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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-27008
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SCHLOTZSKY'S, INC.
(Exact name of registrant as specified in its charter)
TEXAS 74-2654208
(State or other Jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
203 COLORADO STREET, AUSTIN, TEXAS 78701
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (512) 236-3600
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Name of each exchange
Title of each class on which registered
COMMON STOCK, NO PAR VALUE NASDAQ NATIONAL MARKET
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NOT APPLICABLE
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days Yes _X_ No ____
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K / /.
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 20, 1998 was approximately $118,835,000 based upon the
last sales price on March 20, 1998 on the NASDAQ National Market System for the
Company's common stock. For purposes of this computation, all officers,
directors and 10% beneficial owners of the registrant are deemed to be
affiliates. Such determination should not be deemed an admission that such
officers, directors or 10% beneficial owners are, in fact, affiliates of the
Registrant. Registrant had 7,378,567 shares of Common Stock outstanding on March
20, 1998.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement to be filed with the
Securities and Exchange Commission not later than 120 days after the close of
the registrant's fiscal year are incorporated by reference into Part III of this
Form 10-K.
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SCHLOTZSKY'S, INC.
INDEX TO FORM 10-K
YEAR ENDED DECEMBER 31, 1997
PAGE NO.
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PART I
Item 1. Business..................................................................................... 1
Item 2. Properties................................................................................... 15
Item 3. Legal Proceedings............................................................................ 15
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters........................ 16
Item 6. Selected Consolidated Financial Data......................................................... 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation......... 18
Item 8. Financial Statements and Supplementary Data.................................................. 28
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure......... 28
PART III
Item 10. Directors and Executive Officers of the Registrant........................................... 28
Item 11. Executive Compensation....................................................................... 28
Item 12. Security Ownership of Certain Beneficial Owners and Management............................... 28
Item 13. Certain Relationships and Related Transactions............................................... 28
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................. 28
PART I
ITEM 1. BUSINESS
Schlotzsky's, Inc. (the "Company") was formed effective January 1, 1993,
when Schlotzsky's Franchising Limited Partnership, Schlotzsky's-Houston, Ltd.,
Schlotzsky's-San Antonio, Ltd., Schlotzsky's Restaurant Management Corporation,
and Schlotzsky's, Inc. (collectively, the "Predecessor Entities") were merged
into the Company and its two wholly-owned subsidiaries, Schlotzsky's
Restaurants, Inc. and Schlotzsky's Real Estate, Inc. (the "1993 Merger"). In
June 1993, the Company raised $5 million through the sale of Class A Preferred
Stock and used the proceeds to redeem the preferred stock issued in the 1993
Merger to the investors in the Predecessor Entities other than John C. Wooley
and Jeffrey J. Wooley. The Company's other subsidiaries, which are wholly-owned,
are Schlotzsky's Brands, Inc., Schlotzsky's Equipment Corporation, DFW
Restaurant Transfer Corporation, 56th and 6th, Inc., and SREI Turnkey
Development, L.L.C. The Company and its subsidiaries are Texas corporations, and
references to the "Company" include its predecessors, and its and their
subsidiaries, unless the context otherwise requires.
The Company's principal executive offices are located at 203 Colorado
Street, Austin, Texas 78701, and its telephone number is (512) 236-3600.
GENERAL
The Company is a franchisor of quick service restaurants that feature
made-to-order sandwiches with unique sourdough buns. At December 31, 1997, the
Schlotzsky's system included seven Company-owned stores and 666 franchised
stores located in 39 states, the District of Columbia and 14 foreign countries.
System-wide sales were approximately $202.4 million for 1996 and $270.4 million
for 1997. Average unit volumes were $410,000 in 1996 and $455,000 for 1997.
STRATEGY
John C. Wooley and Jeffrey J. Wooley acquired the Company in 1981. They were
attracted to the Company by the unique characteristics of The Schlotzsky's
Original sandwich, the only sandwich sold at Schlotzsky's restaurants at that
time, and the strong brand loyalty that had developed for this sandwich in the
Company's markets. From 1981 to 1991, management tested different strategies to
expand the Company's business, including the development of Company-owned stores
and expanded store menus.
In 1991, the Company began implementing a strategy to achieve its objective
of becoming a leader in the specialty sandwich segment of the restaurant
industry in the United States. The key elements of this strategy are to: offer
an expanded menu of consistent, high quality foods featuring the Company's
proprietary bread recipes, complemented by excellent customer service; expand
the Turnkey Program to develop new stores in high visibility, free-standing
locations; utilize area developers to decentralize franchisee recruiting and
support; develop a strong network of motivated owner-operator franchisees; and
increase awareness of the Schlotzsky's brand through enhanced marketing and
private label products. Recently, the Company revised its strategy to include
the acquisition and development of a limited number of Company-owned stores,
principally for concept development.
MENU OF DISTINCTIVE, HIGH QUALITY PRODUCTS. Schlotzsky's Deli restaurants
offer an expanded menu of consistent, high quality foods featuring the Company's
proprietary bread recipes, complemented by excellent customer service. The menu
features made-to-order sandwiches with bread that is baked fresh from scratch
every day in each restaurant. The Schlotzsky's Original sandwich, which was
introduced in 1971, is a variation of the muffaletta sandwich made with three
meats (lean ham, Genoa salami and cotto salami), three cheeses (mozzarella,
cheddar and parmesan), garlic butter, mustard, marinated black olives, onion,
lettuce and tomato on a toasted sourdough bun. The Schlotzsky's Original
sandwich continues to be the most popular item on the Schlotzsky's menu.
Schlotzsky's Deli restaurants now offer an expanded menu with 15 sandwiches on
four types of bread, 10 sourdough crust pizzas, five salads, soups, chips and
other side items, fresh baked cookies and other desserts, and beverages. At most
locations, sandwiches
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range in price from $2.90 to $4.75 ($7.00 for an oversized Original), and
eight-inch gourmet pizzas are priced between $3.50 and $4.50.
TURNKEY PROGRAM; HIGH VISIBILITY STORES. The Company and its area
developers encourage franchisees to develop free-standing stores with high
visibility and easy access. The Company believes the location of a store is as
important to its success as the efforts of the franchisee, and works with area
developers to assist franchisees in identifying and acquiring superior store
locations. The Company implemented its Turnkey Program as a means of
accelerating the development of high visibility stores and capitalizing on the
Company's experience in evaluating store sites by providing a variety of
services from securing the site, to development and construction of the store.
The Turnkey Program also enhances the quality and consistency of the
free-standing stores developed for franchisees by the Company because of its
experience building prototype stores and its purchasing power with suppliers and
contractors.
AREA DEVELOPERS. The Company has 35 area developers trained to assist the
Company in achieving its expansion goals in the United States. Area developers
provide the following services: they recruit and qualify franchisees; they
assist franchisees in site selection, training, financing, building and opening
stores; they provide ongoing operational support; they monitor product and
service quality; and they help coordinate local advertising. Prior to 1991,
these functions were performed by Company personnel. By utilizing its area
developer network, the Company believes that it can effectively support a
growing number of franchised stores while controlling its overhead costs. Area
developers receive a portion of franchise fees and royalties from each store in
their territories and are motivated to develop their markets and monitor
operating performance. Area developers must meet specific store opening
schedules under their agreements with the Company in order to maintain their
development rights.
MOTIVATED OWNER-OPERATOR FRANCHISEES. The Company is developing a strong
network of owner-operator franchisees. The Company believes that a motivated
owner-operator is an essential key to the success of a store. The Schlotzsky's
system consists almost exclusively of franchised stores, owned and managed by
entrepreneurial franchisees. The Company seeks franchisees who are committed to
providing on-site supervision of store operations and prefers to limit
franchisees to three or four locations in relatively close proximity. As of
December 31, 1997, out of 416 franchisees with stores, 13 franchisees have more
than five stores each and, in the aggregate, account for approximately 12.8% of
the stores in the system.
INCREASED BRAND AWARENESS. The Company seeks to increase awareness of the
Schlotzsky's brand through enhanced marketing and private label products. The
Company is directing its franchising efforts to establish a sufficient number of
stores in larger markets to allow expanded cooperative advertising through
newspaper, radio and television. The Company has developed a complete line of
private label products to increase Schlotzsky's brand awareness. Private label
products are used by franchisees in preparing foods and are displayed at stores
as part of the standard decor package. Some private label products are sold by
franchisees for home consumption.
COMPANY-OWNED STORES. The Company's flagship store in Austin, Texas opened
in 1995, and two stores were acquired from franchisees by the Company in 1996,
one in New York City (Manhattan) and one in Houston. In addition in 1997, the
Company developed or acquired and began operating another store in Houston, one
in Illinois, one in Mississippi, and one in Georgia. In 1998, the Company
completed the relocation of two additional units in Austin, Texas. The Company
operates these stores primarily for product development, concept refinement and
prototype testing and training and to build brand awareness. The Company may
acquire or develop a limited number of other Company-owned stores in the future
for these purposes and may acquire or develop others from time to time with the
intent of transferring them to franchisees.
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EXPANSION
At December 31, 1997, the Schlotzsky's system consisted of 673 stores in 39
states, the District of Columbia, and 14 foreign countries. At December 31, 1995
and 1996, the system included 463 and 573 stores, respectively.
STORE LOCATIONS AS OF DECEMBER 31, 1997
NUMBER OF
LOCATION STORES
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UNITED STATES:
Texas........................................................... 205
Arizona......................................................... 35
Georgia......................................................... 32
California...................................................... 29
Florida......................................................... 28
Michigan........................................................ 24
Tennessee....................................................... 24
Indiana......................................................... 23
Illinois........................................................ 20
Oklahoma........................................................ 18
Wisconsin....................................................... 17
Alabama......................................................... 15
Colorado........................................................ 15
New Mexico...................................................... 15
North Carolina.................................................. 15
South Carolina.................................................. 14
Nebraska........................................................ 11
Ohio............................................................ 11
Missouri........................................................ 10
Louisiana....................................................... 9
Utah............................................................ 9
Arkansas........................................................ 8
Kansas.......................................................... 8
Minnesota....................................................... 8
Nevada.......................................................... 6
Oregon.......................................................... 6
Virginia........................................................ 6
Washington...................................................... 6
Idaho........................................................... 3
Iowa............................................................ 3
Mississippi..................................................... 3
North Dakota.................................................... 3
West Virginia................................................... 3
Hawaii.......................................................... 2
New York........................................................ 2
Pennsylvania.................................................... 2
South Dakota.................................................... 2
Connecticut..................................................... 1
District of Columbia............................................ 1
Kentucky........................................................ 1
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TOTAL U.S....................................................... 653
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INTERNATIONAL:
Argentina....................................................... 3
Japan........................................................... 3
Turkey.......................................................... 3
Australia....................................................... 1
Canada.......................................................... 1
Germany......................................................... 1
Guatemala....................................................... 1
Korea........................................................... 1
Lebanon......................................................... 1
Malaysia........................................................ 1
Mexico.......................................................... 1
Saudi Arabia.................................................... 1
Sweden.......................................................... 1
United Kingdom.................................................. 1
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TOTAL INTERNATIONAL:............................................ 20
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TOTAL STORES:................................................... 673
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TURNKEY PROGRAM
The Company instituted the Turnkey Program to further assist franchisees in
obtaining superior sites and to achieve more rapid penetration in those selected
major markets where the Company believes there is strong demand by franchisees
for good locations. Under the Turnkey Program, the Company works independently
or with an area developer to identify superior store sites within a territory.
The Company will typically purchase or lease a selected site, design and
construct a Schlotzsky's Deli restaurant on the site and sell, lease or sublease
the completed store to a franchisee. Where the Company does not sell the
property to a franchisee, the Company sells the improved property, or, in the
case of a leased property, assigns the lease and any sublease, to an investor.
From time to time, the Company will assign its earnest money contract on a site
and the franchisee's lease to a third-party investor who then assumes the
responsibility for developing the store.
The Company anticipates that the total investment in each developed
free-standing location will be approximately $1,000,000 to $1,500,000 (less for
leased locations). Since the inception of the Turnkey Program, the Company has
typically provided a credit enhancement in the form of a guaranty on the
franchisee's lease for leased locations. In 1997, upon sale of the site or
assignment of its earnest money contract, the Company deferred revenue generated
(even though proceeds were received in cash) and allocable costs incurred in
connection with the property. When a guaranty is terminated, or the Company's
exposure to loss under the guaranty has passed, the Company will recognize the
revenue and allocable costs related to the site. Generally, if no credit
enhancement is provided in connection with such transactions, the Company may
recognize the revenue and allocable expenses in the periods in which the
transactions occur. The Company believes that the Turnkey Program enhances the
Company's ability to recruit qualified franchisees by securing and developing
high profile sites and achieving critical mass for advertising purposes more
quickly in selected markets. In addition, the Company charges a fee when it is
requested to manage construction of a store on property owned by a franchisee or
an investor. This construction management fee is recognized when the store is
opened.
MENU
The Schlotzsky's Deli menu provides customers with popular food items which
the Company believes are fresher, more flavorful and of greater variety than
those offered by competitors. The key menu groups are made-to-order sandwiches
and pizzas, salads, soups, cookies and other desserts, and beverages. Sandwiches
and pizzas are made with delicatessen-style meats, grilled chicken and specialty
cheeses, all of which are purchased ready for use from approved suppliers. The
Company's distinctive sandwich buns and
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pizza crusts are baked daily from scratch, rather than with pre-mixed or frozen
dough, to ensure the highest quality and freshness.
FRANCHISING
The Company has adopted a strategy of franchising, rather than owning
stores. The Company believes that franchisees who own and operate stores are
more highly motivated and manage stores more efficiently than typical
manager-employees. Moreover, franchising allows the Company to expand the number
of stores and penetrate markets more quickly and with less capital than
developing Company-owned stores. Area developers play a role in the Company's
franchising program by recruiting qualified franchisees and by monitoring and
providing a high level of support to franchised stores.
AREA DEVELOPERS. The Company's 35 area developers recruit and qualify
franchisees according to criteria developed by the Company. Once a franchisee is
approved by the Company, the area developer works with the Company to assist the
franchisee in site selection, training, store design and layout, construction
and financing. The area developer provides store opening assistance, monitors
store performance and compliance with product and service quality standards
established by the Company and helps to coordinate cooperative advertising
within his territory. The Company generally pays area developers 50% of all
franchise fees paid by franchisees in their territories, although some area
developers have received up to 100% of certain franchise fees as an inducement
to develop their territories more quickly. In addition, the Company also pays
area developers approximately 42% of the royalties received under franchise
agreements providing for 6% royalties and 12.5% to 25% of royalties received
under franchise agreements providing for 4% royalties, in each case with respect
to franchisees in their territories. Area developers are not required to own or
operate stores, although some of the Company's area developers are also
franchisees, or have investments in franchisees, under separate franchise
agreements. Area developers are granted exclusive rights to one or more
television markets in the United States, typically for a term of 50 years. Each
area developer pays the Company a nonrefundable fee for the exclusive
development rights for a market. The Company typically receives 25% to 50% of
the area developer fee when the area development agreement is signed with the
balance payable with interest over an 18 to 36-month period under a promissory
note from the area developer.
Area development agreements are nonassignable without the prior written
consent of the Company, and consents have been granted from time to time. The
Company retains rights of first refusal with respect to any proposed sale by the
area developer. Area developers are not permitted to compete with the Company.
Area developers typically commit to a store opening schedule for each territory.
If an area developer fails to meet its obligations, the Company can terminate or
repurchase its territory for resale, although the Company has agreed to extend
or waive these store opening schedules for certain area developers.
FRANCHISEES. The Company believes the involvement of owners in daily store
operations is critical to the success of a franchise. The Company prefers
franchisees who will operate no more than three or four stores, located within a
single market. Franchisees are selected on the basis of various factors,
including business background, experience and financial resources. Because the
cost of building and equipping a Schlotzsky's Deli restaurant is somewhat higher
than for some other specialty sandwich franchise operations, the Company's
franchisees must make certain minimum investments into their stores, and
typically must have substantial cash resources or a relatively high net worth to
obtain financing to build and equip stores. While area developers identify and
recruit potential franchisees, all franchisees must be approved by the Company.
FRANCHISE AGREEMENTS. The Company enters into one or more agreements with
each franchisee granting the franchisee the right to develop one or more stores
within a territory over a defined period of time. Once a site for a store has
been selected by the franchisee and accepted by the Company, additional
documentation specifying that site is signed. Under the Company's current
standard franchise agreement, the franchisee is required to pay a franchise fee
of $20,000 for the franchisee's first store and $10,000 for any additional
store. The franchise fee is payable at the time of signing the agreement. The
current
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standard franchise agreement provides for a term of 20 years (with one ten-year
renewal option) and payment of a royalty of 6% of sales. As of December 31,
1997, 127 stores operated under franchise agreements entered into prior to 1991
were paying a royalty of 4% of sales.
The Company has the right to terminate any franchise agreement for certain
specific reasons, including a franchisee's failure to make payments when due or
failure to adhere to the Company's policies and standards. Many state franchise
laws, however, limit the ability of a franchisor to terminate or refuse to renew
a franchise. See "--Government Regulation."
FRANCHISEE TRAINING AND SUPPORT. Each franchisee is required to have a
principal operator approved by the Company who satisfactorily completes the
Company's training program and who devotes full business time and efforts to the
operation of the franchisee's stores. Franchisees may also enroll each store
manager in the Company's training program. The Company provides training at
operating Schlotzsky's Deli restaurants in various locations. In November 1995,
the Company opened its new flagship Schlotzsky's Deli restaurant in Austin,
Texas, which includes training facilities. Most franchisee training is being
conducted at that location. Franchisees are required to pass a minimum skills
test before they can begin operating their first store. An on-site training crew
is provided by the Company or an area developer for three days before and two
days after the opening of a franchisee's first store. Company management and
area developers maintain ongoing communication with franchisees, exchanging
operating and marketing information.
FRANCHISE OPERATIONS. All franchisees are required to operate their stores
in compliance with the Company's policies, standards and specifications,
including matters such as menu items, ingredients, materials, supplies,
services, fixtures, furnishings, decor and signs. Food preparation is
standardized and is limited to baking bread, slicing pre-cooked meats, cheese
and produce, melting cheese and heating sandwiches. Because they usually operate
no more than three stores, franchisees are expected to be actively involved in
monitoring operations at each store. Each franchisee has full discretion to
determine the prices to be charged to its customers. Franchise stores are
periodically inspected by area developers and the Company's field service
representatives. Area developers are responsible for monitoring the Company's
standards and specifications as set forth in the franchise agreement and the
Company's manuals on a continuous basis.
REPORTING. Most Schlotzsky's Deli restaurant franchisees are required to
report weekly sales and other data to the Company. Other franchisees are
required to report monthly. Generally, 6% royalties are payable weekly by
automatic bank drafts and 4% royalties are payable monthly by check. The Company
is evaluating point-of-sale software for use by franchisees to record and report
sales and other operating information and anticipates that new franchisees may
be required to use this point-of-sale software beginning at some point in 1998.
Although the Company has the right to audit franchisees, it relies primarily on
voluntary compliance by franchisees to accurately report sales and remit
royalties.
INTERNATIONAL MASTER LICENSEES. In addition to the Company's expansion in
the United States, the Company has granted nonassignable rights to develop
stores in international markets to master licensees. A master licensee is
typically licensed for 50 years to use the Schlotzsky's trademarks in designated
foreign territories and may grant area development rights and franchises in
those territories. Unlike area developers, master licensees contract directly
with franchisees, and the Company delegates the selection of franchisees and
approval of sites to the master licensees. When a master license is granted, the
master licensee pays the Company a negotiated, nonrefundable license fee. In
some instances, the Company will negotiate a territorial agreement pursuant to
which a foreign territory is reserved and the principal economic terms of the
master license agreement are agreed upon in return for a nonrefundable fee to be
applied toward the master license fee. The Company normally receives 15% to 35%
of the master license fee in cash when the master license or territorial
agreement is signed, with the balance payable with interest over a term of up to
48 months under a promissory note from the master licensee. Typically, the
Company also receives one-third to one-half of any sublicense and franchise fees
and one-third of any royalties received by the master licensee. All amounts
payable to the Company by the master licensees must be paid in U.S. dollars. As
of December 31, 1997, the Company had executed master licenses or
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territorial agreements covering 51 foreign countries. As with area developers,
if master licensees fail to meet their obligations, the Company can terminate
their rights or repurchase their territories for resale. Master licensees are
subject to various laws and regulations regarding franchising and licensing in
their territories and are responsible for complying with these laws and
regulations.
SITE SELECTION
The Company trains area developers to assist franchisees in selecting their
sites and developing their stores. Each franchisee is responsible for selecting
store locations acceptable to the Company. Site selection criteria are based on
accessibility and visibility of the site and selected demographic factors,
including population, residential and commercial density, income, age and
traffic patterns. The Company prefers that franchisees select sites for
free-standing or end-cap stores to maximize store visibility and sales
potential. As the table below indicates, the mix of store sites has changed
since the Company adopted a new strategy in 1991 focusing on higher visibility
stores.
STORES OPENED BETWEEN
AS OF AS OF JANUARY 1, 1992 AND
STORE SITE DECEMBER 31, 1991 DECEMBER 31, 1997 DECEMBER 31, 1997
- ------------------------------------------ --------------------- --------------------- -------------------------
Free-Standing............................. 24% 46% 53%
End-Cap................................... 31 29 26
In-Line................................... 28 12 7
Other..................................... 17 13 14
--- --- ---
Total..................................... 100% 100% 100%
--- --- ---
--- --- ---
The Company has developed a series of prototype store designs and
specifications for free-standing and end-cap stores which its area developers
make available for use by franchisees. These specifications may be adapted to
existing restaurants and other retail spaces.
UNIT ECONOMICS
The Company believes that the Schlotzsky's Deli restaurant concept offers
attractive unit economics. The cost to a franchisee of developing and opening a
prototype Schlotzsky's Deli restaurant (excluding restaurants like the Company's
flagship store) in leased space has recently ranged from approximately $300,000
to $500,000, including leasehold improvements, equipment, fixtures and initial
working capital. During the twelve months ended December 31, 1997, the average
store sales for Schlotzsky's Deli restaurants (excluding non-Deli restaurant
format stores) that were open for the entire period was approximately $442,000,
although store revenue varies significantly depending upon the type, size and
location of the store. The Company believes that food and paper costs for the
Schlotzsky's Deli menu items are relatively low as a percentage of gross store
sales as compared to many quick service restaurant concepts.
FINANCING
The Company typically does not, and is not obligated to, provide financing
to franchisees for the costs of developing and opening stores. Both the Company
and area developers assist franchisees in obtaining financing by identifying
third party financing sources. Certain financial institutions have designed
equipment leasing programs specifically for Schlotzsky's franchisees and have
developed guidelines for sale and leaseback financing for Schlotzsky's stores.
The Company has also identified Small Business Administration lenders which have
made loans to Schlotzsky's franchisees. These lenders are not committed to
provide any financing to franchisees and there can be no assurance that
franchisees will be able to finance their costs of opening stores on suitable
terms.
The Company from time to time agrees to guarantee its franchisees'
obligations to equipment and real property lessors or subordinates all or a
portion of its royalties to the obligations of franchisees on such
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leases. These guaranties provide for a limited number of payments or limited
time period for which the Company may be required to perform on its guaranty. As
of December 31, 1997, the Company had guaranteed an aggregate of approximately
$23.3 million which is principally comprised of real estate and equipment leases
and other obligations of its franchisees.
The Company plans to implement a mortgage financing program pursuant to
which franchisees selected by the Company may obtain financing for the purchase
of real estate, construction costs and equipment. The Company may provide
assistance in the form of a limited guaranty to facilitate the financing.
PURCHASING; PRIVATE LABELING
Franchisees are required to purchase equipment, furniture, smallwares,
merchandising displays and food from suppliers approved by the Company.
Approximately 80% of overall purchases of goods used in daily operations by the
Company's franchised stores are from International Multifoods Corporation, which
provides volume discounts to franchisees based upon system-wide purchases. The
Company believes that comparable goods are available at competitive prices from
numerous other suppliers.
The Company has licensed certain manufacturers to sell Schlotzsky's private
label meats, cheeses, potato chips and other products. The Company receives
licensing fees from these manufacturers based on their sales of private label
products to franchisees. While franchisees are not required to purchase private
label products, other than the Company's proprietary flour mixes, the Company
believes that most franchisees prefer them because they are of equal or superior
quality compared to other brand name products and generally are less expensive
than the supplies available from other approved sources. In addition, some
private label products can be sold separately at stores for home consumption,
enhancing brand awareness and providing franchisees with additional sales and
profit opportunities.
MARKETING
Franchised stores contribute 1% of gross sales to Schlotzsky's N.A.M.F.,
Inc. ("NAMF"), a non-profit corporation administered by the Company. In
addition, franchisees are required by the terms of their franchise agreements to
spend at least 3% of gross sales on advertising. To take advantage of critical
mass in certain television markets, franchisees are encouraged to form
cooperatives where advertising funds can be pooled to maximize the benefits of
advertising for members, or the Company may organize one or more cooperatives to
facilitate the coordinated expenditure of advertising funds for the benefit of
the franchisees. NAMF funds are used principally to develop and produce radio
and television commercials and print advertising for use in local markets,
in-store graphics and displays, and promotions, but such funds may also be used
to pay for media space or time. NAMF has developed advertising campaigns for use
by franchisees centered around different slogans, such as FUNNY NAME. SERIOUS
SANDWICH-Registered Trademark-; ACCEPT NO SUBSTITUTESKY'S-Registered Trademark-;
BEST BUNS IN TOWN-Registered Trademark-; and ORIGINAL TASTE EVERY DAY-TM-.
NAMF's field marketing representatives coordinate advertising campaigns and
promotions for area developers and franchisees.
COMPETITION
The food service industry is intensely competitive with respect to concept,
price, location, food quality and service. There are many well established
competitors with substantially greater financial and other resources than the
Company. Such competitors include a large number of national, regional and local
food service companies, including fast food and quick-service restaurants,
casual full-service restaurants, delicatessens, pizza restaurants and other
convenience dining establishments. Some of the Company's competitors have been
in existence longer than the Company and are better established in markets where
Schlotzsky's stores are or may be located. The Company believes that it competes
for franchisees with franchisors of other restaurants and various concepts.
8
Schlotzsky's stores compete primarily on the basis of distinctive, high
quality food and convenience, rather than price. The Company believes that
Schlotzsky's stores provide the quick service and convenience of fast food
restaurants while offering more distinctive, higher quality products. Pricing is
designed so that customers perceive good value (high quality food at reasonable
prices), even though Schlotzsky's menu prices are typically higher than certain
competitors' prices.
Competition in the food service business is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company's area developers attempt to assist
franchisees in managing or adapting to these factors, but no assurance can be
given that some or all of these factors will not adversely affect some or all of
the franchisees.
TRADEMARKS, SERVICE MARKS AND TRADE SECRETS
The Company owns a number of trademarks and service marks registered with
the United States Patent and Trademark Office. The Company has also registered
or made application to register trademarks in foreign countries where master
licenses have been granted. The flour and bread making recipes and techniques
currently used in Schlotzsky's stores are based on a modification of the
Company's original recipe developed jointly by the Company and Pillsbury
Company. The recipes and techniques are protected by the Company and its
suppliers as trade secrets. The Company has not sought patent protection for
these recipes, and it is possible that competitors could develop flour recipes
and baking procedures that duplicate or closely resemble the Company's. The
Company considers its trademarks, service marks and trade secrets to be critical
to the business and actively defends and enforces them.
GOVERNMENT REGULATION
The Company must comply with regulations adopted by the Federal Trade
Commission (the "FTC") and with several state laws that regulate the offer and
sale of franchises. The Company also must comply with a number of state laws
that regulate certain substantive aspects of the franchisor-franchisee
relationship. The FTC's Trade Regulation Rule on Franchising (the "FTC Rule")
requires that the Company furnish prospective franchisees with a franchise
offering circular containing information prescribed by the FTC Rule.
State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees, by regulating discrimination among franchisees
with regard to charges, royalties or fees, and by restricting the development of
other restaurants within certain proscribed distances from existing franchised
restaurants. Those laws also restrict a franchisor's rights with regard to the
termination of a franchise agreement (for example, by requiring "good cause" to
exist as a basis for the termination), by requiring the franchisor to give
advance notice to the franchisee of the termination and give the franchisee an
opportunity to cure any default, and by requiring the franchisor to repurchase
the franchisee's inventory or provide other compensation. To date, those laws
have not precluded the Company from seeking franchisees in any given area and
have not had a material adverse effect on the Company's operations.
Each Schlotzsky's store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties or failures
in obtaining the required licenses or approvals can delay and sometimes prevent
the opening of a new store.
Schlotzsky's stores must comply with federal and state environmental
regulations, such as those promulgated under the Federal Water Pollution Act,
Federal Clean Water Act of 1977 and the Federal Resource and Conservation
Recovery Act of 1976, but the Company believes that those regulations have not
had a material effect on their operations. More stringent and varied
requirements of local governmental bodies with respect to zoning, land use, and
environmental factors can delay and sometimes prevent development of new stores
in particular locations.
9
The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters, such as minimum wages,
overtime and other working conditions. Significant numbers of the food service
personnel in Schlotzsky's stores receive compensation at rates related to the
federal minimum wage and, accordingly, increases in the minimum wage increase
labor costs at those locations.
The Company and its franchisees also must comply with the provisions of the
Americans with Disabilities Act, which requires that employers provide
reasonable accommodation for employees with disabilities and that restaurants be
accessible to customers with disabilities.
EMPLOYEES
As of December 31, 1997, the Company employed 122 persons at its corporate
headquarters. None of the Company's employees is covered by a collective
bargaining agreement or is represented by any labor union. The Company believes
its relationship with its employees is good.
RISK FACTORS
In addition to the other information contained in this report, the following
factors should be considered carefully in evaluating the Company:
FORWARD LOOKING STATEMENTS. This report contains statements that constitute
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended (the "Securities Act") (and Section 21E of the
Securities Exchange Act of 1934, as amended (the "Exchange Act")). The words
"expect," "estimate," "anticipate," "predict," "believe," "intend," "plan,"
"project" and similar expressions and variations thereof are intended to
identify forward-looking statements. Such statements appear in a number of
places in this Report and include statements regarding the intent, belief or
current expectations of the Company, its directors or its officers with respect
to, among other things: (i) trends affecting the Company's financial condition
or results of operations; (ii) the Company's financing plans; (iii) the
Company's business and growth strategies; and (iv) the declaration and payment
of dividends. Shareholders and prospective investors are cautioned that any such
forward-looking statements are not guarantees of future performance and involve
risks and uncertainties, and that actual results may differ materially from
those projected in the forward-looking statements as a result of various
factors. The accompanying information contained in this Report including,
without limitation, the information set forth under the headings "Management's
Discussion and Analysis of Financial Condition and Results of Operations," and
"Business," as well as information contained in the Company's other filings with
the Securities and Exchange Commission (the "Commission"), identify important
factors that could cause such differences.
RAPID GROWTH STRATEGY. During 1997, 120 new Schlotzsky's stores were
opened. During 1995 and 1996, the Company and its franchisees opened 120 and 135
stores, respectively. This level of store openings is significantly greater than
that experienced by the Company prior to 1995. The Company will rely primarily
upon, its area developers, franchisees, the Turnkey Program, and new geographic
markets to maintain this level of expansion. The number of openings and the
performance of new stores will depend on various factors, including: (i) the
availability of suitable sites for new stores; (ii) the ability of area
developers to recruit qualified franchisees; (iii) the ability of franchisees to
negotiate acceptable lease or purchase terms for new locations, obtain capital
required to construct, build-out and operate new stores, meet construction
schedules, and hire and train qualified store personnel; (iv) the establishment
of brand awareness in new markets; and (v) the ability of the Company and its
area developers to manage this anticipated expansion. Not all of these factors
are within the control of the Company, and there can be no assurance that the
Company will be able to maintain or accelerate its growth or that the Company
will be able to manage its expanding operations effectively. See
"Business--Strategy."
TURNKEY PROGRAM. As of December 31, 1997, the Company had developed 57
stores under the Turnkey Program. In the future, the Company expects to
significantly increase the percentage of new store openings under the Turnkey
Program. The Company has limited experience in implementing this program
10
and there can be no assurance that results experienced to date are indicative of
future performance under the program. In addition, the Company may be unable to
sell properties acquired under the Turnkey Program at a profit or at its cost,
and the Company could be required to sell properties at a loss or hold
properties indefinitely, diminishing the capital available to reinvest in the
Turnkey Program. See "--Credit Risk and Contingencies," "Management's Discussion
and Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources" and "Business--Turnkey Program."
RELIANCE ON AREA DEVELOPERS. The Company relies on its area developers to
find qualified franchisees. Area developers are independent contractors, and are
not employees of the Company. Most area developer agreements specify a schedule
for opening stores in the territory covered by the agreement. In the past, the
Company has agreed to extend or waive development schedules for certain area
developers, and there can be no assurance that area developers will be able to
meet their contractual development schedules. These schedules form the basis for
the Company's expectations regarding the number and timing of new store
openings. Delays in store openings could adversely affect the future operations
of the Company.
From time to time, the Company relies extensively on its area developers,
many of whom do not have experience operating restaurants. In those instances,
the Company has less direct involvement in recruiting franchisees and in
monitoring the quality of franchised stores. The Company provides training and
support to area developers, but the quality of store operations and the ability
of area developers to meet development schedules may be diminished by their lack
of experience. It may be difficult for the Company to enforce its area
development agreements or to terminate the area development rights of area
developers who fail to meet development schedules or other standards and
requirements imposed by the Company, limiting the ability of the Company to
develop the territories of such area developers. See "Business--Franchising."
Between January 1, 1995 and December 31, 1997, 99 of the 375 new stores
opened were within territories controlled by only two area developers. As of
December 31, 1997, these two area developers controlled 14 territories having a
total of 216 stores. As these 14 territories mature, system-wide growth will
depend upon more activity in other territories. The Company believes that the
concentration of store openings among a relatively few area developers is due
primarily to the longer tenure of these area developers with the Company and the
size of the territories covered by their agreements.
DEPENDENCE ON FRANCHISING CONCEPT. Because royalties from franchisees'
sales are a principal component of the Company's revenue base, the Company's
performance depends upon the ability of its franchisees to promote and
capitalize upon the Schlotzsky's concept and its reputation for quality and
value. The Company believes that the cost to a franchisee of opening a
Schlotzsky's Deli restaurant is higher than the store opening costs incurred by
franchisees of many of the Company's competitors for franchisees. This
necessarily limits the number of persons who are qualified to be franchisees of
the Company. The Company has established criteria for area developers to use in
evaluating prospective franchisees, but there can be no assurance that area
developers will recruit franchisees who have the business abilities or financial
resources necessary to open Schlotzsky's stores on schedule or that franchisees
will conduct operations in a manner consistent with the Company's concepts and
standards. See "Business--Franchising."
The Company is subject to various state and federal laws relating to the
franchisor-franchisee relationship. The failure by the Company to comply with
these laws could subject the Company to liability to franchisees and to fines or
other penalties imposed by governmental authorities. The Company believes that
the franchising industry is experiencing an increasing trend of franchisees
filing complaints with state and federal governmental authorities and
instituting lawsuits against franchisors claiming that they have engaged in
unlawful or unfair trade practices or violated express or implied agreements
with franchisees. While the Company's experience is consistent with the trends
in the industry, the Company believes that it is in material compliance with
these laws and regulations and its agreements with franchisees, and that its
relations with its franchisees are generally good. See "Business--Government
Regulation" and "--Litigation."
11
IMPORTANCE OF LICENSING FEES. During the past two years, the Company's
revenue from private label licensing fees (brand contribution) has increased
significantly as the volume of system sales has increased and franchisees have
increased their participation in the Company's purchasing programs. This revenue
is largely dependent upon the voluntary participation of the franchisees. The
Company believes its purchasing programs provide franchisees with significant
cost savings and other advantages. There can be no assurance that the Company's
suppliers will not increase prices to franchisees or that franchisees will not
negotiate more favorable terms from other approved suppliers. Some franchisees
may also object to these fees as a source of revenue to the Company. Any of
these developments could result in reduced purchases by franchisees of private
label products and declining private label licensing revenue to the Company.
This could have a material adverse effect on the financial condition and results
of operations of the Company. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Results of Operations."
CREDIT RISK AND CONTINGENCIES. The Company guarantees certain real estate
and equipment leases and other obligations of its franchisees. The Company
enters into guaranties with respect to most of the leases entered into between
its franchisees and the buyers of the sites developed under the Turnkey Program.
These guaranties typically cover lease payments or various other obligations of
the franchisee for a period ranging from 18 months to five years, and are
effective throughout the term of the 20 year lease. In addition, it is
contemplated that the Company will guarantee a limited portion of most of the
mortgages of certain franchisees who purchase Turnkey Program sites pursuant to
the mortgage financing program which the Company plans to implement during 1998.
See "Business--Turnkey Program." At December 31, 1997, the Company was
contingently liable for approximately $23.3 million which is principally
comprised of real estate and equipment leases and other obligations of its
franchisees.
The Company charges area developers and master licensees a fee ("developer
fee") for the rights to develop a defined territory. Typically, a portion of the
developer fee has been paid in cash and the balance paid with a promissory note
from the area developer or master licensee. The Company periodically evaluates
the credit risk and obtains annual valuations of these notes from an independent
financial services institution with expertise in valuing instruments of this
sort. As of December 31, 1997, the Company held notes receivable from area
developers and master licensees in an aggregate principal amount of
approximately $3.5 million. At December 31, 1997, the principal balance of these
notes had been reserved on the financial statements of the Company by
approximately $443,000, reflecting the fair market value of such notes based
upon valuations from the independent financial services institution. The Company
also holds notes receivable from certain franchisees related to the sale of
Company-owned stores and certain other obligations. As of December 31, 1997, the
outstanding principal amount of these notes was approximately $1,815,000. While
the Company considers it unlikely that there will be defaults on a significant
amount of the notes, such defaults could adversely affect the Company's
financial condition. Parties controlled by or related to directors, officers and
principal shareholders of the Company have provided financing to certain area
developers and master licensees and have guaranteed obligations of certain area
developers and master licensees to the Company. See "Certain
Transactions--Master License and Area Development Agreements" and
"Business--Franchising--International Master Licensees."
A wholly owned subsidiary of the Company is the general partner of a limited
partnership that developed a retail shopping center in the Austin area. The
Company and its subsidiary have guaranteed the repayment of a loan for this
project in the principal amount of $1.1 million due in April 2001. The Company
does not exercise control over the partnership and does not consider its
investment in the retail shopping center to represent a separate line of
business. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."
LIMITED OPERATING HISTORY OF PROTOTYPES. Over the past several years, the
Company has refined its store prototypes and currently encourages franchisees to
develop larger, free-standing stores with higher visibility. This has increased
the costs to franchisees of opening and operating stores. The Company and
franchisees have a limited history of operating these larger stores, and results
achieved to date may not be indicative of future results. There can be no
assurance that, on a sustained basis, the Company will be able
12
to attract and retain franchisees qualified to assume the increased debt and the
management responsibility associated with the larger operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Consolidated Financial Statements of the Company and the
Notes thereto.
GEOGRAPHIC CONCENTRATION. Of the 673 stores in the system at December 31,
1997, 205 were located in Texas. A downturn in the regional economy or other
significant adverse events in Texas could have a material adverse effect on the
Company's financial condition and results of operations.
CERTAIN FACTORS AFFECTING THE RESTAURANT INDUSTRY. The Company and its
franchisees may be affected by risks inherent in the restaurant industry,
including: adverse changes in national, regional or local economic or market
conditions; increased costs of labor (including increases in the minimum wage);
increased costs of food products; management problems; increases in the number
and density of competitors; limited alternative uses for properties and
equipment; changing consumer tastes, habits and spending priorities; changing
demographics; the cost and availability of insurance coverage; uninsured losses;
changes in government regulation; changing traffic patterns; weather conditions;
and local, regional or national health and safety matters. The Company and its
franchisees may be the subject of litigation based on discrimination, personal
injury or other claims, including claims which may be based upon legislation
that imposes liability on restaurants or their employees for injuries or damages
caused by the negligent service of alcoholic beverages to an intoxicated person
or to a minor. The Company can be adversely affected by publicity resulting from
food quality, illness, injury or other health concerns or operating issues
resulting from one restaurant or a limited number of restaurants in the
Schlotzsky's system. None of these factors can be predicted with any degree of
certainty, and any one or more of these factors could have a material adverse
effect on the Company's financial condition and results of operations.
COMPETITION. The food service industry is intensely competitive with
respect to concept, price, location, food quality and service. There are many
well-established competitors with substantially greater financial and other
resources than the Company. These competitors include a large number of
national, regional and local food service companies, including fast food and
quick service restaurants, casual full-service restaurants, delicatessens, pizza
restaurants and other convenience dining establishments. Some of the Company's
competitors have been in existence longer than the Company and may be better
established in markets where Schlotzsky's stores are or may be located. The
Company believes that it competes for franchisees against franchisors of other
restaurants and various other concepts.
Competition in the food service industry is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company's area developers assist franchisees in
managing or adapting to these factors, but no assurance can be given that some
or all of these factors will not adversely affect some or all of the
franchisees. See "Business--Competition."
CONTROL BY PRINCIPAL SHAREHOLDERS. As of December 31, 1997, John C. Wooley
and Jeffrey J. Wooley beneficially owned an aggregate of approximately 12.5% of
the outstanding Common Stock. Additionally, Greenfield Capital Partners B.V. and
NethCorp Investments VI B.V., entities of which Floor Mouthaan, a director of
the Company is the managing director, beneficially owned an aggregate of 5.6% of
the outstanding Common Stock, and Getov Holding B.V. and Buxtehude Holding B.V.,
entities of which John M. Rosillo, a director of the Company, is the managing
director, beneficially owned an aggregate of 3.8% of the outstanding Common
Stock at December 31, 1997. As a result, these shareholders, if they were to act
in concert, would have the ability to influence the outcome of any issue
submitted to a vote of the shareholders. There are no agreements or
understandings among these shareholders regarding the voting of their shares,
but to date they have voted consistently on matters submitted to a vote of the
shareholders.
DEPENDENCE ON MANAGEMENT AND KEY PERSONNEL. The Company's success is highly
dependent upon the efforts of its management and key personnel, including its
Chairman of the Board and President, John C. Wooley. The Company has employment
agreements with John C. Wooley, Jeffrey J. Wooley, Kelly R. Arnold and Karl D.
Martin, each of which includes certain noncompetition provisions that survive
the
13
termination of employment. The employment agreements with John C. Wooley and
Jeffrey J. Wooley were entered into effective February 1998 and will expire in
February 2001. The Company also has obtained certain noncompetition agreements
from several other members of management and key personnel who are not subject
to employment agreements. However, there can be no assurance such noncompetition
agreements will be enforceable. The loss of the services of John C. Wooley or
other management or key personnel could have a material adverse effect on the
Company. The Company does not carry key man life insurance on any of its
officers. See "Management."
GOVERNMENT REGULATION. The restaurant industry is subject to numerous
federal, state and local governmental regulations, including those relating to
the preparation and sale of food and zoning and building requirements. The
Company and its area developers and franchisees are also subject to laws
governing their relationships with employees, including wage and hour laws, and
laws and regulations relating to working and safety conditions and citizenship
or immigration status. The Company's franchise operations are subject to
regulation by the United States Federal Trade Commission and the Company must
also comply with state laws relating to the offer, sale and termination of
franchises and the refusal to renew franchises. The failure to obtain or
maintain approvals to sell franchises could adversely affect the Company.
Increases in the minimum wage rate, employee benefit costs or other costs
associated with employees, could adversely affect the Company's area developers
and franchisees and, therefore, adversely affect the Company. See
"Business--Government Regulation."
ABSENCE OF DIVIDENDS. The Company has never paid cash dividends on its
Common Stock and does not anticipate paying any cash dividends in the
foreseeable future.
POTENTIAL VOLATILITY OF STOCK PRICE. There have been periods of significant
volatility in the market price and trading volume of the Common Stock, which in
many cases were unrelated to the operating performance of, or announcements
concerning, the Company. General market price declines or market volatility in
the future could adversely affect the price of the Common Stock. In addition,
the trading price of the Common Stock has been and is likely to continue to be
subject to significant fluctuations in response to variations in quarterly
operating results, the results of the Turnkey Program, changes in management,
competitive factors, regulatory changes, general trends in the industry,
recommendations by securities industry analysts and other events or factors.
This volatility has been exacerbated by the lack of a significant public float
in the Common Stock. There can be no assurance that an adequate trading market
can be maintained for the Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE. As of December 31, 1997, the Company had
7,334,416 shares of Common Stock outstanding. A substantial number of shares
will become available for sale in the public market at various times. No
predictions can be made as to the effect, if any, that market sales or the
availability of shares for future sale will have on the market price of the
Common Stock. Sales of substantial amounts of Common Stock in the public market,
or the perception that such sales could occur, could adversely affect the
prevailing market price for the Common Stock and could impair the Company's
ability to raise capital through a public offering of equity securities.
ANTI-TAKEOVER PROVISIONS. The Texas Business Combination Law, which became
effective September 1, 1997, restricts certain transactions between a public
corporation and affiliated shareholders. The statute, which is applicable to the
Company, may have the effect of inhibiting a non-negotiated merger or other
business combinations involving the Company.
The Company's Articles of Incorporation and Bylaws include certain
provisions that may have the effect of discouraging or delaying a change in
control of the Company. Directors are elected for staggered three-year terms,
which has the effect of delaying the ability of shareholders to replace specific
directors or effect a change in a majority of the Board of Directors. All
shareholder action must be effected at a duly called annual or special meeting
of shareholders and shareholders must follow an advance notification procedure
for certain shareholder proposals and nominations of candidates for election to
the Board of Directors.
14
The Board of Directors has the authority, without further action by the
shareholders, to issue up to 1,000,000 shares of Preferred Stock in one or more
series and to fix the rights, preferences, privileges and restrictions thereof,
and to issue authorized unissued shares of Common Stock. The issuance of
Preferred Stock or additional shares of Common Stock could adversely affect the
voting power of the Common Stockholders and could have the effect of delaying,
deferring or preventing a change in control of the Company. The issuance of
Preferred Stock also could adversely affect other rights of Common Stockholders,
including creation of a preference upon liquidation or upon the payment of
dividends in favor of the holders of Preferred Stock.
ITEM 2. PROPERTIES
In March 1997, the Company entered into a lease with a limited liability
company owned by John C. Wooley and Jeffrey J. Wooley for a new corporate
headquarters facility in Austin. This lease will expire in 2007. The new
facility consists of approximately 41,000 square feet of office and storage
space. The Company moved to this new facility in November 1997. The former
corporate headquarters facility, consisting of approximately 11,000 square feet
of office space in Austin, was sold by the Company in December 1997. See
"Management's Discussions and Analysis of Financial Condition and Results of
Operations--Results of Operations."
The Company leases approximately 10,000 square feet of space for the
flagship Schlotzsky's Deli restaurant and training facility in Austin and
approximately 7,100 square feet for a store opened in Austin in February 1998.
The Company has a ground lease for an additional 2,700 square foot store which
opened in Austin in February 1998. The Company leases approximately 3,000 square
feet each for two stores which it operates in Houston and the Company has plans
for two additional new stores in Houston. The Company also owns the site of its
store in North Lake, Illinois and leases approximately 1,800 square feet for its
store in New York City. It is contemplated that one of the Houston stores and
the North Lake, Illinois store will be sold, and that the other store in Houston
will be closed when one of the new stores currently in the planning stages for
Houston is opened.
As of December 31, 1997, the Company had 78 store sites in various stages of
development under the Turnkey Program. Construction was completed on two stores
and these stores are operating and under lease. Three of the sites in
development are in various stages of construction and 73 sites remain in the
pre-development stage. The Company also owns three sites, which it contemplates
remarketing. It is contemplated that stores developed under the Turnkey Program
will be sold as they are completed. See "Business--Turnkey Program."
Schlotzsky's Real Estate, Inc., a wholly-owned subsidiary of the Company, is
the general partner and the Company is a limited partner of a limited
partnership which owns a 17,600 square foot shopping center in suburban Austin.
Schlotzsky's Real Estate, Inc. and the Company have a combined 40% interest in
the capital and profits of this limited partnership. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
ITEM 3. LEGAL PROCEEDINGS
The State of New Mexico Taxation and Revenue Department has assessed the
Company $131,000 for gross receipts taxes, penalties and interest for the years
1987 through 1993. The assessment imposes gross receipts taxes on franchise fees
and royalties received by the Company from New Mexico franchisees and NAMF
contributions by those franchisees. The Company filed a protest with the New
Mexico Taxation and Revenue Department claiming that the assessment violates the
Commerce Clause of the United States Constitution because the Company does not
have any physical presence in or substantial nexus with New Mexico. The Company
has reserved a liability for taxes and attorneys' fees in respect of this
assessment. See the Consolidated Financial Statements of the Company and related
Notes included elsewhere in this Prospectus. If other state taxing authorities
attempt to impose taxes on receipts derived by the Company from franchisees in
those states, the Company's financial condition and results of operations could
be materially adversely affected.
15
The Company is subject to routine litigation in the ordinary course of
business, including contract, franchisee, area developer and employment-related
litigation. In the course of enforcing its rights under existing and former
franchise agreements and area developer agreements, the Company is subject to
complaints and letters threatening litigation concerning the interpretation and
application of these agreements, for example, in cases of administration of the
NAMF advertising funds, default or termination of franchisees or area
developers, requirements or payments relating to products used in the stores
(such as private label licensing), and the Turnkey Program. The Company
endeavors to treat its franchisees and area developers reasonably and fairly and
in compliance with applicable contractual provisions with due regard for the
protection of the Company's trademarks, service marks and goodwill. None of
these routine matters, individually or in the aggregate, are believed by the
Company to be material to its business or financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The authorized capital stock of the Company consists of 30,000,000 shares of
Common Stock, no par value, and 1,000,000 shares of Class C Preferred Stock, no
par value. The Company's Common Stock is traded on the National Market of the
National Association of Securities Dealers Automated Quotation System ("NASDAQ")
under the Symbol "BUNZ". Trading began on December 15, 1995 in connection with
the Company's initial public offering. No public market existed for the Common
Stock prior to that time. As of March 20, 1998, 7,378,567 shares of outstanding
Common Stock were owned of record by 251 Shareholders.
The high and low bid prices as reported by NASDAQ for the period from
January 1, 1996 to December 31, 1997 are set forth below:
HIGH LOW
-------- --------
FISCAL 1996:
First Quarter................................... 11 8 7/8
Second Quarter.................................. 13 3/4 9 1/2
Third Quarter................................... 12 3/4 9 3/4
Fourth Quarter.................................. 11 3/4 9 1/4
FISCAL 1997
First Quarter................................... 12 1/4 9 5/8
Second Quarter.................................. 14 1/4 10 3/4
Third Quarter................................... 20 3/8 13 1/4
Fourth Quarter.................................. 20 1/4 14 1/2
These quotations may reflect inter-dealer prices, without retail mark-up,
mark-down or commissions and may not necessarily represent actual transactions.
The Company has never paid and has no current plans to pay cash dividends on its
Common Stock. The Company currently intends to retain earnings for use in the
operation and expansion of the Company's business and does not anticipate paying
cash dividends in the foreseeable future. The declaration and payment of future
dividends will be at the sole discretion of the Board of Directors and will
depend on the Company's profitability, financial condition, capital needs,
future prospects and other factors deemed relevant by the Board of Directors.
The Transfer Agent and Registrar for the Company's Common Stock is Harris
Trust and Savings Bank of Chicago, Illinois.
16
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data for the
Company for the periods and the dates indicated. The historical consolidated
financial data as of and for the years ended December 31, 1995, 1996 and 1997
have been derived from the audited consolidated financial statements of the
Company and its predecessor entities, included elsewhere herein. The balance
sheet data and statement of operations data as of and for the years ended
December 31, 1993 and 1994 have been derived from the Company's audited
financial statements not included or incorporated herein. The selected financial
data should be read in conjunction with, and are qualified in their entirety by,
the Consolidated Financial Statements of the Company and related Notes and other
financial information included elsewhere in this report.
FISCAL YEARS ENDED DECEMBER 31,
-----------------------------------------------------
1993 1994 1995 1996 1997
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Royalties................................................... $ 2,969 $ 4,657 $ 7,425 $ 10,747 $ 14,561
Franchise fees.............................................. 621 1,019 1,494 1,775 1,555
Developer fees.............................................. 2,170 2,793 2,666 1,993 325
Restaurant sales............................................ 623 428 505 3,610 6,364
Brand contribution.......................................... -- 150 397 1,295 2,915
Turnkey development......................................... -- -- 41 726 1,139
Other fees and revenue...................................... 141 256 324 568 1,110
--------- --------- --------- --------- ---------
Total revenue........................................... 6,524 9,303 12,852 20,714 27,969
Costs and expenses:
Service costs:
Royalties................................................. 372 1,122 2,405 3,791 5,373
Franchise fees............................................ 338 661 767 959 813
Restaurant operations:
Cost of sales............................................. 202 188 189 1,183 2,014
Labor costs............................................... 214 154 408 1,424 2,493
Operating expenses........................................ 380 260 251 1,040 1,952
General and administrative.................................. 3,679 4,199 5,751 7,028 8,054
Depreciation and amortization............................... 268 372 458 779 1,155
--------- --------- --------- --------- ---------
Total costs and expenses................................ 5,453 6,956 10,229 16,204 21,854
--------- --------- --------- --------- ---------
Income from operations.................................... 1,071 2,347 2,623 4,510 6,115
Other:
Interest income (expense)................................... (240) (201) (149) 455 753
Other income (expense)...................................... 232 226 138 132 195
--------- --------- --------- --------- ---------
Total other income (expense)............................ (8) 25 (11) 587 948
--------- --------- --------- --------- ---------
Income (loss) before income taxes and extraordinary gain.... 1,063 2,372 2,612 5,097 7,063
Provision for income taxes.................................. 56 927 1,017 1,902 2,614
Gain on extinguishment of debt, net of tax.................. -- 40 38 -- --
--------- --------- --------- --------- ---------
Net income (loss)........................................... $ 1,007 $ 1,485 $ 1,633 $ 3,195 $ 4,449
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Net income per share--basic(1).............................. $ .26 $ .47 $ .47 $ .58 $ .74
Net income per share--diluted(1)............................ $ .26 $ .44 $ .42 $ .57 $ .71
CONSOLIDATED BALANCE SHEET DATA:
Working capital............................................. $ (2,397) $ 1,909 $ 18,750 $ 13,515 $ 42,563
Total assets................................................ 12,364 16,481 36,708 40,979 79,521
Long-term debt, less current maturities(2).................. 6,420 10,452 3,029 3,129 1,936
Stockholders' equity........................................ 584 1,614 28,974 32,312 66,991
- --------------------------
(1) Earnings per share reflects retroactive application of Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earning Per Share."
(2) For 1993 and 1994, long-term debt includes $5,000,000 and $8,000,000,
respectively for redeemable preferred stock.
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company derives its revenue from several sources: royalties, franchise
fees, developer fees (consisting of area developer and master licensee fees),
Company-owned restaurant sales, turnkey development, brand contribution (private
label licensing fees), and other franchise-related activities. Between 1991 and
1994, developer fees and franchise fees grew to represent a significant portion
of total revenue as the Company sold development rights for most of the
television markets in the United States and certain international territories.
Franchise fees, turnkey development and brand contribution increased during this
period as the rate at which stores opened increased. Since the Company has sold
developer rights for virtually all of the United States, developer fees derived
from these non-recurring transactions have declined as a percentage of total
revenue, while franchise fees and royalties based on franchise store sales and
revenue from the Turnkey Program have increased.
Royalties are based on a percentage of franchisees' net sales and are
recognized by the Company in the same period that the franchise store sales
occur. Generally, royalties are earned at the rate of 6% of sales for stores
opened after the 1991 year end, and 4% of sales for stores opened before that
time. Royalties are paid by means of weekly automatic drafts by the Company on
franchisee bank accounts for 6% royalty stores. As of December 31, 1997, 127
franchised stores were paying royalties on a monthly basis at the rate of 4%.
This number of stores will decline as older franchise agreements expire (the
majority of which will expire after 1998). A portion of the royalties received
by the Company are paid to its area developers as royalty service costs for
providing on-going services to franchisees in their territories. As more stores
open under 6% franchise agreements, the Company expects that royalty service
costs will approach 42% of royalties. See "Business--Franchising--Area
Developers." Royalties have increased since 1992 due not only to the growth in
the number of stores, but also to increases in average weekly sales. The
increase in average weekly sales is due primarily to the conversion of older
franchise stores to the Schlotzsky's Deli restaurant concept, as well as the
selection of more free-standing locations for newer stores, which have better
visibility and generally experience higher sales than the smaller "in-line"
stores located in strip shopping centers which are characteristic of stores
opened prior to 1992.
Franchise fees are nonrefundable payments received by the Company from
franchisees and are typically recognized into revenue as stores open. The
franchise fee for a franchisee's initial store is currently $20,000. The
franchise fee for each additional store committed to and opened by a franchisee
is $10,000. Expenses associated with franchise fees are shown as franchise fee
service costs and include the portion of the franchise fee paid to area
developers. The Company generally pays area developers approximately one-half of
the franchise fees collected from franchisees in their development areas,
although the Company agreed to pay some area developers up to 100% of certain
franchise fees as an inducement to develop their territories more quickly. As
the number of stores covered by these enhanced arrangements begins to diminish
and as the Company reacquires a limited number of territories, the Company
expects that franchise fee service costs will decrease as a percentage of
franchise fees to approximately 50%.
Restaurant sales are reported from Company-owned stores, and declined
between 1991 and 1994 as a result of the Company's strategy adopted in 1991 to
develop only franchised stores. The number of Company-owned stores declined from
22 to two stores between 1990 and 1994. Restaurant sales increased significantly
in 1996 because the Company's flagship restaurant in Austin, Texas was in
operation the entire year and because two additional stores were acquired from
franchisees during 1996. Currently, Company stores are operated primarily for
product development, concept refinement and training franchisees. Management
does not believe that the operating cost of sales for Company-owned stores is
indicative of costs for franchised stores on a system-wide basis. Restaurant
sales should increase as the Company opens a limited number of additional
Company-owned stores. See "Business--Strategy--Company-Owned Stores."
18
The Company charges developers a nonrefundable fee for the exclusive rights
to develop a defined territory for a specified term. Typically, a portion of the
developer fee is paid in cash and the balance is paid with a promissory note.
See "Business--Franchising--Area Developers" and "--International Master
Licensees." When the Company has fulfilled substantially all of its contractual
responsibilities and obligations, such as training, providing manuals, and, in
the case of master licensees, reasonable efforts to obtain trademark
registration, the Company recognizes as revenue the cash portion of the fee and
the value of the promissory note, as determined by an independent third party
valuation. These fees have declined in the last two years as most of the
remaining domestic territories have been sold and fees from the licensing of
international territories, which are not aggressively marketed by management,
remain sporadic.
Revenue is also generated from brand contribution (private label licensing
fees) and the Turnkey Program. The Company has licensed manufacturers to produce
Schlotzsky's private label products and began receiving licensing fees from
sales of private label foods to franchisees in late 1994. This revenue has
increased significantly to $1,295,000 for 1996 and $2,915,000 for 1997. The
Company believes that private label licensing fees will increase as system-wide
sales grow. See "Business--Purchasing; Private Labeling" and "Risk
Factors--Importance of Licensing Fees."
Under the Turnkey Program, the Company works independently or with an area
developer to identify superior store sites within a territory. The Company
typically purchases or leases a selected site, designs and constructs a
Schlotzsky's Deli restaurant on the site and sells, leases or subleases the
completed store to a franchisee. Where the Company does not sell the property to
a franchisee, the Company sells the improved property, or, in the case of a
leased property, assigns the lease and any sublease, to an investor. The Company
typically guaranties a portion of the lease in favor of the investor, and is
indemnified by the franchisee in the event the guaranty is called upon. Revenue
and allocable expenses from these transactions have been deferred, even though
the Company typically receives cash when the property is sold. From time to
time, the Company may assign its earnest money contract on a site and the
franchisee's lease to a third party investor who then assumes responsibility for
developing the store. Upon assignment of its earnest money contract, the Company
has deferred revenue and allocable costs where it has provided credit
enhancement. The Company may charge a fee for managing the construction of a
store on a site which it does not own. This revenue is recognized when the fees
are earned and the Company has fulfilled its obligations. The Company believes
that the Turnkey Program enhances the Company's ability to recruit qualified
franchisees by securing and developing high profile sites and achieving critical
mass for advertising purposes more quickly in selected markets. In addition,
while the Company may be called upon to perform on its guaranties, the Company
considers this a customary service benefitting franchisees and, ultimately, the
franchise system. The Company believes that the guaranties enhance the brand
image because they facilitate higher quality restaurants at superior sites which
would otherwise be unavailable to many franchisees. Also, the Company is
immediately benefitted by the increase in cash flows because it has typically
received cash of approximately $100,000 in excess of its costs associated with
each property, and because the Company receives royalties on these prototype
stores that tend to experience higher than average sales.
19
The following table sets forth (i) the percentage relationship to total
revenue of the listed items included in the Company's consolidated statements of
operations, except as otherwise indicated, and (ii) selected store data.
FISCAL YEARS ENDED DECEMBER 31,
----------------------------------------------
1995 1996 1997
-------------- -------------- --------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Royalties....................................... 57.8% 51.9% 52.1%
Franchise fees.................................. 11.6 8.6 5.6
Developer fees.................................. 20.7 9.6 1.2
Restaurant sales................................ 4.0 17.4 22.7
Brand contribution.............................. 3.1 6.3 10.4
Turnkey development............................. .3 3.5 4.1
Other fees and revenue.......................... 2.5 2.7 3.9
-------------- -------------- --------------
Total revenue................................. 100.0 100.0 100.0
Costs and expenses:
Service costs:
Royalties(1).................................. 32.4 35.3 36.9
Franchise fees(2)............................. 51.3 54.0 52.3
Restaurant operations:
Cost of sales(3).............................. 37.3 32.8 31.6
Labor costs(3)................................ 80.8 39.5 39.2
Operating expenses(3)......................... 49.7 28.8 30.7
General and administrative...................... 44.8 33.9 28.8
Depreciation and amortization................... 3.6 3.8 4.1
Total costs and expenses.................... 79.6 78.2 78.1
-------------- -------------- --------------
Income from operations........................ 20.4 21.8 21.9
-------------- -------------- --------------
Other:
Interest income (expense)....................... (1.2) 2.2 2.7
Other income(expense)........................... 1.1 0.6 0.7
-------------- -------------- --------------
Total other income (expense)................ (0.1) 2.8 3.4
-------------- -------------- --------------
Income (loss) before income taxes and
extraordinary gain............................ 20.3 24.6 25.2
Provision for income taxes...................... 7.9 9.2 9.3
Gain on extinguishment of debt, net of tax...... .3 -- --
-------------- -------------- --------------
Net income...................................... 12.7% 15.4% 15.9%
-------------- -------------- --------------
-------------- -------------- --------------
STORE DATA:
System-wide sales(4)............................ $ 142,500 $ 202,400 $ 270,400
Change in same store sales(5)................... 1.7% 3.3% 3.4%
Average annual store sales(6)................... $ 368,000 $ 410,000 $ 455,000
Weighted average weekly store sales(6).......... $ 7,086 $ 7,867 $ 8,753
Change in weighted average weekly store
sales(7)...................................... 12.9% 11.0% 11.3%
Number of stores opened during period........... 120 135 120
Number of stores closed during period........... 10 25 20
Number of stores in operation at end of
period........................................ 463 573 673
- ------------------------
(1) Expressed as a percentage of royalties.
(2) Expressed as a percentage of franchise fees.
(3) Expressed as a percentage of restaurant sales.
20
(4) In thousands. Includes sales for all stores, as reported by franchisees or
derived by the Company from other data reported by franchisees.
(5) Same store sales are based upon stores which were open for the entire period
indicated and for at least 18 months as of the end of the corresponding
prior period.
(6) In actual dollars (rounded in the case of average annual store sales).
(7) Percentage change in weighted average weekly store sales from previous
fiscal year.
RESULTS OF OPERATIONS
FISCAL YEAR 1997 COMPARED TO 1996
REVENUE. Total revenue increased 35.0% from $20,714,000 to $27,969,000.
Royalties increased 35.5% from $10,747,000 to $14,561,000. This increase was
due to the full year impact of stores opened in 1996 and the addition of 120
restaurants opened during the period from January 1, 1997 to December 31, 1997.
Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, an 11.3% increase in average weekly
sales and a 3.4% increase in same store sales.
Franchise fees decreased 12.4% from $1,775,000 to $1,555,000. This decrease
was a result of 15 fewer openings during 1997, as compared to 1996. The fewer
number of openings is principally the result of the Company's increasing
emphasis on superior site selection for larger freestanding stores with higher
visibility and on more highly qualified and better capitalized franchisees.
Developer fees decreased 83.7% from $1,993,000 to $325,000. This decrease
was primarily the result of less emphasis on these transactional fees and the
fact that the development rights to most domestic markets have been sold. The
Company anticipates that developer fees received in the future will primarily
result from re-marketing development rights it re-acquires.
Restaurant sales increased 76.3% from $3,610,000 to $6,364,000. This
increase was attributable to a 17.4% increase in sales volume at the Company's
flagship store and the opening of two additional Company-owned stores in 1997.
In the future, it is contemplated that the Company will market to franchisees
certain of its Company-owned stores, but that several other Company-owned stores
will be developed, operated and maintained by the Company in certain key
markets.
Private label licensing fees (brand contributions) increased 125.1% from
$1,295,000 to $2,915,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well as
the increasing volume of system-wide sales and greater franchisee participation
in the Company's purchasing programs.
Turnkey development revenue increased 56.9% from $726,000 to $1,139,000.
Cash received in excess of costs allocable to 1997 Turnkey Program transactions
in which the Company provided credit enhancement on franchisees' leases was
treated as deferred revenue, and accordingly, did not impact the current year's
revenue or net income. Revenue in 1997 included approximately $303,000 of rental
revenue from sites completed and under lease. Forty sites developed under the
Turnkey Program were sold during 1997, seven of which had no credit enhancement
associated with the transaction, and the revenues from that activity comprises
the balance of Turnkey development revenue generated during this period.
Other fees and revenues increased 95.4% from $568,000 to $1,110,000. This
change was primarily due to the increased level of supplier contributions to the
Company's annual convention held in July 1997.
COSTS AND EXPENSES. Royalty service costs increased 41.7% from $3,791,000
to $5,373,000. This increase was a direct result of the increase in royalty
revenue for 1997, as compared to 1996. Royalty service costs as a percentage of
royalties grew from 35.3% to 36.9%. This increase reflects the growing
percentage of restaurants serviced by the area developer system and whose area
developers receive approximately 42% of the royalties from stores in their
territories.
21
Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 70.2% from $1,183,000 to $2,014,000, but as a percentage of restaurant
sales decreased from 32.8% to 31.6%. Also, restaurant labor costs increased
75.1% from $1,424,000 to $2,493,000, but as a percentage of restaurant sales
decreased from 39.4% to 39.2% for the same period in 1996. These percentage
decreases were primarily due to the improving operational efficiencies attained
in the various Company-owned stores. Restaurant operating expenses have
increased 87.7% from $1,040,000 to $1,952,000, and as a percentage of restaurant
sales increased from 28.8% to 30.7% for 1997, as compared to 1996. The increase
in operating expenses is due to the additional facility costs for the additional
stores the Company operates.
General and administrative expenses increased 14.6% from $7,027,000 to
$8,054,000, but as a percentage of total revenue decreased from 33.9% to 28.8%.
The dollar increase was principally the result of additional personnel at the
corporate office, including certain one-time expenses related to the hiring and
relocation of the individuals. The percentage decrease is the result of revenue
increasing at a greater rate than these expenses for 1997. Turnkey Program costs
were included with general and administrative expenses in 1997 reflecting the
fact that allocable Turnkey costs were deferred along with the revenue deferred
on certain transactions. The remaining nonallocable Turnkey Program costs were
insignificant.
Depreciation and amortization increased 48.4% from $779,000 to $1,156,000,
and as a percentage of revenue increased from 3.8 to 4.1%. This increase was
principally due to amortization of goodwill and other intangibles acquired in
1996 and 1997, and depreciation related to the additional stores the Company was
operating during the year.
OTHER. Net interest income increased 65.5% from $455,000 to $753,000. This
increase was a result of a higher level of funds invested during the more recent
period because of the secondary offering.
INCOME TAX EXPENSE. Income tax expense reflects a combined federal and
state effective tax rate of 37.0% for 1997, which is slightly lower than the
effective combined tax rate for the comparable period in 1996. Based on
projections of taxable income, the Company anticipates that its effective
combined rate for federal and state taxes will be between 37% and 38% in 1998.
FISCAL YEAR 1996 COMPARED TO 1995
REVENUE. Total revenue increased 61.2% from $12,852,000 to $20,714,000.
Royalties and franchise fees increased 44.7% and 18.8% respectively, from
$7,425,000 to $10,747,000 and $1,494,000 to $1,775,000. These increases were
primarily due to the increased number of stores opened during the period as well
as the stronger sales volume of the newer stores. There were 135 store openings
in 1996 compared to 120 openings in 1995. Also, average annualized volumes for
stores opened in 1995 was $480,000 compared to $591,000 for stores opened in
1996.
Developer income decreased by 25.2% from $2,666,000 to $1,993,000 and
decreased as a percentage of revenue from 20.7% to 9.6%. This trend reflects the
Company's transition from one-time nonrecurring transactions to a revenue stream
driven principally by royalties and franchise fees.
During 1996, four territorial agreements were executed for 12 foreign
territories. In addition, six area developer agreements were executed for
domestic territories where the prior area development agreement had been
terminated due to failure to comply with the terms of the agreement or where the
Company bought back the development rights and subsequently resold the rights to
new area developers.
Restaurant sales increased from $506,000 to $3,610,000. Fiscal year 1996 was
the first full year of operations for the Company's flagship store in Austin,
Texas which opened in late 1995, and the Company operated two stores purchased
from franchisees during the second quarter of 1996. It is the Company's
intention to re-market the units acquired from franchisees once operations and
profitability are improved at those stores.
22
Private label licensing fees increased 226.1% from $397,000 to $1,295,000
because of an increase in the volume of these products purchased by franchisees
and the re-negotiated terms of two contracts from major suppliers.
Turnkey development revenue rose from $41,000 to $726,000 in 1996 (of which
$364,000 was rental revenue for periods of operations prior to the sales of the
sites). The completion of 16 Turnkey Program sites and the sale of 10 of these
sites accounted for the increase in 1996.
Other fees and revenues increased 75.3% from $324,000 to $568,000 due
primarily to an increase in the overhead recovery from the Company's national
advertising fund and other nonrecurring miscellaneous fees.
COSTS AND EXPENSES. Royalty service costs increased 57.6% from $2,405,000
to $3,791,000. This increase was a result of the growth in royalty revenue and
the increasing percentage of Schlotzsky's restaurants under the area developer
program for the year ended December 31, 1996, as compared to the same period in
the prior year. Likewise, royalty service costs as a percentage of royalties
increased from 32.4% to 35.3%.
Franchise fee development costs increased 25.0% from $767,000 to $959,000.
This increase was a result of the number of stores opened during the period.
Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 525.9% from $189,000 to $1,183,000. This increase reflects the impact
of full-year operations at the Company's flagship store which opened in Austin,
Texas in November 1995, and the operation of two stores acquired from
franchisees in the second quarter of 1996. The Company expects these costs to
increase only slightly in 1997 as expenses level off at the flagship store,
subject to opportunities to acquire, operate and improve other franchisee stores
that are not performing well. It is contemplated that the Company would
re-market such stores after improvements are made.
Restaurant labor cost and operating expenses also reflect the impact of
full-year operations at the Company's flagship store and the addition of the two
former franchisee restaurants now being operated by the Company. Labor costs
increased 249.0% from $408,000 to $1,424,000. Additionally, restaurant operating
expenses grew 314.3% from $251,000 to $1,040,000 for the twelve months ended
December 31, 1996. Due to the training and product development performed at the
flagship store, the Company does not anticipate these costs to be indicative of
those of a franchised restaurant.
General and administrative expenses increased 22.2% from $5,751,000 to
$7,027,000. This increase was primarily due to the addition of staff at the
corporate office, the strengthening of reserves for certain receivables, and
other administrative costs. In addition, a one-time expense related to the
exercise of certain stock options by a former employee was incurred in the
second quarter of 1996.
Depreciation and amortization increased 70.1% from $458,000 to $779,000. The
increase was primarily due to first time depreciation of improvements and
equipment at the Company's flagship store and the two additional stores acquired
from franchisees during the second quarter of 1996. Amortization of pre-opening
costs for the flagship store and the royalty value related to remarketing the
two newly acquired stores were the primary factors contributing to an increase
in amortization expense.
OTHER. A portion of the proceeds from the Company's initial public offering
was used to retire debt, with a portion invested in short-term liquid
securities. As a result, net interest income was $455,000 for 1996, a $604,000
improvement from the net interest expense incurred during 1995.
INCOME TAX EXPENSES. Income tax expense for the year reflects a combined
federal and state effective tax rate of 37.3% in 1996 compared to the prior
year's rate of 38.9%.
23
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $5,608,000 for 1997. Royalties
from the addition of new stores and increased private label licensing fees
(brand contributions) resulted in net income of $4,449,000 for the year.
Proceeds from the sales of Turnkey Program properties generated $29,977,000 of
cash flow while $28,355,000 of cash was used in purchasing and developing new
sites under the Turnkey Program. Accounts receivable increased $6,995,000 during
the year primarily because proceeds from a number of Turnkey Program projects
disposed of at the end of the year were not received until after year end.
Accounts payable and accrued liabilities increased $4,421,000 primarily because
of construction costs incurred during the fourth quarter that were due
subsequent to the end of the year. Net cash of $8,798,000 was used in investing
activities primarily consisting of expenditures of $7,436,000 on the completion
of Company-owned stores, three future sites of additional Company stores and the
construction of its new corporate headquarters. As a result of the sale of the
Company's former headquarters and a Company-owned store, sale of equipment
generated $1,655,000 of cash flow. Also, the Company used $2,722,000 to
re-acquire the development rights to several domestic territories and re-acquire
franchise rights in some selected markets. During 1997, financing activities
provided cash of approximately $28,805,000 due primarily to the issuance of
1,731,825 shares of common stock in the Company's secondary public offering. The
Company used proceeds from the offering to retire approximately $2,537,000 of
debt during the year.
Net cash used in operating activities in 1996 was $2,168,000. Net cash used
in investing activities was $4,246,000 in 1996 primarily as a result of
re-acquisition of several domestic development territories. The acquisition of
these territories along with the purchase of two stores from franchisees, was a
cash use of approximately $1,912,000. The Company also invested $1,664,000 in
the development of Company-owned stores. Additionally, the Company invested
$300,000 to acquire a preferred equity interest in a master licensee. In 1996,
financing activities used net cash of $292,000. The Company retired debt of
approximately $915,000 during the period. In connection with the purchase of two
stores and rights to several territories, the Company issued $584,000 of notes
payable and long-term debt.
At December 31, 1997, the Company had approximately $2,187,000 of debt
outstanding. During 1996, the Company borrowed approximately $584,000 in
connection with the re-acquisition of certain domestic development rights
described above. Notes payable were issued to the area developers whose
development rights were re-acquired. The interest rates on the notes range from
8.5% to 9.0% and all mature prior to the end of 1998. During 1997, the Company
borrowed an additional $1,113,000 primarily in connection with the
re-acquisition of certain domestic development rights. These notes bear interest
at rates ranging from 9.0% to 10.6% and all mature by the end of 2002. The
Company guarantees certain real estate leases, equipment leases and other
obligations of franchisees. At December 31, 1997, these contingent liabilities
totaled approximately $23,288,000. Included in this amount is a construction
loan for a limited partnership in which the Company and its subsidiary,
Schlotzsky's Real Estate, Inc., own a combined 40% interest in capital and
profits. The loan, for which the Company is liable for the full amount, had a
balance of $1,117,000 at December 31, 1997, bears interest at prime plus 1.25%
and matures April 2001. Monthly payments are being made by the limited
partnership.
The Company plans to develop additional Company-owned stores in the next 18
months in the Austin market and certain selected other markets. Funds of
approximately $8,000,000 are estimated to be required for the development of
Company-owned stores. Two stores have opened in the first quarter of 1998 and
the Company completed the construction of its new Company headquarters in the
fourth quarter of 1997. Proceeds from the secondary public offering were used to
complete these construction projects.
The Company continues to expand and refine its Turnkey Program and expects
that it will have 50 to 100 sites under contract or at various stages of
development at any given time. The Company has used the net proceeds from its
public offerings and the proceeds from sites it has sold and contracts assigned
to finance the activity of the Turnkey Program. With the anticipated growth in
the Turnkey Program, the capital required to finance the Turnkey Program will
increase significantly. During 1997, the Company completed transactions
involving 41 sites under the Turnkey Program, which consisted of 33 completed
stores, 7 assignments of earnest money contracts and the completion of one
Company-owned store.
24
Seventy-eight properties were under contract or in various stages of development
at December 31, 1997. The tables below provide a summary of the Turnkey Program
activity since its inception and a summary of the status of the Turnkey Program
at December 31, 1997.
Turnkey development revenue consists of the following:
FOR THE YEAR ENDED DECEMBER
31,
------------------------------
1996 1997
-------------- --------------
Sales to investors and franchisees................ $ 6,638,150 $ 23,022,364
Development and construction management fees...... 174,979 190,000
-------------- --------------
Gross Turnkey Program revenue................... 6,813,129 23,212,364
Turnkey Program costs............................. (6,455,618) (21,013,973)
-------------- --------------
Net revenue from Turnkey Program projects....... 357,511 2,198,391
Rental income..................................... 368,402 303,091
Interim construction interest..................... -- 1,270
Less: deferred revenue............................ -- (1,364,142)
-------------- --------------
Total Turnkey Program revenue................... $ 725,913 $ 1,138,610
-------------- --------------
-------------- --------------
The following table reflects system performance of the Turnkey Program since
its inception in 1995.
NUMBER OF UNITS
-------------------------------------
1995 1996 1997
----- ----- -----
Sites in process at beginning of year................................ -- 27 30
Sites beginning development during the year.......................... 32 19 90
Sites completed as Company-owned stores.............................. -- (1) (1)
Sites inventoried to real estate held for sale....................... -- (5) --
Sites sold--revenue recognized....................................... (5) (10) (7)
Sites sold--revenue deferred......................................... -- -- (33)
Other................................................................ -- -- (1)
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Sites in process at end of year...................................... 27 30 78
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INVESTED AT
DECEMBER 31,
1997
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Opened (receiving rent & royalties).................................. 2 8 2 $1,646,000
Investment Sites (under construction)................................ 9 9 3 4,092,000
Predevelopment Site (prequalification)............................... 11 13 73 1,213,000
Other................................................................ 5 -- -- --