control of the Company. Directors are elected to staggered three-year terms, which has the effect of delaying the ability of shareholders to replace specific directors or effect a change in a majority of the Board of Directors. The Bylaws provide that a director may only be removed for cause by vote of the holders of at least two-thirds of the shares present in person or by proxy at a meeting of shareholders called expressly for that purpose. All other shareholder action must be effected at a duly called annual or special meeting and shareholders must follow an advance notification procedure for certain shareholder proposals and nominations to the Board of Directors.

      The Board of Directors has the authority, without further action by the shareholders, to issue up to 1,000,000 shares of Preferred Stock in one or more series and to fix the rights, preferences, privileges and restrictions thereof, and to issue additional authorized, unissued shares of Common Stock. The issuance of Preferred Stock or additional shares of Common Stock could adversely affect the voting power of the Common Stockholders and could have the effect of delaying, deferring or preventing a change in control of the Company. The issuance of Preferred Stock could have other adverse effects on Common Stockholders, including creation of a preference upon liquidation or the payment of dividends in favor of the holders of Preferred Stock.

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

      We have issued a promissory note payable to the seller of certain rights to an area developer territory with a principal amount outstanding of approximately $18.0 million as of December 31, 2003. The note is subject to acceleration by the payee, among other rights, if there is a change in control of the Company (defined to include the acquisition of at least 20% of the outstanding Common Stock by someone other than NS Associates I, Ltd. and certain affiliated parties.)

      Stock Repurchase Program. In January 2001, the Board of Directors increased the existing authorization to repurchase shares of our outstanding Common Stock to 1,000,000 shares. Since then, the Company repurchased 179,525 shares at a total cost of approximately $738,000. We do not have any current plans to repurchase any shares in the near future.

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

      We operate 37 restaurants in 12 states. Fifteen of these restaurants are in our portfolio of restaurants to be operated for the long term. Of these units, 14 are in Texas and one is in Georgia. The remaining 22 restaurants are considered available for sale. Five of these restaurants are located in Texas, four in Georgia, two each in North Carolina, Mississippi and Tennessee, and one each in Alabama, Arkansas, Arizona, Minnesota, New Mexico, New York and Utah. The properties consist of land, building, leasehold improvements, and restaurant equipment. The equipment is typically owned, and the land and building are either owned or leased. In addition, we have certain excess undeveloped or partially developed real estate held for sale.

      New Florida Markets, Ltd. and Deli Keys, Ltd. v. Schlotzsky’s, Inc., Schlotzsky’s Franchise Limited Partnership, Schlotzsky’s Franchisor, LLC, Schlotzsky’s Franchise Operations, LLC, Schlotzsky’s NAMF, Inc., and Schlotzsky’s NAMF Funding, LLC (Case No. 701140045603), was filed on or about June 23, 2003 with the American Arbitration Association. Claimant is the area developer for the Tampa, Orlando, and West Palm Beach development areas. On July 14, 2003, Deli Keys, Ltd., an area developer for the Miami development area, joined the arbitration as an additional Claimant. They allege that Respondents frustrated their ability to develop, in part because of the Company’s “Turnkey” program under which Respondents developed a number of restaurants during the period 1995 until 2000 in which Respondents were involved in acquiring sites, building restaurants for franchisees and, in certain instances, guaranteeing franchise debts or leases. Claimant also alleges Respondents breached the Area Developer Agreements by failing to provide adequate licensing support, negotiating with license prospects, failing to establish and administer a local advertising group, pledging royalties, changing the area developer manual, refunding franchise fees, and forcing Claimants to purchase errors and omissions insurance. Other claims include breach of the implied covenant of good faith and fair dealing, constructive termination, and violation of the Texas Deceptive Trade Practices Act. Claimants seek actual, compensatory, and punitive damages of an unspecified amount, attorneys’ fees, and costs. The arbitration proceeding is scheduled to begin in May 2004.

      John D. Wright and James E. Wright v. Schlotzsky’s, Inc. and Schlotzsky’s Real Estate, Inc. (U.S. District Court for the Eastern District of Michigan — Case No. 03-70244) was filed on or about June 9, 2003 as a Counterclaim and Third Party Claim in a collection action originally filed by Schlotzsky’s Real Estate, Inc. (“SREI”) in January 2003. James Wright, John Wright, Lorraine Wright, and Kimberly Wright v. Schlotzsky’s, Inc. and Schlotzsky’s Real Estate, Inc., in the Circuit Court for the County of Genessee, State of Michigan (Case No. 02-74931-CK), was filed on or about July 1, 2003 as a Third Party Complaint in a foreclosure action. The Wrights are principals and guarantors of J. Wright Franchise Development, LLC, a former franchisee that had operated a Schlotzsky’s Deli in Grand Blanc, Michigan and filed Chapter 11 bankruptcy. In January 2003, SREI filed suit against John and James Wright for collection of $283,872.68 due under a promissory note. In the instant case, the Wrights allege that they were induced into participating in the Company’s Turnkey program and that an employee of the Company represented that the restaurant would attain a certain level of sales. The Wrights’ claims include fraud in the inducement, fraudulent and negligent misrepresentation, and breach of the Michigan Franchise Investment Act. They sought damages of an unspecified amount, attorneys’ fees, and costs. The parties agreed to settle both lawsuits on March 5, 2004, with all parties withdrawing their claims with prejudice.

      Robert Coshott v. Schlotzsky’s, Inc. (Cause No. GN 1-02279), was filed on July 24, 2001, in the 200th Judicial District Court of Travis County, Texas. Plaintiff is the Master Licensee for Australia and New Zealand, and he opened a Schlotzsky’s Deli restaurant in Melbourne, Australia. Plaintiff brings causes of action for fraud and/or negligent misrepresentation. Plaintiff alleges that he experienced problems with certain equipment specified or approved by the Company, that the Company’s system and equipment did not generate

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      Dae Kim, DWK Enterprises, Inc., and Aecon International, Inc. v. John Wooley, Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership, Schlotzsky’s N.A.M.F., Inc., Schlotzsky’s National Advertising Association, Inc., and Schlotzsky’s, Brands, Inc., Schlotzsky’s Brand Products, L.P., Schlotzsky’s Real Estate, Inc., and Schlotzsky’s Restaurants, Inc. (Cause No. 2001-CI-13672) was originally filed in the 73rd Judicial District Court of Bexar County, Texas on or about September 25, 2001 (after a similar lawsuit was filed and later withdrawn in Harris County, Texas) against Schlotzsky’s, Inc., John Wooley, Schlotzsky’s Franchising Limited Partnership, and Schlotzsky’s NAMF, Inc. (“Defendants”). Plaintiffs are, or claim to be, franchisees in Houston and San Antonio Texas, and Plaintiff Kim was an area developer for those markets. Plaintiffs bring causes of action for breach of contract, breach of fiduciary duty, breach of the duty of good faith and fair dealing, civil conspiracy, tortious interference with contract, tortious interference with prospective business relationship, violation of the Texas Deceptive Trade Practices and Consumer Protection Act, restraint of trade, detrimental reliance-fraud in the inducement, and defamation-business disparagement. They seek an unspecified amount of money damages plus exemplary damages, attorneys’ fees, pre-judgment interest, costs, and a jury trial. Defendants, except for Mr. Wooley, who was previously dismissed from the case, answered and asserted counterclaims alleging breach of contract and that Plaintiffs’ claim under the Texas Deceptive Trade Practices Act is groundless in fact or in law and brought in bad faith or for the purpose of harassment, and seeks money damages, costs of court, penalty fees, costs incurred in performing the accounting, attorneys’ fees, and pre- and post-judgment interest. Defendants (except for Mr. Wooley) removed the case to federal court. The case was remanded to state court on April 17, 2003. The case is not yet set for trial.

      U.S. Restaurant Properties Operating L.P. v. Schlotzsky’s, Inc. (Cause No. 03-01758) was filed on February 27, 2003, in the District Court of Dallas County, B-44th Judicial District. Plaintiff is a real estate investment company that owns certain Schlotzsky’s restaurants and leases them to franchisees. It alleges that in 1997 and 1998 we entered into several agreements where we agreed to guarantee certain lease agreements. Plaintiff claims that in 1998 the parties entered into an agreement whereby Plaintiff agreed to release Schlotzsky’s from its guaranty obligations pertaining to six properties in which the tenants had defaulted, in exchange for Schlotzsky’s agreement to purchase six other properties. Plaintiffs are seeking an order requiring us to purchase six properties for a total purchase price of over $4.5 million. In the alternative, Plaintiff is seeking damages or an order reinstating the previously released guaranties. Plaintiff’s claims include breach of contract and a request for attorneys’ fees. The trial date has been scheduled for September 20, 2004.

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

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      Not applicable.

PART II

      The authorized capital stock of the Company consists of 30,000,000 shares of Common Stock, no par value, and 1,000,000 shares of Class C Preferred Stock, no par value (including 200,000 shares of Class C Series A Junior Participating Preferred Stock reserved for issuance under our Shareholder Rights Plan). Our Common Stock is traded on the NASDAQ National Market under the symbol “BUNZ”. As of March 26, 2004, 7,338,661 shares of outstanding Common Stock were owned by approximately 280 beneficial owners and 4,500 shareholders of record.

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

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

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

      The Company discloses information about its securities authorized for issuance under equity compensation plans in Item 12 of this report.

      The following table sets forth selected consolidated financial data for the Company for the periods and the dates indicated. The consolidated balance sheet data as of December 31, 2003 and 2002 and the consolidated statement of operations data for the years ended December 31, 2003, 2002 and 2001 have been derived from the audited consolidated financial statements of the Company, included elsewhere herein. The consolidated balance sheet data as of December 31, 2000 and 1999 and consolidated statement of operations data for the years ended December 31, 2000 and 1999 have been derived from the Company’s audited financial statements not included or incorporated herein. The selected financial data should be read in

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