UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

OR

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____to _____

Commission File No. 000-50052

COSÌ, INC.

(Exact name of registrant as specified in its charter)

1751 Lake Cook Road

Deerfield, Illinois 60015

(Address of principal executive offices) (Zip Code)

(847) 597-8800

(Registrant's telephone number, including area code)

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 o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x Noo

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

Accelerated filer o

Non-Accelerated filer o

Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

Number of shares of Common Stock, $.01 par value, outstanding as of November 7, 2013: 18,096,107

---

---

COSI, INC.

Index to Form 10-Q

For the nine-month period ended September 30, 2013

---

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

Cosi, Inc.

Consolidated Balance Sheets

As of September 30, 2013 and December 31, 2012

(dollars in thousands)

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

---

Cosi, Inc.

Consolidated Statements of Operations and Comprehensive Loss

For the Three and Nine Months Ended September 30, 2013 and October 1, 2012

(dollars in thousands, except share and per share data)

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

---

Cosi, Inc.

Consolidated Statement of Stockholders' Equity

For the Nine Months Ended September 30, 2013

(unaudited)

(dollars in thousands, except share data)

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

---

Cosi, Inc.

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2013 and October 1, 2012

(dollars in thousands)

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

---

COSI, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1 – Basis of Presentation

We have prepared the accompanying unaudited condensed consolidated financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”).  In our opinion, the financial statements reflect all adjustments that are necessary for a fair presentation of the results of operations for the periods shown. All such adjustments are of a normal recurring nature. In preparing financial statements in conformity with U.S. GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates.

As used in this quarterly report on Form 10-Q, unless the context requires otherwise, the terms “we,” “our,” “Company” or “Cosi” refer to Cosi, Inc. and its consolidated subsidiaries.

The balance sheet at December 31, 2012 has been derived from audited financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

The results for the three and nine months ended September 30, 2013 and October 1, 2012 are not indicative of the results for the full fiscal year.

Certain amounts in the December 31, 2012 consolidated balance sheet, the consolidated statement of stockholder’s equity, and the consolidated statement of operations have been reclassified to conform to the September 30, 2013 presentation as a result of the reverse stock split that the Company filed on May 8, 2013.

This report should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, as filed with the Securities and Exchange Commission (“SEC”).

There have been no material changes to our significant accounting policies and estimates from the information provided in Note 1 of our consolidated financial statements included in our Form 10-K for the fiscal year ended December 31, 2012.

Note 2 – Stock-Based Compensation Expense

A summary of non-cash, stock-based compensation expense is as follows:

As of September 30, 2013, the unrecognized compensation expense related to stock options and restricted shares of common stock granted under the Cosi, Inc. 2005 Omnibus Long-Term Incentive Plan, as amended, (the “2005 Plan”) was approximately $0.1 million and is being recognized on a straight-line basis over the remaining vesting period through fiscal 2017.

---

 

We did not grant any stock options or restricted shares of common stock to employees or non-employee directors in the three months ended September 30, 2013 and October 1, 2012.

In the three months ended September 30, 2013 and October 1, 2012, 2,000 and 44,900 shares, respectively, of previously issued restricted common stock were forfeited. The value of these forfeitures, based on the closing price of our common stock on the date of the grants, was approximately $0.01 and $0.1 million, respectively.

During the nine months ended September 30, 2013 and October 1, 2012, 270,800 and 53,400 shares, respectively, of previously issued restricted common stock were forfeited. The value of the forfeited shares, based on the closing price of our common stock on the date of the grants, was approximately $0.7 million during the nine months ended September 30, 2013 and immaterial during the nine months ended October 1, 2012. The reversal of the previously amortized costs in the accompanying consolidated statements of operations for the nine months ended September 30, 2013 and October 1, 2012 was approximately $0.2 million and $0.01 million, respectively.

Note 3 – Earnings Per Share

Basic earnings per share is calculated by dividing the net income available to common shareholders by the weighted-average common shares outstanding during each period. Diluted earnings per share (“diluted EPS”) is calculated using net income available to common shareholders divided by diluted weighted-average shares of common stock outstanding during each period. Potentially dilutive securities include unvested stock and common stock related to stock options.  Diluted EPS considers the impact of potentially dilutive securities except in periods of net loss because the inclusion of these securities would have had an anti-dilutive effect. As of September 30, 2013 and October 1, 2012, there were, respectively, 17,575 and 277,763 unvested restricted shares of common stock outstanding and 53,652 and 39,252 out-of-the-money stock options to purchase shares of common stock. The unvested restricted shares meet the requirements for participating securities but were not included in the computation of basic and diluted earnings per share because we incurred a net loss in all periods presented and, hence, the impact would be anti-dilutive. The outstanding stock options to purchase shares of common stock also meet the requirements of participating securities for purposes of calculating diluted EPS but were not included since they were out-of-the-money.

Note 4 – Asset Impairments

In accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 360 (ASC Topic 360), Property, Plant & Equipment, we evaluate possible impairments at the individual restaurant level periodically and record an impairment loss whenever we determine impairment factors are present. We consider a history of poor financial operating performance to be the primary indicator of potential impairment for individual restaurant locations. We determine whether a restaurant location is impaired based on expected undiscounted cash flows, generally for the remainder of the lease term, and then determine the impairment charge based on discounted cash flows for the same period.

Restaurants are not considered for impairment during the period before they enter the comparable restaurant base, unless specific circumstances warrant otherwise.

We did not record any asset impairment charges during the three months ended September 30, 2013 and October 1, 2012. The asset impairment charges during the nine months ended September 30, 2013 were approximately $0.7 million. We did not record any asset impairment charges during the nine months ended October 1, 2012.

---

Note 5 – Lease Termination Costs

We incurred lease termination costs of approximately $0.1 million in the nine months ended September 30, 2013 and none during the same period ended October 1, 2012. Future store closings, if any, resulting from our decision to close underperforming locations prior to their scheduled lease expiration dates may result in additional lease termination charges. For all exit activities, we estimate our likely liability under contractual leases for restaurants that have been closed. Such estimates have affected the amount and timing of charges to operating results and are impacted by management’s judgments about the time it may take to find a suitable subtenant or assignee, or the terms under which a termination of the lease agreement may be negotiated with the landlord. We recognize costs associated with exit or disposal activities at the time a commitment to an exit or disposal plan is communicated to the landlord.

Note 6 – Contingencies

From time to time, we are a defendant in litigation arising in the ordinary course of our business.  As of the date of this report, there are no legal proceedings that would require accrual or disclosure under ASC 450.

Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing

On August 20, 2013, the Company received notice from the Listing Qualifications Department of the Nasdaq Stock Market indicating that, for the period ended July 1, 2013, the Company no longer met the required minimum of $10,000,000 in stockholders' equity needed for continued listing under Listing Rule 5450(b)(1)(A). The notification letter stated that the Company had until October 4, 2013 to submit a plan to regain compliance. If a plan was submitted and accepted, the Company could be afforded up to 180 calendar days, or until February 16, 2014, to regain compliance. If a plan was submitted and not accepted, the Company might appeal to a Nasdaq Listing Qualifications Panel. Alternatively, the Company might consider applying for a transfer to The Nasdaq Capital Market provided it satisfied the requirements for continued listing on that market.

On October 4, 2013, the Company submitted an application to transfer its securities to The Nasdaq Capital Market. On October 7, 2013, the Company received notice from the Nasdaq Listing Qualifications Department indicating that the application was approved and that the Company’s securities would be transferred to the Nasdaq Capital Market at the opening of business on October 9, 2013.

Note 7 – Income Taxes

We have recorded a full valuation allowance to reduce our deferred tax assets related primarily to net operating loss carryforwards. Our determination of the valuation allowance is based on an evaluation of whether it is more likely than not that we will be able to utilize the net operating loss carryforwards, based on the Company’s operating results. A positive adjustment to income will be recorded in future years if we determine that we could realize these deferred tax assets.

As of December 31, 2012, we had net operating loss (“NOL”) carryforwards of approximately $212.9 million for U.S. federal income tax purposes. Under the Internal Revenue Code, an “ownership change” with respect to a corporation can significantly limit the amount of pre-ownership change NOLs and certain other tax assets that the corporation may utilize after the ownership change to offset future taxable income, possibly reducing the amount of cash available to the corporation to satisfy its obligations. An ownership change generally would occur if the aggregate stock ownership of holders of at least 5% of our stock increases by more than 50 percentage points over the preceding three-year period. We do not believe that the rights offering and the related private placement of common stock that we completed in fiscal 2010 have triggered an ownership change. The purchase of shares of our common stock pursuant to the rights offering and private placement of common stock that we completed during the third quarter of fiscal 2012 may trigger an ownership change with respect to our common stock. In addition, a limitation would not have an impact on our consolidated financial statements as we have recorded a valuation allowance for the entire amount of our deferred tax assets.

---

 

We adopted ASC 740-10, Income Taxes, which prescribes a comprehensive financial statement model of how a company should recognize, measure, present and disclose uncertain tax positions that the company has taken or expects to take in its income tax returns. The standard requires that only income tax benefits that meet the “more likely than not” recognition threshold be recognized or continue to be recognized on the effective date. Initial recognition amounts would have been reported as a cumulative effect of a change in accounting principle.

Should the Company need to accrue interest or penalties on uncertain tax positions, it would recognize the interest as interest expense and the penalties as a general and administrative expense.

Due to our unexpired NOLs, Cosi could be subject to IRS income tax examination for the tax year 1996 and all subsequent years. We could also be subject to state income tax examinations in certain states where we have unexpired NOLs.

---

The following discussion and analysis of our financial condition and results of operations for the fiscal quarters ended September 30, 2013 and October 1, 2012 should be read in conjunction with “Selected Consolidated Financial Data” and our audited consolidated financial statements and the notes to those statements that are in our 2012 Annual Report on Form 10-K. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under “Cautionary Note Regarding Forward-Looking Statements” below and elsewhere in this Quarterly Report.

OVERVIEW

System-wide restaurants:

As of September 30, 2013, there were 72 Company-owned and 51 franchised restaurants operating in 16 states, the District of Columbia, the United Arab Emirates (“UAE”), and Costa Rica. During the three months ended September 30, 2013, three new franchised restaurants opened, one in Costa Rica and two college campus locations with a new franchisee. During the same period, two Company-owned and two franchised restaurants closed. In the three months ended October 1, 2012, we closed two Company-owned restaurants at the expiration of their leases. In addition, two franchised restaurants closed during the same quarter. Subsequent to the end of the third quarter of fiscal 2013, we sold one Company-owned restaurant in Owings Mills, Maryland to a new franchisee.

Our restaurants offer innovative, savory, made-to-order products featuring our authentic hearth-baked crackly-crust signature Cosi® bread and fresh distinctive ingredients. We maintain a pipeline of new menu offerings that are introduced periodically through limited time offerings to keep our products relevant to our target customers. Our menu features high-quality, made-to-order hot and cold sandwiches, hand-tossed salads, bowls, breakfast wraps, Cosi® Squagels®, hot melts, flatbread pizzas, S’mores and other desserts, and a variety of coffees along with other soft drink beverages, bottled beverages including premium still and sparkling water, teas, alcoholic beverages, and other specialty coffees and beverages. Our restaurants offer lunch and afternoon coffee in a counter-service format, with most offering breakfast and/or dinner and dessert menus as well.

We are currently eligible to offer franchises in 46 states and the District of Columbia. We offer franchises to area developers and individual franchise operators. The initial franchise fee, payable to us, for both an area developer and an individual franchise operator, is $40,000 for the first restaurant and $35,000 for each additional restaurant.

---

We believe that offering Cosi® franchised restaurants to area developers and individual franchisees offers the prospects of strong financial returns. By franchising, we believe we will be able to increase the presence of our restaurants in various markets throughout the country and generate additional revenue without the large upfront capital commitments and risk associated with opening Company-owned restaurants.

We believe that incorporating a franchising and area developer model into our strategy will position us to maximize the market potential for the Cosi® brand and concept consistent with our available capital, and we expect that Company-owned restaurants (restaurants that we own as opposed to franchised restaurants) will always be an important part of our new restaurant growth.

We also continue to explore non-traditional franchise opportunities such as our grab-and-go format (“Cosi Pronto®”), as well as concepts in educational establishments, airports, train stations and other public venues that meet our operating and financial criteria.

Recent Developments

Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing

On August 20, 2013, the Company received notice from the Listing Qualifications Department of the Nasdaq Stock Market indicating that, for the period ended July 1, 2013, the Company no longer met the required minimum of $10,000,000 in stockholders' equity needed for continued listing under Listing Rule 5450(b)(1)(A). The notification letter stated that the Company had until October 4, 2013 to submit a plan to regain compliance. If a plan was submitted and accepted, the Company could be afforded up to 180 calendar days, or until February 16, 2014, to regain compliance. If a plan was submitted and not accepted, the Company might appeal to a Nasdaq Listing Qualifications Panel. Alternatively, the Company might consider applying for a transfer to The Nasdaq Capital Market provided it satisfied the requirements for continued listing on that market.

On October 4, 2013, the Company submitted an application to transfer its securities to The Nasdaq Capital Market. On October 7, 2013, the Company received notice from the Nasdaq Listing Qualifications Department indicating that the application was approved and that the Company’s securities would be transferred to the Nasdaq Capital Market at the opening of business on October 9, 2013.

Critical Accounting Policies

Our discussion and analysis of our consolidated financial condition and results of operations is based upon the consolidated financial statements and notes to the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of the consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.

 

We believe the application of our accounting policies, and the estimates inherently required therein, are reasonable and generally accepted for companies in the restaurant industry. We believe that the following addresses the more critical accounting policies used in the preparation of our consolidated financial statements and requires management’s most difficult and subjective judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. There have been no material changes in the application of our most critical accounting policies and estimates, judgments and assumptions during the third quarter of fiscal 2013.

---

Long Lived Assets: ASC 360-10-35 Property, Plant, & Equipment requires management judgments regarding the future operating and disposition plans for marginally-performing assets, and estimates of expected realizable values for assets to be sold. The application of this standard has affected the amount and timing of charges to operating results that have been significant in recent years. We evaluate possible impairment at the individual restaurant level periodically and record an impairment loss whenever we determine impairment factors are present. We consider a history of poor financial operating performance to be the primary indicator of potential impairment for individual restaurant locations. We determine whether a restaurant location is impaired based on expected undiscounted cash flows, generally for the remainder of the lease term, and then determine the impairment charge based on discounted cash flows for the same period.  Restaurants are not considered for impairment during the “ramp-up” period before they enter the comparable restaurant base, unless specific circumstances warrant otherwise.

Lease Termination Charges: ASC 420-10-30 Exit or Disposal Cost Obligations requires companies to recognize a liability for the costs associated with an exit or disposal activity at the time a lease termination commitment is made and communicated to the landlord. For all exit activities, we estimate our likely liability under contractual leases for restaurants that have been closed. Such estimates have affected the amount and timing of charges to operating results and are impacted by management’s judgments about the time it may take to find a suitable subtenant or assignee, or the terms under which a termination of the lease agreement may be negotiated with the landlord.

Accounting for Lease Obligations: In accordance with ASC 840-10-25 Leases, we recognize rent expense on a straight-line basis over the lease term commencing on the date we take possession. We include any rent escalations, rent abatements during the construction period and any other rent holidays in our straight-line rent expense calculation.

Landlord Allowances: In accordance with ASC 840-10-25 Leases, we record landlord allowances as deferred rent in other long-term liabilities on the consolidated balance sheets and amortize them on a straight-line basis over the term of the related leases.

Stock-Based Compensation Expense:  In accordance with ASC 718-10-25 Compensation – Stock Compensation we recognize stock-based compensation expense according to the fair value recognition provision, which generally requires, among other things, that all employee share-based compensation be measured using a fair value method and that all the resulting compensation expense be recognized in the financial statements.

We measure the estimated fair value of our granted stock options using a Black-Scholes pricing model and of our restricted stock based on the fair market value of a share of registered stock on the date of grant. The weighted average fair values of the stock options granted through 2013, the last time we issued stock options, were determined using the Black-Scholes option-pricing model.

Income Taxes: We have recorded a full valuation allowance to reduce our deferred tax assets that relate primarily to net operating loss carry-forwards. Our determination of the valuation allowance is based on an evaluation of whether it is more likely than not that we will be able to utilize the net operating loss carry-forwards based on the Company’s operating results. A positive adjustment to income will be recorded in future years if we determine that we could realize these deferred tax assets.

 

Revenue

 

Restaurant Net Sales: Our Company-owned restaurant sales are composed almost entirely of food and beverage sales. We record revenue at the time of the purchase of our products by our customers.

 

Franchise Fees and Royalties: Franchise fees and royalties includes fees earned from franchise agreements entered into with area developers and franchise operators, as well as royalties received based on sales generated at franchised restaurants. We recognize the franchise fee in the period in which a franchise location opens or when fees are forfeited as a result of a termination of an area developer agreement. We recognize franchise royalties in the period in which sales are made by our franchise operators.

 

Gift Card Sales: We offer our customers the opportunity to purchase gift cards at our restaurants and through our website. Customers can purchase these cards at varying dollar amounts. At the time of purchase by the customer, we record a gift card liability for the face value of the card purchased. We recognize the revenue and reduce the gift card liability when the gift card is redeemed. We do not reduce our recorded liability for potential non-use of purchased gift cards.

---

COMPARABLE RESTAURANT SALES

In calculating comparable restaurant sales, we include a restaurant in the comparable restaurant base after it has been in operation for 15 full months. We remove from the comparable restaurant base for the period any restaurant that is temporarily shut down for remodeling during that period. As of September 30, 2013 and October 1, 2012, there were 72 and 77 restaurants in our comparable restaurant base, respectively.

Costs and Expenses

 

Cost of Food and Beverage. Cost of food and beverage is composed of food and beverage costs. Food and beverage costs are variable and fluctuate with sales volume.

 

Restaurant Labor and Related Benefits. The costs of restaurant labor and related benefits include direct hourly and management wages, bonuses, payroll taxes, health insurance and all other fringe benefits.

 

Occupancy and Other Restaurant Operating Expenses. Occupancy and other restaurant operating expenses include direct restaurant-level operating expenses, including the cost of paper and packaging, supplies, repairs and maintenance, utilities, rent and related occupancy costs.

 

General and Administrative Expenses. General and administrative expenses include all corporate and administrative functions that support our restaurants and provide an infrastructure to operate our business. Components of these expenses include executive management costs; supervisory and staff salaries; non-field stock-based compensation expense; non-field bonuses and related taxes and employee benefits; travel; information systems; training; support center rent and related occupancy costs; and professional and consulting fees. The salaries, bonuses and employee benefits costs included as general and administrative expenses are generally more fixed in nature and do not vary directly with the number of restaurants we operate. Stock-based compensation expense includes the charges related to recognizing the fair value of stock options and restricted stock as compensation for awards to certain key employees and non-employee directors, except the costs related to stock-based compensation for restaurant employees which are included in restaurant labor and related benefits.

 

Depreciation and Amortization. Depreciation and amortization principally relates to restaurant assets.

---

RESULTS OF OPERATIONS

Our operating results for the three and nine months ended September 30, 2013 and October 1, 2012, expressed as a percentage of total revenues (except where otherwise noted), were as follows:

(1)	These are expressed as a percentage of restaurant net sales versus all other items expressed as a percentage of total revenues

---

Restaurant Net Sales

 

Restaurant net sales: Restaurant net sales decreased 12.8%, or approximately $3.0 million, in the three months ended September 30, 2013, as compared to the same period of fiscal 2012, due to an approximately $2.0 million decrease in net sales related to Company-owned restaurants closed during and after the third quarter of fiscal 2012, as well as an approximately $1.0 million, or 4.8%, decrease in net sales in our comparable restaurant base. The decrease in comparable restaurant net sales was comprised of 6.1% decrease in transactions, partially offset by a 1.3% increase in average check price.

In the nine months ended September 30, 2013, restaurant net sales decreased 12.0%, or approximately $8.8 million, as compared to the same period of fiscal 2012, due to a decrease of approximately $5.4 million in net sales related to Company-owned restaurants closed during and after the first quarter of fiscal 2012, as well as a decrease of approximately $3.4 million, or 5.0%, in net sales in our comparable restaurant base. The decrease in comparable restaurant net sales was comprised of 6.5% decrease in transactions, partially offset by 1.5% increase in average check price.

Franchise Fees and Royalties

Franchise fees and royalties: The increase in franchise fees and royalties in the three months ended September 30, 2013 is due entirely to the franchise fees recognized from the opening of three new franchised restaurants in the third quarter of fiscal 2013. The decrease in franchise fees and royalties of approximately $0.2 million in the nine months ended September 30, 2013 is due primarily to the lower royalties resulting from the closing of franchised restaurants during and after the first quarter of fiscal 2012, as well as the higher franchise fees recognized during fiscal 2012 resulting from two cancelled area development agreements.

---

Costs and Expenses

Cost of food and beverage: The increase in cost of food and beverage, as a percentage of restaurant net sales, for the three and nine months ended September 30, 2013, is largely due to a shift in menu sales mix towards products and day-parts with higher food costs as a percentage of sales, as well as the impact of higher costs for the seasonal limited time offer promotional items when compared to the items promoted last year. Also driving the increase in the cost of food and beverage, as a percentage of restaurant net sales, was the introduction of a new product line of bowls in 2013 which, as a category, have a higher cost of goods as a percentage of net sales than our other entrée categories. Beverage sales, primarily fountain drinks and coffee, which historically have a lower average cost than non-beverage product offerings, declined in both the three- and nine-month periods compared to the prior-year periods.

Restaurant labor and related benefits: The increase in restaurant labor and related benefits, as a percentage of restaurant net sales, is due primarily to the deployment of additional hourly labor in the third quarter of fiscal 2013 as part of an initiative to improve guest experience and speed of service, as well as the unfavorable impact on labor from the decrease in comparable net restaurant sales, primarily the impact on the fixed-portion of manager labor. The cost of healthcare-related benefits was also higher in the third quarter of fiscal 2013, as compared to the same period last year.

---

Occupancy and other restaurant operating expenses: The increase in occupancy and other restaurant operating expenses, as a percentage of restaurant net sales, is due primarily to the unfavorable effect on fixed occupancy-related costs of the decrease in comparable net restaurant sales, slightly higher costs for repairs and maintenance of existing Company-owned restaurants, and the increase in paper and packaging costs resulting from a year-over-year increase in catering sales.

General and administrative expenses: The decrease in general and administrative expenses in the three months ended September 30, 2013 of approximately $0.4 million is due primarily to labor savings resulting from an administrative workforce reductions that occurred during the second quarter of fiscal 2013, lower expenses for third-party professional fees, lower costs for marketing materials and advertising media expense, and the costs of certain relocation expenses incurred during the third quarter of fiscal 2012.

The decrease in general and administrative expenses in the nine months ended September 30, 2013 of approximately $0.2 million is due primarily to the lower expense for third-party professional fees, lower costs for marketing materials and advertising media expense, the costs of certain relocation expenses incurred during the third quarter of fiscal 2012, partially offset by the charge of approximately $0.5 million taken for severance pay resulting from an administrative workforce reduction during the second quarter of fiscal 2013.

---

Depreciation and amortization: The decrease in depreciation and amortization expense in the three and nine months ended September 30, 2013 is due primarily to the impact of impairments recorded during and subsequent to the first quarter of fiscal 2012, as well as the continued depreciation and amortization of our comparable restaurant base.

Restaurant pre-opening expenses: The restaurant pre-opening expenses in the three and nine months ended September 30, 2013 relate to the relocation of our restaurant at the Easton Town Center Mall in Columbus, Ohio.

Provision for losses on asset impairments and disposals: In the nine months ended September 30, 2013, we recorded a provision for losses on asset impairments and disposals of approximately $0.7 million related to six underperforming restaurants. The provisions for losses on asset impairments and disposals in the rest of the periods presented are immaterial and relate to asset disposals from the closing of Company-owned restaurants.

Lease termination and closed store costs: The lease termination and closed store costs in the three and nine months ended September 30, 2013 and October 1, 2012 relate to closing of Company-owned restaurants during these periods.

---

Other income: The other income recognized in the three and nine months ended September 30, 2013 and October 1, 2012 relates to the discounting of the long-term portion of a note receivable.

Net loss and comprehensive loss: The increase in net loss is due primarily to the unfavorable effect of the decrease in comparable restaurant net sales on the fixed-portion of manager labor and occupancy-related costs, the increase in food and beverage and paper and packaging costs, the net impact of locations closed during and subsequent to the second quarter of fiscal 2012, and higher costs for repairs and maintenance of existing Company-owned restaurants, partially offset by the savings realized from the administrative workforce reductions that occurred during the second quarter of fiscal 2013, lower depreciation expense, savings in third-party professional fees, and lower costs for marketing materials and advertising media expense.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were approximately $8.3 million on September 30, 2013, compared to $15.4 million on December 31, 2012. We had positive working capital of approximately $0.8 million on September 30, 2013, compared to $7.1 million on December 31, 2012. The decrease in working capital in the nine months ended September 30, 2013 was a result of funding our operating loss, net of depreciation and other non-cash expenses, as well as payments made for capital expenditures. Our principal requirements for cash during the remainder of fiscal 2013 will be for working capital needs and routine maintenance of our existing restaurants.

Net cash used in operating activities in the nine months ended September 30, 2013 was approximately $5.5 million, compared to $2.4 million in the nine months ended October 1, 2012. The increase was primarily the result of the higher operating loss, net of depreciation and other non-cash expenses, partially offset by the collection of $0.6 million in franchise and other miscellaneous receivables, and the higher vendor payments made during the nine months of fiscal 2012.

Net cash used in investing activities in the nine months ended September 30, 2013 increased to approximately $1.7 million, compared to $1.1 million, in the nine months ended October 1, 2012, and was the result of capital expenditures for existing Company-owned restaurants, as well as payments for construction of a new restaurant location in Easton Town Center Mall in Columbus, Ohio, as a relocation for an existing site in the mall.

---

No cash was used in or provided by financing activities in the nine months ended September 30, 2013 compared to approximately $12.6 million in the same period of fiscal 2012 associated with the shareholder rights offering and the private placement of shares to our executive officers and outside directors.

During the first three quarters of fiscal 2013, as well as the last two quarters of fiscal 2012, a total of five payments of $62,500 each were not received as scheduled in accordance with the terms of the Subordinated Secured Promissory Note associated with the sale of restaurants to a franchisee in 2010. The balance of the Note, as of September 30, 2013, is $925,000. The Company and franchisee expect payments to resume by the end of fiscal 2013.

We expect to incur capital costs associated with the maintenance of existing Company-owned restaurants during the remainder of fiscal 2013. As we currently have no credit facility or available line of credit, we expect to fund any required restaurant capital maintenance costs on existing Company-owned restaurants or capital needs to open new restaurants from cash and cash equivalents on hand, expected cash flows generated by existing Company-owned restaurants, and expected franchise fees and royalties.

We believe that our current cash and cash equivalents, the expected cash flows from Company-owned restaurant operations, the expected franchise fees and royalties, and the proceeds from sale of Company-owned restaurant to franchisees, if any, will be sufficient to fund our cash requirements for working capital needs and capital improvements and maintenance of existing restaurants for the next twelve months. Our conclusion is based on our projected financial performance for fiscal 2013 and includes a sensitivity analysis that projects varying levels of decline in consumer demand. The range of levels selected was based on our reasonable expectation of demand given the seasonality of our historical performance. In analyzing our capital cash outlays during the first nine months of fiscal years 2013 and 2012, 48.4% and 96.4%, respectively, of our capital expenditures were spent on improvements and repairs and maintenance associated with existing Company-owned locations. The balance of the capital cash outlays was spent on the relocation of an existing restaurant in 2013 and on information technology-related projects in 2012.

If the performance of our Company-owned restaurants does not improve, if new franchised restaurants do not open according to our expectations, if we do not generate the franchise fees and royalties that we currently expect, if we are unable to refranchise non-core markets to existing or new franchisees, if we are unable to exit underperforming units as expected, if we incur significant unanticipated cash requirements beyond our normal liquidity needs, or if we experience other unforeseen circumstances then, in order to fund our cash requirements, we may have to effect further labor reductions in general and administrative support functions, seek to sell certain Company-owned locations to franchisees and/or other third parties, seek other sources of  financing or take other actions necessitated by the impact of such unanticipated circumstances.

There can be no assurance that we will be able to obtain such financing or sell Company-owned locations to franchisees or other third parties or that we will be able to do so in a timely manner and on acceptable terms to meet our requirements. Given the continued instability in the credit and financial markets, it may be difficult for the Company to obtain additional financing and for franchisees to obtain the financing necessary to open restaurants or to acquire Company-owned locations. An inability to access additional sources of liquidity to fund our cash needs could materially adversely affect our financial condition and results of operations.

 

If internally generated cash flow from our restaurants does not meet our expectations, our business, results of operations and financial condition could be materially adversely affected.

 

Our cash resources, and therefore our liquidity, are highly dependent upon the level of internally generated cash from operations and upon future financing transactions. Although we believe that we have sufficient liquidity to fund our working capital requirements for the next twelve months, if cash flows from our existing restaurants or cash flows from new restaurants that we open or from franchise fees and royalties do not meet our expectations or are otherwise insufficient to satisfy our cash needs, we may have to seek additional financing from external sources to continue funding our operations or reduce or cease our plans to open or franchise new restaurants. We cannot predict whether such financing will be available on terms acceptable to us, or at all.

---

We may need additional capital in the future and it may not be available on acceptable terms.

 

We have entered into agreements that create contractual obligations.  These obligations will have an impact on future liquidity and capital resources. The table below presents a summary of these obligations as of September 30, 2013:

(1)	Amounts shown are net of an aggregate $0.6 million of sub-lease rental income due under non-cancelable subleases and include aggregate accrued contractual lease increases of approximately $1.9 million, which are included in other long-term liabilities in the attached consolidated balance sheets.

(2)	Amounts shown are related to contractual obligations for lease termination agreements. These obligations are non-interest bearing and are included in other long-term liabilities in the attached consolidated balance sheets.

We are obligated under non-cancelable operating leases for our restaurants and our administrative offices. Lease terms are generally ten years with renewal options and generally require us to pay a proportionate share of real estate taxes, insurance and common area and other operating costs. Some restaurant leases provide for contingent rental payments which are not included in the above table.

Certain of our lease agreements provide for scheduled rent increases during the lease term or for rental payments to commence at a date other than the date of initial occupancy. Rent expense is recognized on a straight‑line basis over the term of the respective lease from the date we take possession. Our obligation with respect to these scheduled rent increases has been presented as a long‑term liability in “Other liabilities” in the accompanying consolidated balance sheets and totaled approximately $1.9 million and $2.3 million as of September 30, 2013 and October 1, 2012, respectively.

 

Certain of our leases also provide for landlord contributions to offset a portion of the cost of our leasehold improvements. These allowances are recorded as deferred liabilities and amortized on a straight-line basis as a reduction to rent expense over the term of the related leases. Included in “Other liabilities” in the accompanying consolidated balance sheets as of September 30, 2013 and October 1, 2012 are landlord allowances of approximately $0.6 million and $0.5 million, respectively.

 

As of September 30, 2013, the Company had outstanding approximately $0.2 million in standby letters of credit, which were provided as security deposits for certain of the lease obligations. The letters of credit are fully secured by cash deposits or marketable securities held in accounts at the issuing banks and are not available for withdrawal by the Company. These amounts are included as a component of “Other assets” in the accompanying consolidated balance sheets.

---

Purchase Commitments

We have agreements with some of the nation’s largest food, paper, and beverage manufacturers in the industry. This enables us to provide our restaurants with high quality proprietary food products and non-food items at competitive prices. We source and negotiate prices directly with these suppliers and distribute these products to our restaurants primarily through a national network that consists of some of the nation’s largest independent distributors. These primary suppliers and independent distributors have parallel facilities and systems to minimize the risk of any disruption of our supply chain. We do not utilize a commissary system. Our inventory control system allows each restaurant to place orders electronically with our master distributor and then transmits the invoices electronically to our accounts payable system.

We have an agreement with Distribution Market Advantage, Inc. (“Distribution Marketing Advantage”) that provides us access to a national network of independent distributors. Under this agreement the independent distributors supply us with approximately 80% of our food and paper products, primarily under pricing agreements that we negotiate directly with the suppliers. This agreement was renegotiated and has been extended through December 2013.

We have a long-term beverage marketing agreement with the Coca‑Cola Company. We received a marketing allowance under this agreement, which is being recognized as a reduction to expense ratably based on actual products purchased. Effective January 1, 2011, the beverage marketing agreement with the Coca-Cola Company was amended to provide for additional products as well as higher marketing allowances based on purchases.

In October 2010, we entered into an agreement to purchase all contracted coffee products through a single supplier, Royal Cup Coffee, Inc. This agreement expires in October 2015.

Self‑Insurance

We have a self‑insured group health insurance plan. We are responsible for all covered claims to a maximum limit of $100,000 per participant and an additional aggregating maximum limit of $50,000 for the plan year. Benefits paid in excess of these limits are reimbursed to the plan under our stop-loss policy. In addition, we have an aggregate stop-loss policy whereby our liability for total claims submitted cannot exceed a pre‑determined dollar factor based upon, among other things, past years’ claims experience, actual claims paid, the number of plan participants and monthly accumulated aggregate deductibles. During the first nine months of fiscal years 2013 and 2012, we did not exceed this pre-determined maximum. For our 2013 plan year, the pre-determined dollar amount is $1.8 million. The balance in the self-insurance reserve account as of September 30, 2013 and October 1, 2012 was approximately $0.2 million and $0.1 million, respectively.

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

 

We caution that any forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995) contained or incorporated by reference in this Form 10-Q or made by our management involve risks and uncertainties and are subject to change based on various important factors, many of which may be beyond our control. Accordingly, our future performance and financial results may differ materially from those expressed or implied in any such forward-looking statements. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Any such forward-looking statements are subject to risks and uncertainties, including, without limitation, those described in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. If any of these risks or uncertainties actually occurs, our business, financial condition or operating results could be materially and adversely affected, and the trading price of our common stock could decline. We do not undertake to publicly update or revise our forward-looking statements even if our future changes make it clear that any projected results expressed or implied therein will not be realized.

---

Listed below are just some of the factors that would impact our forward looking statements:

 

·	the cost of our principal food products and supply and delivery shortages or interruptions;

 

·	labor shortages or increased labor costs;

 

·	changes in demographic trends and consumer tastes and preferences, including changes resulting from concerns over nutritional or safety aspects of beef, poultry, produce or other foods or the effects of food-borne illnesses, such as E.coli, “mad cow disease” and avian influenza or “bird flu;”

 

·	competition in our markets, both in our existing business and locating suitable restaurant sites;

 

·	our operation and execution in new and existing markets;

 

·	expansion into new markets, including foreign countries;

 

·	our ability to attract and retain qualified franchisees and our franchisees’ ability to open restaurants on a timely basis;

 

·	our ability to locate suitable restaurant sites in new and existing markets and negotiate acceptable lease terms;

 

·	the rate of our internal growth, and our ability to generate increased revenue from our new and existing restaurants;

 

·	our ability to generate positive cash flow from  existing and new restaurants;

 

·	fluctuations in our quarterly results due to seasonality;

 

·	increased government regulation and our ability to secure required governmental approvals and permits;

 

·	our ability to create customer awareness of our restaurants in new markets;

 

·	the reliability of our customer and market studies;

 

·	cost effective and timely planning, design and build-out of new restaurants;

 

·	our ability to recruit, train and retain qualified corporate and restaurant personnel and management;

 

·	market saturation due to new restaurant openings;

 

·	inadequate protection of our intellectual property;

 

·	our ability to obtain additional capital and financing on acceptable terms;

 

·	adverse weather conditions, which impact customer traffic at our restaurants; and

 

·	adverse economic conditions.

 

The words “believe,” “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “plan,” “strive,” “project” or similar words, or the negatives of these words, identify forward‑looking statements. We qualify any forward‑looking statements entirely by these cautionary factors.

---

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Interest Rate Risk

Our market risk exposures are related to our cash and cash equivalents and interest that we may pay on debt. We have no derivative financial commodity instruments. We invest our excess cash in investment grade, highly liquid, short‑term investments. These investments are not held for trading or other speculative purposes. Changes in interest rates affect the investment income we earn on our investments and, therefore, impact our cash flows and results of operations. During the first nine months of fiscal 2013, we held no short-term investments and, as a result, a hypothetical one percentage point interest change from those in effect would not have resulted in a fluctuation of interest income. During the first nine months of fiscal years 2013 and 2012, interest income was immaterial.

Commodity Risk

We are exposed to commodity price risks. Many of the ingredients we use to prepare our food, as well as our packaging materials, are commodities or ingredients that are affected by the price of other commodities, exchange rates, foreign demand, weather, seasonality, production, availability, and other factors outside our control. Some of these commodities are purchased under agreements in effect for periods ranging from one month to one year, usually at fixed prices. As a result, we are subject to commodity risk that current market prices may be below our contractual prices. We also purchase certain ingredients at spot prices, as well as prices that are based on specific formulas related to key components within the commodity category, which could adversely affect our operating result in periods of rising commodity or ingredient prices if we choose, for competitive or other reasons, not to increase menu prices at the same rate at which ingredient costs increase, or if menu price increases result in customer resistance. During the first nine months of fiscal years 2013 and 2012, we did not utilize derivative instruments in managing commodity risk.

Foreign Currency Risk

As of September 30, 2013, all of our transactions are conducted, and our accounts denominated, in U.S. dollars. Accordingly, we are not exposed to foreign currency risk.

Item 4. Controls and Procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our “disclosure controls and procedures” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the fiscal year covered by this report. Based on this evaluation, our Chief  Executive Officer and our Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective (i) to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) to ensure that information required to be disclosed by us in the reports that we submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

There have  been no changes in our internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the first fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

---

Part II.  OTHER INFORMATION

Item 1:    LEGAL PROCEEDINGS

From time to time, we are a defendant in litigation arising in the ordinary course of our business. As of the date of this report, there are no legal proceedings pending which, at this time, are expected to have a material adverse effect if decided against the Company.

 

Item 1A:  RISK FACTORS

In addition to the other information set forth in this report, the factors discussed in “Part I.  Item 1A.  Risk Factors” in our Annual Report on Form 10-K for our 2012 fiscal year could materially affect the Company’s business, financial condition or operating results. There have been no material changes in our risk factors since our Annual Report on Form 10-K for the year ended December 31, 2012.

Item 5:  EXHIBITS

 

Exhibit Number	Description
Exhibit 31.1	Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2	Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1	Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

101

The following financial information, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheet as of September 30, 2013 and December 31, 2012, (ii) Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2013 and October 1, 2012, (iii) Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and October 1, 2012; and (iv) Notes to Consolidated Financial Statements. In accordance with Regulation S-T, the XBRL-related information in Exhibit 101 to this Quarterly Report on Form 10-Q shall be deemed to be “furnished” and not “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be deemed part of a registration statement, prospectus or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filings.

---

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

 

---

EXHIBIT INDEX

101

The following financial information, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheet as of September 30, 2013 and December 31, 2012, (ii) Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2013 and October 1, 2012, (iii) Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and October 1, 2012; and (iv) Notes to Consolidated Financial Statements. In accordance with Regulation S-T, the XBRL-related information in Exhibit 101 to this Quarterly Report on Form 10-Q shall be deemed to be “furnished” and not “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be deemed part of a registration statement, prospectus or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filings.

 

 

---