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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-27008
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SCHLOTZSKY'S, INC.
(Exact name of registrant as specified in its charter)
TEXAS 74-2654208
(State or other Jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
203 COLORADO STREET, AUSTIN, TEXAS 78701
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (512) 236-3600
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
Name of each exchange
Title of each class on which registered
COMMON STOCK, NO PAR VALUE NASDAQ NATIONAL MARKET
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
PREFERRED STOCK PURCHASE RIGHTS
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ ].
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 19, 1999 was approximately $60,849,000 based upon the
last sales price on March 19, 1999 on the NASDAQ National Market System for the
Company's common stock. For purposes of this computation, all officers,
directors and 10% beneficial owners of the registrant are deemed to be
affiliates. Such determination should not be deemed an admission that such
officers, directors or 10% beneficial owners are, in fact, affiliates of the
Registrant. Registrant had 7,401,338 shares of Common Stock outstanding on
March 19, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement to be filed with
the Securities and Exchange Commission not later than 120 days after the close
of the registrant's fiscal year are incorporated by reference into Part III of
this Form 10-K.
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SCHLOTZSKY'S, INC.
INDEX TO FORM 10-K
YEAR ENDED DECEMBER 31, 1998
PAGE NO.
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PART I
Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters . . . 17
Item 6. Selected Consolidated Financial Data. . . . . . . . . . . . . . . . . . . . 18
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 7A. Quantitative and Qualitative Disclosures About Market Risk. . . . . . . . . 28
Item 8. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . 29
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . 29
PART III
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . 30
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 12. Security Ownership of Certain Beneficial Owners and Management . . . . . . 30
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . 30
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. . . . . . 30
PART I
ITEM 1. BUSINESS
Schlotzsky's, Inc. (the "Company") was formed effective January 1, 1993,
when Schlotzsky's Franchising Limited Partnership, Schlotzsky's-Houston, Ltd.,
Schlotzsky's-San Antonio, Ltd., Schlotzsky's Restaurant Management Corporation,
and Schlotzsky's, Inc. (collectively, the "Predecessor Entities") were merged
into the Company and its two wholly-owned subsidiaries, Schlotzsky's
Restaurants, Inc. and Schlotzsky's Real Estate, Inc. (the "1993 Merger"). In
June 1993, the Company raised $5 million through the sale of Class A Preferred
Stock and used the proceeds to redeem the preferred stock issued in the 1993
Merger to the investors in the Predecessor Entities other than John C. Wooley
and Jeffrey J. Wooley. The Company's other subsidiaries, which are wholly-owned,
are Schlotzsky's Brands, Inc., Schlotzsky's Equipment Corporation, DFW
Restaurant Transfer Corp., 56th and 6th, Inc., and SREI Turnkey Development,
L.L.C. The Company and its subsidiaries are Texas corporations, and references
to the "Company" include its predecessors, and its and their subsidiaries,
unless the context otherwise requires.
The Company's principal executive offices are located at 203 Colorado
Street, Austin, Texas 78701, and its telephone number is (512) 236-3600.
GENERAL
The Company is a franchisor of quick service restaurants that feature
made-to-order sandwiches with unique sourdough buns. At December 31, 1998, the
Schlotzsky's system included eight Company-owned stores and 742 franchised
stores located in 38 states, the District of Columbia and 13 foreign countries.
System-wide sales were approximately $270.4 million for 1997 and $348.5 million
for 1998. Weighted average annual unit volumes were $455,000 in 1997 and
$503,000 for 1998.
STRATEGY
John C. Wooley and Jeffrey J. Wooley acquired the Company in 1981. They
were attracted to the Company by the unique characteristics of The Schlotzsky's
Original sandwich, the only sandwich sold at Schlotzsky's restaurants at that
time, and the strong brand loyalty that had developed for this sandwich in the
Company's markets. From 1981 to 1991, management tested different strategies to
expand the Company's business, including the development of Company-owned stores
and expanded store menus.
In 1991, the Company began implementing a strategy to achieve its objective
of becoming a leader in the specialty sandwich segment of the restaurant
industry in the United States. The key elements of this strategy are to: offer
an expanded menu of consistent, high quality foods featuring the Company's
proprietary bread recipes, complemented by excellent customer service; use the
Turnkey Program to develop new stores in high visibility, free-standing
locations; utilize area developers to decentralize certain labor intensive
aspects of franchisee recruiting and support; develop a strong network of
motivated owner-operator franchisees; and increase awareness of the Schlotzsky's
brand through enhanced marketing and private label products. Recently, the
Company revised its strategy to include the acquisition and development of a
limited number of Company-owned stores, principally for concept development.
The Company anticipates that it will initiate national network television
advertising in the Spring of 1999.
MENU OF DISTINCTIVE, HIGH QUALITY PRODUCTS. Schlotzsky's Deli restaurants
offer an expanded menu of consistent, high quality foods featuring the Company's
proprietary bread recipes, complemented by excellent customer service. The menu
features made-to-order sandwiches with bread that is baked fresh from scratch
every day for every restaurant. The Schlotzsky's Original sandwich, which was
introduced in 1971, is a variation of the muffaletta sandwich made with three
meats (lean ham, Genoa salami and cotto salami), three cheeses (mozzarella,
cheddar and parmesan), garlic butter, mustard, marinated black olives, onion,
lettuce and tomato on a toasted sourdough bun. The Schlotzsky's Original
sandwich continues to be the most popular item on the Schlotzsky's menu.
Schlotzsky's Deli restaurants now offer an expanded menu with 15 sandwiches on
four types of bread, 10 sourdough crust pizzas, five salads, soups, chips and
other side items, fresh baked cookies and other desserts, and
1
beverages. At most locations, sandwiches range in price from $3.00 to $4.75
($7.00 for an oversized Original), and eight-inch gourmet pizzas are priced
between $3.50 and $4.50.
TURNKEY PROGRAM; HIGH VISIBILITY STORES. The Company and its area
developers encourage franchisees to develop free-standing stores with high
visibility and easy access. The Company believes the location of a store is as
important to its success as the efforts of the franchisee, and works with area
developers to assist franchisees in identifying and acquiring superior store
locations. The Company implemented its Turnkey Program as a means of
accelerating the development of high visibility stores and capitalizing on the
Company's experience in evaluating store sites by providing a variety of
services from securing the site, to development and construction of the store.
The Turnkey Program also enhances the quality and consistency of the
free-standing stores developed for franchisees by the Company because of its
experience building prototype stores and its purchasing power with suppliers and
contractors.
AREA DEVELOPERS. The Company has 32 area developers trained to assist the
Company in achieving its expansion goals in the United States. Area developers
provide the following services: they recruit and qualify franchisees; they
assist franchisees in site selection, training, financing, building and opening
stores; they provide ongoing operational support; they monitor product and
service quality; and they help coordinate local advertising. Prior to 1991,
these functions were performed by Company personnel. By utilizing its area
developer network, the Company believes that it can effectively support a
growing number of franchised stores while controlling its overhead costs. Area
developers receive a portion of franchise fees and royalties from each store in
their territories and are motivated to develop their markets and monitor
operating performance. Generally, area developers have been required to meet
specific store opening schedules under their agreements with the Company in
order to maintain their development rights. The Company recently contracted
with several area developers to buy down their portion of franchise fees and
royalties in return for cash or the combination of cash and a note. As a result
of these contracts, it is contemplated that store opening schedules for these
area developers will be eliminated.
MOTIVATED OWNER-OPERATOR FRANCHISEES. The Company is developing a strong
network of owner-operator franchisees. The Company believes that a motivated
owner-operator is an essential key to the success of a store. The Schlotzsky's
system consists almost exclusively of franchised stores, owned and managed by
entrepreneurial franchisees. The Company seeks franchisees who are committed to
providing on-site supervision of store operations and prefers to limit
franchisees to three or four locations in relatively close proximity. As of
December 31, 1998, out of 458 franchisees with stores, 9 franchisees have more
than five stores each and, in the aggregate, account for approximately 8.8% of
the stores in the system.
INCREASED BRAND AWARENESS. The Company seeks to increase awareness of the
Schlotzsky's brand through enhanced marketing and private label products. The
Company is directing its franchising efforts to establish a sufficient number of
stores in larger markets to allow expanded cooperative advertising through
newspaper, radio and television. The Company has developed a complete line of
private label products to increase Schlotzsky's brand awareness. Private label
products are used by franchisees in preparing foods and are displayed at stores
as part of the standard decor package. Some private label products are sold by
franchisees for home consumption. In 1999, Schlotzsky's brand chips became
available for retail purchase outside of the restaurant system for the first
time in the domestic superstores of one of the world's largest retailers. The
Company expects to continue to explore alternative channels for retail
distribution of some of its private label products.
COMPANY-OWNED STORES. The Company's flagship store in Austin, Texas opened
in 1995, and two stores were acquired from franchisees by the Company in 1996,
one in New York City (Manhattan) and one in Houston. In addition, in 1997, the
Company developed or acquired and began operating another store in Houston, one
in Illinois, one in Mississippi, and one in Georgia. In 1998, the Company
completed the relocation of two additional units in Austin, Texas, acquired two
stores in College Station, Texas and opened a store in Cedar Park, Texas. Also
during 1998, the stores in Houston, Illinois and Mississippi were reclassified
as "held for sale" and so were not considered to be part of the portfolio of
Company-owned units at the end of the year. The operating results of the units
held for sale are considered an operating cost of the Turnkey Program and are
reported in Turnkey Program cost. Results from restaurants the Company intends
to own and operate on a longer term basis are reflected in restaurant operations
figures. The Company anticipates opening or acquiring additional stores in Texas
during 1999. The Company operates these stores primarily for product
development, concept refinement, prototype testing and training, and to build
brand awareness. The Company may acquire or develop a limited number of other
Company-owned stores in the future for these purposes and may acquire or develop
others from time to time with the intent of transferring them to franchisees.
2
EXPANSION
At December 31, 1998, the Schlotzsky's system consisted of 750 stores in 38
states, the District of Columbia, and 13 foreign countries. At December 31, 1996
and 1997, the system included 573 and 673 stores, respectively.
STORE LOCATIONS AS OF DECEMBER 31, 1998
NUMBER
LOCATION OF STORES
-------- ---------
UNITED STATES:
Texas. . . . . . . . . . 219
Arizona. . . . . . . . . 40
Georgia. . . . . . . . . 36
Tennessee. . . . . . . . 35
Florida. . . . . . . . . 31
Illinois . . . . . . . . 29
Indiana. . . . . . . . . 25
Michigan . . . . . . . . 23
California . . . . . . . 22
North Carolina . . . . . 21
Wisconsin. . . . . . . . 20
Colorado . . . . . . . . 20
Oklahoma . . . . . . . . 18
Alabama. . . . . . . . . 18
South Carolina . . . . . 17
Ohio . . . . . . . . . . 16
New Mexico . . . . . . . 15
Missouri . . . . . . . . 12
Kansas . . . . . . . . . 12
Nebraska . . . . . . . . 11
Louisiana. . . . . . . . 10
Utah . . . . . . . . . . 10
Minnesota. . . . . . . . 9
Arkansas . . . . . . . . 7
Nevada . . . . . . . . . 7
Virginia . . . . . . . . 6
Oregon . . . . . . . . . 6
Mississippi. . . . . . . 5
Idaho. . . . . . . . . . 5
Washington . . . . . . . 4
Iowa . . . . . . . . . . 3
West Virginia. . . . . . 3
North Dakota . . . . . . 3
Kentucky . . . . . . . . 3
South Dakota . . . . . . 2
Hawaii . . . . . . . . . 2
Pennsylvania . . . . . . 2
New York . . . . . . . . 2
District of Columbia . . 1
---
TOTAL U.S. . . . . . . . 730
3
INTERNATIONAL:
Argentina. . . . . . . . 3
Japan. . . . . . . . . . 3
Turkey . . . . . . . . . 3
Malaysia . . . . . . . . 2
Canada . . . . . . . . . 1
China. . . . . . . . . . 1
Germany. . . . . . . . . 1
Guatemala. . . . . . . . 1
Lebanon. . . . . . . . . 1
Mexico . . . . . . . . . 1
Morocco. . . . . . . . . 1
Saudi Arabia . . . . . . 1
United Kingdom . . . . . 1
---
TOTAL INTERNATIONAL: . . 20
---
TOTAL STORES:. . . . . . 750
---
---
TURNKEY PROGRAM
The Company instituted the Turnkey Program to further assist franchisees in
obtaining superior sites and to achieve more rapid penetration in those selected
major markets where the Company believes there is strong demand by franchisees
for good locations. The Company believes that the Turnkey Program enhances the
Company's ability to recruit qualified franchisees by securing and developing
high profile sites and achieving critical mass for advertising purposes more
quickly in selected markets. Under the Turnkey Program, the Company works
independently or with an area developer to identify superior store sites within
a territory. The Company will typically perform various services including, but
not limited to, site selection, feasibility analysis, environmental studies,
site work, permitting and construction management, receiving a fee and
recognizing revenue upon the completion of these services. The Company may
assign its earnest money contract on a site to a franchisee, or a third-party
investor, who then assumes responsibility for developing the store. The Company
may also purchase or lease a selected site, design and construct a Schlotzsky's
Deli restaurant on the site and sell, lease or sublease the completed store to a
franchisee. Where the Company does not sell the property to a franchisee, the
Company sells the improved property, or, in the case of a leased property,
assigns the lease and any sublease, to an investor.
From inception of the Turnkey Program through 1997, the Company
typically provided credit enhancement in the form of limited guaranties on
the franchisees' leases for leased locations sold to investors. The Company
obtained agreements from the franchisees to indemnify the Company in case the
guaranties are called upon. Upon sale of the leased site or assignment of
its earnest money contract, the Company has deferred revenue generated (even
though proceeds were received in cash) and allocable costs incurred in
connection with the property. When a lease guaranty is terminated, or the
Company's exposure to loss under the guaranty has passed, the Company
recognizes the revenue and allocable costs related to the site. Generally,
if no credit enhancement is provided in connection with such transactions,
the Company recognizes the revenue and allocable expenses in the periods in
which the transactions occur. During 1998, the Company began emphasizing
ownership of the real estate by franchisees through a program which entails
acquiring the rights to a superior site and reselling the property, or its
rights (with any improvements), to a franchisee whose permanent mortgage loan
will be financed by a third party financial institution. The Company
provides credit enhancement for the franchisee in the form of a limited
guaranty in favor of the lender. These guarantees are usually for loan
payments required to be made during the first two to five years and are
limited to 15% to 25% of the principal amount of the loan. Generally, in
those cases, the Company recognizes the revenue and allocable expenses in the
period in which the transaction occurs. The Company will often interim
finance land and building costs in anticipation of permanent financing by a
financial institution. In addition, the Company charges a fee when it is
requested to manage construction of a store on property owned by a franchisee
or an investor. This construction management fee is recognized when the store
is completed. The Company anticipates that the total investment in each
developed free-standing location will be approximately $1,200,000 to
$2,000,000 (less for leased locations).
4
MENU
The Schlotzsky's Deli menu provides customers with popular food items which
the Company believes are fresher, more flavorful and of greater variety than
those offered by competitors. The key menu groups are made-to-order sandwiches
and pizzas, salads, soups, cookies and other desserts, and beverages. Sandwiches
and pizzas are made with delicatessen-style meats, grilled chicken and specialty
cheeses, all of which are purchased ready for use from approved suppliers. The
Company's distinctive sandwich buns and pizza crusts are baked daily from
scratch, rather than with pre-mixed or frozen dough, to ensure the highest
quality and freshness.
FRANCHISING
The Company has adopted a strategy of franchising, rather than owning
stores. The Company believes that franchisees who own and operate stores are
more highly motivated and manage stores more efficiently than typical
manager-employees. Moreover, franchising allows the Company to expand the number
of stores and penetrate markets more quickly and with less capital than
developing Company-owned stores. Area developers play a role in the Company's
franchising program by recruiting qualified franchisees and by monitoring and
providing support to franchised stores.
AREA DEVELOPERS. The Company's 32 area developers recruit and qualify
franchisees according to criteria developed by the Company. Once a franchisee is
approved by the Company, the area developer works with the Company to assist the
franchisee in site selection, training, store design and layout, construction
and financing. The area developer provides store opening assistance, monitors
store performance and compliance with product and service quality standards
established by the Company and helps to coordinate cooperative advertising
within his territory. The Company pays area developers 50% of all franchise fees
paid by franchisees in their territories, although some area developers have
received up to 100% of certain franchise fees as an inducement to develop their
territories more quickly. In addition, the Company also pays area developers
approximately 42% of the royalties received under franchise agreements
providing for 6% royalties and 12.5% to 25% of royalties received under
franchise agreements providing for 4% royalties, in each case with respect to
franchisees in their territories.
It is contemplated that the percentage of franchise fees and royalties
payable to certain area developers could be reduced to approximately 33% and
21%, respectively, if proposed transactions are consummated. There can be no
assurance that such transactions will be completed. Area developers are not
required to own or operate stores, although some of the Company's area
developers are also franchisees, or have investments in franchisees, under
separate franchise agreements. Area developers are granted exclusive rights to
one or more television markets in the United States, typically for a term of 50
years. Each area developer pays the Company a nonrefundable fee for the
exclusive development rights for a market. The Company typically receives 25% to
50% of the area developer fee when the area development agreement is signed with
the balance payable with interest over an 18 to 36-month period under a
promissory note from the area developer.
Area development agreements are nonassignable without the prior written
consent of the Company, and consents have been granted from time to time. The
Company retains rights of first refusal with respect to any proposed sale by the
area developer. Area developers are not permitted to compete with the Company.
Area developers typically commit to a store opening schedule for each territory.
The Company has agreed to extend or waive store opening schedules for certain
area developers under certain conditions, and may eliminate the schedules for
those whose royalties are bought down. If an area developer fails to meet its
obligations, the Company can terminate or repurchase its territory.
FRANCHISEES. The Company believes the involvement of owners in daily store
operations is critical to the success of a franchise. The Company prefers
franchisees who will operate no more than three or four stores, located within a
single market. Franchisees are selected on the basis of various factors,
including business background, experience and financial resources. Because the
cost of building and equipping a Schlotzsky's Deli restaurant is somewhat higher
than for some other specialty sandwich franchise operations, the Company's
franchisees must make certain minimum investments into their stores and
typically must have substantial cash resources or a relatively high net worth to
obtain financing to build and equip stores. While area developers identify and
recruit potential franchisees, all franchisees must be approved by the Company.
5
FRANCHISE AGREEMENTS. The Company enters into one or more agreements with
each franchisee granting the franchisee the right to develop one or more stores
within a territory over a defined period of time. Once a site for a store has
been selected by the franchisee and accepted by the Company, additional
documentation specifying that site is signed. Under the Company's current
standard franchise agreement, the franchisee is required to pay a franchise fee
of $30,000 for the franchisee's first store and $20,000 for any additional
store. The franchise fee is payable at the time of signing the agreement. The
current standard franchise agreement provides for a term of 20 years (with one
ten-year renewal option) and payment of a royalty of 6% of sales. As of December
31, 1998, 98 stores operated under franchise agreements entered into prior to
1991 were paying a royalty of 4% of sales.
The Company has the right to terminate any franchise agreement for certain
specific reasons, including a franchisee's failure to make payments when due or
failure to adhere to the Company's policies and standards. Many state franchise
laws, however, limit the ability of a franchisor to terminate or refuse to renew
a franchise. See "Government Regulation."
FRANCHISEE TRAINING AND SUPPORT. Each franchisee is required to have a
principal operator approved by the Company who satisfactorily completes the
Company's training program and who devotes full business time and efforts to the
operation of the franchisee's stores. Franchisees may also enroll each store
manager in the Company's training program. The Company provides training at
operating Schlotzsky's Deli restaurants in various locations. In November 1995,
the Company opened its new flagship Schlotzsky's Deli restaurant in Austin,
Texas, which includes training facilities. Most franchisee training is being
conducted at that location. Franchisees are required to pass a minimum skills
test before they can begin operating their first store. An on-site training crew
is provided by the Company or an area developer for three days before and two
days after the opening of a franchisee's first store. Company management and
area developers maintain ongoing communication with franchisees, exchanging
operating and marketing information.
FRANCHISE OPERATIONS. All franchisees are required to operate their stores
in compliance with the Company's policies, standards and specifications,
including matters such as menu items, ingredients, materials, supplies,
services, fixtures, furnishings, decor and signs. Food preparation is
standardized and is limited to baking bread, slicing pre-cooked meats, cheese
and produce, melting cheese and heating sandwiches. Because they usually operate
no more than three stores, franchisees are expected to be actively involved in
monitoring operations at each store. Each franchisee has full discretion to
determine the prices to be charged to its customers. Franchise stores are
periodically inspected by area developers and the Company's field service
representatives. The Company's field service representatives and area developers
monitor compliance with the Company's standards and specifications as set forth
in the franchise agreement and the Company's manuals.
REPORTING. Most Schlotzsky's Deli restaurant franchisees are required to
report weekly sales and other data to the Company. Other franchisees are
required to report monthly. Generally, 6% royalties are payable weekly by
automatic bank drafts and 4% royalties are payable monthly by check. The Company
is evaluating software for use by franchisees to record and report sales and
other operating information and anticipates that franchisees may be able to
license this software beginning at some point in 1999. Although the Company has
the right to audit franchisees, it relies primarily on voluntary compliance by
franchisees to accurately report sales and remit royalties. The Company expects
to begin auditing some franchise locations during 1999.
INTERNATIONAL MASTER LICENSEES. In addition to the Company's expansion in
the United States, the Company has granted nonassignable rights to develop
stores in international markets to master licensees. A master licensee is
typically licensed for 50 years to use the Schlotzsky's trademarks in designated
foreign territories and may grant area development rights and franchises in
those territories. Unlike area developers, master licensees contract directly
with franchisees, and the Company delegates the selection of franchisees and
approval of sites to the master licensees. When a master license is granted, the
master licensee pays the Company a negotiated, nonrefundable license fee. In
some instances, the Company will negotiate a territorial agreement pursuant to
which a foreign territory is reserved and the principal economic terms of the
master license agreement are agreed upon in return for a nonrefundable fee to be
applied toward the master license fee. The Company normally receives 15% to 35%
of the master license fee in cash when the master license or territorial
agreement is signed, with the balance payable with interest over a term of up to
48 months under a promissory note from the master licensee. Typically, the
Company also receives one-third to one-half of any sublicense and franchise fees
and one-third of any royalties received by
6
the master licensee. All amounts payable to the Company by the master
licensees must be paid in U.S. dollars. As of December 31, 1998, the Company
had executed master licenses or territorial agreements covering 49 foreign
countries. As with area developers, if master licensees fail to meet their
obligations, the Company can terminate their rights or repurchase their
territories. Master licensees are subject to various laws and regulations
regarding franchising and licensing in their territories and are responsible
for complying with these laws and regulations.
SITE SELECTION
The Company and its area developers often assist franchisees in selecting
their sites and developing their stores. Each franchisee is responsible for
selecting store locations acceptable to the Company. Site selection criteria are
based on accessibility and visibility of the site and selected demographic
factors, including population, residential and commercial density, income, age
and traffic patterns. The Company prefers that franchisees select sites for
free-standing stores to maximize store visibility and sales potential. As the
table below indicates, the mix of store sites has changed since the Company
adopted a new strategy in 1991 focusing on higher visibility stores.
STORES OPENED BETWEEN
AS OF AS OF JANUARY 1, 1992 AND
STORE SITE DECEMBER 31, 1991 DECEMBER 31, 1998 DECEMBER 31, 1998
---------- ----------------- ----------------- ---------------------
Free-Standing . . . . . . . 24% 52% 57%
End-Cap . . . . . . . . . . 31 27 24
In-Line . . . . . . . . . . 28 11 7
Other . . . . . . . . . . . 17 10 12
--- --- ---
Total . . . . . . . . . . . 100% 100% 100%
--- --- ---
--- --- ---
The Company has developed a series of prototype store designs and
specifications for free-standing and end-cap stores which it makes available for
use by franchisees. These specifications may be adapted to existing restaurants
and other retail spaces.
UNIT ECONOMICS
The Company believes that the Schlotzsky's Deli restaurant concept offers
attractive unit economics. The cost to a franchisee of developing and opening a
prototype Schlotzsky's Deli restaurant (excluding restaurants like the Company's
flagship store) in leased space has recently ranged from approximately $300,000
to $500,000, including leasehold improvements, equipment, fixtures and initial
working capital. While the initial cost of owning a free-standing, prototype
restaurant ranges from $1,200,000 to $2,000,000, the monthly payments at
interest rates in effect at December 31, 1998 were favorable compared to monthly
rent at comparable leased locations. During the twelve months ended December 31,
1998, the weighted average store sales for Schlotzsky's Deli restaurants was
approximately $503,000, although store revenue varies significantly depending
upon the type, size and location of the store. The Company believes that food
and paper costs for the Schlotzsky's Deli menu items are relatively low as a
percentage of gross store sales as compared to many quick service restaurant
concepts.
FINANCING
With respect to non-Turnkey Program stores, the Company usually does not,
and is not obligated to, provide financing to franchisees for the costs of
developing and opening stores. Both the Company and area developers assist
franchisees in obtaining financing by identifying third party financing sources.
Certain financial institutions have designed equipment leasing programs
specifically for Schlotzsky's franchisees and have developed guidelines for sale
and leaseback financing for Schlotzsky's stores. The Company has also identified
Small Business Administration lenders which have made loans to Schlotzsky's
franchisees. These lenders are not committed to provide any financing to
franchisees and there can be no assurance that franchisees will be able to
finance their costs of opening stores on suitable terms.
7
The Company has negotiated with certain financial institutions to provide
mortgage loans to qualified franchisees with stores developed through the
Turnkey Program. These loans typically would involve a limited guaranty by the
Company. In certain cases, the Company acquires the right to the land and, in
connection with the sale of the land to a franchisee (or another buyer who plans
to subsequently sell the property to a franchisee), provides interim financing
in anticipation of permanent financing by a financial institution. These loans
may be in the form of construction draw notes or mortgages. The Company had
loaned an aggregate of approximately $7.3 million to various franchisees through
this program, which had not been assigned to a financial institution as of
December 31, 1998. There can be no assurance that financial institutions will
agree to accept assignments of these or future loans made by the Company on
acceptable terms, if at all.
The Company from time to time agrees to guaranty its franchisees'
obligations to equipment and real property lessors or subordinates all or a
portion of its royalties to the obligations of franchisees on such leases. These
guaranties provide for a limited number of payments or limited time period for
which the Company may be required to perform on its guaranty.
As of December 31, 1998, the Company had guarantied an aggregate of
approximately $26.4 million which is principally comprised of real estate leases
and mortgages, as well as equipment leases and other obligations of its
franchisees.
PURCHASING; PRIVATE LABELING
Franchisees are required to purchase equipment, furniture, smallwares,
merchandising displays and food from suppliers approved by the Company.
Approximately 80-85% of overall purchases of goods used in daily operations by
the Company's franchised stores are from International Multifoods Corporation,
which provides volume discounts to franchisees based upon system-wide purchases.
The Company believes that comparable goods are available at competitive prices
from numerous other suppliers.
The Company has licensed certain manufacturers to sell Schlotzsky's private
label meats, cheeses, potato chips and other products. The Company receives
licensing fees from these manufacturers based on their sales of private label
products to franchisees. While franchisees are not required to purchase private
label products, other than the Company's proprietary flour mixes, the Company
believes that most franchisees prefer them because they are of equal or superior
quality compared to other brand name products and generally are less expensive
than the supplies available from other approved sources. In addition, some
private label products can be sold separately at stores for home consumption,
enhancing brand awareness and providing franchisees with additional sales and
profit opportunities.
MARKETING
Franchised stores contribute 1% of gross sales to Schlotzsky's N.A.M.F.,
Inc. ("NAMF"), a non-profit corporation administered by the Company. NAMF funds
are used principally to develop and produce radio and television commercials and
print advertising for use in local markets, in-store graphics and displays, and
promotions, but such funds may also be used to pay for media space or time. NAMF
has developed advertising campaigns for use by franchisees centered around
different slogans, such as FUNNY NAME. SERIOUS SANDWICH.-Registered Trademark-;
ACCEPT NO SUBSTITUTESKY'S-Registered Trademark-; BEST BUNS IN TOWN-Registered
Trademark-; and ORIGINAL TASTE EVERY DAY. NAMF'S field marketing representatives
coordinate advertising campaigns and promotions for area developers and
franchisees.
Franchisees are required by the terms of their franchise agreements to
spend at least 3% of gross sales on advertising. Effective January 1, 1999, the
Company began collecting 1.75% of the 3% for network television advertising. The
Company anticipates that network advertising will be initiated during the Spring
of 1999. The Company has requested franchisees to form local advertising groups
to pool the remainder of the 3% in order to maximize the benefits of local
advertising for members.
COMPETITION
8
The food service industry is intensely competitive with respect to concept,
price, location, food quality and service. There are many well established
competitors with substantially greater financial and other resources than the
Company. Such competitors include a large number of national, regional and local
food service companies, including fast food and quick-service restaurants,
casual full-service restaurants, delicatessens, pizza restaurants and other
convenience dining establishments. Some of the Company's competitors have been
in existence longer than the Company and are better established in markets where
Schlotzsky's stores are or may be located. The Company believes that it competes
for franchisees with franchisors of other restaurants and various concepts.
Schlotzsky's stores compete primarily on the basis of distinctive, high
quality food and convenience, rather than price. The Company believes that
Schlotzsky's stores provide the quick service and convenience of fast food
restaurants while offering more distinctive, higher quality products. Pricing is
designed so that customers perceive good value (high quality food at reasonable
prices), even though Schlotzsky's menu prices are typically higher than certain
competitors' prices.
Competition in the food service business is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company and its area developers attempt to assist
franchisees in managing or adapting to these factors, but no assurance can be
given that some or all of these factors will not adversely affect some or all of
the franchisees.
TRADEMARKS, SERVICE MARKS AND TRADE SECRETS
The Company owns a number of trademarks and service marks registered with
the United States Patent and Trademark Office. The Company has also registered
or made application to register trademarks in foreign countries where master
licenses have been granted. The flour and bread making recipes and techniques
currently used in Schlotzsky's stores are based on a modification of the
Company's original recipe developed jointly by the Company and Pillsbury
Company. The recipes and techniques are protected by the Company and its
suppliers as trade secrets. The Company has not sought patent protection for
these recipes, and it is possible that competitors could develop flour recipes
and baking procedures that duplicate or closely resemble the Company's. The
Company considers its trademarks, service marks and trade secrets to be critical
to the business and actively defends and enforces them.
GOVERNMENT REGULATION
The Company must comply with regulations adopted by the Federal Trade
Commission (the "FTC") and with several state laws that regulate the offer and
sale of franchises. The Company also must comply with a number of state laws
that regulate certain substantive aspects of the franchisor-franchisee
relationship. The FTC's Trade Regulation Rule on Franchising (the "FTC Rule")
requires that the Company furnish prospective franchisees with a franchise
offering circular containing information prescribed by the FTC Rule.
State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees, by regulating discrimination among franchisees
with regard to charges, royalties or fees, and by restricting the development of
other restaurants within certain proscribed distances from existing franchised
restaurants. Those laws also restrict a franchisor's rights with regard to the
termination of a franchise agreement (for example, by requiring "good cause" to
exist as a basis for the termination), by requiring the franchisor to give
advance notice to the franchisee of the termination and give the franchisee an
opportunity to cure any default, and by requiring the franchisor to repurchase
the franchisee's inventory or provide other compensation. To date, those laws
have not precluded the Company from seeking franchisees in any given area and
have not had a material adverse effect on the Company's operations.
Each Schlotzsky's store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties or failures
in obtaining the required licenses or approvals can delay and sometimes prevent
the opening of a new store.
Schlotzsky's stores must comply with federal and state environmental
regulations, such as those promulgated under the Federal Water Pollution Act,
Federal Clean Water Act of 1977 and the Federal Resource and
9
Conservation Recovery Act of 1976, but the Company believes that those
regulations have not had a material effect on their operations. More
stringent and varied requirements of local governmental bodies with respect
to zoning, land use, and environmental factors can delay and sometimes
prevent development of new stores in particular locations.
The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters, such as minimum wages,
overtime and other working conditions. Significant numbers of the food service
personnel in Schlotzsky's stores receive compensation at rates related to the
federal minimum wage and, accordingly, increases in the minimum wage increase
labor costs at those locations.
The Company and its franchisees also must comply with the provisions of the
Americans with Disabilities Act, which requires that employers provide
reasonable accommodation for employees with disabilities and that restaurants be
accessible to customers with disabilities.
EMPLOYEES
As of December 31, 1998, the Company employed 159 persons at its corporate
headquarters. None of the Company's employees is covered by a collective
bargaining agreement or is represented by any labor union. The Company believes
its relationship with its employees is good.
RISK FACTORS
In addition to the other information contained in this report, the
following factors should be considered carefully in evaluating the Company:
FORWARD LOOKING STATEMENTS. This report contains statements that
constitute "forward-looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended (the "Securities Act" and Section 21E of the
Securities Exchange Act of 1934, as amended (the "Exchange Act")). The words
"expect," "estimate," "anticipate," "contemplate," "predict," "believe,"
"intend," "plan," "project" and similar expressions and variations thereof are
intended to identify forward-looking statements. Such statements appear in a
number of places in this Report and include statements regarding the intent,
belief or current expectations of the Company, its directors or its officers
with respect to, among other things: (i) trends affecting the Company's
financial condition or results of operations; (ii) the Company's financing
plans; (iii) the Company's business and growth strategies, including strategies
related to the Company's Turnkey Program and plans concerning the Company's
relationship with its area developers; and (iv) the declaration and payment of
dividends. Shareholders and prospective investors are cautioned that any such
forward-looking statements are not guaranties of future performance and involve
risks and uncertainties, and that actual results may differ materially from
those projected in the forward-looking statements as a result of various
factors. The accompanying information contained in this Report including,
without limitation, the information set forth under the headings "Management's
Discussion and Analysis of Financial Condition and Results of Operations," and
"Business," as well as information contained in the Company's other filings with
the Securities and Exchange Commission (the "Commission"), identify important
factors that could cause such differences.
RAPID GROWTH STRATEGY. During 1998, 107 new Schlotzsky's stores were
opened. During 1996 and 1997, the Company and its franchisees opened 135 and
120 stores, respectively. This level of store openings is significantly greater
than that experienced by the Company prior to 1995. The Company will rely
primarily upon its franchisees, area developers, the Turnkey Program, and new
geographic markets to maintain this level of expansion. The number of openings
and the performance of new stores will depend on various factors, including: (i)
the availability of suitable sites for new stores; (ii) the ability to recruit
qualified franchisees; (iii) the ability of franchisees to negotiate acceptable
lease or purchase terms for new locations, obtain capital required to construct,
build-out and operate new stores, meet construction schedules, and hire and
train qualified store personnel; (iv) the establishment of brand awareness in
new markets; and (v) the ability of the Company to manage this anticipated
expansion. Not all of these factors are within the control of the Company, and
there can be no assurance that the Company will be able to maintain or
accelerate its growth or that the Company will be able to manage its expanding
operations effectively. See "Business -- Strategy."
10
TURNKEY PROGRAM. As of December 31, 1998, the Company had developed 128
stores under the Turnkey Program, 39 of which were developed during 1998. The
Company expects that the Turnkey Program will continue to produce approximately
30% to 40% of new store development. The Company has limited experience in
implementing this program, which has evolved significantly since its
inception. There can be no assurance that results experienced to date are
indicative of future performance under the program. The Company may be unable
to sell properties acquired under the Turnkey Program at a profit or at its
cost, and the Company could be required to sell properties at a loss or hold
properties indefinitely, diminishing the capital available to reinvest in the
Turnkey Program. The Company may also be unable to obtain permanent third
party financing for interim loans made to the Company's franchisees, which
would further diminish capital available for the Turkey Program. See "--
Credit Risk and Contingencies," "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources" and "Business -- Turnkey Program."
RELIANCE ON AREA DEVELOPERS. The Company relies on certain area developers
to find qualified franchisees in their areas. Area developers are independent
contractors, and are not employees of the Company. Through 1998, most area
developer agreements specified a schedule for opening stores in the territory
covered by the agreement. It is contemplated that in 1999, the Company will
eliminate the development schedule for several area developers in connection
with the buy down of their rights to receive future franchise fees and
royalties. In addition, the Company has agreed in the past to extend or waive
development schedules for certain area developers. There can be no assurance
that area developers will be able to meet their contractual development
schedules. These schedules are a significant factor in the Company's
expectations regarding the number and timing of new store openings. Delays in
store openings could adversely affect the future operations of the Company.
From time to time, the Company relies extensively on certain area
developers, many of whom do not have experience operating restaurants. In those
instances, the Company has less direct involvement in recruiting franchisees and
in monitoring the quality of franchised stores. The Company provides training
and support to area developers, but the quality of store operations and the
ability of area developers to meet development schedules may be diminished by
their lack of experience. It may be difficult for the Company to enforce its
area development agreements or to terminate the area development rights of area
developers who fail to meet development schedules or other standards and
requirements imposed by the Company, limiting the ability of the Company to
develop the territories of such area developers. See "Business -- Franchising."
Between January 1, 1996 and December 31, 1998, 123 of the 362 new stores
opened were within territories controlled by only two area developers. As of
December 31, 1998, these two area developers controlled 14 territories having a
total of 308 stores. As these territories mature, system-wide growth will depend
upon more activity in other territories. Because of its plans to buy down the
percentages of franchise fees and royalties payable to certain area developers,
the Company will be primarily responsible for recruiting franchisees and will
receive limited assistance with openings from many of its area developers. The
Company believes that the concentration of store openings among a relatively few
area developers is due primarily to the longer tenure of these area developers
with the Company and the size and maturity of the territories covered by their
agreements.
DEPENDENCE ON FRANCHISING CONCEPT. Because royalties from franchisees'
sales are a principal component of the Company's revenue base, the Company's
performance depends upon the ability of its franchisees to promote and
capitalize upon the Schlotzsky's concept and its reputation for quality and
value. The Company believes that the cost to a franchisee of opening a
Schlotzsky's Deli restaurant is higher than the store opening costs incurred by
franchisees of many of the Company's competitors for franchisees. This
necessarily limits the number of persons who are qualified to be franchisees of
the Company. The Company has established criteria to use in evaluating
prospective franchisees, but there can be no assurance that it, or its area
developers, will recruit franchisees who have the level of business abilities or
financial resources necessary to open Schlotzsky's stores on schedule or that
franchisees will conduct operations in a manner consistent with the Company's
concepts and standards. See "Business -- Franchising."
The Company is subject to various state and federal laws relating to the
franchisor-franchisee relationship. The failure by the Company to comply with
these laws could subject the Company to liability to franchisees and to fines
or other penalties imposed by governmental authorities. The Company believes
that the franchising industry is experiencing an increasing trend of
franchisees filing complaints with state and federal governmental authorities
and instituting lawsuits against franchisors claiming that they have engaged
in unlawful or unfair trade practices or violated express or implied
agreements with franchisees.
11
While the Company's experience is consistent with the trends in the industry,
the Company believes that it is in material compliance with these laws and
regulations and its agreements with franchisees, and that its relations with
its franchisees are generally good. See "Business --Government Regulation"
and "-- Litigation."
IMPORTANCE OF LICENSING FEES. During the past three years, the Company's
revenue from private label licensing fees (brand contribution) has increased
significantly as the volume of system sales has increased, terms with certain
major suppliers have been renegotiated, and franchisees have increased their
participation in the Company's purchasing programs. This revenue is largely
dependent upon the voluntary participation of the franchisees. In 1999, the
Company anticipates renegotiating the terms of the contracts with some of its
suppliers and will explore other alternative retail channels of distribution for
some of its private label products.
The Company believes its purchasing programs provide franchisees with
significant cost savings and other advantages. There can be no assurance that
the Company's suppliers will not increase prices to franchisees or that
franchisees will not negotiate more favorable terms from other approved
suppliers. Some franchisees may also object to these fees as a source of revenue
to the Company. Any of these developments could result in reduced purchases by
franchisees of private label products and declining private label licensing
revenue to the Company. This could have a material adverse effect on the
financial condition and results of operations of the Company. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Results of Operations."
CREDIT RISK AND CONTINGENCIES. The Company guaranties certain real estate
obligations and equipment leases and other obligations of its franchisees. The
Company has entered into guaranties with respect to most of the leases between
its franchisees and the buyers of the sites developed under the Turnkey Program.
These guaranties typically cover lease payments or various other obligations of
the franchisee for a period ranging from 18 months to five years, and are
effective throughout the term of the 20 year lease. The Company guaranties a
limited portion of most of the mortgages of certain franchisees who purchase
Turnkey Program sites pursuant to the mortgage financing program which the
Company began implementing during 1998. See "Business -- Turnkey Program" and
"Business - Financing." At December 31, 1998, the Company was contingently
liable for approximately $26.4 million which is principally comprised of
guaranties on real estate leases and mortgages, equipment leases and other
obligations of its franchisees.
During 1998, the mortgage financing program substantially replaced the
lease transactions completed in the Turnkey Program during prior years. While
the Company provided financing for several mortgages which were sold or held for
sale to financial institutions, there can be no assurance that the financial
institutions will accept all or most of the mortgages that the Company expects
to assign. The principal amount of the loans outstanding under the mortgage
financing program as of December 31, 1998 was approximately $7.3 million. The
Company charges area developers and master licensees a fee ("developer fee") for
the rights to develop a defined territory. Typically, a portion of the developer
fee has been paid in cash and the balance paid with a promissory note from the
area developer or master licensee. The Company periodically evaluates the credit
risk and obtains annual valuations of these notes from an independent financial
services institution with expertise in valuing instruments of this sort. As of
December 31, 1998, the Company held notes receivable from area developers and
master licensees in an aggregate principal amount of approximately $5.2 million.
At December 31, 1998, the principal balance of these notes had been reserved on
the financial statements of the Company by approximately $593,000, reflecting
the fair market value of such notes based upon valuations from a third party
valuation service. The Company also holds notes receivable from certain
franchisees related to the sale of Company-owned stores and certain other
obligations. As of December 31, 1998, the outstanding principal amount of these
notes was approximately $8,092,000. While the Company considers it unlikely that
there will be defaults on a significant amount of the notes, such defaults could
adversely affect the Company's financial condition. Parties controlled by or
related to directors, officers and principal shareholders of the Company have
provided financing to certain area developers and master licensees and have
guarantied obligations of certain area developers and master licensees to the
Company. See "Certain Transactions -- Master License and Area Development
Agreements" and "Business -- Franchising -- International Master Licensees."
A wholly owned subsidiary of the Company is the general partner of a
limited partnership that developed a retail shopping center in the Austin area.
The Company and its subsidiary have guarantied the repayment of a loan for this
project in the principal amount of $1.1 million due in April 2001. The Company
does not exercise control over the partnership and does not consider its
investment in the retail shopping center to represent a separate line of
12
business. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources."
LIMITED OPERATING HISTORY OF PROTOTYPES. Over the past several years, the
Company has refined its store prototypes and currently encourages franchisees to
develop larger, free-standing stores with higher visibility. This has increased
the costs to franchisees of opening and operating stores. The Company and
franchisees have a limited history of operating these prototype stores, and
results achieved to date may not be indicative of future results. There can be
no assurance that, on a sustained basis, the Company will be able to attract and
retain franchisees qualified to assume the increased debt and the management
responsibility associated with the larger operations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements of the Company and the Notes thereto.
GEOGRAPHIC CONCENTRATION. Of the 750 stores in the system at December 31,
1998, 219 were located in Texas. A downturn in the regional economy or other
significant adverse events in Texas could have a material adverse effect on the
Company's financial condition and results of operations.
CERTAIN FACTORS AFFECTING THE RESTAURANT INDUSTRY. The Company and its
franchisees may be affected by risks inherent in the restaurant industry,
including: adverse changes in national, regional or local economic or market
conditions; increased costs of labor (including increases in the minimum wage);
increased costs of food products; management problems; increases in the number
and density of competitors; limited alternative uses for properties and
equipment; changing consumer tastes, habits and spending priorities; changing
demographics; the cost and availability of insurance coverage; uninsured losses;
changes in government regulation; changing traffic patterns; weather conditions;
and local, regional or national health and safety matters. The Company and its
franchisees may be the subject of litigation based on discrimination, personal
injury or other claims, including claims which may be based upon legislation
that imposes liability on restaurants or their employees for injuries or damages
caused by the negligent service of alcoholic beverages to an intoxicated person
or to a minor. The Company can be adversely affected by publicity resulting from
food quality, illness, injury or other health concerns or operating issues
resulting from one restaurant or a limited number of restaurants in the
Schlotzsky's system. None of these factors can be predicted with any degree of
certainty, and any one or more of these factors could have a material adverse
effect on the Company's financial condition and results of operations.
COMPETITION. The food service industry is intensely competitive with
respect to concept, price, location, food quality and service. There are many
well-established competitors with substantially greater financial and other
resources than the Company. These competitors include a large number of
national, regional and local food service companies, including fast food and
quick service restaurants, casual full-service restaurants, delicatessens, pizza
restaurants and other convenience dining establishments. Some of the Company's
competitors have been in existence longer than the Company and may be better
established in markets where Schlotzsky's stores are or may be located. The
Company believes that it competes for franchisees against franchisors of other
restaurants and various other concepts.
Competition in the food service industry is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company and its area developers assist
franchisees in managing or adapting to these factors, but no assurance can be
given that some or all of these factors will not adversely affect some or all of
the franchisees. See "Business -- Competition."
CONTROL BY PRINCIPAL SHAREHOLDERS. As of December 31, 1998, John C. Wooley
and Jeffrey J. Wooley beneficially owned an aggregate of approximately 13.9% of
the outstanding Common Stock. Additionally, Greenfield Capital Partners B.V. and
NethCorp Investments VI B.V., entities of which Floor Mouthaan, a director of
the Company is the managing director, beneficially owned an aggregate of 5.6% of
the outstanding Common Stock, and Getov Holding B.V., an entity of which John M.
Rosillo, a director of the Company, is the managing director, beneficially owned
1.7% of the outstanding Common Stock at December 31, 1998. As a result, these
shareholders, if they were to act in concert, would have the ability to
influence the outcome of any issue submitted to a vote of the shareholders.
There are no agreements or understandings among these shareholders regarding the
voting of their shares, but to date they have voted consistently on matters
submitted to a vote of the shareholders.
13
DEPENDENCE ON MANAGEMENT AND KEY PERSONNEL. The Company's success is
highly dependent upon the efforts of its management and key personnel, including
its Chairman of the Board and President, John C. Wooley. The Company has
employment agreements with John C. Wooley, Jeffrey J. Wooley, Kelly R. Arnold
and Karl D. Martin, each of which includes certain noncompetition provisions
that survive the termination of employment. The employment agreements with John
C. Wooley and Jeffrey J. Wooley were entered into effective February 1998 and
will expire in February 2001. The Company also has obtained certain
noncompetition agreements from several other members of management and key
personnel who are not subject to employment agreements. However, there can be no
assurance such noncompetition agreements will be enforceable. The loss of the
services of John C. Wooley or other management or key personnel could have a
material adverse effect on the Company. The Company does not carry key man life
insurance on any of its officers. See "Management."
GOVERNMENT REGULATION. The restaurant industry is subject to numerous
federal, state and local governmental regulations, including those relating to
the preparation and sale of food and zoning and building requirements. The
Company and its area developers and franchisees are also subject to laws
governing their relationships with employees, including wage and hour laws, and
laws and regulations relating to working and safety conditions and citizenship
or immigration status. The Company's franchise operations are subject to
regulation by the United States Federal Trade Commission and the Company must
also comply with state laws relating to the offer, sale and termination of
franchises and the refusal to renew franchises. The failure to obtain or
maintain approvals to sell franchises could adversely affect the Company.
Increases in the minimum wage rate, employee benefit costs or other costs
associated with employees, could adversely affect the Company and its area
developers and franchisees. See "Business -- Government Regulation."
ABSENCE OF DIVIDENDS. The Company has never paid cash dividends on its
Common Stock and does not anticipate paying any cash dividends in the
foreseeable future.
POTENTIAL VOLATILITY OF STOCK PRICE. There have been periods of
significant volatility in the market price and trading volume of the Common
Stock, which in many cases were unrelated to the operating performance of, or
announcements concerning, the Company. General market price declines or market
volatility in the future could adversely affect the price of the Common Stock.
In addition, the trading price of the Common Stock has been and is likely to
continue to be subject to significant fluctuations in response to variations in
quarterly operating results, the results of the Turnkey Program, changes in
management, competitive factors, regulatory changes, general trends in the
industry, recommendations by securities industry analysts and other events or
factors. This volatility has been exacerbated by the lack of a significant
public float in the Common Stock. There can be no assurance that an adequate
trading market can be maintained for the Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE. As of December 31, 1998, the Company had
7,391,942 shares of Common Stock outstanding. A substantial number of shares
will become available for sale in the public market at various times. No
predictions can be made as to the effect, if any, that market sales or the
availability of shares for future sale will have on the market price of the
Common Stock. Sales of substantial amounts of Common Stock in the public market,
or the perception that such sales could occur, could adversely affect the
prevailing market price for the Common Stock and could impair the Company's
ability to raise capital through a public offering of equity securities.
ANTI-TAKEOVER PROVISIONS. The Texas Business Combination Law, which became
effective September 1, 1997, restricts certain transactions between a public
corporation and affiliated shareholders. The statute, which is applicable to the
Company, may have the effect of inhibiting a non-negotiated merger or other
business combinations involving the Company.
The Company's Articles of Incorporation and Bylaws include certain
provisions that may have the effect of discouraging or delaying a change in
control of the Company. Directors are elected for staggered three-year terms,
which has the effect of delaying the ability of shareholders to replace specific
directors or effect a change in a majority of the Board of Directors. The
Bylaws were amended in 1998 to provide that a director may only be removed for
cause by vote of the holders of at least two-thirds of the shares present in
person or by proxy at a meeting of shareholders called expressly for that
purpose. All shareholder action must be effected at a duly called annual or
special meeting of shareholders and shareholders must follow an advance
notification procedure for certain shareholder proposals and nominations of
candidates for election to the Board of Directors.
14
The Board of Directors has the authority, without further action by the
shareholders, to issue up to 1,000,000 shares of Preferred Stock in one or more
series and to fix the rights, preferences, privileges and restrictions thereof,
and to issue authorized unissued shares of Common Stock. The issuance of
Preferred Stock or additional shares of Common Stock could adversely affect the
voting power of the Common Stockholders and could have the effect of delaying,
deferring or preventing a change in control of the Company. The issuance of
Preferred Stock also could adversely affect other rights of Common Stockholders,
including creation of a preference upon liquidation or upon the payment of
dividends in favor of the holders of Preferred Stock.
In December 1998, the Company announced that the Board of Directors had
adopted a Shareholder's Rights Plan and approved a dividend of one Right for
each share of Company Common Stock outstanding. Under the plan, each shareholder
of record receives one Right for each share of Common Stock held. Initially, the
Rights are not exercisable and automatically trade with the Common Stock. There
are no separate Rights certificates at this time. Each Right entitles the holder
to purchase one one-hundredth of a share of Company Class C Series A Junior
Participating Preferred Stock for $75.00 (the "Exercise Price").
The Rights separate and become exercisable upon the occurrence of certain
events, such as an announcement that an "acquiring person" (which may be a group
of affiliated persons) beneficially owns, or has acquired the rights to own,
20% or more of the outstanding Common Stock, or upon the commencement of a
tender offer or exchange offer that would result in an acquiring person
obtaining 20% or more of the outstanding shares of Common Stock.
Upon becoming exercisable, the Rights entitle the holder to purchase
Common Stock with a value of $150 for $75. Accordingly, assuming the Common
Stock had a per share value of $75 at the time, the holder of a right could
purchase two shares for $75. Alternatively, the Company may permit a holder to
surrender a Right in exchange for stock or cash equivalent to one share of
Common Stock (with a value of $75) without the payment of any additional
consideration. In certain circumstances, the holders have the right to acquire
common stock of an acquiring company having a value equal to two times the
Exercise Price of the Rights.
The Rights have certain anti-takeover effects. The Rights will cause
substantial dilution to an acquiring person. Accordingly, the existence of the
Rights may deter certain acquirers from making takeover proposals or tender
offers.
ITEM 2. PROPERTIES
In March 1997, the Company entered into a lease with a limited liability
company owned by John C. Wooley and Jeffrey J. Wooley for a new corporate
headquarters facility in Austin. This lease will expire in 2007. The facility
consists of approximately 41,000 square feet of office and storage space. The
Company moved to this new facility in November 1997. The former corporate
headquarters facility, consisting of approximately 11,000 square feet of office
space in Austin, was sold by the Company in December 1997. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Results of Operations."
The Company leases approximately 10,000 square feet of space for the
flagship Schlotzsky's Deli restaurant and training facility in Austin and
approximately 7,100 square feet for a store opened in Austin in February 1998.
The Company has a ground lease for an additional 2,700 square foot store which
opened in Austin in February 1998, and owns the real estate for a 3,200 square
foot store opened in Austin in December 1998. The Company leases approximately
3,000 square feet each for two stores which it operates in Houston. The Company
leases two stores in College Station, Texas with an aggregate of 5,400 square
feet of space. The Company also owns the sites of two stores in North Lake,
Illinois and Pearl, Mississippi and leases approximately 1,800 square feet for
its store in New York City. It is contemplated that the Houston stores, the
Pearl, Mississippi store and the North Lake, Illinois store will be sold.
As of December 31, 1998, the Company had 86 store sites in various stages
of development under the Turnkey Program. Development was completed on 71 sites
and these sites are operating and under lease or mortgage. Four of the sites in
development are in various stages of construction and 82 sites remain in the
pre-development stage. The Company also owns five sites, which it contemplates
remarketing. It is contemplated that sites acquired under the
15
Turnkey Program will be sold to franchisees and investors at various stages
of development or after completion. See "Business -- Turnkey Program."
Schlotzsky's Real Estate, Inc., a wholly-owned subsidiary of the Company,
is the general partner and the Company is a limited partner of a limited
partnership which owns a 17,600 square foot shopping center in suburban Austin.
Schlotzsky's Real Estate, Inc. and the Company have a combined 40% interest in
the capital and profits of this limited partnership. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
ITEM 3. LEGAL PROCEEDINGS
The State of New Mexico Taxation and Revenue Department has assessed the
Company $131,000 for gross receipts taxes, penalties and interest for the years
1987 through 1993. The assessment imposes gross receipts taxes on franchise fees
and royalties received by the Company from New Mexico franchisees and NAMF
contributions by those franchisees. The Company filed a protest with the New
Mexico Taxation and Revenue Department claiming that the assessment violates the
Commerce Clause of the United States Constitution because the Company does not
have any physical presence in or substantial nexus with New Mexico. The Company
has reserved a liability for taxes and attorneys' fees in respect of this
assessment. If other state taxing authorities attempt to impose taxes on
receipts derived by the Company from franchisees in those states, the Company's
financial condition and results of operations could be materially adversely
affected.
On February 8, 1999, the Lone Star Ladies Investment Club, et al., filed a
consolidated amended class action lawsuit in the Western District of Texas
against the Company and four of its officers and directors (Monica Gill,
Executive Vice President and Chief Financial Officer; John M. Rosillo, director;
Jeffrey J. Wooley, Senior Vice President and director; and John C. Wooley,
President and Chairman of the Board of Directors). The complaint, alleges
securities fraud arising from a change in the timing of recognition of revenue
from the sale of real estate properties in connection with which the Company
provided limited guaranties on franchisees leases of the properties. In April
1998, Registrant announced that 1997 earnings would be lower than previously
announced because it would defer revenue received in the fourth quarter from
such real estate transactions rather than recognizing it during the period in
which the transaction occurred, as previously contemplated. Plaintiffs seek
monetary damages in an unspecified amount. The Company believes that the
allegations are without merit and intends to vigorously defend against the suit.
The Company is subject to routine litigation in the ordinary course of
business, including contract, franchisee, area developer and employment-related
litigation. In the course of enforcing its rights under existing and former
franchise agreements and area developer agreements, the Company is subject to
complaints and letters threatening litigation concerning the interpretation and
application of these agreements, for example, in cases of administration of the
NAMF advertising funds, default or termination of franchisees or area
developers, requirements or payments relating to products used in the stores
(such as private label licensing), and the Turnkey Program. The Company
endeavors to treat its franchisees and area developers reasonably and fairly and
in compliance with applicable contractual provisions with due regard for the
protection of the Company's trademarks, service marks and goodwill. None of
these routine matters, individually or in the aggregate, are believed by the
Company to be material to its business or financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The authorized capital stock of the Company consists of 30,000,000 shares
of Common Stock, no par value, and 1,000,000 shares of Class C Preferred Stock,
no par value. The Company's Common Stock is traded on the National Market of
the National Association of Securities Dealers Automated Quotation System
("NASDAQ") under the Symbol "BUNZ". Trading began on December 15, 1995 in
connection with the Company's initial public offering. No public market existed
for the Common Stock prior to that time. As of March 19, 1999, 7,401,338 shares
of outstanding Common Stock were owned by approximately 6,000 beneficial owners
constituting 283 shareholders of record.
The high and low bid prices as reported by NASDAQ for the period from
January 1, 1997 to December 31, 1998 are set forth below:
HIGH LOW
------ ------
FISCAL 1997:
First Quarter . . . . . . . . . . . 12 1/4 9 5/8
Second Quarter . . . . . . . . . . . 14 1/4 10 3/4
Third Quarter . . . . . . . . . . . 20 3/8 13 1/4
Fourth Quarter . . . . . . . . . . . 20 1/4 14 1/2
FISCAL 1998
First Quarter . . . . . . . . . . . 23 3/8 14 3/4
Second Quarter . . . . . . . . . . . 22 5/8 13 3/16
Third Quarter . . . . . . . . . . . 18 1/2 9 1/8
Fourth Quarter . . . . . . . . . . . 11 1/4 9 1/4
These quotations may reflect inter-dealer prices, without retail mark-up,
mark-down or commissions and may not necessarily represent actual transactions.
The Company has never paid and has no current plans to pay cash dividends on its
Common Stock. The Company currently intends to retain earnings for use in the
operation and expansion of the Company's business and does not anticipate paying
cash dividends in the foreseeable future. The declaration and payment of future
dividends will be at the sole discretion of the Board of Directors and will
depend on the Company's profitability, financial condition, capital needs,
future prospects and other factors deemed relevant by the Board of Directors.
On December 18, 1998, the Board of Directors adopted resolutions regarding
the designation, preferences, and rights of Class C Series A Junior
Participating Preferred Stock in connection with the adoption of a Shareholders'
Rights Plan. See "Risk Factors - Anti Takeover Provisions."
The Transfer Agent and Registrar for the Company's Common Stock is Harris
Trust and Savings Bank of Chicago, Illinois.
17
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data for the
Company for the periods and the dates indicated. The historical consolidated
financial data as of and for the years ended December 31, 1996, 1997 and
1998 have been derived from the audited consolidated financial statements of the
Company and its predecessor entities, included elsewhere herein. The balance
sheet data and statement of operations data as of and for the years ended
December 31, 1994, and 1995 has been derived from the Company's audited
financial statements not included or incorporated herein. The selected
financial data should be read in conjunction with, and are qualified in their
entirety by, the Consolidated Financial Statements of the Company and related
Notes and other financial information included elsewhere in this report.
FISCAL YEARS ENDED DECEMBER 31,
----------------------------------------------------------
1994 1995 1996 1997 1998
------ ------ ------ ------ ------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF Operations Data:
Revenue:
Royalties . . . . . . . . . . . . . . . . . . . . . . . . $4,657 $7,425 $10,747 $14,561 $18,885
Franchise fees. . . . . . . . . . . . . . . . . . . . . . 1,019 1,494 1,775 1,555 1,365
Developer fees. . . . . . . . . . . . . . . . . . . . . . 2,793 2,666 1,993 325 270
Restaurant sales. . . . . . . . . . . . . . . . . . . . . 428 505 3,610 6,364 7,720
Brand contribution. . . . . . . . . . . . . . . . . . . . 150 397 1,295 2,915 4,003
Turnkey development . . . . . . . . . . . . . . . . . . . -- 41 726 1,139 8,314
Other fees and revenue. . . . . . . . . . . . . . . . . . 256 324 568 1,110 1,291
------- ------- ------- ------- -------
Total revenue. . . . . . . . . . . . . . . . . . . . 9,303 12,852 20,714 27,969 41,848
Costs and expenses:
Service costs:
Royalties. . . . . . . . . . . . . . . . . . . . . . . 1,122 2,405 3,791 5,373 7,225
Franchise fees . . . . . . . . . . . . . . . . . . . . 661 767 959 813 697
Restaurant operations:
Cost of sales. . . . . . . . . . . . . . . . . . . . . 188 189 1,183 2,014 2,513
Labor costs. . . . . . . . . . . . . . . . . . . . . . 154 408 1,424 2,493 3,205
Operating expenses . . . . . . . . . . . . . . . . . . 260 251 1,040 1,952 2,168
Turnkey development costs . . . . . . . . . . . . . . . . 16 332 519 368 4,806
General and administrative. . . . . . . . . . . . . . . . 4,183 5,419 6,509 7,686 11,472
Depreciation and amortization . . . . . . . . . . . . . . 372 458 779 1,155 1,885
------- ------- ------- ------- -------
Total costs and expenses . . . . . . . . . . . . . . 6,956 10,229 16,204 21,854 33,971
------- ------- ------- ------- -------
Income from operations . . . . . . . . . . . . . . . . 2,347 2,623 4,510 6,115 7,877
Other:
Interest income (expense) . . . . . . . . . . . . . . . . (201) (149) 455 753 2,058
Other income. . . . . . . . . . . . . . . . . . . . . . . 226 138 132 195 --
------- ------- ------- ------- -------
Total other income (expense) . . . . . . . . . . . . 25 (11) 587 948 2,058
------- ------- ------- ------- -------
Income before income taxes and
Extraordinary gain . . . . . . . . . . . . . . . . . . 2,372 2,612 5,097 7,063 9,935
Provision for income taxes. . . . . . . . . . . . . . . . 927 1,017 1,902 2,614 3,729
Gain on extinguishment of debt, net of tax. . . . . . . . 40 38 -- -- --
------- ------- ------- ------- -------
Net income. . . . . . . . . . . . . . . . . . . . . . . . $1,485 $1,633 $3,195 $4,449 $6,206
------- ------- ------- ------- -------
------- ------- ------- ------- -------
Net income per share - basic(1) . . . . . . . . . . . . . $0.47 $0.47 $0.58 $0.74 $0.84
Net income per share - diluted(1) . . . . . . . . . . . . $0.44 $0.42 $0.57 $0.71 $0.82
Working capital . . . . . . . . . . . . . . . . . . . . . $1,909 $18,750 $13,515 $42,563 $26,224
Total assets. . . . . . . . . . . . . . . . . . . . . . . 16,481 36,708 40,979 79,521 104,228
Long-term debt, less current maturities(2). . . . . . . . 10,452 3,029 3,129 1,936 9,219
Stockholders' equity. . . . . . . . . . . . . . . . . . . 1,614 28,974 32,312 66,991 73,963
- - ------------
(1) Earnings per share reflects retroactive application of statement of
financial accounting standards ("SFAS") no. 128, "Earning Per Share."
(2) For 1994, long-term debt includes $8,000,000 for redeemable preferred
stock.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The Company derives its revenue from several sources: royalties, franchise
fees, developer fees (consisting of area developer and master licensee fees),
Company-owned restaurant sales, Turnkey development, brand contribution (private
label licensing fees), and other franchise-related activities. Between 1991 and
1994, developer fees grew to represent a significant portion of total revenue as
the Company sold development rights for most of the television markets in the
United States and certain international territories. Franchise fees, Turnkey
development and brand contribution increased following this period as the rate
at which stores opened increased. Since the Company has sold developer rights
for virtually all of the United States, developer fees derived from these
non-recurring transactions have declined as a percentage of total revenue, while
typically brand contributions, franchise fees and royalties based on franchise
store sales and revenue from the Turnkey Program have increased.
Royalties are based on a percentage of franchisees' net sales and are
recognized by the Company in the same period that the franchise store sales
occur. Generally, royalties are earned at the rate of 6% of sales for stores
opened after 1991 and 4% of sales for stores opened before that time.
Royalties are paid by means of weekly automatic drafts by the Company on
franchisee bank accounts for 6% royalty stores. As of December 31, 1998, 98
franchised stores were paying royalties on a monthly basis at the rate of 4%.
This number of stores will decline as older franchise agreements expire (the
majority of which will expire after 1999). A portion of the royalties
received by the Company are paid to its area developers as royalty service
costs for providing on-going services to franchisees in their territories.
See "Business -- Franchising --Area Developers." Royalties have increased
since 1992 due not only to the growth in the number of stores, but also to
increases in average weekly sales. The increase in average weekly sales is
due primarily to the conversion of older franchise stores to the Schlotzsky's
Deli restaurant concept, as well as the selection of more free-standing
locations for newer stores, which have better visibility and generally
experience higher sales than the smaller "in-line" stores located in strip
shopping centers which are characteristic of stores opened prior to 1992.
Franchise fees are payments received by the Company from franchisees and
are typically recognized into revenue as stores open. The franchise fee for a
franchisee's initial store is currently $30,000. The franchise fee for each
additional store committed to and opened by a franchisee is $20,000. Expenses
associated with franchise fees are shown as franchise fee service costs and
include the portion of the franchise fee paid to area developers. The Company
generally pays area developers approximately one-half of the franchise fees
collected from franchisees in their development areas. As the Company
reacquires a limited number of territories and buys down the percentage of
participation by certain area developers, the Company expects that franchise
fee service costs will decrease as a percentage of franchise fees to less
than 50%.
Restaurant sales are reported from Company-owned stores, and declined
between 1991 and 1994 as a result of the Company's strategy adopted in 1991
to develop only franchised stores. The number of Company-owned stores
declined from 22 to two stores between 1990 and 1994. Restaurant sales
increased significantly in 1996 because the Company's flagship restaurant in
Austin, Texas was in operation the entire year and because two additional
stores were acquired from franchisees during 1996. Currently, Company stores
are operated primarily for product development, concept refinement and
training franchisees. Management does not believe that the operating cost of
sales for Company-owned stores is indicative of costs for franchised stores
on a system-wide basis. Restaurant sales should increase as the Company
continues to acquire or open a limited number of additional Company-owned
stores. See "Business -- Strategy -- Company-Owned Stores."
The Company charges developers a nonrefundable fee for the exclusive
rights to develop a defined territory for a specified term. Typically, a
portion of the developer fee is paid in cash and the balance is paid with a
promissory note. See "Business -- Franchising -- Area Developers" and "--
International Master Licensees." When the Company has fulfilled substantially
all of its contractual responsibilities and obligations, such as training,
providing manuals, and, in the case of master licensees, reasonable efforts
to obtain trademark registration, the Company recognizes as revenue the cash
portion of the fee and the value of the promissory note, as determined by an
independent third party valuation. These fees have declined in the last three
years as most of the remaining domestic territories have
19
been sold and fees from the licensing of international territories, which are
not aggressively marketed by management, remain sporadic.
Revenue is also generated from brand contribution (private label
licensing fees) and the Turnkey Program. The Company has licensed
manufacturers to produce Schlotzsky's private label products and began
receiving licensing fees from sales of private label foods to franchisees in
late 1994. This revenue has increased significantly to $1,295,000 for 1996,
$2,915,000 for 1997 and $4,003,000 for 1998. The Company believes that
private label licensing fees will increase as a greater portion of the
systems' menu ingredients are covered by the program, system-wide sales grow
and terms with various suppliers are renegotiated. See "Business --
Purchasing; Private Labeling" and "Risk Factors -- Importance of Licensing
Fees."
The Company instituted the Turnkey Program to further assist franchisees
in obtaining superior sites and to achieve more rapid penetration in those
selected major markets where the Company believes there is strong demand by
franchisees for good locations. Under the Turnkey Program, the Company works
independently or with an area developer to identify superior store sites
within a territory. The Company will typically perform various consulting
services including, but not limited to, site selection, feasibility analysis,
environmental studies, site work, permitting and construction management,
receiving a fee and recognizing revenue upon the completion of these
services. The Company may assign its earnest money contract on a site to a
franchisee, or a third-party investor, who then assumes responsibility for
developing the store. The Company may also purchase or lease a selected site,
design and construct a Schlotzsky's Deli restaurant on the site and sell,
lease or sublease the completed store to a franchisee. Where the Company does
not sell the property to a franchisee, the Company sells the improved
property, or, in the case of a leased property, assigns the lease and any
sublease, to an investor.
The Company anticipates that the total investment in each developed
free-standing location will be approximately $1,200,000 to $2,000,000 (less for
leased locations). From inception of the Turnkey Program through 1997, the
Company typically provided a credit enhancement in the form of a limited
guaranty on the franchisee's lease for leased locations. Upon sale of the
leased site or assignment of its earnest money contract, the Company has
deferred revenue generated (even though proceeds were received in cash) and
allocable costs incurred in connection with the property. When a lease guaranty
is terminated, or the Company's exposure to loss under the guaranty has passed,
the Company recognizes the revenue and allocable costs related to the site.
Generally, if no credit enhancement is provided in connection with such
transactions, the Company may recognize the revenue and allocable expenses in
the periods in which the transactions occur. During 1998, the Company began
emphasizing ownership of the real estate by franchisees through a program which
entails acquiring the rights to a superior site and reselling the property, or
its rights (with any improvements), to a franchisee whose mortgage loan is
financed by a third party financial institution. The Company provides credit
enhancement for the franchisee in the form of a limited guaranty in favor of the
lender. Generally, in those cases, the Company recognizes the revenue and
allocable expenses in the period in which the transaction occurs. In some
cases, the Company may interim finance land and building costs in anticipation
of permanent financing by a financial institution. The Company believes that
the Turnkey Program enhances the Company's ability to recruit qualified
franchisees by securing and developing high profile sites and achieving critical
mass for advertising purposes more quickly in selected markets. In addition, the
Company charges a fee when it is requested to manage construction of a store on
property owned by a franchisee or an investor. This construction management fee
is recognized when the store is completed.
20
The following table sets forth (i) the percentage relationship to total
revenue of the listed items included in the Company's consolidated statements of
operations, except as otherwise indicated, and (ii) selected store data.
FISCAL YEARS ENDED DECEMBER 31,
---------------------------------------
1996 1997 1998
--------- --------- ---------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Royalties. . . . . . . . . . . . . . . . . . . . . . . . . 51.9% 52.1% 45.1%
Franchise fees . . . . . . . . . . . . . . . . . . . . . . 8.6 5.6 3.3
Developer fees . . . . . . . . . . . . . . . . . . . . . . 9.6 1.2 0.6
Restaurant sales . . . . . . . . . . . . . . . . . . . . . 17.4 22.7 18.4
Brand contribution . . . . . . . . . . . . . . . . . . . . 6.3 10.4 9.6
Turnkey development. . . . . . . . . . . . . . . . . . . . 3.5 4.1 19.9
Other fees and revenue . . . . . . . . . . . . . . . . . . 2.7 3.9 3.1
--------- --------- ---------
Total revenue. . . . . . . . . . . . . . . . . . . . . 100.0 100.0 100.0
Costs and expenses:
Service costs:
Royalties(1). . . . . . . . . . . . . . . . . . . . . . . 35.3 36.9 38.3
Franchise fees(2) . . . . . . . . . . . . . . . . . . . . 54.0 52.3 51.1
Restaurant operations:
Cost of sales(3). . . . . . . . . . . . . . . . . . . . . 32.8 31.6 32.6
Labor costs(3). . . . . . . . . . . . . . . . . . . . . . 39.5 39.2 41.5
Operating expenses(3) . . . . . . . . . . . . . . . . . . 28.8 30.7 28.1
Turnkey development costs (4) . . . . . . . . . . . . . . 71.5 32.3 57.8
General and administrative . . . . . . . . . . . . . . . . 31.4 27.5 27.4
Depreciation and amortization. . . . . . . . . . . . . . . 3.8 4.1 4.5
Total costs and expenses . . . . . . . . . . . . . . . 78.2 78.1 81.2
--------- --------- ---------
Income from operations. . . . . . . . . . . . . . . . . . 21.8 21.9 18.8
Other:
Interest income . . . . . . . . . . . . . . . . . . . . . 2.2 2.7 4.9
Other income. . . . . . . . . . . . . . . . . . . . . . . 0.6 0.7 0.0
--------- --------- ---------
Total other income . . . . . . . . . . . . . . . . . . 2.8 3.4 4.9
--------- --------- ---------
Income before income taxes. . . . . . . . . . . . . . . . 24.6 25.3 23.7
Provision for income taxes. . . . . . . . . . . . . . . . 9.2 9.3 8.9
--------- --------- ---------
Net income. . . . . . . . . . . . . . . . . . . . . . . . 15.4% 15.9% 14.8%
--------- --------- ---------
--------- --------- ---------
STORE DATA:
System-wide sales(5). . . . . . . . . . . . . . . . . . . $202,400 $270,400 $348,500
Change in same store sales(6) . . . . . . . . . . . . . . 3.3% 3.4% 3.1%
Weighted average annual store sales(7). . . . . . . . . . $410,000 $455,000 $503,000
Weighted average weekly store sales(7). . . . . . . . . . $ 7,867 $ 8,753 $ 9,671
Change in average weighted weekly store sales(8) . . . . 11.0% 11.3% 10.5%
Number of stores opened during period . . . . . . . . . . 135 120 107
Number of stores closed during period . . . . . . . . . . 25 20 30
Number of stores in operation at end of period. . . . . . 573 673 750
- - ---------------------------------
(1) Expressed as a percentage of royalties.
(2) Expressed as a percentage of franchise fees.
(3) Expressed as a percentage of restaurant sales.
(4) Expressed as a percentage of Turnkey development.
(5) In thousands. Includes sales for all stores, as reported by
franchisees or derived by the Company from other data reported by
franchisees.
(6) Same store sales are based upon stores which were open for the entire
period indicated and for at least 18 months as of the end of the
corresponding prior period, including stores which were temporarily
closed and reopened within 6 months.
(7) In actual dollars (rounded in the case of average annual store sales).
(8) Percentage change in weighted average weekly store sales from previous
fiscal year.
21
RESULTS OF OPERATIONS
FISCAL YEAR 1998 COMPARED TO 1997
REVENUE. Total revenue increased 49.6% from $27,969,000 to $41,848,000.
Royalties increased 29.7% from $14,561,000 to $18,885,000. This increase
was due to the full year impact of stores opened in 1997 and the addition of 107
restaurants opened during the period from January 1, 1998 to December 31, 1998.
Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, a 10.5% increase in average weekly
sales and a 3.1% increase in same store sales.
Franchise fees decreased 12.2% from $1,555,000 to $1,365,000. This decrease
was a result of 13 fewer openings during 1998, as compared to 1997. The fewer
number of openings is principally the result of the Company's increasing
emphasis on superior site selection for larger freestanding stores with higher
visibility and on more highly qualified and better capitalized franchisees.
Developer fees decreased 16.9% from $325,000 to $270,000. This decrease was
primarily the result of less emphasis on these transactional fees and the fact
that the development rights to most domestic markets have been sold. The Company
anticipates that developer fees received in the future will primarily result
from re-marketing development rights it has acquired.
Restaurant sales increased 21.3% from $6,364,000 to $7,720,000. This
increase was attributable to a 6.2% increase in sales volume at the Company's
flagship store and the relocation and reopening of two Company-owned stores
during 1998. In the future, it is contemplated that several more Company-owned
stores will be developed, operated and maintained by the Company in certain key
markets.
Private label licensing fees (brand contributions) increased 37.3% from
$2,915,000 to $4,003,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well as
the increasing volume of system-wide sales and greater franchisee participation
in the Company's purchasing programs. During 1999, the Company expects
additional products will be added to its private label program and alternative
retail channels of distribution of its products may become available, resulting
in the potential for further increases in licensing fees.
Turnkey development revenue increased from $1,139,000 to $8,314,000. In
contrast with 1997 when 33 of 40 Turnkey Program transactions involved the
Company's credit enhancement on franchisee leases, only five of the 69 Turnkey
Program transactions involved such lease guaranties in 1998. Of the $8,314,000,
$2,102,000 was related to transactions completed during 1997 involving the
Company's lease guaranties, which were terminated during 1998. The remainder of
the transactions in 1998 involved sales of rights to real estate to franchisees
or investors (who acquired with the objective of selling developed properties to
franchisees). Revenue in 1998 also included approximately $258,000 of rental
revenue from sites completed and under lease. The Company anticipates that
Turnkey development revenue may be reduced in the future as a greater emphasis
is placed on lowering the cost to franchisees of each project.
Other fees and revenues increased 16.1% from $1,110,000 to $1,289,000. This
change was primarily due to the increased level of supplier contributions to the
Company's annual convention held in July 1998.
COSTS AND EXPENSES. Royalty service costs increased 34.5% from $5,373,000
to $7,225,000. This increase was a direct result of the increase in royalty
revenue for 1998, as compared to 1997. Royalty service costs as a percentage of
royalties grew from 36.9% to 38.3%. This increase reflects the growing
percentage of restaurants serviced by the area developer system and whose area
developers receive approximately 42% of the royalties from the stores in their
territories. During 1999, the Company expects developer service costs as a
percentage of royalty revenue to decrease as the Company intends to buy-down the
rights and obligations of several of its area developers and to re-acquire the
rights to a limited number of territories.
Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 24.8% from $2,014,000 to $2,513,000, and as a percentage of restaurant
sales increased from 31.6% to 32.6%. Also, restaurant labor costs
22
increased 28.6% from $2,493,000 to $3,205,000, and as a percentage of
restaurant sales increased from 39.2% to 41.5% for the same period in 1997.
These percentage increases were primarily due to operational inefficiencies
experienced in re-opening two Company-owned stores. Restaurant operating
expenses have increased 11.1% from $1,952,000 to $2,168,000, but as a
percentage of restaurant sales decreased from 30.7% to 28.1% for 1998, as
compared to 1997. This decrease is due to the increasing sales outpacing the
increased costs associated with operating the new stores.
Turnkey development costs increased from $368,000 to $4,806,000 and as a
percentage of Turnkey development revenue increased from 32.3% to 57.8%. These
increases are primarily the result of $1,063,000 of costs deferred in 1997 being
recognized in 1998, the addition of staff to the Turnkey Program in late 1997
and during 1998 and certain costs being recognized for sites no longer being
pursued.
General and administrative expenses increased 49.3% from $7,686,000 to
$11,471,000, and as a percentage of total revenue remained relatively stable at
27.4%.
Depreciation and amortization increased 63.1% from $1,156,000 to
$1,885,000, and as a percentage of revenue increased from 4.1 to 4.5%. This
dollar increase was principally due to amortization of goodwill and other
intangibles acquired in 1997 and 1998, and depreciation related to the
additional stores the Company was operating during the year.
OTHER. Net interest income increased 173.3% from $753,000 to $2,058,000.
This increase was a result of funds being loaned for Turnkey mortgages and
interim construction financing under the Turnkey Development Program.
INCOME TAX EXPENSE. Income tax expense reflects a combined federal and
state effective tax rate of 37.5% for 1998, which is slightly higher than the
effective combined tax rate for the comparable period in 1997. Based on
projections of taxable income, the Company anticipates that its effective
combined rate for federal and state taxes will remain fairly stable.
FISCAL YEAR 1997 COMPARED TO 1996
REVENUE. Total revenue increased 35.0% from $20,714,000 to $27,969,000.
Royalties increased 35.5% from $10,747,000 to $14,561,000. This increase
was due to the full year impact of stores opened in 1996 and the addition of 120
restaurants opened during the period from January 1, 1997 to December 31, 1997.
Also contributing to the increase was the growing influence of larger
freestanding stores with higher visibility, an 11.3% increase in average weekly
sales and a 3.4% increase in same store sales.
Franchise fees decreased 12.4% from $1,775,000 to $1,555,000. This decrease
was a result of 15 fewer openings during 1997, as compared to 1996. The fewer
number of openings was principally the result of the Company's increasing
emphasis on superior site selection for larger freestanding stores with higher
visibility and on more highly qualified and better capitalized franchisees.
Developer fees decreased 83.7% from $1,993,000 to $325,000. This decrease
was primarily the result of less emphasis on these transactional fees and the
fact that the development rights to most domestic markets have been sold.
Restaurant sales increased 76.3% from $3,610,000 to $6,364,000. This
increase was attributable to a 17.4% increase in sales volume at the Company's
flagship store and the opening of two additional Company-owned stores in 1997.
Private label licensing fees (brand contributions) increased 125.1% from
$1,295,000 to $2,915,000. The increase was the result of more favorable terms
with certain major suppliers than terms in place in the prior year, as well as
the increasing volume of system-wide sales and greater franchisee participation
in the Company's purchasing programs.
23
Turnkey development revenue increased 56.9% from $726,000 to $1,139,000.
Cash received in excess of costs allocable to 1997 Turnkey Program transactions
in which the Company provided credit enhancement on franchisees' leases was
treated as deferred revenue, and accordingly, did not impact the 1997 revenue or
net income. Revenue in 1997 included approximately $303,000 of rental revenue
from sites completed and under lease. Forty sites developed under the Turnkey
Program were sold during 1997, seven of which had no credit enhancement
associated with the transaction and the revenues from that activity comprise the
balance of Turnkey development revenue generated during 1997.
Other fees and revenues increased 95.4% from $568,000 to $1,110,000. This
change was primarily due to the increased level of supplier contributions to the
Company's annual convention held in July 1997.
COSTS AND EXPENSES. Royalty service costs increased 41.7% from $3,791,000
to $5,373,000. This increase was a direct result of the increase in royalty
revenue for 1997, as compared to 1996. Royalty service costs as a percentage of
royalties grew from 35.3% to 36.9%. This increase reflected the growing
percentage of restaurants serviced by the area developer system and whose area
developers receive approximately 42% of the royalties from the stores in their
territories.
Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 70.3% from $1,183,000 to $2,014,000, but as a percentage of restaurant
sales decreased from 32.8% to 31.6%. Also, restaurant labor costs increased
75.1% from $1,424,000 to $2,493,000, but as a percentage of restaurant sales
decreased from 39.5% to 39.2% for the same period in 1996. These percentage
decreases were primarily due to the improving operational efficiencies attained
in the various Company-owned stores. Restaurant operating expenses increased
87.7% from $1,040,000 to $1,952,000, and as a percentage of restaurant sales
increased from 28.8% to 30.7% for 1997, as compared to 1996. The increase in
operating expenses is due to the additional facility costs for the additional
stores the Company operates.
Turnke