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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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 NOVEMBER 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____ TO____ .
COMMISSION FILE NUMBER: 0-17442
MERITAGE HOSPITALITY GROUP INC.
(Exact name of registrant as specified in its charter)
MICHIGAN 38-2730460
(State or other jurisdiction (I.R.S. Employer Identification Number)
of incorporation or organization)
1971 EAST BELTLINE AVE., N.E., SUITE 200
GRAND RAPIDS, MICHIGAN 49525
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (616) 776-2600
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on which Registered
------------------- -----------------------------------------
Common Shares, $0.01 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No [X]
As of February 18, 2004, there were 5,268,600 common shares of the registrant
outstanding. The aggregate market value of the common shares held by
non-affiliates was $14,999,454 based on the closing sales price on the American
Stock Exchange on the last business day of the registrant's most recently
completed second fiscal quarter (i.e. June 1, 2003).
Documents Incorporated by Reference: None.
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MERITAGE HOSPITALITY GROUP INC.
INDEX TO ANNUAL REPORT ON FORM 10-K
PAGE
----
PART I
Item 1 - Business 3
Item 2 - Properties 10
Item 3 - Legal Proceedings 12
Item 4 - Submission of Matters to Vote of Security-Holders 13
PART II
Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities 14
Item 6 - Selected Financial Data 17
Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operations 18
Item 7A - Quantitative and Qualitative Disclosures About Market Risk 32
Item 8 - Financial Statements and Supplementary Data 32
Item 9 - Changes in and Disagreements With Accountants on Accounting
and Financial Disclosure 32
PART III
Item 10 - Directors and Executive Officers of the Registrant 33
Item 11 - Executive Compensation 35
Item 12 - Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 36
Item 13 - Certain Relationships and Related Transactions 36
Item 14 - Controls and Procedures 37
Item 15 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K 38
FORWARD-LOOKING STATEMENTS
Certain statements contained in this report that are not historical
facts constitute forward-looking statements, within the meaning of the Private
Securities Litigation Reform Act of 1995, and are intended to be covered by the
safe harbors created by that Act. Forward-looking statements may be identified
by words such as "estimates," "anticipates," "projects," "plans," "expects,"
"believes," "should," and similar expressions, and by the context in which they
are used. Such statements are based only upon current expectations of the
Company. Any forward-looking statement speaks only as of the date made. Reliance
should not be placed on forward-looking statements because they involve known
and unknown risks, uncertainties and other factors which may cause actual
results, performance or achievements to differ materially from those expressed
or implied. Meritage undertakes no obligation to update any forward-looking
statements to reflect events or circumstances after the date on which they are
made.
Statements concerning expected financial performance, business
strategies and action which Meritage intends to pursue to achieve its strategic
objectives, constitute forward-looking information. Implementation of these
strategies and achievement of such financial performance are subject to numerous
conditions, uncertainties and risk factors, which could cause actual performance
to differ materially from the forward-looking statements. These include, without
limitation: competition; changes in the national or local economy; changes in
consumer tastes and eating habits; concerns about the nutritional quality of our
restaurant menu items; concerns about consumption of beef or other menu items
due to diseases including E. coli, hepatitis, and mad cow; promotions and price
discounting by competitors; severe weather; changes in travel patterns; road
construction; demographic trends; the cost of food, labor and energy; the
availability and cost of suitable restaurant sites; the ability to finance
expansion; interest rates; insurance costs; the availability of adequate
managers and hourly-paid employees; directives issued by the franchisor
regarding operations and menu pricing; the general reputation of Meritage's and
its franchisors' restaurants; legal claims; and the recurring need for
renovation and capital improvements. Also, Meritage is subject to extensive
government regulations relating to, among other things, zoning, public health,
sanitation, alcoholic beverage control, environment, food preparation, minimum
and overtime wages and tips, employment of minors, citizenship requirements,
working conditions, and the operation of its restaurants. Because Meritage's
operations are concentrated in certain areas of Michigan, a marked decline in
Michigan's economy, or a local economy encompassing a restaurant, could
adversely affect our operations.
2
PART I
ITEM 1. BUSINESS.
THE COMPANY
Meritage Hospitality Group Inc. was incorporated in Michigan in 1986,
and is primarily engaged in the franchised retail food service business through
its Wendy's of Michigan business segment and its O'Charley's of Michigan
business segment. Meritage's principal executive office is located at 1971 East
Beltline Ave., N.E., Suite 200, Grand Rapids, Michigan 49525. Its telephone
number is (616) 776-2600, its facsimile number is (616) 776-2776, and its
website address is www.meritagehospitality.com. Meritage's common shares are
listed on the American Stock Exchange under the symbol "MHG."
WENDY'S OF MICHIGAN - BUSINESS SEGMENT
Meritage operates 47 "Wendy's Old Fashioned Hamburgers" quick-service
restaurants in Western and Southern Michigan. Meritage is the nation's only
publicly traded Wendy's franchisee. Approximately 75% of the Wendy's restaurant
properties are owned by the Company. The remaining properties are leased.
Meritage serves over nine million Wendy's customers annually. All restaurants
are operated pursuant to franchise agreements with Wendy's International, Inc.,
the franchisor of the nationally recognized quick-service restaurant system that
operates under the distinctive "Wendy's" brand name. On average, Meritage opened
a new Wendy's restaurant every eight weeks during the last four years. The
Company's growth strategy is to expand its Wendy's business through the
development of new restaurants within the Company's designated market area, and
through the development and/or acquisition of Wendy's restaurants in other
market areas.
O'CHARLEY'S OF MICHIGAN - BUSINESS SEGMENT
Meritage recently executed an exclusive multi-unit development
agreement with casual service restaurant franchisor, O'Charley's Inc., to
develop O'Charley's restaurants throughout the State of Michigan. Meritage is
the nation's first O'Charley's franchisee. All O'Charley's restaurants will be
operated pursuant to operating agreements with O'Charley's Inc., the franchisor
of the casual service restaurant system that operates 206 restaurants in 16
states in the Southeast and Midwest. The Company's development agreement calls
for the development of a minimum of 15 O'Charley's restaurants over the next
seven years.
The Company's Wendy's restaurants are operated by Wendy's of Michigan,
a Michigan limited partnership that is owned by a wholly-owned subsidiary of
Meritage. The Company's O'Charley's restaurants will be operated by O'Charley's
of Michigan, a Michigan limited liability company that is owned by Meritage. For
convenience, Meritage and its subsidiaries will be collectively referred to as
"Meritage" or "the Company" throughout this report.
WENDY'S OPERATIONS
Meritage's restaurants are located in the Michigan counties of Allegan,
Calhoun, Ionia, Kalamazoo, Kent, Muskegon, Newaygo, Ottawa and Van Buren. This
includes the metropolitan areas encompassing the cities of Grand Rapids,
Kalamazoo, Battle Creek, Muskegon and Holland. This geographical area generally
comprises Meritage's designated market area.
3
Menu
Each Wendy's restaurant offers a diverse menu containing a variety of
food items featuring hamburgers and chicken breast sandwiches, all of which are
prepared to order with the customer's choice of condiments. The Wendy's menu
includes other items such as chili, baked and French fried potatoes, chicken
nuggets, chicken strips, freshly prepared salads, soft drinks, "Frosty" desserts
and children's meals. Each Wendy's restaurant features soft drink products
supplied by the Pepsi-Cola Company and its affiliates. Wendy's International
maintains significant discretion over the menu items that are offered in the
Company's restaurants.
Restaurant Layout and Operation
The Company's restaurants typically range from 2,700 to 3,400 square
feet with a seating capacity of between 90 and 130 people, and are typically
open from 10:30 a.m. until midnight. Generally, the dining areas are carpeted
and informal in design, with tables for two to four people. All restaurants also
feature a drive-through window. Sales from drive-through customers accounted for
more than half of the total restaurant sales in fiscal 2003. A comprehensive
reporting system provides restaurant sales and operating data (including product
sales mix, food usage and labor cost information) with respect to each of the
Company's restaurants. Physical inventories of all food items and restaurant
supplies are taken weekly and monthly.
Marketing and Promotion
Wendy's International requires that at least 4% of the Company's
restaurant sales be contributed to an advertising and marketing fund, 2% of
which is used to benefit all restaurants owned and franchised by Wendy's
International. The Wendy's National Advertising Program uses these funds to
develop advertising and sales promotion materials and concepts to be implemented
nationally. The remainder of the funds must be used on local advertising. The
Company typically spends local advertising dollars in support of national
television advertising, local television and radio advertising, print media,
local promotions and community goodwill projects.
Raw Materials and Energy
The Company's restaurants comply with uniform recipe and ingredient
specifications provided by Wendy's International. Food and beverage inventories
and restaurant supplies are purchased from independent vendors that are approved
by Wendy's International. Wendy's International does not sell food or supplies
to the Company. The Company's principal sources of energy for its operations are
electricity and natural gas. The Company has not experienced any significant
shortages of food, equipment, fixtures or other products that are necessary to
restaurant operations. While no such shortages are anticipated, the Company
believes that alternate suppliers are available if any shortage were to occur.
To date, the supply of energy available to the Company has been sufficient to
maintain normal operations.
Seasonality
The Company's business is subject to seasonal fluctuations. Like the
rest of the quick-service industry, traffic typically increases during the
summer months, which results in increased revenues during those months.
4
Relationship with Franchisor
Meritage operates its restaurants pursuant to various agreements
(including one franchise agreement for each restaurant) with Wendy's
International. These agreements grant privileges such as the right to utilize
Wendy's International's trademarks, service marks, designs and other proprietary
rights (such as "Wendy's" and "Wendy's Old Fashioned Hamburgers") in connection
with the operation of its Wendy's restaurants. These agreements also impose
requirements regarding the preparation and quality of food products, the level
of service, capital improvements, and general operating procedures. The
Company's franchise agreements (including options to renew) range from
approximately 23 to 29 years.
The franchise agreements with Wendy's International provide, among
other things, that a change in the operational control of Wendy's of Michigan,
or the removal of a guarantor of the franchise agreements, cannot occur without
the prior consent of Wendy's International. In addition, any proposed sale of
the Wendy's business, ownership interests or franchise rights is subject to the
consent of, and a right of first refusal by, Wendy's International. These
agreements also grant Wendy's International wide discretion over many aspects of
the restaurant operations, and often require the consent of Wendy's
International to carry out certain operational transactions. If Meritage needs
the consent of Wendy's International to proceed with its business plans and such
consent is not obtained, Meritage will not be able to proceed with its plans
which, in turn, could adversely affect Meritage's growth strategy. If Meritage
were to proceed without Wendy's International's consent when required, Wendy's
International could terminate the franchise agreements or exercise its right to
purchase the Wendy's restaurants.
Meritage's growth strategy involves the expansion of its restaurant
operations through the development or acquisition of additional Wendy's
restaurants. In addition to paying monthly fees, Meritage is required to pay
Wendy's International a technical assistance fee upon the opening of new Wendy's
restaurants. Meritage is permitted to develop new Wendy's restaurants and
convert competitive units located in its designated market area subject to the
standard expandability criteria and site standards of Wendy's International.
Meritage is prohibited from acquiring or developing new Wendy's restaurants
outside of its designated market area unless Wendy's International, in its sole
discretion, consents. While the franchise agreements are in place, Meritage is
also prohibited from acquiring or developing any other types of quick-service
restaurants within Meritage's designated market area, or outside of Meritage's
designated market area if the restaurant sells hamburgers, chicken sandwiches or
products similar to Wendy's International, and is located within a three mile
radius of another Wendy's restaurant. For two years after the expiration or
termination of the franchise agreements, Meritage is prohibited from
participating in any quick-service restaurant business that sells hamburgers,
chicken sandwiches or products similar to Wendy's International, and is located
within Meritage's designated market area.
The reputation of Meritage's restaurants is largely dependent on the
entire Wendy's restaurant chain, which in turn is dependent upon the management
and financial condition of Wendy's International and the performance of Wendy's
restaurants operated by other Wendy's franchisees. Should Wendy's International
be unable to compete effectively with similar restaurant chains in the future,
Meritage would be materially and adversely affected. Furthermore, many of the
attributes which lead to the success of Wendy's operations are factors over
which Meritage has no control, such as national marketing, introduction of new
products, quality assurance and other operational systems.
Meritage cannot conduct its Wendy's operation without its affiliation
with Wendy's International. Any termination of the franchise agreements would
have a material adverse effect on Meritage's financial condition and results of
operations.
5
Personnel
Meritage employs approximately 1,700 people of which approximately 275
are full-time employees. The Company strives to maintain quality and uniformity
throughout its restaurants by continual in-service training of employees and by
field visits from Company supervisors and Wendy's International representatives.
In general, the Company believes that it fosters a good working relationship
with its employees.
O'CHARLEY'S OPERATIONS
Meritage's O'Charley's restaurants will be located throughout the State
of Michigan, but will be concentrated in the metropolitan areas encompassing the
cities of Detroit, Grand Rapids, Kalamazoo and Lansing. Except for Lenawee
County in southeast Michigan, Meritage has the exclusive right to operate
O'Charley's restaurants in the State of Michigan.
Menu
The O'Charley's menu is mainstream, but innovative and distinctive in
taste. The O'Charley's menu features approximately 50 items including USDA
Choice hand-cut and aged steaks, baby-back ribs basted with O'Charley's own
tangy BBQ sauce, chicken that is always fresh and never frozen, fresh salmon and
grilled tuna with a spicy ginger sauce, a variety of fresh-cut salads with
special recipe salad dressings and O'Charley's hot, freshly-baked yeast rolls.
Also offered are a wide variety of alcoholic beverages including beer, wine and
cocktails. The restaurants are open seven days a week and serve lunch, dinner
and Sunday brunch. Special menu items include "limited-time" promotions,
O'Charley's Express Lunch, daily special selection and a special kids menu.
Restaurant Layout and Operation
O'Charley's restaurants seek to create a casual, neighborhood
atmosphere through an open layout and exposed kitchen, and by tailoring the
decor of each restaurant to the local community. The O'Charley's restaurants are
free-standing brick buildings that will range from 5,000 to 6,800 internal
square feet with seating for 190 to 275 customers, including approximately 52
bar seats. The exterior features old-style red brick, bright red and green neon
borders, multi-colored awnings and attractive landscaping. The interior is open,
casual and well lighted, and features warm woods, exposed brick, color prints
and hand painted murals depicting local history, people, places and events. In
addition, the kitchen design provides flexibility in the types of food items
that can be prepared to adapt to changing customer tastes and preferences.
Marketing and Promotion
O'Charley's Inc. employs an advertising and marketing plan for the
development of television, radio and newspaper advertising for O'Charley's
restaurants, and also incorporates point of sale and local restaurant marketing.
The focus of marketing efforts is to build brand loyalty and emphasize the
distinctiveness of the O'Charley's atmosphere and menu offerings. O'Charley's
generally requires that 4% of a franchisee's restaurant sales be contributed to
advertising, marketing and promotion. The Company's contributions include: 1%
for a production fund, 1% - 2% for a local advertising fund, and 1% - 2% for a
national fund which is used to benefit all restaurants in the O'Charley's
system. The combined local and national fund cannot exceed 3% in the aggregate.
A national fund has not been established at this time, making the Company's
total contribution 3% of restaurant sales.
6
Raw Materials and Energy
The Company's O'Charley's restaurants will comply with uniform recipe
and ingredient specifications provided by the franchisor. O'Charley's Inc.
operates a 220,000 square foot commissary in Nashville, Tennessee through which
the Company can purchase a substantial amount of its food products and supplies
for its operations. The commissary operates a USDA-approved and inspected
facility at which beef is aged and cut, and at which O'Charley's signature yeast
rolls, salad dressings and sauces are produced. The Company's food and beverage
inventories and restaurant supplies will either be purchased from the
O'Charley's commissary or from national vendors approved by O'Charley's Inc. The
Company's principal sources of energy for its operations will likely be
electricity and natural gas.
Relationship with Franchisor
Meritage will operate its O'Charley's restaurants pursuant to various
agreements with O'Charley's Inc., including a primary development agreement and
an operating agreement for each restaurant it opens. These agreements grant
privileges such as the right to utilize O'Charley's trademarks, service marks,
designs and other proprietary rights in connection with the operation of its
O'Charley's restaurants. These agreements also impose requirements regarding the
preparation and quality of food products, the level of service, capital
improvements, and general operating procedures. The development agreement
requires the Company to develop at least 15 O'Charley's restaurants over a seven
year period, with approximately three-quarters being developed in the Detroit
metropolitan market. The operating agreements (including options to renew) are
effective for 40 years.
The agreements with O'Charley's Inc. provide, among other things, that
a change in the controlling interest of the Company's O'Charley's operating
entity, or a transfer of a non-controlling interest in the operating entity to a
defined competitor or unapproved entity, cannot occur without the prior consent
of O'Charley's Inc. In addition, any proposed sale of controlling interest of
the Company's O'Charley's operating entity is subject to a right of first
refusal by O'Charley's Inc. These agreements also grant O'Charley's Inc. wide
discretion over many aspects of the restaurant operations, and may require the
consent of O'Charley's Inc. to carry out certain operational transactions. If
Meritage needs the consent of O'Charley's Inc. to proceed with its business
plans and such consent is not obtained, Meritage will not be able to proceed
with its plans which, in turn, could adversely affect Meritage's growth
strategy. If Meritage were to proceed without O'Charley's Inc.'s consent when
required, O'Charley's Inc. could terminate its agreements with the Company.
In addition to paying the advertising and marking fees referenced
above, Meritage is required to pay O'Charley's Inc. an initial license fee of
$425,000 for its first 15 restaurants (half of which was paid upon execution of
the development agreement), a fee of 4% of sales for certain rights granted and
certain services to be rendered, and other miscellaneous fees associated with
training and services to be provided. Pursuant to its operating agreements,
Meritage and certain of its key personnel are subject to (i) confidentiality
requirements relating to certain of O'Charley's information, knowledge,
know-how, techniques and other materials used in its O'Charley's operations, and
(ii) non-competition covenants that prohibit the acquisition of, operation of or
affiliation with certain types of full service, casual dining restaurants that
are considered a competitor of the O'Charley's restaurants in the United States
during the term of the agreements, and for a two-year period after expiration or
termination of such agreements with the competitor's restaurants located within
a 15-mile radius of an O'Charley's restaurant.
The reputation of Meritage's restaurants is largely dependent on the
entire O'Charley's restaurant chain, which in turn is dependent upon the
management and financial condition of O'Charley's Inc., and the performance of
each O'Charley's restaurant. Should O'Charley's Inc. be unable to compete
7
effectively with similar restaurant chains, Meritage would be materially and
adversely affected. Furthermore, many of the attributes which lead to the
success of O'Charley's operations are factors over which Meritage has no
control, such as national advertising and marketing, menu products, quality
assurance and other operational systems.
Meritage cannot conduct its O'Charley's operation without its
affiliation with O'Charley's Inc. Any termination of the development agreement
or operating agreements would likely have a material adverse effect on
Meritage's financial condition and results of operations.
Personnel
Each O'Charley's restaurant typically employs five to six managers (a
general manager, two to three assistant managers, a kitchen manager and an
assistant kitchen manager), and an average of approximately 80 full-time and
part-time employees. The Company currently employs a Chief Operating Officer to
oversee day-to-day operations. Ultimately, we will employ area supervisors who
have a day-to-day responsibility for the operating performance of approximately
three or more O'Charley's restaurants.
With the assistance of O'Charley's Inc., the Company will employ
various recruiting and training programs to retain employees that are
well-suited to manage its restaurant operations. Management trainees are
required to complete a multi-week training program that familiarizes them with
the responsibilities required to manage O'Charley's restaurants, operations,
management objectives, controls and evaluation criteria. In addition, the
Company will undertake continual in-service training of employees and conduct
field visits with representatives from the Company and O'Charley's Inc.
COMPETITION AND INDUSTRY CONDITIONS
Meritage operates within the quick-service restaurant ("QSR") industry
through its Wendy's operations, and will operate within the full-service, casual
dining restaurant industry through its O'Charley's operations.
QSR Industry
The QSR industry is characterized by customers who are looking for
convenient and quick meals that are ordered, paid for and picked up at a cash
register. Within the quick-service market, the hamburger market segment
comprises approximately half of the entire market (with the pizza, chicken,
other sandwich, and Mexican and Asian market segments comprising a significant
portion of the remainder). The hamburger market segment is dominated by
McDonald's, Burger King and Wendy's. According to the National Restaurant
Association ("NRA"), a restaurant industry trade association, the QSR industry
is forecasted to have total sales of $123.9 billion in 2004. In addition, in
2004, the industry is expected to post its strongest sales growth in three
years. In this industry, the NRA observed a trend of stronger concepts taking
over weaker ones, and customers that look for new tastes and enhanced restaurant
decor. According to the NRA, some of the primary challenges facing the QSR
industry in 2004 will be heightened competition, health-insurance costs,
responding to health and nutritional trends, energy costs, convenience and
service.
Most of the Wendy's restaurants operated by the Company are located in
close proximity to their principal quick-service restaurant competitors (e.g.
McDonald's, Burger King and Taco Bell) who are highly competitive on the basis
of price and value perception, service, location, food quality, menu variety,
quality and speed of service, attractiveness of facilities, effectiveness of
marketing and new product development. In recent years, these competitors have
attempted to draw customer traffic through
8
a strategy of deeply discounting the price of their primary food products. While
the Company lowered the prices of certain menu times in 2003, it does not
believe that this is a profitable long-term strategy. Instead, it believes that
the competitive position of a Wendy's restaurant is ultimately enhanced by its
unique qualities such as the use of fresh ground beef, a diverse menu, food
prepared to order with an emphasis on quality, nutrition and taste, pleasant and
speedy service, and the atmosphere of its restaurants. Based on information from
Wendy's International, average same-store restaurant sales for all franchised
domestic Wendy's restaurants was $1,265,000 in 2003 and $1,251,000 in 2002,
compared to Meritage average same-store restaurant sales (for restaurants in
full operation during the given year) of $1,040,000 in 2003 and $1,143,000 in
2002.
Casual Dining Restaurant Industry
According to the NRA, projected sales at full-service restaurants
(which includes fine, casual and family dining restaurants) in the U.S. in 2004
will be $157.9 billion, giving the industry a 4.6% growth rate - the strongest
since 2001. Within the industry, 65% of casual-dining operators expect sales in
2004 to be better than sales in 2003. According to the NRA, some factors that
will help drive sales at full-service restaurants in 2004 include the desire for
fun and convenience, demographics and tourism. In addition, the industry will
continue to benefit from the spending of the baby-boomers, the nation's largest
demographic group. The NRA reports that this group tends to go to casual-dining
restaurants more frequently than people in other age groups. According to the
NRA, some of the primary challenges facing the casual-dining industry in 2004
will be retention of repeat customers, adapting to the ever-changing tastes and
preferences of its customers, responding to the desire for more convenience,
competition and energy costs. The repeat customer is a high priority as research
shows that more than two-thirds of sales at full-service restaurants are derived
from this demographic.
Regional Outlook
All of the Company's restaurants are located within the State of
Michigan. According to the NRA, the East North Central Region (which includes
Michigan, Wisconsin, Illinois, Indiana and Ohio) is expected to experience an
increase in total restaurant sales of 3.8%. The regions restaurants are
projected to register sales of $53.6 billion in 2004, with Michigan projected to
account for $11 billion. Of the five states in the region, only Michigan is
projected to have job growth greater than the national average, 1.1% compared to
0.9%.
In general, the Company intends to achieve growth by (i) developing new
Wendy's restaurants in its existing market, (ii) developing and/or acquiring
Wendy's restaurants in other markets, (iii) developing O'Charley's restaurants
in its market area, and (iv) increasing sales and maintaining low costs at
existing restaurants. The Company will continue to explore other acquisitions or
developments that complement its restaurant operations.
If our restaurants are unable to compete successfully with other
restaurants in new and existing markets, our results of operations will be
adversely affected. The restaurant industry is intensely competitive with
respect to price, service, location and food quality, and there are many
well-established competitors with substantially greater financial and other
resources than Meritage, including a large number of national and regional
restaurant chains. Some of our competitors have been in existence for a
substantially longer period than Meritage and may be better established in the
markets where our restaurants are or may be located. To the extent that we open
restaurants in larger cities and metropolitan areas, we expect competition to be
more intense in those markets. We also compete with other restaurants for
experienced management personnel and hourly employees and with other restaurants
and retail establishments for quality sites.
9
RISKS AND GOVERNMENTAL REGULATIONS
Meritage is subject to numerous uncertainties and risk factors inherent
in the food service industry. These include, among others: competition; changes
in local and national economic conditions; changes in consumer tastes and eating
habits; concerns about the nutritional quality of quick-service or casual dining
menu items; concerns about consumption of beef or other menu items due to
diseases such as E. coli, hepatitis, and mad cow; promotions and price
discounting by competitors; severe weather; changes in travel patterns; road
construction; demographic trends; the cost of food, labor, fuel and energy; the
availability and cost of suitable restaurant sites; the ability to finance
expansion; fluctuating interest rates; insurance costs; the availability of an
adequate number of managers and hourly-paid employees; directives issued by the
franchisor regarding its operations and nationally advertised pricing; the
general reputation of Meritage's and its franchisors' restaurants; legal claims;
and the recurring need for renovation and capital improvements.
Also, the Company is subject to various federal, state and local laws
and governmental regulations relating to, among other things, zoning, restaurant
operations, public health certification regarding the preparation and sale of
food, alcoholic beverage control, discharge of materials into the environment,
sanitation and minimum wages. The Company believes its operations would be
adversely affected if these permits were not obtained, renewed, or were
terminated. The Company has no reason to anticipate, however, that this may
occur. In addition, changes regarding minimum wage laws or other laws governing
the Company's relationship with its employees (e.g. overtime wages and tips,
health care coverage, employment of minors, citizenship requirements, working
conditions, etc.) could have an adverse effect on the Company's operations.
On average, 10% of O'Charley's Inc.'s restaurant sales are attributable
to the sale of alcoholic beverages. Each O'Charley's restaurant, where permitted
by local and state law, will have licenses from regulatory authorities allowing
it to sell liquor, beer and wine. The failure of a restaurant to obtain or
retain liquor service licenses could adversely affect operations. Once a liquor
license is obtained, Meritage will be subject to "dram-shop" statutes and
interpretations which generally provide a person injured by an intoxicated
person the right to recover damages from an establishment that wrongfully served
alcoholic beverages to the intoxicated person.
The Federal Americans With Disabilities Act prohibits discrimination on
the basis of disability in public accommodations and employment. Our restaurants
are designed to be accessible to the disabled and we believe that we are in
substantial compliance with all current applicable regulations relating to
restaurant accommodations for the disabled. The development and construction of
additional restaurants will be subject to compliance with applicable zoning,
land use and environment regulations.
ITEM 2. PROPERTIES.
Each Wendy's restaurant is built to specifications provided by Wendy's
International as to its exterior style and interior decor. Typical freestanding
restaurants are one-story brick buildings constructed on sites of approximately
40,000 square feet, with parking for 50 to 70 vehicles. The restaurants, which
range from 2,700 to 3,400 square feet, typically have a food preparation area, a
dining room with seating capacity for 90 to 130 persons, and a double pick-up
window for drive-through service. The dimensions and layout of three Wendy's
restaurants which are part of a combination store concept with a fuel purveyor
are basically the same except that the restaurants are connected to a 3,500
square foot convenience store and gas station facility.
10
Of the 47 Wendy's restaurants that the Company operates, it (i) owns
the land and buildings comprising 36 restaurants, (ii) leases the land and
buildings comprising 10 restaurants, and (iii) owns the building and leases the
land comprising one restaurant. The term of the leases (including options to
renew) range from approximately 5 to 27 years. The structures range from being
brand new to approximately 29 years old. In the past fiscal year, however,
Meritage performed major remodels on eight of its older Wendy's restaurants such
that, by the end of the year, all but two of its Wendy's restaurants are under
five years old or have been recently remodeled. The land and buildings owned by
the Company are subject to encumbrances described in "Financing and
Encumbrances." Development plans for 2004, include opening two or three new
Wendy's restaurants in the Company's market area.
As the development agreement with O'Charley's was not entered into
until late December 2003, the Company does not currently operate any O'Charley's
restaurants. Each O'Charley's restaurant will be built to specifications
provided by O'Charley's Inc. as to its exterior style and interior decor. The
typical O'Charley's restaurant is a free-standing building ranging in size from
approximately 6,400 to 6,800 square feet with seating for approximately 275
customers, including approximately 52 bar seats. In certain areas, the Company
may also consider a smaller free-standing building of approximately 5,000 square
feet with seating for approximately 190 customers. O'Charley's restaurants seek
to create a casual, neighborhood atmosphere through an open layout and exposed
kitchen, and by tailoring the interior decor toward the local community. The
exterior features red and green neon borders, multi-colored awnings and
attractive landscaping. The interior is open, casual and well lighted with warm
woods, exposed brick, color prints and hand-painted murals depicting local
history, people, places and events. The Company plans to open two or three
O'Charley's restaurants in 2004.
The Company leases approximately 7,500 square feet of office space
located at 1971 East Beltline Ave., N.E., Suite 200, Grand Rapids, Michigan,
which serves as the corporate headquarters and the registered office of the
Company and its subsidiaries. The office, which is equipped with a 35-seat
management training facility, is located only a few hundred feet from one of the
Company's Wendy's restaurants.
The Company believes that all of its properties are adequately covered
by insurance.
FINANCING AND ENCUMBRANCES
In fiscal 1998 and 1999, the Company borrowed $11,740,000 from Captec
Financial Group, Inc. ("Captec"), now serviced by BNY Asset Solutions LLC, to
purchase existing Wendy's restaurants, refinance existing restaurant
indebtedness, and build new Wendy's restaurants. This long-term indebtedness is
secured by the real estate and equipment of 13 Company-owned Wendy's
restaurants. The Captec loans have terms ranging from fifteen to twenty years,
require monthly payments of $99,980, and carry fixed interest rates that range
from 7.8% to 8.5%.
From fiscal 1999 through fiscal 2003, the Company borrowed $17,127,000
from Fleet Business Credit, LLC ("Fleet") to build and equip 16 Wendy's
restaurants. All indebtedness to Fleet is secured by the real estate and
equipment associated with these 16 sites. Fifteen Fleet loans have 15-year terms
and 20-year amortizations, require monthly payments of $138,070, and carry fixed
interest rates ranging from 6.3% to 8.7%. One loan has 10-year term and 20-year
amortization, requires a monthly payment of $7,629, and carries a variable
interest rate equal to the 30-day LIBOR plus 2.75%. The Company's CEO, Robert E.
Schermer, Jr., has personally guaranteed over $3.9 million of the Fleet loans.
These guarantees terminate three years from the date of the loan provided
certain Company financial covenants and conditions are otherwise met.
11
In fiscal 2002 and 2003, the Company borrowed $7,494,000 from General
Electric Capital Business Asset Funding Corporation ("GE") to build and equip
six Wendy's restaurants. This long-term indebtedness is secured by the related
real estate and equipment. The GE loans have 10-year terms and 20-year
amortizations, require monthly payments of approximately $45,000, and carry
floating interest rates equal to 2.55% over the 30-day LIBOR. The Company also
utilizes construction loan financing with GE for the development of its Wendy's
restaurants. This construction financing requires monthly payments of interest
only at a variable interest rate equal to the 30-day LIBOR plus 2.75% until
conversion into a permanent mortgage loan, after which it will have terms and
rates as noted above.
The Company also holds a $4.8 million forward commitment from GE to
provide additional financing for the construction and equipment associated with
the development of four additional Wendy's restaurants. Indebtedness under the
commitments will be secured by the real estate and equipment of the new
restaurants. The Company can choose between fixed interest rates (2.61% plus the
10-year Swap rate) or floating interest rates (2.55% over the 30-day LIBOR with
an option to convert to a fixed rate during the first two years).
In 2002, the Company borrowed $1,225,000 from Fifth Third Bank to build
and equip one new restaurant. This long-term indebtedness is secured by the
related real estate and equipment. This loan has a 5-year term and graduated
amortization (from 18 to 13.5 years during the term of the loan), requiring
graduated monthly payments (from $8,800 to $11,000 during the term of the loan),
and carries a floating interest rate equal to Fifth Third Bank's prime rate.
The Company entered into a $2.6 million credit facility with Standard
Federal Bank in December 2003 consisting of (i) a one-year $600,000 line of
credit secured by inventory and equipment of seven leased stores, and certain
other receivables, and (ii) a two-year $2,000,000 revolving line of credit
secured by real estate purchased with this facility. The facility requires
monthly payments of interest only at Standard Federal's prime rate plus 0.25%.
As of February 18, 2004, there is no outstanding balance on this credit
facility.
The Captec, Fleet, GE, Fifth Third and Standard Federal loan documents
contain financial covenants that require the maintenance of certain financial
ratios. Certain loan documents also contain requirements that limit the amount
of currently generated operating cash flow that can be utilized to fund
corporate level expenses.
As for the O'Charley's segment, the Company holds a $6,300,000
financing proposal from GE to provide financing for the construction and
equipment associated with the development of three O'Charley's restaurants.
Indebtedness under the financing proposal will be secured by the equipment and
real estate or leasehold interest associated with the new restaurants. The
Company can choose between fixed interest rates (3.11% plus the 10-year Swap
rate) or floating interest rates (3.05% over the 30-day LIBOR with an option to
convert to a fixed rate during the first two years).
ITEM 3. LEGAL PROCEEDINGS.
The Company is involved in various routine legal proceedings that are
incidental to its business. Except as noted below, all of these proceedings
arose in the ordinary course of the Company's business and, in the opinion of
the Company, any potential liability of the Company with respect to these legal
proceedings will not, in the aggregate, be material to the Company's
consolidated financial statements. The Company maintains various types of
insurance standard to the industry that will insure over (subject to
deductibles) many legal proceedings brought against the Company. In addition,
several legal claims are regularly assumed by the Company's vendors.
12
The Company has received bills for unpaid Michigan Single Business
Taxes from 1997 through 2000 of approximately $125,000 plus interest and
penalties. These taxes are associated with fees paid to the Company's franchisor
during those years. The Company's believes that the Michigan Department of
Treasury has incorrectly characterized these fees as a "royalty," and therefore
no tax is due from the Company on these fees. A Department of Treasury Referee
has been assigned to the matter and a conference will likely occur in 2004.
In the fall of 2001, the Company sold a former restaurant site to
individuals under a land contract. The site was sold for $400,000 and the
purchaser made a $35,000 down payment. In the fall of 2003, the purchaser
committed various breaches (including nonpayment of taxes and monthly
installments, and failing to obtain insurance coverage). The principal balance
on the land contract was approximately $360,300. In October 2003, the Company
filed a Complaint for Possession after Land Contract Forfeiture. A judgment of
possession was entered on October 30, 2003, and the Company took possession on
January 29, 2004.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS.
There were no matters submitted to a vote of security holders of the
Company during the fourth quarter of fiscal 2003.
13
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.
MARKET INFORMATION
Meritage's common shares have been listed on the American Stock
Exchange under the symbol "MHG" since 1999. The following table sets forth the
high and low closing sales prices reported by the American Stock Exchange for
the Company's common shares for the two most recent fiscal years.
HIGH LOW
---- ---
FISCAL YEAR ENDED DECEMBER 1, 2002
First Quarter $ 5.15 $ 3.60
Second Quarter $ 5.50 $ 4.59
Third Quarter $ 6.70 $ 5.00
Fourth Quarter $ 6.75 $ 4.95
HIGH LOW
---- ---
FISCAL YEAR ENDED NOVEMBER 30, 2003
First Quarter $ 5.04 $ 4.75
Second Quarter $ 4.85 $ 4.03
Third Quarter $ 4.50 $ 4.10
Fourth Quarter $ 4.87 $ 4.05
HOLDERS
As of February 18, 2004, there were approximately 630 record holders of
the Company's common shares, which the Company believes represents approximately
1,200 beneficial holders.
DIVIDENDS
Meritage paid no dividends on its common shares in the last two fiscal
years. Because the Company intends to reinvest excess cash into the development
of new Wendy's restaurants, it does not intend to pay any cash dividends on
common shares in fiscal 2004. In addition, certain of the Company's loan
agreements contain restrictions which limits the Company's ability to declare a
cash dividend.
14
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following is information as of February 18, 2004:
EQUITY COMPENSATION PLAN INFORMATION
NUMBER OF SECURITIES
NUMBER OF SECURITIES WEIGHTED-AVERAGE REMAINING AVAILABLE FOR
TO BE ISSUED UPON EXERCISE PRICE OF FUTURE ISSUANCE UNDER
EXERCISE OF OUTSTANDING EQUITY COMPENSATION PLANS
OUTSTANDING OPTIONS, OPTIONS, WARRANTS (EXCLUDING SECURITIES
WARRANTS, AND RIGHTS AND RIGHTS REFLECTED IN COLUMN (a))
PLAN CATEGORY (a) (b) (c)
------------- -------------------- ----------------- -------------------------
EQUITY COMPENSATION PLANS APPROVED BY
SECURITY HOLDERS:
1996 Management Equity Incentive Plan 695,275 $ 2.68 2,504
1996 Directors' Share Option Plan (1) 62,000 $ 5.31 0
2002 Management Equity Incentive Plan 223,730 $ 5.07 526,270
EQUITY COMPENSATION PLANS NOT APPROVED BY
SECURITY HOLDERS:
1999 Directors' Compensation Plan (2) (2) (2)
2001 Directors' Share Option Plan (3) 17,000 $ 3.96 101,000
TOTAL 1,009,255 $ 3.40 629,774
(1) The 1996 Directors' Share Option Plan terminated in April 2001. Certain
options granted under the Plan remain outstanding.
(2) The 1999 Directors' Compensation Plan, as amended, was adopted by the Board
of Directors in February 1999. Pursuant to the Plan, all non-employee
directors receive a retainer of $1,000 for each meeting of the Board of
Directors attended, and $1,000 for each committee meeting attended. The
committee fees are reduced by 50% if the committee meeting is held on the
same day as a Board meeting. Compensation is paid quarterly in arrears. At
the election of the director, compensation is paid in cash or with Company
common shares which are priced at the average fair market value during the
five trading days prior to the end of the fiscal quarter. The Plan will
terminate pursuant to its terms on November 30, 2008.
(3) The 2001 Directors' Share Option Plan, as amended, was adopted by the Board
of Directors in May 2001. The Plan provides for 120,000 common shares to be
the subject of options which may be granted to non-employee directors.
Under the Plan, non-employee directors are granted an option to purchase
5,000 common shares upon initial election to the Board, and another option
to purchase 1,000 common shares upon each subsequent election. The
committee administering the Plan may also, from time to time, grant
additional options on such terms and conditions as the committee may
determine. The Plan will terminate pursuant to its terms on May 15, 2006.
SALE OF UNREGISTERED SECURITIES
In December 2003, the Company completed a private equity offering of
Units and Series B Convertible Preferred Shares (the "Preferred Shares"). Each
Unit was priced at $6.00 and consists of one common share and warrants to
purchase one common share. The warrants are divided into one-half each of a
Class A Warrant to purchase one common share at a price of $6.00 per share
expiring six years from the date of issuance, and a Class B Warrant to purchase
one common share at a price of $9.00 per share expiring nine years from the date
of issuance. The Preferred Shares were priced at $10.00 each, and are
convertible into common shares at any time beginning on the first anniversary of
the date of issuance at a conversion price of $5.57 per common share, taking
each Preferred Share at its liquidation value of $10.00 per Preferred Share. The
Preferred Shares have an annual dividend rate of $.80 per share. The right to
payment of dividends is cumulative. The dividend is payable in equal quarterly
installments on the first day of each January, April, July and October to
holders of record as of the 15th day of the preceding month, commencing January
1, 2004. At any time after two years from issuance, the Registrant may, upon 15
days written notice, redeem all or part of the Preferred Shares at a redemption
price of $11.00 per Preferred Share plus accrued but unpaid dividends. After the
third anniversary of the
15
date of issuance, the redemption price shall be $10.00 per Preferred Share plus
accrued but unpaid dividends. No voting rights are provided except as required
by law and with the exception that, if at any time the Registrant fails to make
six quarterly dividend payments, the number of directors constituting the
Registrant's Board of Directors will be increased by two and the Preferred
Shareholders, voting as a class with each Preferred Share having one vote, will
be entitled to elect two directors to the Board, which members will remain on
the Board as long as any arrearages in dividend payments remain outstanding.
A total of $7.5 million was raised from 35 purchasers in the private
equity offering. Two purchasers acquired a total of $2.5 million in Units
(416,666 common shares, 208,333 Class A Warrants and 208,333 Class B Warrants).
33 purchasers acquired $5.0 million in Preferred Shares (500,000 Preferred
Shares). A commission of 4% was paid on the sale of 300,000 Preferred Shares.
The common shares, Warrants and Preferred Shares issued were not registered
under the Securities Act of 1933 pursuant to the exemption provided by Section
4(2) of the Securities Act of 1933 and Section 506 of Regulation D.
16
ITEM 6. SELECTED FINANCIAL DATA.
In 2001, the Company elected a 52-53 week fiscal year for tax and
financial reporting purposes. The fiscal year ends on the Sunday closest to
November 30th. The following table sets forth the selected financial information
of the Company for the fiscal years ended November 30, 2003, December 1, 2002
and December 2, 2001, and the fiscal years ended November 30, 2000 and 1999 (all
of which contained 52 weeks).
(In thousands except for per share information)
FISCAL YEAR ENDED
----------------------------------------------------------
2003 2002 2001 2000 1999 *
---- ---- ---- ---- ----
SUMMARY OF OPERATIONS
Continuing operations
Food and beverage revenue $ 48,513 $ 45,953 $ 38,356 $ 33,105 $ 29,752
Total operating expenses 46,684 43,409 36,702 33,407 28,898
Operating income (loss) 1,830 2,544 1,654 (302) 854
Earnings (loss) from continuing operations 740 709 532 (1,353) 323
Discontinued operations
Gain on disposal of business segment - - - - 150
Net earnings (loss) 740 709 532 (1,353) 472
Preferred stock dividends 27 27 27 33 40
Net earnings (loss) on common shares 714 683 505 (1,386) 432
Earnings (loss) per common share - basic
Earnings (loss) from continuing operations $ 0.13 $ 0.13 $ 0.10 $ (0.25) $ 0.05
Net earnings (loss) $ 0.13 $ 0.13 $ 0.10 $ (0.25) $ 0.08
Earnings (loss) per common share - diluted
Earnings (loss) from continuing operations $ 0.13 $ 0.12 $ 0.10 $ (0.25) $ 0.05
Net earnings (loss) $ 0.13 $ 0.12 $ 0.10 $ (0.25) $ 0.08
BALANCE SHEET DATA
Property & equipment $ 41,288 $ 38,076 $ 28,781 $ 19,093 $ 16,684
Total assets 50,030 46,712 37,837 27,045 25,201
Long-term obligations (1) 35,560 32,281 24,159 18,224 15,091
Stockholders' equity 8,374 7,609 6,337 4,531 5,883
Cash dividends declared per common share $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.00
(1) For comparative purposes, long-term obligations include current portions of
long-term obligations.
* The 1999 selected financial data reflects the Company's former lodging
industry segment as a discontinued operation.
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OVERVIEW
Through its operation of 48 Wendy's restaurants in Western and Southern
Michigan, Meritage has been one of the fastest growing franchisees in the
"Wendy's Old Fashioned Hamburger" restaurants chain for the last several years,
averaging a new Wendy's restaurant every eight weeks for the last four years.
These restaurants operate in the intensely competitive quick-service restaurant
industry and are located in close proximity to their principal quick-service
restaurant competitors (e.g. McDonald's, Burger King and Taco Bell) who are
highly competitive on the basis of price and value perception, service,
location, food quality, menu variety, quality and speed of service,
attractiveness of facilities, effectiveness of marketing and new product
development. Wendy's competes by offering a diverse menu, quality food prepared
to order, pleasant and speedy service, and a pleasant atmosphere in its
restaurants. It also competes by offering unique qualities such as the use of
fresh ground beef.
Food and beverage revenue was up 5.6% in fiscal 2003 compared to the
prior year, primarily due to revenues from new restaurants. Fiscal 2003,
however, was a challenging year for the Company as well as the entire
quick-service industry. Various factors affected operating results including a
sluggish economic climate - especially in West Michigan where unemployment in
July reached a ten-year high. At the same time, we experienced intense price
discounting by our competitors, and were forced to lower certain menu prices to
comply with Wendy's International's national advertising campaign. However,
year-over-year same store sales decreases narrowed during each of the first
three quarters of fiscal 2003, and turned positive in the fourth quarter. With
the exception of rising beef costs, the Company has been successful in
controlling costs and improving store operations. Due to our high beef costs,
the Company is continuing to evaluate its menu pricing in an effort to improve
margins without jeopardizing the improved customer traffic trend. Net earnings
in fiscal 2003 were enhanced by a $751,000 gain from the sale of surplus real
estate adjacent to three restaurants, and a $500,000 income tax benefit due to a
reduction in the valuation allowance for deferred tax assets.
In December 2003, the Company completed a private equity offering that
netted the company approximately $4.8 million to begin the rollout of its
O'Charley's casual dining restaurant franchise described more fully in Item 1.
The O'Charley's development agreement, which encompasses the State of Michigan,
calls for a minimum of 15 O'Charley's restaurants to be opened over the next
seven years. The successful rollout of O'Charley's could provide a significant
increase in the Company's future earnings and cash flow.
18
RESULTS OF OPERATIONS
The following summarizes the results of operations for the years ended
November 30, 2003 December 1, 2002, December 2, 2001.
Statements of Operations
--------------------------------------------------------------------
$ in Thousands % of Revenue
---------------------------------- ----------------------------
2003 2002 2001 2003 2002 2001
---------------------------------- ----------------------------
Food and beverage revenue $ 48,513 $ 45,953 $ 38,356 100.0% 100.0% 100.0%
Costs and expenses
Cost of food and beverages 12,272 11,184 10,080 25.3 24.3 26.3
Operating expenses 28,606 26,860 22,553 59.0 58.5 58.8
General and administrative
Restaurant operations 1,303 1,352 1,198 2.7 2.9 3.1
Corporate level expenses 1,266 1,239 1,178 2.6 2.7 3.1
Michigan single business tax 250 173 205 0.5 0.4 0.5
Depreciation and amortization 2,986 2,419 1,770 6.1 5.3 4.6
Goodwill amortization - 182 182 - 0.4 0.5
Impairment of assets - - (464) - - (1.2)
---------------------------------- ----------------------------
Total costs and expenses 46,683 43,409 36,702 96.2 94.5 95.7
---------------------------------- ----------------------------
Earnings from operations 1,830 2,544 1,654 3.8 5.5 4.3
Other income (expense)
Interest expense (2,388) (2,026) (1,553) (4.9) (4.4) (4.1)
Interest income 28 100 106 0.1 0.2 0.3
Other income 20 33 31 0.0 0.1 0.1
Gain on sale of non-operating property 750 41 309 1.5 0.1 0.8
---------------------------------- ----------------------------
Total other income (expense) (1,590) (1,852) (1,107) (3.3) (4.0) (2.9)
---------------------------------- ----------------------------
Earnings before income taxes 240 692 547 0.5 1.5 1.4
Income tax benefit (expense) 500 17 (15) 1.0 0.0 (0.0)
---------------------------------- ----------------------------
Net earnings $ 740 $ 709 $ 532 1.5% 1.5% 1.4%
================================== ============================
19
COMPARISON OF FISCAL YEARS 2003 AND 2002
REVENUE
Food and beverage revenue increased 5.6% in fiscal 2003 compared to
fiscal 2002. This increase was attributable to revenue from new restaurants.
Average food and beverage revenue for stores in full operation during the same
quarters of fiscal 2003 and 2002 ("same store sales") is set forth below:
Increase Increase
Average Sales per Store 2003 2002 (Decrease) (Decrease)%
- ----------------------- -------------- -------------- ---------- -----------
Fourth Quarter $ 269,395 $ 265,421 $ 3,974 1.5%
Third Quarter 280,360 298,098 (17,738) (6.0)%
Second Quarter 259,478 287,238 (27,760) (9.7)%
First Quarter 231,083 266,265 (35,182) (13.2)%
-------------- -------------- -----------
Year to Date $ 1,040,316 $ 1,117,022 $ (76,706) (6.9)%
============== ============== ===========
The decrease in same store sales in fiscal 2003 was attributable to (i)
intense price discounting by our primary competitors, (ii) the lowering of
certain menu prices in January 2003 to comply with Wendy's International's
national advertising, (iii) a sluggish economic climate in West Michigan which
resulted in high unemployment within our market, and (iv) a negative sales
impact at certain existing stores due to the opening of new stores. In addition,
sales for the first six months of fiscal 2003 were impacted by strong sales in
the first six months of 2002 over the comparable periods in 2001, and greater
seasonal disparities including a harsher winter in 2003 compared to the winter
of 2002, and colder than normal temperatures in the spring of 2003.
These factors contributed to a decrease in average store customer
traffic of approximately 2% in fiscal 2003 compared to fiscal 2002, and a
decrease in the average customer ticket of approximately 5%. An unfavorable
sales trend was experienced throughout the quick-service restaurant industry in
fiscal 2003. Management cautions that it remains difficult to accurately
forecast how competitor discounting, menu price adjustments, consumer spending
trends, the economic climate in West Michigan and the other factors noted above
will affect the Company's future revenue. However, the negative sales trend that
began in the third quarter of fiscal 2002 has improved each quarter of fiscal
2003. Improved operations, in the areas of service, cleanliness and safety
control, along with continued superior food quality, have had a positive impact.
After lighter customer traffic in the first half of fiscal 2003 compared to
fiscal 2002, average customer count was up nearly 1% in the third quarter of
fiscal 2003 and up nearly 6% in the fourth quarter of 2003.
COST OF FOOD AND BEVERAGES
The 4.1% increase in cost of food and beverages, from 24.3% of revenue
to 25.3% of revenue, was due to (i) price reductions made to certain menu items
in January 2003 resulting in an increase in the sales mix of these menu items
which have lower profit margins compared to other menu items, and (ii) a
significant increase in beef costs in the second half of 2003. Unusually high
beef costs are expected to continue through at least the first half of fiscal
2004. As a result, the Company expects its cost of food and beverage percentage
to be higher in fiscal 2004 than in fiscal 2003. Meritage purchases its beef
pursuant to agreements negotiated by Wendy's International. Meritage's food and
beverage costs for fiscal 2003 and fiscal 2002 were in line with guidelines
established by Wendy's International.
20
Beginning in fiscal 2003, the Company began accounting for vendor
allowances as a reduction to Cost of Food and Beverages rather than as a
reduction in Operating Expenses. Amounts previously reported in the 2002
consolidated financial statements have been reclassified to conform to the
presentation used in 2003. This reclassification decreased Cost of Food and
Beverages and increased Operating Expenses by $512,000 for the year ended
December 1, 2002.
OPERATING EXPENSES
Operating expenses in fiscal 2003, as a percentage of revenue, were
consistent with fiscal 2002 (59.0% in fiscal 2003 compared to 58.5% in fiscal
2002). The following table presents the expense categories that comprise
operating expenses:
Increase
2003 2002 (Decrease)
---- ---- ----------
As a percentage of revenue:
Labor and related expenses 34.3 33.7 0.6
Occupancy expenses 8.6 8.6 0.0
Advertising 4.0 4.0 0.0
Franchise fees 4.0 4.0 0.0
Paper costs 3.2 3.2 0.0
Other operating expenses 4.9 5.0 (0.1)
----- ----- ----
Total operating expenses 59.0 58.5 0.5
===== ===== ====
The increase in labor and related expenses as a percentage of revenue
was largely a function of the decrease in same store sales. Store management
salaries increased 0.7 percentage points, and crew labor increased 0.2
percentage points, due primarily to fixed costs as operations require minimum
staffing levels despite lower sales volumes. In response, management has
implemented labor cost reductions and cost containment measures which have been
successful in controlling labor and related costs. There was no change in the
Company's average labor rate in fiscal 2003 compared to fiscal 2002. This wage
rate trend was slightly better than that experienced by Wendy's International on
a nationwide basis, but was reflective of the weaker economy in West Michigan.
Reductions in training payroll and health insurance costs partially offset the
increases in crew and management labor.
Occupancy expenses were 8.6% of revenue in both fiscal 2003 and fiscal
2002, as increases in utility costs were offset by a reduction in property taxes
and rent expense. The decrease in rent expense, as a percentage of revenue, was
caused by an increase in the percentage of Company owned versus leased
restaurants. The Company owns all nine of the new stores it opened since the
beginning of fiscal 2002. During this period, it also purchased three previously
leased restaurants.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased $55,000, from $2,764,000
in fiscal 2002 to $2,819,000 in fiscal 2003. The increase was attributable to a
$77,000 increase in Michigan Single Business Tax expense due to the fiscal 2002
tax being lower than normal as a result of a tax refund from the filing of
amended tax returns. Restaurant level general and administrative expense
decreased due to a reduction in payroll and related fringe benefits and a
reduction in recruiting costs. Reductions in corporate level payroll and related
fringe benefits were slightly offset by increases in professional fees,
directors' fees and expenses, and directors and officers liability insurance.
These increases were related in large part to additional requirements under the
Sarbanes-Oxley Act of 2002 and a change in the Company's independent auditors.
As a percentage of revenue, general and administrative expenses decreased due to
the increase in revenue.
21
DEPRECIATION AND AMORTIZATION
The increase in depreciation and amortization expense was primarily due
to the depreciation of buildings and equipment associated with new restaurants.
The Company owns all nine of the new stores it opened since the beginning of
fiscal 2002. During this period, the Company also purchased three previously
leased restaurants that were demolished and rebuilt. The decision to rebuild
these restaurants and the closing of an existing restaurant whose lease had
expired, combined with major remodels to other restaurants, resulted in
accelerated depreciation of approximately $314,000 in fiscal 2003 due to the
shortening of asset lives. The increase in depreciation expense was partially
offset by a reduction in goodwill amortization expense of $182,000 for fiscal
2003 compared to fiscal 2002. Beginning in fiscal 2003, the Company no longer
amortizes goodwill in accordance with Statement of Financial Accounting
Standards No. 142 (see Note A of the consolidated financial statements).
INTEREST EXPENSE
The increase in interest expense was primarily related to additional
long-term debt of $6.6 million in fiscal 2003 used to develop new restaurants,
combined with a full year of interest expense on $8.0 million of long-term debt
incurred in fiscal 2002 for the development of new restaurants and the
acquisition of restaurants that were previously leased. Because it is a fixed
cost, interest expense (as a percentage of revenue) was also negatively impacted
by the decrease in same store sales. Approximately 75% of the Company's
long-term debt is at fixed interest rates. See Item 2 - Financing and
Encumbrances and Note F of the consolidated financial statements (beginning on
page F-1) for additional details regarding the Company's long-term debt.
GAIN ON SALE OF NON-OPERATING PROPERTY
The gain on sale of non-operating property in fiscal 2003 resulted from
the sale of surplus real estate located adjacent to three restaurants that
opened in fiscal 2002. In connection with the Company's new store development,
from time to time the Company acquires surplus real estate adjacent to a
restaurant site that it is developing that it may sell or use for other purposes
following the development of such restaurant. While the goal is to realize a
gain on the disposition of such surplus real estate, there are no assurances
that this will occur. The Liquidity and Capital Resources section of this item
discusses current pending sales of surplus real estate.
INCOME TAX BENEFIT
The $500,000 income tax benefit in fiscal 2003 was the result of a
reduction in the deferred tax valuation allowance related to the future use of
the Company's net operating loss carryforwards. This reduction was made based on
the assessment of an increased likelihood of the realizabilty of deferred tax
assets.
COMPARISON OF FISCAL YEARS 2002 AND 2001
REVENUE
Food and beverage revenue increased 19.8% in fiscal 2002 compared to
fiscal 2001. This increase was almost entirely attributable to revenue from new
restaurants. Average food and beverage revenue for stores in full operation
during the same quarters of fiscal 2002 and 2001 ("same store sales") follows:
22
Increase Increase
Average Sales per Store 2002 2001 (Decrease) (Decrease)%
- ----------------------- -------------- -------------- ---------- ------------
Fourth Quarter $ 271,224 $ 289,942 $ (18,718) (6.5)%
Third Quarter 302,937 303,959 (1,022) (0.3)%
Second Quarter 295,328 287,763 7,565 2.6 %
First Quarter 273,234 255,885 17,349 6.8 %
-------------- -------------- ----------
Year to Date $ 1,142,723 $ 1,137,549 $ 5,174 0.5 %
============== ============== ==========
The slight increase in same store sales in fiscal 2002 was attributable
to (i) increased menu prices that increased the average customer ticket by
approximately 2%, (ii) improved customer service times and better trained
restaurant teams, and (iii) strong demand for Wendy's new "Garden Sensations"
salads introduced in January 2002. As illustrated in the table above, the
Company experienced a negative sales trend over the course of fiscal 2002.
Factors contributing to this trend included (i) intense promotional discounting
by the Company's major competitors, especially during the fourth quarter of
fiscal 2002, (ii) a sluggish consumer spending environment, and (iii) an overall
decline in the West Michigan economy including rising unemployment. These
factors contributed to a decrease in customer traffic of approximately 2% in
fiscal 2002 compared to fiscal 2001.
COST OF FOOD AND BEVERAGES
The 7.6% reduction in cost of food and beverages from fiscal 2001 to
fiscal 2002, from 26.3% of revenue to 24.3% of revenue, was largely due to
improved food cost controls as the Company realized the benefits of a new food
cost software program and improved operational procedures. Increased menu prices
combined with declining beef and chicken costs also contributed to the
improvement in the cost of food and beverage percentage. Food and beverage costs
in fiscal 2002 and 2001 were in line with guidelines established by Wendy's
International.
Beginning in fiscal 2003, the Company began accounting for vendor
allowances as a reduction to Cost of Food and Beverages rather than as a
reduction in Operating Expenses. Amounts previously reported in the 2002 and
2001 consolidated financial statements have been reclassified to conform to the
presentation used in 2003. This reclassification decreased Cost of Food and
Beverages and increased Operating Expenses by $512,000 and $554,000 for the
years ended December 1, 2002 and December 2, 2001, respectively.
OPERATING EXPENSES
Operating expenses in fiscal 2002, as a percentage of revenue, were
consistent with fiscal 2001 (58.5% in fiscal 2002 compared to 58.8% in fiscal
2001). The following table presents the expense categories that comprise
operating expenses:
Increase
2002 2001 (Decrease)
---- ---- ----------
As a percentage of revenue:
Labor and related expenses 33.7 34.0 (0.3)
Occupancy expenses 8.6 8.8 (0.2)
Advertising 4.0 4.0 0.0
Franchise Fees 4.0 4.0 0.0
Paper Costs 3.2 3.2 0.0
Other operating expenses 5.0 4.8 0.2
---- ---- ----
Total operating expenses 58.5 58.8 (0.3)
==== ==== ====
23
The decrease in labor and related expenses as a percentage of revenue
was primarily the result of decreases in (i) hourly wages, (ii) training
payroll, and (iii) employee health insurance costs (in May 2002 the Company
moved to a self-insured health care plan). The reduction in hourly wages was
partially due to a slight decrease in the Company's average hourly wage rate of
less than 1%, which followed an increase of only 2% in fiscal 2001. These
reductions were partially offset by increases in store management salaries.
As a percentage of revenue, the decrease in occupancy expense was due
to lower rent expense as the percentage of Company owned versus leased
restaurants increased over last year. Of the fourteen new stores opened since
the beginning of fiscal 2001, thirteen are owned. Also, two previously leased
restaurants were purchased in fiscal 2002. The decrease in rent was partially
offset by increases in property taxes, property insurance rates and utility
costs.
The increase in other operating expenses was primarily due to monthly
fees for a new food cost software program implemented in January 2002 which
helped reduce food costs.
GENERAL AND ADMINISTRATIVE
The decrease in general and administrative expenses as a percentage of
revenue was primarily due to the increase in revenue. In 2001 the Company added
new positions to facilitate its aggressive development plan, the costs of which
were leveraged over higher sales volumes in 2002. Total general and
administrative expenses for restaurant operations increased 12.8% in fiscal 2002
over fiscal 2001 while corporate level general and administrative expenses
increased 5.3%. Of the corporate level increase, $47,000 was attributable to
property taxes incurred on surplus land held for sale and development. Although
general and administrative expenses increased, they were more than offset by the
19.8% increase in revenue. The decrease in Michigan Single Business Tax expense
was due to a tax refund following the filing of amended tax returns.
DEPRECIATION AND AMORTIZATION
Increases in depreciation and amortization expense were primarily due
to the depreciation of buildings and equipment associated with new restaurants
(Meritage opened a total of fourteen new restaurants in fiscal 2001 and 2002).
Meritage owns the buildings and equipment associated with thirteen of these
restaurants. Meritage also acquired four restaurant properties in the last two
fiscal years that were previously leased. Restaurants at two of these locations
were demolished and rebuilt in fiscal 2002. Additional depreciation resulted
from remodeling five restaurants since the second quarter of 2001.
SALE OF IMPAIRED ASSETS
The gain on sale of impaired assets in fiscal 2001 resulted from the
sale of a closed restaurant for more than its carrying value. An impairment loss
had been properly recognized in fiscal 2000 as a result of reducing these assets
to their estimated fair value in fiscal 2000 in accordance with Statement of
Financial Accounting Standards No. 121.
INTEREST EXPENSE
The increase in interest expense was primarily related to additional
long-term debt of $8.0 million in fiscal 2002 to develop new restaurants,
combined with a full year of interest expense on $6.4 million of long-term debt
incurred in fiscal 2001 for the development of new restaurants.
24
GAIN ON SALE OF NON-OPERATING PROPERTY
The $309,000 gain on sale of non-operating property in fiscal 2001
resulted from the sale of surplus real estate. In connection with the Company's
new store development, from time to time the Company acquires surplus real
estate adjacent to a restaurant site that it is developing that it may sell or
use for other purposes following the development of such restaurant.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows - Fiscal Year Ended November 30, 2003
Cash and cash equivalents ("cash") decreased $132,000, to $769,000 as
of November 30, 2003:
Net cash provided by operating activities $ 1,769,000
Net cash used in investing activities (5,099,000)
Net cash provided by financing activities 3,198,000
--------------
Net decrease in cash $ (132,000)
==============
Net cash provided by operating activities decreased $982,000 from
fiscal 2002 due primarily to a decrease in net earnings of $1,162,000 excluding
the non-cash income tax benefit of $500,000, and excluding the non-operating
gains on the sale of surplus real estate of $751,000 included in cash provided
by operating activities. This decrease was partially offset by an increase in
depreciation and amortization expense of $399,000. The remaining decrease was
primarily due to changes in current assets and liabilities.
Net cash used in investing activities decreased $6,914,000 from fiscal
2002, and included $5,398,000 used to develop new restaurants and $769,000 used
to upgrade and remodel existing restaurants. This compares to (i) $8,342,000
invested in fiscal 2002 to develop new restaurants, (ii) $2,365,000 used to
purchase and develop new restaurants that were previously leased, and (iii)
$1,216,000 used to upgrade and remodel existing restaurants. In fiscal 2003,
these investments in property and equipment were offset by proceeds from the
sale of surplus real estate of $1,328,000.
Net cash provided by financing activities decreased $5,301,000 from
fiscal 2002 due to (i) a $4,456,000 decrease in net loan proceeds used to
finance new store development (after net increases/reductions to the Company's
line of credit), (ii) proceeds of $539,000 from a note receivable in the first
quarter of fiscal 2002, and (iii) an increase in fiscal 2003 in principal
payments on long-term obligations including capital leases of $387,000.
Cash Flows - Fiscal Year Ended December 1, 2002
Cash and cash equivalents ("cash") decreased $763,000 to $901,000 as of
December 1, 2002:
Net cash provided by operating activities $ 2,751,000
Net cash used in investing activities (12,013,000)
Net cash provided by financing activities 8,499,000
---------------
Net decrease in cash $ (763,000)
===============
The $2,006,000 decrease in net cash provided by operating activities
from fiscal 2001 to fiscal 2002 was primarily the result of the receipt of
$3,000,000 in marketing funds from the Company's primary beverage supplier in
March 2001. Since then, no additional marketing funds have been received.
25
Partially offsetting this decrease was a $1,564,000 improvement in net earnings
before depreciation and amortization, and gains on the sale of non-operating and
impaired assets (non-cash adjustments to net earnings). The remaining decrease
was primarily due to changes in current assets and liabilities of $596,000.
Net cash used in investing activities increased $1,119,000 from fiscal
2001. In fiscal 2002, the Company invested $11,923,000 in property, plant and
equipment including (i) $8,342,000 used to develop new restaurants, (ii)
$2,365,000 used to purchase and develop new restaurants that were previously
leased, and (iii) $1,216,000 used to upgrade and remodel existing restaurants.
This compares to $12,514,000 invested in fiscal 2001 in connection with (i) the
development of new restaurants ($9,737,000), (ii) the purchase of two
restaurants that were previously leased ($800,000), (iii) improvements to
existing restaurants and offices ($881,000), and (iv) the purchase of surplus
property held for sale or development ($1,096,000). In fiscal 2001, these
investments in assets were offset by proceeds from the sale of non-operating
assets of $1,779,000 including the sale of closed restaurant properties for
$847,000 and the sale of surplus land for $932,000.
Net cash provided by financing activities increased $1,486,000 from
fiscal 2001 due to (i) a $2,096,000 increase in net loan proceeds (after net
increases/reductions to the Company's line of credit) used to finance new store
development, (ii) proceeds of $539,000 from a note receivable in February 2002,
and (iii) a decrease in principal payments on long-term obligations including
capital leases of $91,000. Also, in fiscal 2002 the Company made no open market
purchases of the Company's common stock, compared to fiscal 2001 when $239,000
of Company stock was purchased. These increases in fiscal 2002 were offset by a
decrease in cash provided by financing activities of $1,505,000 from a private
placement of common stock in February 2001.
Financial Condition
As of November 30, 2003, Meritage's current liabilities exceeded its
current assets by $3,245,000 compared to December 1, 2002, when current
liabilities exceeded current assets by $3,178,000. At these dates, the ratios of
current assets to current liabilities were 0.28:1 and 0.32:1, respectively. The
cash flows discussion provides details regarding the net decrease in cash and
the most significant items affecting working capital.
In fiscal 2002, cash flow provided by operations was sufficient to meet
the Company's obligations from existing operations including debt service and
necessary capital improvements to existing restaurants. In fiscal 2003, however,
cash flow provided by operations was approximately $500,000 less than cash
required for payment of obligations from existing operations including debt
service and capital improvements, including major restaurant remodels performed
in fiscal 2003. This deficiency was primarily due to same store sales decreases
in the first three quarters of fiscal 2003 compared to comparable prior year
quarters. This negative sales trend was reversed in the fourth quarter of fiscal
2003, and management anticipates that a positive sales trend will continue into
fiscal 2004. In January 2003, the Company reduced prices on certain menu items
to better compete with the intense price discounting affecting the quick-service
restaurant industry. These price reductions were intended to increase sales and
profits. As illustrated in the table at the beginning of this Item,
year-over-year quarterly same store sales decreases narrowed and turned positive
in the fourth quarter. Meritage has also implemented various cost cutting
measures and will continue to emphasize cost containment while evaluating
additional cost cutting measures.
26
More than offsetting the fiscal 2003 operating cash flow deficiency
described above was proceeds of $1,328,000 from non-operating gains from the
sale of surplus real estate. Future sales of remaining non-operating assets
(primarily surplus real estate) without any underlying debt, could provide an
estimated $700,000 of cash in fiscal 2004. At November 30, 2003, the Company
also had a note receivable of approximately $360,000 (with no underlying debt)
related to the sale of a former restaurant site to individuals on a land
contract. In the fall of 2003, the purchasers committed various breaches
including nonpayment of monthly installments. In October 2003, the Company filed
a Complaint for Possession after Land Contract Forfeiture. A judgment of
possession was entered on October 30, 2003, and the Company took possession on
January 29, 2004. The Company has begun the process of marketing the property
(land and building). Management believes the property has a fair value of at
least the amount owed under the land contract, and proceeds from a sale of this
property in fiscal 2004 would provide additional cash.
The Company slowed its Wendy's new store development in fiscal 2003
compared to prior years. The Company opened three new restaurants in fiscal 2003
and expects to open up to three additional restaurants in fiscal 2004. The new
store development for 2004 will depend primarily on the adequacy of new store
sites. New Wendy's restaurants require an investment in real estate and
equipment. Investments average approximately $1.25 to $1.5 million per
restaurant, of which Meritage typically invests $250,000 to $300,000 of equity
per restaurant. Any remaining investment is typically funded through long-term
financing. Meritage has an existing financing commitment from GE Capital
Franchise Finance Corporation to build four new restaurants. The commitment
requires a minimum 18% equity investment by Meritage. Borrowings will be secured
with mortgages maturing in ten years with monthly payments based on a 20-year
amortization schedule that permits Meritage to select either a fixed or variable
interest rate. The variable interest rate under these loans is equal to 2.55%
plus the one-month LIBOR rate (3.6% as of February 18, 2004, adjusted monthly),
and the fixed rate is equal to 2.61% plus the then 10-year U.S. Dollar Interest
Rate Swaps (7.1% as of February 18, 2004).
As the Company's new store development slowed in fiscal 2003,
management directed significant capital resources toward major store remodels.
In the second quarter, Meritage restructured a lease covering five of its older
sites. Under the amendment, the monthly rent will be reduced from 8.5% of sales
to 7.5% of sales beginning in January 2004. In addition, the lessor invested
$828,000 for capital improvements to the five restaurants. In addition to the
landlord's investment, the Company also spent approximately $127,000 in
additional capital improvements at these restaurants. Meritage also invested
approximately $642,000 for capital improvements at its other older restaurants.
At November 30, 2003, all but two of the Company's restaurants are either less
than five years old or recently remodeled. In addition to the major store
remodels, in September 2003 the Company purchased a previously leased restaurant
for $616,000. This restaurant was demolished, rebuilt at a cost of approximately
$900,000 (including equipment package), and reopened in December 2003. Another
previously leased restaurant was purchased in December 2003 for $350,000. This
restaurant was demolished and a new restaurant is presently under construction
at an estimated cost of approximately $900,000 (including equipment package).
The purchases, demolition, rebuilding, and equipment are being financed under
the GE Capital commitment described above.
The Company's $3.5 million line of credit with Fleet Business Credit,
LLC was scheduled to mature on December 31, 2003. The existing balance on this
line of credit of approximately $362,000 was refinanced with Standard Federal
Bank on December 18, 2003. The new credit facility is comprised of two lines of
credit, one for general working capital purposes in the amount of $600,000 and
one for restaurant development purposes in the amount of $2,000,000. The
combined lines of credit require monthly payments of interest only at a variable
interest rate equal to the prime rate plus 0.25% (4.25% at November 30, 2003).
The $362,000 balance was refinanced under the $600,000 line of credit. This
balance was paid off in January 2003. Any future borrowings under the $600,000
line of credit will be
27
due December 31, 2004 and any borrowings under the $2,000,000 line of credit
will be due December 31, 2005.
Meritage's various loan and franchise agreements contain covenants
requiring the maintenance of certain financial ratios including:
- Fixed Charge Coverage Ratio ("FCCR") of not less than 1.2:1 for the
Wendy's operations; FCCR is defined as the ratio of Operating Cash
Flow (the sum of earnings before interest, taxes, depreciation and
amortization, operating lease expense, and non-recurring items) to
Fixed Charges (the sum of debt service including principal and
interest payments plus operating lease expense).
- FCCR of not less than 1.2:1 for certain Wendy's restaurants loans
subject to a real estate mortgage;
- FCCR of not less than 1.4:1 for certain Wendy's restaurants loans
subject to a business value loan;
- Leverage Ratio (Funded Debt: Earnings Before Interest, Taxes,
Depreciation and Amortization) not to exceed 5.5:1;
- Debt Service Coverage Ratio ("DSCR") of not less than 1.2:1; DSCR is
defined as the ratio of Adjusted EBITDA (the sum of earnings before
interest, taxes, depreciation and amortization, non-cash losses, less
distributions and non-cash gains, plus or minus non-recurring items)
to Debt Service (the sum of principal and interest payments); and
- restrictions against using operating cash flow from the Wendy's
business for other means if such use would cause the FCCR to be less
than 1.2:1.
At November 30, 2003, Meritage was in compliance with these covenants.
Because the Company has slowed its new store growth and its store
remodeling program is substantially complete, Meritage believes that with
continued improvement in its year-over-year same store sales and continued
emphasis on controlling costs, it will be able to meet the current obligations
over the next twelve months with cash generated from operations. Funding of the
start-up phase and rollout of the O'Charley's restaurant concept is discussed
below. In addition to cash generated from operations and proceeds from the sale
of non-operating assets discussed above, Meritage could use the following other
sources to meet its current obligations over the next twelve months:
- utilizing cash balances;
- borrowing on its $2.6 million line of credit;
- financing or deferring Wendy's capital expenditures and store
remodels;
- deferring Wendy's new store openings;
- financing or leasing Wendy's equipment packages at new restaurants;
and
- selling surplus real estate that is acquired with future Wendy's
restaurant sites.
There can be no assurances, however, that Meritage will be able to complete the
above activities or that completion would yield the results expected.
In December 2003, the Company completed a $7,500,000 private equity
offering, primarily to be used for the development of O'Charley's restaurants in
accordance with the terms of the franchise development agreement. The offering
included the issuance of 416,666 Units for $2,500,000, and 500,000 Series B
Convertible Preferred Stock shares for $5,000,000. See Item 5, Sale of
Unregistered Securities, for details regarding the terms of this new equity.
Under an agreement dated December 19, 2003, $2,450,980 of the proceeds were used
by the Company to purchase 500,200 common shares from a retiring executive of
the Company. After the purchase of these shares and the payment of costs
28
associated with the private equity offering, stockholders' equity increased by
approximately $4,800,000. Out of the $4,800,000 in net proceeds from the
offering, the Company paid off the balance on its line of credit of
approximately $362,000, and paid $212,500 to O'Charley's upon execution of the
development agreement. Meritage also used approximately $55,000 from the
offering to buy back 10,500 shares of its own stock in open market transactions
between January 12 and January 24, 2004. The Board of Directors previously
approved these purchases of common stock.
The balance of the offering proceeds are expected to be used to finance
the start-up/pre-opening phase and the development of future O'Charley's
restaurants. Until the O'Charley's business segment generates positive cash,
offering proceeds may have to be used to make the $100,000 quarterly dividend
payment on the Company's Series B preferred stock. Meritage's development
agreement with O'Charley's requires the Company to open a minimum of fifteen
restaurants in the next seven years. Meritage has a $6.3 million financing
proposal from GE Capital to provide debt financing for the first three
O'Charley's restaurants. See Item 2, Financing and Encumbrances, for more
details of the financing proposal. The Company will lease some of the
O'Charley's restaurants depending on site availability and plans to own the
equipment at leased restaurants. However, equipment financing (lease or debt)
would also be available. New restaurants owned by the Company require an
investment in real estate and equipment. Investments are expected to average
between approximately $2.6 to $3.2 million per restaurant with land and site
development costs being the significant variables. The Company expects to
finance owned restaurants using the GE Capital financing which requires a
minimum 20% equity investment by Meritage. Meritage plans to open two or three
O'Charley's restaurants in fiscal 2004.
OFF-BALANCE SHEET ARRANGEMENTS
At November 30, 2003 the Company was a 19% owner of a real estate
investment company that is the landlord of one of the Company's restaurants. As
a 19% owner, the Company guaranteed 19% of a $2.8 million mortgage used to
finance the acquisition and development of the real estate. In the event of a
default, the Company would have to perform its obligations under the guaranty.
In January 2004, the Company sold its 19% interest in this entity to its CEO and
its obligations under the guaranty were terminated at the same time.
In 2002, the Company guaranteed the indebtedness of its CEO to a bank
in the amount of $538,900 in connection with the CEO's purchase of 250,000
shares of the Company's common stock. The 250,000 shares of stock secure the
bank loan. Under the terms of an indemnification agreement between the Company
and the CEO, in the event that the Company becomes liable for this indebtedness,
the Company would be subrogated to the bank's rights and remedies. The
indemnification agreement also provides that, if at any time during the term of
the agreement the Company's stock price closes below $3.00 per share for two
consecutive trading days, the Company may order the CEO to repay the outstanding
balance on the CEO's bank loan. If the CEO fails to pay off the bank loan, the
Company has the right to pay off the loan and take possession of the 250,000
shares securing the bank debt. In such event, the CEO agrees to pay any costs
incurred by the Company in acquiring free and clear possession of the stock.
29
CONTRACTUAL OBLIGATIONS
The following table sets forth the Company's contractual obligations at November
30, 2003:
Payments Due by Period
----------------------------------------------------------------------------------
Contractual Obligation Total 1 Year 2-3 Years 4-5 Years Thereafter
- ---------------------- ----- ------ --------- --------- ----------
Long-term obligations and lines
of credit $ 35,506,000 $ 1,419,000 $ 3,543,000 $ 3,989,000 $ 26,555,000
Obligations under capital lease 54,000 54,000 - - -
Operating leases 8,484,000 893,000 1,693,000 1,513,000 4,385,000
Capital expenditure commitments 1,250,000 1,250,000 - - -
Purchase obligations (1) 3,073,000 600,000 1,200,000 1,200,000 73,000
-------------- ------------ -------------- -------------- --------------
Total Contractual Obligations $ 48,367,000 $ 4,216,000 $ 6,436,000 $ 6,702,000 $ 31,013,000
============== ============ ============== ============== ==============
(1) Purchase obligations represent unearned vendor allowances related to
long-term agreements with the Company's beverage suppliers to purchase
fountain beverage syrup. The amounts represent estimated allowances to be
earned using actual fiscal 2003 purchases to estimate future purchases.
This obligation is included on the balance sheet under the caption
"unearned vendor allowances."
CRITICAL ACCOUNTING POLICIES
The Company's discussion and analysis of its financial condition and
results of operations are based upon the Company's consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these consolidated
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets, liabilities, revenues and expenses. The
significant accounting policies are discussed in Note A of the Company's
consolidated financial statements (beginning on page F-1). Certain of these
accounting policies are subject to judgments and uncertainties, which affect the
application of these policies. The Company bases its estimates on historical
experience and on various other assumptions believed to be reasonable under the
circumstances. On an on-going basis, the Company evaluates its estimates. In the
event estimates or assumptions prove to be different from actual results,
adjustments are made in subsequent periods to reflect more current information.
Management believes that any subsequent revisions to estimates used would not
have a material effect on the financial condition or results of operations of
the Company. The material accounting policies that the Company believes are most
critical to the understanding of the Company's financial position and results of
operations that require significant management estimates and judgments are
discussed below.
The Company is self-insured up to a $25,000 per participant stop loss
level for costs associated with benefits paid under employee health care
programs. The Company bases its estimated liability upon historical loss
experience provided by its third party administrator and judgments about the
present and expected levels of claim costs including claims incurred but not
reported. The Company has been self-insured for a limited period (since May
2002), and because of the unpredictable nature of self-insurance, actual future
events could result in adjustments to our estimated liability.
Income taxes are accounted for by using an asset and liability
approach. Deferred tax assets and liabilities are recognized for the expected
future tax consequences of temporary differences between the financial basis and
tax basis of assets and liabilities. Deferred tax assets and liabilities are
measured using enacted tax rates. In assessing the realizabilty of deferred tax
assets, management considers whether it is more likely than not that some
portion or all of the deferred tax assets will not be realized. The ultimate
realization of deferred tax assets is dependent upon the generation of future
taxable income
30
during the periods in which those temporary differences become deductible.
Management primarily considers the scheduled reversal of deferred tax
liabilities, projected future taxable income, and tax planning strategies in
making this assessment. To the extent that available evidence about the future
raises doubt about the realization of a deferred income tax asset, a valuation
allowance is established.
Depreciation is computed principally using the straight-line method
based upon estimated useful lives ranging from 3 to 15 years for furniture and
equipment and up to 30 years for property. Amortization of leasehold
improvements is provided over the terms of the various leases. These estimates
require assumptions that are believed to be reasonable. In the ordinary course
of business the Company, from time to time, experiences accelerated depreciation
due to the shortening of the estimated useful lives of assets in connection with
major restaurant remodels and upgrades, and the occasional demolition of an
existing restaurant building that is replaced by a new building on the same
site.
Long-lived assets are tested for impairment annually and when an event
occurs that indicates an impairment may exist. Judgments regarding the existence
of impairment are based on several factors including but not limited to, market
conditions, operational performance, and estimated future cash flows. If the
carrying value of a long-lived asset is considered impaired, an impairment
charge is recorded to adjust the asset to its fair value.
The Company has $4,430,000 of goodwill recorded at November 30, 2003,
related to prior acquisitions. New accounting standards adopted in fiscal 2003
require that goodwill (i) must be reviewed for impairment at least annually and
as indicators of impairment occur, and (ii) is no longer amortized. The annual
evaluation of goodwill impairment requires the use of estimates about future
cash flows of each reporting unit to determine estimated fair values. Changes in
forecasted operations and changes in discount rates can materially affect these
estimates. However, once an impairment of goodwill has been recorded it cannot
be reversed.
An accrual has been made for estimated Michigan single business taxes
related to bills received from the Michigan Department of Treasury ("Treasury")
for unpaid single business taxes for fiscal years 1997 through 2001, related to
fees paid to the Company's franchisor (Wendy's International) during those
years. Among other things, the Company believes the Treasury has incorrectly
characterized these fees as a "royalty." The estimated liability is based on the
settlement of litigation between the Company and Treasury related to the same
matter for fiscal years 1991 through 1994 and on the tax treatment by Treasury
of other quick-service restaurant franchisees relating to the same tax issue.
INFLATION AND CHANGING PRICES
The impact of inflation on the cost of food and beverages, labor and
related expenses, occupancy costs, equipment, land and construction costs could
adversely affect the Company's operations. Inflation did not have a significant
impact on the Company's operations with the exception of increasing beef costs
throughout fiscal 2003 and especially in the fourth quarter. These higher than
normal beef costs have carried over into fiscal 2004. Periodic increases in
food, labor and other operating expenses such as utility costs would normally be
passed on to customers in the form of price increases. However, highly
competitive market conditions have limited the Company's ability to offset
higher beef costs through menu price increases.
31
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Because all of Meritage's operations are in the United States, currency
exposure is eliminated. All of Meritage's debt is in U.S. dollars and
approximately 75% of its debt is at fixed interest rates which limits financial
instrument risk. The Company's mortgage loans that have variable interest rates
contain provisions to convert to a fixed interest rate between the seventh and
twenty-fourth month after the loan closing date. This would allow the company to
continue to limit exposure to interest rate fluctuations. Accordingly, Meritage
does not utilize any derivatives to alter interest rate risk. In the normal
course of business, Meritage purchases certain products (primarily food items)
that can be affected by fluctuating commodity prices. Most of these products are
purchased under agreements negotiated by Wendy's International that are outside
Meritage's control. It is the Company's understanding that Wendy's utilizes
various purchasing and pricing techniques in an effort to minimize volatility.
As a result, Meritage does not make use of financial instruments to hedge
commodity prices. While fluctuating commodity prices, such as the cost of beef
may impact the Company's cost of food, Meritage retains some ability to adjust
its menu pricing to offset these increases. However, highly competitive market
conditions have limited the Company's ability to offset higher beef costs
through menu price increases.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements and supplementary data included in the report
under this Item are set forth at the end of this report beginning on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
In February 2003, Meritage determined, for itself and on behalf of its
subsidiaries, to dismiss its independent auditors, Grant Thornton LLP ("Grant
Thornton"), and to engage Ernst & Young LLP ("Ernst & Young") as its new
independent auditors. The change in auditors was approved by the Audit Committee
of the Board of Directors. Previous to that, the Audit Committee interviewed
Ernst & Young after reviewing a proposal that Ernst & Young submitted. As a
result, Ernst & Young is auditing the 2003 consolidated financial statements
contained in this Report.
Grant Thornton's reports on the Company's consolidated financial
statements for the fiscal years ended December 1, 2002, and December 2, 2001 did
not contain an adverse opinion or disclaimer of opinion, nor were they qualified
or modified as to uncertainty, audit scope or accounting principles. During the
fiscal years ended December 1, 2002 and December 2, 2001, and through the date
of dismissal (the "Relevant Period"), (1) there were no disagreements with Grant
Thornton on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedure which, if not resolved to
Grant Thornton's satisfaction, would have caused Grant Thornton to make
reference to the subject matter of the disagreement(s) in connection with its
reports on the Company's consolidated financial statements for such years; and
(2) there were no reportable events as described in Item 304(a)(1)(v)
("Reportable Events") of the Securities and Exchange Commission's (the
"Commission") Regulation S-K.
During the Relevant Period, neither the Company nor anyone acting on
its behalf, consulted with Ernst & Young regarding (1) the application of
accounting principles to a specified transaction, completed or proposed, or the
type of audit opinion that might be rendered on the Company's consolidated
financial statements, or (2) any matter that was the subject of either a
disagreement or a reportable event as set forth in Items 304(a)(2)(i) and (ii)
of Regulation S-K.
32
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Directors, Executive Officers and Significant Employees
The following is information concerning the current directors,
executive officers and significant employees of the Company as of February 18,
2004:
COMMON SHARES
BENEFICIALLY OWNED
------------------
NAME AND AGE (1) POSITION AMOUNT PERCENTAGE
---------------- -------- ------ ----------
Robert E. Schermer, Sr. (2)(3)(4) Chairman of the Board of Directors 790,918 15.0%
68
Robert E. Schermer, Jr. (3)(5)(6) Chief Executive Officer, President 830,797 15.1%
45 and Director
Robert H. Potts (6) Vice President of Real Estate 79,703 1.5%
50
James R. Saalfeld (6) Vice President, Secretary, 112,636 2.1%
36 Treasurer and General Counsel
James P. Bishop (2)(3)(7)(8)(9) Director 46,430 *
63
Joseph L. Maggini (2)(7)(8)(9) Director 423,428 8.0%
64
Brian N. McMahon (2)(7)(8)(9) Director 5,663 *
51
All Current Executive Officers and 2,289,575 40.4%
Directors as a Group (7 persons)
* Less than 1%
(1) Unless otherwise indicated, the persons named have sole voting and
investment power and beneficial ownership of the securities.
(2) Includes options held by non-employee directors that are presently
exercisable, or exercisable within 60 days, pursuant to the 1996 Directors'
Share Option Plan and the 2001 Directors' Share Option Plan as follows: for
Mr. Schermer, Sr. 7,000 shares, for Mr. Bishop 10,000 shares, for Mr.
Maggini 7,000 shares, and for Mr. McMahon 5,000 shares.
(3) Executive Committee Member.
(4) Includes 7,000 shares held by Mr. Schermer, Sr.'s wife.
(5) Includes 7,050 shares held by Mr. Schermer, Jr. as a custodian for his
minor child.
(6) Includes options presently exercisable, or exercisable within 60 days,
pursuant to the 1996 Management Equity Incentive Plan and the 2002
Management Equity Incentive Plan as follows: for Mr. Schermer, Jr. 231,522
shares, for Mr. Potts 31,000 shares, and for Mr. Saalfeld 100,359 shares.
(7) Compensation Committee Member.
(8) Audit Committee Member.
(9) Nominating Committee Member.
Robert E. Schermer, Sr. has been a director of the Company since
January 25, 1996. He is currently Senior Vice President and a Managing Director
of Robert W. Baird & Co. Incorporated, an investment banking and securities
brokerage firm headquartered in Milwaukee, Wisconsin. Mr. Schermer has held this
position for more than five years. He is the father of Robert E. Schermer, Jr.
Robert E. Schermer, Jr. has been a director of the Company since
January 25, 1996. He has been Chief Executive Officer of the Company since
October 6, 1998. Mr. Schermer also served as President of the Company from
October 1998 until October 2000, and again since February 2004.
33
Robert H. Potts has been Vice President of Real Estate for the Company
since March 5, 2001. From 1989 to 2001, Mr. Potts was with Meijer Inc., a
multi-billion dollar supermarket and general merchandise retailer, where he held
the position of Senior Counsel. Mr. Potts is a licensed member of the Michigan
Bar.
James R. Saalfeld has been Vice President, Secretary and General
Counsel of the Company since March 20, 1996. Mr. Saalfeld has been Treasurer of
the Company since June 2002. From 1992 until 1996, Mr. Saalfeld was with Dykema
Gossett PLLC, a law firm headquartered in Detroit, Michigan. Mr. Saalfeld is a
licensed member of the Michigan Bar.
James P. Bishop has been a director of the Company since July 16, 1998.
He is a CPA and the President and majority owner of the Bishop, Gasperini &
Flipse, P.C. accounting firm in Kalamazoo, Michigan, where he has worked since
1973. Mr. Bishop was appointed by Michigan's Governor to the Administrative
Committee on Public Accountancy in 1993.
Joseph L. Maggini has been a director of the Company since January 25,
1996. Since founding the company in 1974, Mr. Maggini has served as President
and Chairman of the Board of Magic Steel Corporation, a steel service center
located in Grand Rapids, Michigan.
Corporate Governance
At a meeting of the Board of Directors in December 2003, the Board
adopted a Code of Ethics which is included as an exhibit to this Report.
Each Audit Committee member is able to read and understand fundamental
financial statements. James P. Bishop has been designated as the Audit Committee
financial expert, and each member of the Committee is independent as that term
is used in Item 7(d)(3(iv) of Schedule 14A.
In February 2004, the Company's Board of Directors established a
Nominating Committee which is responsible for identifying nominees for the
annual election of members of the Board of Directors, and recommending nominees
in the event of Board vacancies and to comprise the Board's various committees.
The Board also established a Nominating Committee Charter which is available
free of charge by request to the Company's Secretary. The Committee will
evaluate and consider candidates recommended by directors, officers and
shareholders. The Nominating Committee is composed of Messrs. Bishop, Maggini
and McMahon, all of whom meet the applicable standards for independence.
Additional information regarding corporate governance will be contained
in the Company's proxy statement to be issued in connection with the 2004 Annual
Shareholders' Meeting.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's officers, directors and persons owning more than ten percent of the
Company's common shares to file reports of ownership with the SEC and to furnish
the Company with copies of these reports. Based solely upon its review of
reports received by it, or upon written representation from certain reporting
persons that no reports were required, the Company believes that during fiscal
2003 all filing requirements were met except for Mr. Schermer, Sr. who untimely
reported a purchase of 2,000 common shares owned by his wife.
34
ITEM 11. EXECUTIVE COMPENSATION.
The following table sets forth information regarding compensation paid
by the Company to its Chief Executive Officer and executive officers or
significant employees earning in excess of $100,000 in fiscal 2003:
SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION
ANNUAL COMPENSATION SECURITIES
FISCAL (1) UNDER-LYING OTHER ANNUAL
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS OPTIONS COMPENSATION
--------------------------- ------ ------ ----- ----------- ------------
Robert E. Schermer, Jr. 2003 $ 171,000 (2) $ 46,743 25,000 ---
Chief Executive Officer 2002 $ 172,000 (2) $ 39,715 71,631 ---
2001 $ 150,500 (2) $ 34,848 90,000 ---
Robert E.Riley 2003 $ 165,734 (2) $ 46,743 25,000 ---
President (3) 2002 $ 164,731 (2) $ 39,715 71,631 ---
2001 $ 145,000 $ 34,848 190,000 ---
James R.Saalfeld 2003 $ 112,350 $ 33,020 20,000 ---
Vice President, General 2002 $ 113,096 $ 25,860 54,018 ---
Counsel, Secretary & Treasurer 2001 $ 107,125 $ 22,616 27,500 ---
Robert H.Potts 2003 $ 112,350 $ 33,520 20,000 ---
Vice President of Real Estate 2002 $ 112,346 $ 25,860 22,000 ---
2001 $ 74,136 (4) $ 17,366 (4) 15,000 ---
(1) Includes bonuses earned during the fiscal year but paid in the next fiscal
year.
(2) Also received an annual automobile allowance.
(3) Mr. Riley, who served as President throughout fiscal 2003, resigned in
January 2004.
(4) Reflects salary and bonus for partial year of employment.
STOCK OPTIONS
The following tables contain information concerning the grant of stock
options to the executives and employees identified in the Summary Compensation
Table and the appreciation of such options:
OPTION GRANTS IN FISCAL 2003
POTENTIAL REALIZABLE
% OF TOTAL VALUE AT ASSUMED ANNUAL
NUMBER OF OPTIONS RATES OF STOCK PRICE
SECURITIES GRANTED TO EXERCISE APPRECIATION FOR OPTION
UNDERLYING EMPLOYEES IN PRICE EXPIRATION TERM
NAME OPTIONS GRANTED FISCAL 2002 ($ PER SHARE) DATE 5% 10%
---- --------------- ------------ ------------ ---------- -- ---
Robert E. Schermer, Jr. 25,000 21.7 % $ 4.95 12/17/12 $ 77,839 $ 197,258
Robert E. Riley 25,000 21.7 % $ 4.95 12/17/12 $ 77,839 $ 197,258
James R. Saalfeld 20,000 17.4 % $ 4.95 12/17/12 $ 62,271 $ 157,806
Robert H. Potts 20,000 17.4 % $ 4.95 12/17/12 $ 62,271 $ 157,806
35
FISCAL 2003 OPTION EXERCISES AND FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT
OPTIONS AT FISCAL YEAR END FISCAL YEAR END
SHARES ACQUIRED
NAME ON EXERCISE VALUE REALIZED EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE
---- ----------- -------------- ------------------------- -------------------------
Robert E. Schermer, Jr. --- --- 221,522 / 80,314 $386,269 / $ 90,471
Robert E. Riley --- --- 181,501 / 105,130 $343,796 / $150,191
James R. Saalfeld --- --- 97,721 / 41,438 $139,924 / $ 21,745
Robert H. Potts --- --- 27,250 / 29,750 $ 37,538 / $ 17,363
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Other than certain of the Company's directors and officers as
identified in Item 10 above, no other shareholders are known by the Company to
beneficially own 5% or more of the Company's outstanding common shares as of
January 29, 2003, except for Peter D. Wierenga who reported beneficial ownership
of 271,109 (5.0%) on November 9, 2000. Mr. Wierenga's business address is
reported in his Schedule 13D as 3703 S. Division Ave., Grand Rapids, Michigan
49503.
As required by Item 201(d) of Regulation S-K, the Company incorporates
in this Item 12 the Equity Compensation Plan Information table contained in Item
5 of this report.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
On February 9, 2001, Meritage completed the sale of 762,500
unregistered common shares at $2.1556 per share in a private placement. The
proceeds of the placement were used for the continued development of its Wendy's
operations. Mr. Schermer, Jr., the Company's CEO, purchased 250,000 common
shares in the private placement. In March 2002, Meritage provided a guaranty to
the financial institution that advanced funds to Mr. Schermer to purchase the
250,000 shares. The Board determined that the transaction was beneficial and
fair to Meritage for several reasons including the fact that Mr. Schemer had
personally guaranteed over $4.2 million of Meritage's long-term indebtedness. To
date, no modifications or renewals of the guaranty have occurred.
Pursuant to the private equity offering of Units and Series B
Convertible Preferred Shares (the "Preferred Shares") that was completed in
December 2003, and which is reported in greater detail in Part II, Item 5 of
this Report, on December 22, 2003, Joseph L. Maggini, a member of the Board of
Directors, purchased 166,666 Units (i.e., 166,666 Meritage common shares, and
warrants to purchase an additional 166,666 Meritage common shares), and 100,000
Preferred Shares. On the same day, a limited liability company of which Robert
E. Schermer, Jr. (the Company's CEO and a director) is a 40% owner, purchased
250,000 Units (i.e., 250,000 Meritage common shares, and warrants to purchase an
additional 250,000 Meritage common shares), and a limited liability company of
which Mr. Schermer is a 50% owner purchased 100,000 Preferred Shares. The Board
obtained a valuation analysis, and a special committee of disinterested
independent directors obtained a fairness opinion, regarding aspects of the
private offering.
In December 2003, the Company purchased all of Mr. Riley's and his
spouse's outstanding Meritage common shares (500,200 shares) at a price of $4.90
per share pursuant to a stock redemption agreement approved by the Board of
Directors. Under the agreement, the Company received various
36
considerations from Mr. Riley. Funds from the private offering described above
were used to purchase the Riley shares. Pursuant to the agreement, on January
16, 2004, Mr. Riley resigned as an officer and director of the Company, but will
continue to work for the Company in other capacities.
In January 2004, pursuant to a purchase and sale agreement, Mr.
Schermer, Jr. purchased from the Company a 19% interest in a real estate
investment company that is the landlord of one of the Company's Wendy's
restaurants. The purchase price was $190,000. Pursuant to the agreement, as
authorized by a special committee of disinterested independent directors, Mr.
Schermer obtained a discharge of a $535,000 guaranty that the Company previously
provided to secure the investment company's indebtedness. A fairness opinion was
obtained by the disinterested independent directors in connection with this
transaction. Due to Mr. Schermer's purchase of the 19% interest, all of the
Company's future payments under the lease dated March 23, 2000 (i.e., total rent
payments of approximately $9,500 per month) will be to an entity that is owned,
in part, by a related party.
ITEM 14. CONTROLS AND PROCEDURES.
As of November 30, 2003, an evaluation was completed under the
supervision and with the participation of the Company's management, including
the Company's Chief Executive Officer, President, General Counsel and
Controller, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures. Based on that evaluation, the Company's
management including the Chief Executive Office, President, General Counsel and
Controller, concluded that the Company's disclosure controls and procedures were
effective as of November 30, 2003. There have been no changes to the Company's
internal controls over financial reporting that occurred during the fourth
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, Meritage's internal control over financial reporting.
37
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) and (2) Financial Statements and Schedules.
All financial statements required to be filed by Item 8 of this Form
10-K and included in this report are set forth at the end of this report
beginning on page F-1. All schedules required by this Form 10-K have been
omitted because they were inapplicable, included in the Consolidated Financial
Statements or Notes to Consolidated Financial Statements, or otherwise were not
required under instructions contained in Regulation S-X.
(a)(3) Exhibit List.
The following documents are exhibits to this Annual Report:
Exhibit No. Description of Document
- ----------- -----------------------
3.1 Amended and Restated Articles of Incorporation (1).
3.2 Restated and Amended Bylaws (2).
10.1 Sample Construction Loan Agreement with Captec Financial Group, Inc. (3).
10.2 Sample Promissory Note with Captec Financial Group, Inc. regarding real
estate financing (3).
10.3 Sample Mortgage with Captec Financial Group, Inc. regarding real estate
financing (3).
10.4 Sample Promissory Note with Captec Financial Group, Inc.regarding leasehold
financing (3).
10.5 Sample Mortgage with Captec Financial Group, Inc. regarding leasehold
financing (3).
10.6 Sample Promissory Note with Captec Financial Group, Inc. regarding business
value financing (3).
10.7 Sample Security Agreement with Captec Financial Group, Inc. regarding business
value financing (3).
10.8 Sample Loan Agreement with Fleet Business Credit Corporation (4).
10.9 Sample Promissory Note with Fleet Business Credit Corporation (4).
10.10 Sample Mortgage with Fleet Business Credit Corporation (4).
10.11 Sample Guaranty with Fleet Business Credit Corporation (4).
10.12 Sample Promissory Note with GE Capital Franchise Finance Corporation (5).
10.13 Sample Mortgage with GE Capital Franchise Finance Corporation (5).
10.14 Sample Guaranty with GE Capital Franchise Finance Corporation (5).
38
10.15 Sample Construction Loan Agreement with GE Capital Franchise
Finance Corp. (6).
10.16 Promissory Note for Line of Credit with Standard Federal Bank
(1).
10.17 Promissory Note for Revolving Line of Credit with Standard
Federal Bank (1).
10.18 Business Loan Agreement regarding Line of Credit with Standard
Federal Bank. (1).
10.19 Security Agreement regarding Line of Credit with Standard
Federal Bank. (1).
10.20 Consent Agreement dated May 1997 between Wendy's
International, Inc., Wendy's of Michigan, Meritage Hospitality
Group Inc., MHG Food Service Inc., Meritage Capital Corp., MCC
Food Service Inc., Robert E. Schermer, Jr. and Christopher B.
Hewett, with sample Unit Franchise Agreement, Guaranties, and
Release of Claims attached as exhibits (7).
10.21 Agreement and Consent dated August 1998 between WM Limited
Partnership - 1998, Meritage Hospitality Group Inc., MHG Food
Service Inc., Meritage Capital Corp., MCC Food Service Inc.,
Robert E. Schermer, Jr., and Christopher B. Hewett (3).
10.22 Agreement and Consent dated December 1998 between WM Limited
Partnership - 1998, Meritage Hospitality Group Inc., MHG Food
Service Inc., Meritage Capital Corp., MCC Food Service Inc., S
& Q Management, LLC, Robert E. Schermer, Jr., Christopher B.
Hewett, and Ray E. Quada (8).
10.23 Agreement and Consent dated June 2001 between WM Limited
Partnership - 1998, Meritage Hospitality Group Inc., MHG Food
Service Inc., RES Management, LLC, S & Q Management, LLC,
Robert E. Schermer, Jr. and The Estate of Ray E. Quada (9).
10.24 Development Agreement between O'Charley's Inc., Meritage
Hospitality Group Inc., and OCM Development Company, LLC, with
Sample Confidentiality and Non-Compete Agreement, Guaranty and
Lease Rider attached (1).
10.25 Sample Operating Agreement between O'Charley's Inc., Meritage
Hospitality Group Inc., and OCM Food Service, LLC, with Sample
Confidentiality and Non-Compete Agreement, Software License
and Support Agreement and Guaranty attached (1).
10.26 Sample indemnification agreement for officers and directors of
the Company (10).
10.27 Indemnification Agreement among Meritage Hospitality Group
Inc., MHG Food Service Inc., WM Limited Partnership - 1998,
RES Management, LLC, and Robert E. Schermer, Jr. (9).
10.28 Guaranty by Meritage Hospitality Group Inc. to Huntington
National Bank relating to Promissory Note by Robert E.
Schermer, Jr. to Huntington National Bank (11).
10.29 Stock Redemption Agreement among Meritage Hospitality Group
Inc., Robert E. Riley and his spouse (12) and (1).
10.30 Purchase and Sale Agreement among Meritage Hospitality Group
Inc. and Robert E. Schermer, Jr. regarding purchase of 19%
interest in real estate investment company (1).
39
10.31 Warrant Agreement among Meritage Hospitality Group Inc. and
LaSalle Bank, NA Class A and Class B Warrants to purchase
Meritage common stock (1).
MANAGEMENT COMPENSATORY CONTRACTS
10.32 Amended 1996 Management Equity Incentive Plan (1).
10.33 Amended 1996 Directors' Share Option Plan (1).
10.34 Amended 2001 Directors' Share Option Plan (1).
10.35 Amended 1999 Directors' Compensation Plan (1).
10.36 Amended 2002 Management Equity Incentive Plan (1).
14 Code of Ethics (1).
21 Subsidiaries of the Registrant (1).
23.1 Consent of Ernst & Young LLP for fiscal year 2003 (1).
23.2 Consent of Grant Thornton LLP for fiscal years 2001 and 2002 (1).
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer (1).
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer (1).
32.1 Section 1350 Certification of Chief Executive Officer (1).
32.2 Section 1350 Certification of Chief Financial Officer (1).
Exhibits previously filed and incorporated by reference from:
(1) Filed herewith.
(2) The Quarterly Report on Form 10-Q for the Company's fiscal quarter ended
June 2, 2002.
(3) The Quarterly Report on Form 10-Q for the Company's fiscal quarter ended
August 31, 1998.
(4) The Quarterly Report on Form 10-Q for the Company's fiscal quarter ended
May 31, 1999.
(5) The Quarterly Report on Form 10-Q for the Company's fiscal quarter ended
September 1, 2002.
(6) The Annual Report on Form 10-K for the Company's fiscal year ended December
1, 2002.
(7) The Quarterly Report on Form 10-Q for the Company's fiscal quarter ended
May 31, 1997.
(8) The Annual Report on Form 10-K for the Company's fiscal year ended November
30, 1998.
(9) The Annual Report on Form 10-K for the Company's fiscal year ended December
2, 2001.
(10) The Annual Report on Form 10-K for the Company's fiscal year ended November
30, 1997.
(11) The Quarterly Report on Form 10-Q for the Company's fiscal quarter ended
March 3, 2002.
(12) Amendment No. 3 to Schedule 13D for Robert E. Riley dated September 10,
2003.
40
(b) Reports on Form 8-K.
On December 22, 2003, the Company filed a Form 8-K under Item 5
reporting the initial closing of a private offering of (i) Units at an offering
price of $6.00 per Unit, with each Unit consisting of one share of Company
common stock, 0.5 of a Class A Warrant, and 0.5 of a Class B Warrant, and (ii)
Series B Convertible Preferred Stock of the Company. It was reported that the
Registrant received gross proceeds of $4,500,000 in connection with the sale of
416,666 Units (for $2,500,000) and 200,000 Preferred Shares (for $2,000,000).
On December 29, 2003, the Company filed a Form 8-K under Item 5
reporting that Meritage had issued a press release reporting on the execution of
a franchise development agreement with O'Charley's, Inc. to operate O'Charley's
restaurants throughout the State of Michigan, and the completion of the initial
stage of a private equity offering.
On January 5, 2004, the Company filed a Form 8-K under Item 5 reporting
that Meritage had issued a press release reporting on the completion of the
Company's private equity offering referenced above.
On January 9, 2004, the Company filed a Form 8-K under Item 5 reporting
that Meritage had issued a press release reporting the 2003 fiscal year end
financial results.
41
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
MERITAGE HOSPITALITY GROUP INC.
Dated: February 19, 2004 By /s/ Robert E. Schermer, Jr.
-----------------------------------------
Robert E. Schermer, Jr.
President & Chief Executive Officer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Robert E. Schermer, Sr. Chairman of the Board of Directors February 19, 2004
- -------------------------------
Robert E. Schermer, Sr.
/s/ Robert E. Schermer, Jr. President, Chief Executive Officer and February 19, 2004
- ------------------------------- Director (Principal Executive Officer)
Robert E. Schermer, Jr.
/s/ William D. Badgerow Controller (Principal Financial & February 19, 2004
- ------------------------------- Accounting Officer)
William D. Badgerow
/s/ James P. Bishop Director February 19, 2004
- -------------------------------
James P. Bishop
/s/ Joseph L. Maggini Director February 19, 2004
- -------------------------------
Joseph L. Maggini
/s/ Brian N. McMahon Director February 19, 2004
- -------------------------------
Brian N. McMahon
42
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
Page
----
Report of Independent Auditors ......................... F-2
Report of Independent Certified Public Accountants ..... F-3
FINANCIAL STATEMENTS
Consolidated Balance Sheets............................. F-4
Consolidated Statements of Income....................... F-6
Consolidated Statements of Stockholders' Equity......... F-7
Consolidated Statements of Cash Flows................... F-9
Notes to Consolidated Financial Statements ............. F-11
F-1
REPORT OF INDEPENDENT AUDITORS
To the Shareholders and Board of Directors
Meritage Hospitality Group Inc.
We have audited the accompanying consolidated balance sheet of Meritage
Hospitality Group Inc. and subsidiaries as of November 30, 2003, and the related
consolidated statements of income, stockholder's equity, and cash flow for the
year then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Meritage
Hospitality Group Inc. and subsidiaries at November 30, 2003, and the
consolidated results of their operations and their cash flows for the year then
ended in conformity with accounting principles generally accepted in the United
States.
As discussed in Note A to the consolidated financial statements, in fiscal 2003
the Company changed its method of accounting for goodwill and other intangible
assets.
/s/ Ernst & Young LLP
Grand Rapids, Michigan
December 30, 2003
F-2
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors
Meritage Hospitality Group Inc.
We have audited the accompanying consolidated balance sheet of Meritage
Hospitality Group Inc. (a Michigan corporation) and subsidiaries as of December
1, 2002, and the related consolidated statements of income, stockholders' equity
and cash flows for each of the two years in the period ended December 1, 2002.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Meritage Hospitality
Group Inc. and subsidiaries as of December 1, 2002, and the consolidated results
of their operations and their consolidated cash flows for each of the two years
in the period ended December 1, 2002, in conformity with accounting principles
generally accepted in the United States of America.
/s/ Grant Thornton LLP
Southfield, Michigan
December 19, 2002
(except for Note E, of which
the date is January 31, 2003)
F-3
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
NOVEMBER 30, 2003 AND DECEMBER 1, 2002
NOVEMBER 30, DECEMBER 1,
2003 2002
--------------- --------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 769,072 $ 901,113
Receivables 76,214 235,766
Inventories 262,058 208,197
Prepaid expenses and other current assets 144,001 161,189
--------------- --------------
Total Current Assets 1,251,345 1,506,265
PROPERTY, PLANT AND EQUIPMENT, NET 41,287,877 38,076,198
DEFERRED INCOME TAXES 694,000 -
OTHER ASSETS
Note receivable 323,568 319,593
Non-operating property 269,949 728,383
Goodwill 4,429,849 4,429,849
Franchise costs, net of amortization of $164,311
and $129,943, respectively 1,010,689 995,057
Financing costs, net of amortization of $148,466
and $90,466, respectively 606,976 591,475
Deposits and other assets 156,210 65,423
--------------- --------------
Total Other Assets 6,797,241 7,129,780
--------------- --------------
Total Assets $ 50,030,463 $ 46,712,243
=============== ==============
F-4
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - CONTINUED
NOVEMBER 30, 2003 AND DECEMBER 1, 2002
LIABILITIES AND STOCKHOLDERS' EQUITY
NOVEMBER 30, DECEMBER 1,
2003 2002
--------------- -------------
CURRENT LIABILITIES
Current portion of long-term obligations $ 1,419,028 $ 1,141,281
Current portion of obligations under capital lease 53,937 341,993
Trade accounts payable 1,057,370 1,466,713
Accrued liabilities 1,966,280 1,733,840
--------------- -------------
Total Current Liabilities 4,496,615 4,683,827
UNEARNED VENDOR ALLOWANCES 3,073,429 3,621,736
LONG-TERM OBLIGATIONS 34,086,701 30,736,582
OBLIGATIONS UNDER CAPITAL LEASE - 60,749
STOCKHOLDERS' EQUITY
Preferred stock - $0.01 par value
shares authorized: 5,000,000; 200,000 shares designated
as Series A convertible cumulative preferred stock
shares issued and outstanding: 29,520 (liquidation
value - $295,200) 295 295
Common stock - $0.01 par value
shares authorized: 30,000,000
shares issued and outstanding: 5,360,203 and
5,342,800, respectively 53,603 53,428
Additional paid in capital 13,635,104 13,584,800
Accumulated deficit (5,315,284) (6,029,174)
--------------- -------------
Total Stockholders' Equity 8,373,718 7,609,349
--------------- -------------
Total Liabilities and Stockholders' Equity $ 50,030,463 $ 46,712,243
=============== =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
F-5
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
2003 2002 2001
---------------- --------------- ---------------
Food and beverage revenue $ 48,513,456 $ 45,952,990 $ 38,356,360
Cost and expenses
Cost of food and beverages 12,272,050 11,183,572 10,080,371
Operating expenses 28,606,742 26,860,460 22,552,664
General and administrative expenses 2,819,095 2,763,970 2,580,966
Depreciation and amortization 2,985,929 2,600,921 1,952,426
Impairment of assets - - (463,952)
---------------- --------------- ---------------
Total cost and expenses 46,683,816 43,408,923 36,702,475
---------------- --------------- ---------------
Earnings from operations 1,829,640 2,544,067 1,653,885
Other income (expense)
Interest expense (2,388,080) (2,025,713) (1,553,249)
Interest income 28,192 99,961 105,708
Other income, net 19,990 33,356 30,975
Gain on sale of non-operating property 750,716 40,636 309,263
---------------- --------------- ---------------
Total other expense (1,589,182) (1,851,760) (1,107,303)
---------------- --------------- ---------------
Earnings before income taxes 240,458 692,307 546,582
Income tax benefit (expense) 500,000 17,000 (15,000)
---------------- --------------- ---------------
Net earnings 740,458 709,307 531,582
Preferred stock dividends 26,568 26,568 26,568
---------------- --------------- ---------------
Net earnings on common shares $ 713,890 $ 682,739 $ 505,014
================ =============== ===============
Earnings per common share - basic $ .13 $ .13 $ .10
================ =============== ===============
Earnings per common share - diluted $ .13 $ .12 $ .10
================ =============== ===============
Weighted average shares outstanding - basic 5,347,531 5,332,134 5,236,149
================ =============== ===============
Weighted average shares outstanding - diluted 5,648,252 5,685,789 5,287,007
================ =============== ===============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
F-6
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE
SERIES A RECEIVABLE
CONVERTIBLE ADDITIONAL FROM
PREFERRED COMMON PAID-IN SALE OF ACCUMULATED
STOCK STOCK CAPITAL SHARES DEFICIT TOTAL
----------- ----------- -------------- ---------- ----------- -----------
Balance at December 1, 2000 295 44,548 11,703,257 - (7,216,927) 4,531,173
Issuance of 978,211 shares of common
stock - 9,783 2,068,341 (538,900) - 1,539,224
Purchase of 109,296 shares of
common stock - (1,093) (237,296) - - (238,389)
Preferred stock dividends paid - - - - (26,568) (26,568)
Net earnings - - - - 531,582 531,582
----------- ----------- -------------- ---------- ----------- -----------
Balance at December 2, 2001 $ 295 $ 53,238 $ 13,534,302 $ (538,900) $(6,711,913) $ 6,337,022
Payment received on note receivable
from sale of common stock - - - 538,900 - 538,900
Issuance of 19,001 shares of common
stock - 190 50,498 - - 50,688
Preferred stock dividends paid - - - - (26,568) (26,568)
Net earnings - - - - 709,307 709,307
----------- ----------- -------------- ---------- ----------- -----------
Balance at December 1, 2002 $ 295 $ 53,428 $ 13,584,800 $ - $(6,029,174) $ 7,609,349
F-7
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE
SERIES A RECEIVABLE
CONVERTIBLE ADDITIONAL FROM
PREFERRED COMMON PAID-IN SALE OF ACCUMULATED
STOCK STOCK CAPITAL SHARES DEFICIT TOTAL
----------- ----------- -------------- ---------- ----------- -----------
Balance at December 2, 2002 $ 295 $ 53,428 $ 13,584,800 $ - $(6,029,174) $ 7,609,349
Issuance of 18,203 shares of common stock - 183 54,380 - - 54,563
Purchase of 800 shares of common stock - (8) (4,076) - - (4,084)
Preferred stock dividends paid - - - - (26,568) (26,568)
Net earnings - - - - 740,458 740,458
----------- ----------- -------------- ---------- ----------- -----------
Balance at November 30, 2003 $ 295 $ 53,603 $ 13,635,104 $ - $(5,315,284) $ 8,373,718
=========== =========== ============== ========== =========== ===========
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
F-8
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
2003 2002 2001
---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net earnings $ 740,458 $ 709,307 $ 531,582
Adjustments to reconcile net earnings to net
cash provided by operating activities
Depreciation and amortization 2,985,929 2,600,921 1,952,426
Amortization of financing costs 58,000 43,858 38,388
Deferred income taxes (694,000) - -
Compensation paid by issuance of common stock 31,500 28,000 34,478
Gain on sale of non-operating property (750,716) (40,636) (309,263)
Gain on impaired assets - - (463,952)
(Decrease) increase in unearned vendor allowances (548,307) (543,971) 2,422,985
Decrease (increase) in current assets
Receivables 159,552 (106,604) (69,557)
Inventories (53,861) (5,489) 25,315
Prepaid expenses and other current assets 17,188 40,696 (34,517)
Increase (decrease) in current liabilities
Trade accounts payable (409,343) (116,582) 206,953
Income taxes payable - (17,264) 15,000
Accrued liabilities 232,440 158,562 406,570
------------ ------------ ------------
Net cash provided by operating activities 1,768,840 2,750,798 4,756,408
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property, plant and equipment (6,166,884) (11,916,966) (11,418,474)
Purchase of assets held for sale (118,573) (5,658) (1,095,578)
Payment for franchise agreements (75,000) (150,000) (175,000)
Proceeds from sale of operating property 29,547 800 -
Proceeds from sale of non-operating assets 1,327,724 40,636 1,779,056
(Increase) decrease in deposits and other assets (95,666) 18,392 16,337
------------ ------------ ------------
Net cash used in investing activities (5,098,852) (12,012,796) (10,893,659)
F-9
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
2003 2002 2001
---- ---- ----
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from borrowings on line of credit $ 629,688 $ 3,295,238 $ 2,650,000
Principal payments on line of credit (2,481,719) (2,081,071) (1,967,500)
Proceeds from long-term obligations 6,616,451 8,005,871 6,441,453
Principal payments on long-term obligations (1,136,554) (791,996) (831,576)
Payments on obligations under capital lease (348,805) (306,305) (357,767)
Payments of financing costs (73,501) (157,546) (160,995)
Payment received on note receivable - 538,900 -
Proceeds from issuance of common stock 23,063 22,688 1,504,746
Purchase of common stock (4,084) - (238,389)
Preferred stock dividends paid (26,568) (26,568) (26,568)
------------ ------------ ------------
Net cash provided by financing activities 3,197,971 8,499,211 7,013,404
------------ ------------ ------------
Net (decrease) increase in cash (132,041) (762,787) 876,153
Cash and cash equivalents - beginning of year 901,113 1,663,900 787,747
------------ ------------ ------------
Cash and cash equivalents - end of year $ 769,072 $ 901,113 $ 1,663,900
============ ============ ============
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for interest $ 2,337,000 $ 1,956,000 $ 1,499,000
Cash paid for income taxes $ - $ - $ -
SCHEDULE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
Sale of impaired asset
Selling price of asset $ - $ - $ 400,000
Note receivable obtained from buyer - - 365,000
------------ ------------ ------------
Cash down payment received from buyer $ - $ - $ 35,000
============ ============ ============
Issuance of 250,000 shares of common stock
in exchange for note receivable $ - $ - $ 538,900
============ ============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
F-10
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
The Company currently conducts its business in the quick-service restaurant
industry operating 48 Wendy's Old Fashioned Hamburgers restaurants under
franchise agreements with Wendy's International, Inc. All operations of the
Company are located in Michigan.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries, MHG Food Service Inc., OCM Food Service, LLC, and
OCM Development, LLC. Intercompany balances and transactions have been
eliminated in consolidation.
FISCAL PERIOD
The Company has elected a 52/53 week fiscal period for tax and financial
reporting purposes. The fiscal period ends on the Sunday closest to November 30.
The three years in the period ended November 30, 2003 each contained 52 weeks.
USE OF ESTIMATES
The preparation of consolidated financial statements in accordance with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent liabilities at the date
of the financial statements, and the reported amounts of revenues and expenses
during the reporting period. The Company bases its estimates on historical
experience and on various other assumptions believed to be reasonable under the
circumstances, however, actual results could differ from those estimates.
REVENUE RECOGNITION
Revenues consist of restaurant food and beverage sales and are net of applicable
sales taxes. Food and beverage revenue is recognized upon delivery of services.
CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company considers
all highly liquid debt instruments with original maturities of three months or
less to be cash equivalents. The Company had no cash equivalents at November 30,
2003, and cash equivalents were $265,000 at December 1, 2002, consisting
entirely of corporate variable rate put bonds.
RECEIVABLES
Receivables consist primarily of amounts due the Company for gift certificates
sold by the franchisor and other franchisees that have been redeemed at the
Company's restaurants. No allowance for doubtful accounts is deemed necessary.
F-11
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INVENTORIES
Inventories are stated at the lower of cost or market as determined by the
first-in, first-out method. Inventories consist of restaurant food items,
beverages and serving supplies.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. Depreciation is computed
principally using the straight-line method based upon estimated useful lives
ranging from 3 to 15 years for furniture and equipment and up to 30 years for
buildings. Amortization of leasehold improvements is provided over the terms of
the various leases.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company adopted SFAS No. 144, Accounting for the Impairment or Disposal of
Long-lived Assets, as of December 2, 2002. Prior to the adoption of SFAS No.
144, the Company accounted for long-lived assets in accordance with SFAS No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of. SFAS No. 144 provides a single accounting model for
long-lived assets to be disposed of. SFAS No. 144 also changes the criteria for
classifying an asset held for sale, broadens the scope of business to be
disposed of that qualify for reporting as discontinued operations and changes
the timing for recognizing losses on such operations. The adoption of SFAS No.
144 did not have a material effect on the consolidated financial statements.
In accordance with SFAS No. 144, long-lived assets, such as property and
equipment, and purchased intangibles subject to amortization, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to its estimated undiscounted future cash flows expected to be generated by the
asset. If the carrying amount of an asset exceeds its estimated future cash
flows, an impairment charge is recognized by the amount by which the carrying
amount of the asset exceeds the fair value of the asset. Assets to be disposed
of would be separately presented in the consolidated balance sheet and reported
at the lower of carrying amount or fair value less costs to sell, and would no
longer be depreciated. The assets and liabilities of a disposed group classified
as held for sale would be presented separately in the appropriate asset and
liability sections of the consolidated balance sheet. In 2003 and 2002, there
was no impact to the consolidated financial statements due to this impairment
review. In 2001 the Company recorded a gain on the sale of impaired assets of
$463,952. This gain resulted from the sale of two restaurant buildings that were
written down to their estimated fair value in 2000 in accordance with SFAS No.
121.
FRANCHISE AGREEMENT COSTS
Costs capitalized under the Company's franchise agreements are amortized using
the straight-line method over the terms of the individual franchise agreements
including options to renew.
FINANCING COSTS
Financing costs are amortized using the straight-line method, which approximates
the effective interest rate method, over the terms of the various loan
agreements.
F-12
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
GOODWILL
Effective December 2, 2002, the Company adopted Statement of Financial
Accounting ("SFAS") No. 142, Goodwill and Intangible Assets. This statement
changed the accounting for goodwill and other intangible assets, and no longer
requires amortization of goodwill; rather tests for impairment are performed
annually, or more frequently if indicators of impairment occur. In accordance
with the transition provisions of SFAS No. 142, the Company completed the step
one transition test in the first quarter of 2003, which resulted in no
impairment of goodwill. The Company performs its annual impairment test in the
fourth quarter of each fiscal year and in 2003 the test indicated no goodwill
impairment. Prior to the adoption of SFAS No. 142, goodwill was amortized on a
straight-line basis over 30 years. The effect of applying the non-amortization
provisions of SFAS No. 142 for the years ended November 30, 2003, December 1,
2002, and December 2, 2001, are as follows:
2003 2002 2001
---- ---- ----
Reported net earnings $ 740,458 $ 709,307 $ 531,582
Add back goodwill amortization, net of tax - 181,529 181,529
----------- ---------- ------------
Adjusted net earnings $ 740,458 $ 890,836 $ 713,111
=========== ========== ============
Net earnings per share - basic
Reported net earnings $ 0.13 $ 0.13 $ 0.10
Add back goodwill amortization, net of tax - 0.03 0.03
----------- ---------- ------------
Adjusted net earnings per share $ 0.13 $ 0.16 $ 0.13
=========== ========== ============
Net earnings per share - diluted
Reported net earnings $ 0.13 $ 0.12 $ 0.10
Add back goodwill amortization,
net of tax - 0.03 0.03
----------- ---------- ------------
Adjusted net earnings per share $ 0.13 $ 0.15 $ 0.13
=========== ========== ============
The Company has no other intangible assets subject to SFAS No. 142.
SELF-INSURANCE
The Company is self-insured up to a $25,000 per participant stop loss level for
costs associated with benefits paid under employee health care programs. The
Company bases its estimated liability upon historical loss experience provided
by its third party administrator and judgments about the present and expected
levels of claim costs including claims incurred but not reported.
F-13
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
OBLIGATIONS UNDER CAPITAL LEASE
Lease transactions relating to certain restaurant buildings are classified as
capital leases. These assets have been capitalized and the related obligations
recorded based on the present values of the minimum lease payments at the
inception of the leases. Amounts capitalized are being amortized over the terms
of the leases.
STOCK-BASED COMPENSATION
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment to FASB Statement No.
123. This statement amends SFAS No. 123, Accounting for Stock Based
Compensation, to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock based employee
compensation, and requires disclosure in interim financial statements about the
method of accounting for stock based employee compensation and the effect of the
method used on reported results. The Company accounts for its stock based
employee compensation plans under APB Opinion No. 25, Accounting for Stock
Issued to Employees, and does not currently intend to adopt a fair value method
of accounting for stock based employee compensation. As a result, no
compensation costs have been recognized. Had compensation cost for the plans
been determined based on the fair value of the options at the grant dates
consistent with the method of SFAS No. 123, the Company's net earnings and net
earnings per common share would have been as follows for the years ended
November 30, 2003, December 1, 2002, and December 2, 2001:
2003 2002 2001
---- ---- ----
Net earnings as reported $ 740,458 $ 709,307 $ 531,582
Less: Total stock-based employee
compensation expense determined
under fair value based method, net
of tax 587,016 503,617 289,340
----------- ---------- ------------
Pro forma net earnings $ 153,442 $ 205,690 $ 242,242
=========== ========== ============
Net earnings per share - basic
As reported $ 0.13 $ 0.13 $ 0.10
Pro forma $ 0.02 $ 0.03 $ 0.04
Net earnings per share - diluted
As reported $ 0.13 $ 0.12 $ 0.10
Pro forma $ 0.02 $ 0.03 $ 0.04
F-14
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK-BASED COMPENSATION (CONTINUED)
The fair value of each grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions for grants in 2003, 2002 and 2001: dividend yield of 0%; expected
volatility of 71.0% in 2003, 42.5% in 2002, and 40.2% in 2001; risk-free
interest rates ranging from 3.6% - 4.5% in 2003, 5.6% in 2002, and 5.2% -5.6% in
2001; and expected life of ten years.
ADVERTISING COSTS AND OTHER FRANCHISE FEES
Fees due under the Company's franchise agreements and advertising costs are
based primarily on a percentage of monthly food and beverage revenue. These
costs are charged to operations as incurred. Advertising expense was
approximately $1,941,000, $1,838,000 and $1,521,000 for the years ended November
30, 2003, December 1, 2002, and December 2, 2001, respectively.
PRE-OPENING COSTS
Pre-opening costs represent costs incurred prior to a restaurant opening and are
expensed as incurred.
INCOME TAXES
Income taxes are accounted for by using an asset and liability approach.
Deferred tax assets and liabilities are recognized for the expected future tax
consequences of temporary differences between the financial basis and tax basis
of assets and liabilities. Deferred tax assets and liabilities are measured
using enacted tax rates.
F-15
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EARNINGS PER COMMON SHARE
Basic earnings per share is computed by dividing earnings on common shares by
the weighted average number of common shares outstanding during each year.
Diluted earnings per share reflect per share amounts that would have resulted if
dilutive potential common stock had been converted to common stock. The
following table reconciles the numerators and denominators used to calculate
basic and diluted earnings per share for the years ended November 30, 2003,
December 1, 2002, and December 2, 2001:
2003 2002 2001
---- ---- ----
Numerators
Net earnings $ 740,458 $ 709,307 $ 531,582
Less preferred stock dividends 26,568 26,568 26,568
--------------- -------------- ---------------
Net earnings on common shares -
basic and diluted $ 713,890 $ 682,739 $ 505,014
=============== ============== ===============
Denominators
Weighted average common shares
outstanding - basic 5,347,531 5,332,134 5,236,149
Effect of dilutive securities
Stock options 300,721 353,655 50,858
--------------- -------------- ---------------
Weighted average common shares
outstanding - diluted 5,648,252 5,685,789 5,287,007
=============== ============== ===============
For the years ended November 30, 2003, December 1, 2002, and December 2, 2001,
convertible preferred stock was not included in the computation of diluted
earnings per common share because the effect of conversion of preferred stock
would be antidilutive.
Certain exercisable stock options were not included in the computations of
diluted earnings per share for the years ended November 30, 2003, December 1,
2002, and December 2, 2001, because the option prices were greater than the
average market prices for the periods. The number of stock options outstanding
which were not included in the calculation of diluted earnings per share, and
the ranges of exercise prices were 322,730 at $4.95 - $7.00, 207,730 at $5.16 -
$7.00, and 465,080 at $2.35 - $7.00, at November 30, 2003, December 1, 2002, and
December 2, 2001, respectively.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of financial instruments have been determined in
accordance with SFAS No. 107, Disclosures about Fair Value of Financial
Instruments. The Company's financial instruments consist of cash and cash
equivalents, receivables, notes receivable, trade accounts payable and long-term
obligations. The Company's estimate of the fair values of these financial
instruments approximates their carrying value at November 30, 2003, December 1,
2002 and December 2, 2001, except for long-term obligations, which has been
disclosed in Note E.
F-16
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECENTLY ISSUED ACCOUNTING STANDARDS
In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting
and Disclosure Requirements, Including Indirect Guarantees of Indebtedness of
Others. This interpretation changes current practice in accounting for, and
disclosure of, guarantees and requires certain guarantees to be recorded at fair
value on the Company's balance sheet. Interpretation No. 45 also requires a
guarantor to make disclosures even when the likelihood of making payments under
the guarantee is remote. These disclosures were effective immediately and are
included in Note N "Guarantees, Commitments and Contingencies." The initial
recognition and measurement provisions are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002. The Company does not
expect that the implementation of Interpretation No. 45 will have a material
effect on its consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, as revised December 2003 (FIN 46(R)). This new rule
requires that companies consolidate a variable interest entity if the company is
subject to a majority of the risk of loss from the variable interest entity's
activities, or is entitled to receive a majority of the entity's residual
returns, or both. The Company has no special purpose entities, as defined, nor
has it acquired a variable interest in an entity where the Company is the
primary beneficiary since January 31, 2003. The provisions of FIN 46(R)
currently are required to be applied as of the end of the first reporting period
that ends after March 15, 2004 for the variable interest entities in which the
company holds a variable interest that it acquired on or before January 31,
2003. The Company does not expect that the implementation of Interpretation
46(R) will have a material effect on its consolidated financial statements.
Up-front consideration received from vendors linked to future purchases is
initially deferred, and then is recognized as earned vendor allowances as the
purchases occur over the term of the vendor arrangement. In November 2002, the
Emerging Issues Task Force ("EITF") reached a final consensus on EITF 02-16,
Accounting by a Customer (Including a Reseller) for Certain Consideration
Received from a Vendor. EITF 02-16 addresses how a reseller of a vendor's
product should account for cash consideration received from a vendor. The EITF
issued guidance on the following two items: (1) cash consideration received from
a vendor should be recognized as a reduction of cost of sales in the reseller's
income statement, unless the consideration is reimbursement for selling costs or
payment for assets or services delivered to the vendor, and (2)
performance-driven vendor rebates or refunds (e.g., minimum or specified
purchase or sales volumes) should be recognized only if the payment is
considered probable, in which case the method of allocating such payments in the
financial statements should be systematic and rational based on the reseller's
progress in achieving the underlying performance targets. In accordance with
EITF 02-16, the Company began applying item 1 beginning in fiscal 2003. As a
result of applying item 1, reclassifications were made to the consolidated
financial statements to decrease the Cost of Food and Beverages by $512,000 and
$554,000 for the years ended December 1, 2002 and December 2, 2001,
respectively, and Operating Expenses were increased by the same amounts for
those periods. The Company previously applied item 2. Therefore, the provisions
of item 2 had no effect on the Company's consolidated financial statements.
F-17
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECENTLY ISSUED ACCOUNTING STANDARDS (CONTINUED)
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150
modifies the definition of "liabilities" in SFAS No. 6, "Elements of Financial
Statements," to encompass certain obligations that a reporting entity can or
must settle by issuing its own common shares. The Statement affects accounting
for three types of freestanding financial instruments, (i) mandatorily
redeemable shares which an issuing company is obligated to buy back in exchange
for cash or other assets, (ii) put options or forward purchase contracts that do
or may require the issuer to buy back some of its shares in exchange for cash or
other assets, and (iii) obligations that can be settled with shares, the
monetary value of which is fixed, tied solely or predominantly to a variable
such as a market index, or varies inversely with the value of the issuee's
shares. The Statement considers each of these types of instruments as a
liability, as opposed to recent practice that may have classified the instrument
as mezzanine financing or equity, and increases disclosures for alternate
settlement methods. This Statement was effective for the Company beginning May
31, 2003, and adoption of this Statement had no effect on the Company's
consolidated financial statements.
FINANCIAL STATEMENT PRESENTATION
Certain amounts previously reported in the 2002 and 2001 consolidated financial
statements have been reclassified to conform to the presentation used in 2003.
NOTE B - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are summarized as follows at November 30, 2003 and
December 1, 2002:
2003 2002
---------------- ----------------
Land and improvements $ 17,700,289 $ 14,791,974
Buildings and improvements 17,948,013 15,777,169
Furnishings and equipment 11,457,994 10,237,452
Leasehold improvements 1,071,759 1,090,097
Leased property under capital leases 873,100 983,292
Construction in progress 941,184 1,584,649
---------------- ----------------
49,992,339 44,464,633
Less accumulated depreciation and amortization (8,704,462) (6,388,435)
---------------- ----------------
$ 41,287,877 $ 38,076,198
================ ================
Depreciation and amortization expense was approximately $2,926,000, $2,371,000,
and $1,730,000 for the years ended November 30, 2003, December 1, 2002, and
December 2, 2001, respectively.
F-18
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE B - PROPERTY, PLANT AND EQUIPMENT (CONTINUED)
In the ordinary course of business the Company, from time to time, experiences
accelerated depreciation primarily due to the shortening of the estimated useful
lives of assets in connection with major restaurant remodels and upgrades, and
the occasional demolition of an existing restaurant building replaced by a new
building on the same site. Accelerated depreciation related to these activities
included in the depreciation amounts above was approximately $314,000, $159,000,
and $92,000 for the years ended November 30, 2003, December 1, 2002, and
December 2, 2001, respectively.
NOTE C - NOTE RECEIVABLE
Note receivable at November 30, 2003 and December 1, 2002 consisted of a land
contract receivable, collateralized by land and building, requiring monthly
payments of $2,678 including interest at 8.0% from March 2002 through February
2004, when the remaining balance is due. As of November 30, 2003 the debtor was
in default under the terms of the land contract, including non-payment of
required monthly installments. In October 2003 the Company filed a Complaint for
Possession after Land Contract Forfeiture. A judgment of possession was entered
on October 30, 2003. The Company expects to take possession of the property in
January 2004 at which time the asset will be classified as an asset held for
sale. Management believes the property has a market value in excess of the book
value of the note receivable at November 30, 2003.
NOTE D - ACCRUED LIABILITIES
Accrued liabilities consist of the following at November 30, 2003 and December
1, 2002:
2003 2002
------------- -------------
Payroll and related payroll taxes $ 1,056,294 $ 920,511
Property taxes 316,522 452,520
Interest expense 123,547 130,639
Other expenses 469,917 230,170
------------- -------------
$ 1,966,280 $ 1,733,840
============= =============
F-19
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE E - LONG-TERM OBLIGATIONS AND LINES OF CREDIT
For the years ended November 30, 2003 and December 1, 2002, the Company
maintained a $3,500,000 revolving line of credit, requiring monthly payments of
interest only at a variable interest rate equal to 30-day LIBOR plus 2.5%
through December 2003. The average interest rate on these borrowings for 2003
and 2002 was 3.8% and 4.4%, respectively. At November 30, 2003, $362,135 was
outstanding under this line of credit. On December 18, 2003, the Company secured
a $2,600,000 credit facility with a bank comprised of two lines of credit, one
for general working capital purposes in the amount of $600,000, and one for
restaurant development purposes in the amount of $2,000,000. Borrowings under
the working capital and restaurant development lines expire in December 2004 and
December 2005, respectively, and will be charged interest at a rate equal to the
prime rate plus 0.25%. The amount outstanding under the previous line of credit
has been paid off using funds available under the $600,000 working capital line
of credit, and as such, has been included in long-term obligations in the table
below. Long-term obligations and lines of credit consist of the following at
November 30, 2003 and December 1, 2002:
2003 2002
----------- --------------
Lines of credit - requiring monthly payments of interest only. $ 362,135 $ 362,135
Mortgage notes payable - fixed rate, due in monthly installments
totaling $214,232 including fixed interest rates ranging from 6.28% to
8.70% maturing from November 2014 through July 2019. Certain of these
notes are partially guaranteed by an officer of the Company.
23,869,379 24,538,717
Mortgage notes payable - variable rate, due in monthly installments
totaling $53,736 including interest ranging from 30-day LIBOR plus
2.55% (3.67% at November 30, 2003) and the prime rate (4.00% at
November 30, 2003) maturing from February 2008 through November 2013. 8,217,364 3,695,229
Notes payable, due in monthly installments totaling $10,802 including
interest at 8.15% through September 2013. 874,821 930,514
Equipment notes payable - fixed rate, due in monthly installments
totaling $13,717 including interest ranging from 8.02% to 8.39%
maturing from November 2006 through December 2007. 521,708 619,553
Equipment notes payable - variable rate, requiring monthly payments of
principal increasing from $8,566 to $11,407 over the remaining terms of
the notes, plus interest equal to the 30-day commercial paper plus 2.5%
(3.55% at November 30, 2003), maturing from December 2006 through
November 2007. 444,895 544,704
Construction loan payable, with interest accruing at a variable
interest rate equal to 30-day LIBOR plus 2.75% (3.87% at November 30,
2003) until conversion to a permanent mortgage loan; the permanent
mortgage loan will require monthly installments of principal and
interest based on a 20-year amortization and a variable interest rate
equal 30-day LIBOR plus 2.55% at the time of conversion. The loan will
mature 10 years from the time of conversion. 1,215,427 1,187,011
----------- --------------
35,505,729 31,877,863
Less current portion 1,419,028 1,141,281
----------- --------------
$34,086,701 $ 30,736,582
=========== ==============
F-20
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE E - LONG-TERM OBLIGATIONS (CONTINUED)
Substantially all property, plant and equipment owned by the Company is pledged
as collateral for the Company's long-term obligations and lines of credit.
Minimum principal payments on long-term obligations to maturity as of November
30, 2003 are as follows:
2004 $ 1,419,028
2005 1,899,918
2006 1,642,893
2007 1,672,259
2008 2,316,846
Thereafter 26,554,785
----------------
$ 35,505,729
================
Loan covenants of the various loan agreements include requirements for
maintenance of certain financial ratios. At November 30, 2003 the Company was in
compliance with these covenants.
At November 30, 2003, the estimated fair value of the Company's long-term
obligations, including the current portion, was approximately $37,024,000, which
was $1,518,000 greater than the carrying value. The estimated fair value of the
Company's lines of credit and variable rate term loans included in this estimate
approximated the carrying value. The estimated fair value is based on rates
anticipated to be available to the Company for debt with similar terms and
maturities, and requires the use of estimates and market assumptions.
Accordingly, the estimated fair value is not necessarily indicative of amounts
that could be realized in a current market exchange. The use of different
estimates and/or assumptions may have a material effect on the estimated fair
value. Although the Company is not aware of any factors that would significantly
affect the estimated fair value amounts, such amounts have not been revalued for
purposes of these consolidated financial statements since November 30, 2003, and
current estimates of fair value may differ significantly from the amounts
presented.
F-21
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE F - INCOME TAXES
Deferred tax assets and liabilities at November 30, 2003, and December 1, 2002
consist of the following:
2003 2002
---- ----
Deferred tax assets:
Carryforwards, consisting of net
operating losses and AMT credits $ 1,469,000 $ 1,585,000
Unearned vendor allowances 107,000 -
Other 84,000 87,000
-------------- --------------
1,660,000 1,672,000
Deferred tax liabilities:
Depreciation and amortization (480,000) (709,000)
Other (68,000) (45,000)
-------------- --------------
(548,000) (754,000)
Less valuation allowance (418,000) (918,000)
-------------- --------------
Net deferred tax asset $ 694,000 $ -
============== ==============
Net operating loss carryforwards totaling $3,874,000 and $4,549,000 at November
30, 2003 and December 1, 2002, respectively, are available to offset future
taxable income and expire through years ending in 2022.
The Company regularly assesses the realizability of its deferred tax assets and
the related need for, and amount of, a valuation allowance. Management bases
this assessment primarily on the future reversals of existing taxable temporary
differences and future taxable income exclusive of reversing temporary
differences and carryforwards. Upon completion of this assessment in 2003, the
Company reduced its valuation allowance against the net operating loss
carryforwards by $500,000. This reduction was based on a recent taxable income
history that is projected to continue into the foreseeable future. The Company
continues to maintain a valuation allowance due to the uncertainty of the level
of future taxable income related to the development of future O'Charley's
restaurants (see Note N). In 2002 and 2001 the Company maintained a valuation
allowance against the entire balance of net deferred tax assets.
F-22
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE F - INCOME TAXES (CONTINUED)
The income tax provision reconciled to the tax computed at the statutory federal
rate for continuing operations was as follows for the years ended November 30,
2003, December 1, 2002, and December 2, 2001:
2003 2002 2001
---- ---- ----
Tax expense at statutory rates
applied to income before
federal income tax $ 82,000 $ 235,000 $ 186,000
Permanent differences - - 3,000
Other, net (82,000) 146,000 (56,000)
Changes in valuation allowance (500,000) (398,000) (118,000)
------------ ---------- ------------
Income tax (benefit) expense $ (500,000) $ (17,000) $ 15,000
============ ========== ============
NOTE G - LEASE COMMITMENTS
The Company leases land and buildings used in operations under operating
agreements, with remaining lease terms including renewal options ranging from
five to twenty-seven years.
Total lease expense (including taxes, insurance and maintenance when included in
rent) related to all operating leases and all percentage rentals were as follows
for the years ended November 30, 2003, December 1, 2002, and December 2, 2001:
2003 2002 2001
---- ---- ----
Minimum rentals $ 688,644 $ 713,863 $ 758,307
Percentage rentals 173,911 279,211 335,470
----------- ---------- -------------
$ 862,555 $ 993,074 $ 1,093,777
=========== ========== =============
F-23
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE G - LEASE COMMITMENTS (CONTINUED)
Leases for seven restaurant buildings (excluding land which is accounted for as
an operating lease) have been capitalized. Minimum future obligations under
capital leases and noncancellable operating leases in effect are as follows:
CAPITAL OPERATING
YEARS ENDING LEASES LEASES
------------ -------------- ------------
2004 $ 54,685 $ 893,380
2005 - 895,244
2006 - 797,251
2007 - 777,652
2008 - 735,652
Thereafter - 4,384,781
-------------- ------------
Total minimum lease obligations 54,685 $ 8,483,960
============
Less amount representing interest imputed at
approximately 11% 748
--------------
Present value of minimum lease obligations $ 53,937
==============
In addition to minimum future obligations, percentage rentals may be paid under
all restaurant leases on the basis of percentage of sales in excess of minimum
prescribed amounts.
NOTE H - UNEARNED VENDOR ALLOWANCES
The Company has entered into long-term agreements with its beverage suppliers.
The agreements require the Company to purchase 1,948,000 gallons of fountain
beverage syrup from the suppliers over the terms of the agreements. In exchange,
the Company received $4,948,000 in marketing and conversion funds that, in
accordance with the provisions of EITF 02-16 (see Recently Issued Accounting
Standards included in Note A), will be recognized as a reduction to cost of food
and beverages as the gallons of fountain beverage syrup are purchased. At
November 30, 2003 and December 1, 2002, 1,100,000 and 1,264,000 gallons,
respectively, remained to be purchased under the agreements.
F-24
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE I - SERIES A CONVERTIBLE CUMULATIVE PREFERRED STOCK
The Company previously designated a series of non-voting preferred stock. The
shares have an annual dividend rate of $0.90 per share and the payment of the
dividends is cumulative. The shares are convertible into common shares at the
conversion price of $7.00 per share. The shares have a liquidation value of
$10.00 per share.
Under certain conditions relating to the market value of the Company's common
stock, the Company has the option to cause the preferred stock to be converted
into common stock.
NOTE J - EMPLOYEE BENEFIT PLANS
The Company maintains a 401(k) plan that covers substantially all of its
employees. Contributions to the plan may be made by plan participants through
elective salary deductions and by the Company (which are at the Company's
discretion). Contributions to the plan and plan expenses paid by the Company
totaled $5,830, $5,484 and $28,445 for the years ended November 30, 2003,
December 1, 2002, and December 2, 2001, respectively.
NOTE K - RELATED PARTY
An officer of the Company has provided personal guarantees to Wendy's
International to facilitate the granting of Wendy's franchise agreements.
NOTE L - STOCK OPTION PLANS
The 1996 Management Equity Incentive Plan, as amended, authorized 725,000 shares
of common stock to be granted for options that may be issued under the plan. In
May 2002 shareholders approved the 2002 Management Equity Incentive Plan
authorizing 750,000 shares of common stock to be granted for options that may be
issued under this plan. The Compensation Committee of the Board of Directors has
the discretion to designate an option to be an incentive share option or a
non-qualified share option. The Plans provide that the option price is not less
than the fair market value of the common stock at the date of grant. Options
granted under the Plans become exercisable pursuant to a vesting schedule
adopted by the Compensation Committee which administers the Plan. Vesting
schedules for options outstanding range from immediate to five years. Options
granted under the Plans may have a term from one to ten years. For options
outstanding at November 30, 2003, the range of exercise prices was $1.50 per
share to $5.16 per share; the weighted average exercise price was $3.26 per
share; and the weighted average remaining option term was approximately 7.4
years.
The 1996 Directors' Share Option Plan (the "1996 Plan") and the 2001 Directors'
Share Option Plan (the "2001 Plan") provide for the non-discretionary grant of
options to non-employee directors of the Company. The 1996 Plan terminated
pursuant to its terms in 2001. However options granted under the 1996 Plan
remain valid for the period of the respective option grants. The 2001 Plan,
which became effective in May 2001, allows for the grant of additional options
for a maximum of 120,000 shares. The 2001 Plan provides that the option price is
the last closing sales price of the common stock on the date of grant. The 2001
Plan provides that each non-employee director, on the date such person becomes a
non-employee director, will be granted options to purchase 5,000 shares of
common stock. Provided that
F-25
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE L - STOCK OPTION PLANS (CONTINUED)
such person is still serving as a non-employee director, they will automatically
be granted options to purchase 1,000 additional shares each year thereafter on
the date of the Annual Shareholders' Meeting and may, from time to time, be
granted additional options on such terms and conditions as adopted by the
Compensation Committee that administers the Plan. Options granted under the 2001
Plan have a term of ten years and vest immediately. For options outstanding
under both plans at November 30, 2003, the range of exercise prices was $1.38
per share to $7.00 per share; the weighted average exercise price was $5.02 per
share; and the weighted average remaining option term was approximately 4.5
years.
The following table summarizes the changes in the number of common shares under
stock options granted pursuant to the preceding plans:
1996 AND 2002 MANAGEMENT 1996 AND 2001 DIRECTORS'
EQUITY INCENTIVE PLAN SHARE OPTION PLANS
------------------------------ ----------------------------
AVERAGE OPTION AVERAGE OPTION
SHARES UNDER PRICE SHARES UNDER PRICE
OPTION PER SHARE OPTION PER SHARE
------------ -------------- ------------ --------------
Outstanding at
December 1, 2000 436,739 $ 4.10 79,000 $ 5.51
Granted 430,000 $ 2.18 5,000 $ 2.17
Exercised (8,471) $ 1.69 - -
Forfeited (269,293) $ 5.70 (10,000) $ 6.63
--------- -----------
Outstanding at
December 2, 2001 588,975 $ 2.30 74,000 $ 4.76
Granted 256,280 $ 4.63 5,000 $ 5.16
Exercised (7,500) $ 3.03 (9,000) $ 2.15
Forfeited (22,500) $ 3.03 - -
--------- -----------
Outstanding at
December 1, 2002 815,255 $ 3.01 70,000 $ 5.12
Granted 115,000 $ 4.95 9,000 $ 4.23
Exercised (11,250) $ 2.05 - -
--------- -----------
Outstanding at
November 30, 2003 919,005 $ 3.26 79,000 $ 5.02
========= ===========
Exercisable at:
December 2, 2001 235,339 $ 2.41 74,000 $ 4.76
========= ===========
December 1, 2002 428,215 $ 2.82 70,000 $ 5.12
========= ===========
November 30, 2003 621,064 $ 3.02 79,000 $ 5.02
========= ===========
Available for grant at:
December 2, 2001 127,554 115,000
========= ===========
December 1, 2002 643,774 110,000
========= ===========
November 30, 2003 528,774 101,000
========= ===========
F-26
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE M - GUARANTEES, COMMITMENTS AND CONTINGENCIES
The Company is a 19% owner of a real estate investment company that is the
landlord of one of the Company's restaurants. As a 19% owner, the Company
guaranteed 19% of the total loan balance of approximately $2.8 million. This
mortgage loan was used to finance the acquisition and development of the real
estate and matures in July 2008. In the event of a default under the terms of
the mortgage, the Company would have to perform its obligations under the
guaranty. As of November 30, 2003 the Company does not foresee a default under
the mortgage loan and therefore, no liability has been recorded.
In February 2002, the Company guaranteed the indebtedness of its CEO to a bank
in the amount of $538,900 in connection with the CEO's purchase of 250,000
shares of the Company's common stock. The 250,000 shares of stock secure the
bank loan. Under the terms of an indemnification agreement between the Company
and the CEO, in the event that the Company becomes liable for this indebtedness,
the Company would be subrogated to the bank's rights and remedies. The
indemnification agreement also provides that, if at any time during the term of
the agreement the Company's stock price closes below $3.00 per share for two
consecutive trading days, the Company may order the CEO to repay the outstanding
balance on the CEO's bank loan. If the CEO fails to pay off the bank loan, the
Company has the right to pay off the CEO's bank loan and take possession of the
250,000 shares securing the bank debt. In such event, the CEO agrees to pay any
costs incurred by the Company in acquiring free and clear possession of the
stock.
As of November 30, 2003, the Company has forward commitments totaling
approximately $4,800,000 to finance the land and building for four additional
Wendy's restaurants. The commitments are for 10-year real estate mortgages
(20-year amortization) at variable interest rates equal to 2.55% over the 30-day
LIBOR, or fixed interest rates equal to 2.61% over the then current 10- year
U.S. Dollar Interest Rate Swaps.
In addition to the guarantees described above, the Company is party to several
agreements executed in the ordinary course of business that provide for
indemnification of third parties under specified circumstances. Generally, these
agreements obligate the Company to indemnify the third parties only if certain
events occur or claims are made, as these contingent events or claims are
defined in each of these agreements. The Company is not currently aware of
circumstances that would require it to perform its indemnification obligations
under any of these agreements.
The Company is involved in certain routine legal proceedings which are
incidental to its business. All of these proceedings arose in the ordinary
course of the Company's business and, in the opinion of the Company, any
potential liability of the Company with respect to these legal actions will not,
in the aggregate, be material to the Company's consolidated financial
statements. The Company maintains various types of insurance standard to the
industry which would cover most actions brought against the Company.
As of November 30, 2003, the Company has capital expenditure commitments
outstanding related to a new restaurant totaling approximately $1,250,000.
F-27
MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
YEARS ENDED NOVEMBER 30, 2003, DECEMBER 1, 2002, AND DECEMBER 2, 2001
NOTE N - SUBSEQUENT EVENT
In December 2003, the Company completed a $7,500,000 private equity offering,
primarily to be used for the development of O'Charley's restaurants in
accordance with the terms of a franchise development agreement. The offering
included the issuance of 416,666 Units for $2,500,000. Each unit consisted of
(i) one share of the Company's Common Stock, (ii) 0.5 Class A Warrant to
purchase one Common Share at a price of $6.00 per share expiring six years from
the date of issuance, and (iii) 0.5 Class B Warrant to purchase one Common Share
at a price of $9.00 per share expiring nine years from the date of issuance. The
offering also included the issuance of 500,000 shares of the Company's Series B
Preferred Stock for $5,000,000. The preferred shares have an annual dividend
rate of $0.80 per share and the payment of the dividends is cumulative. One year
from the issuance date the preferred shares become convertible into common
shares at the conversion price of $5.57 per share based on a liquidation value
of $10.00 per share. After two years from the issuance date the Company may (but
is not required to) redeem the preferred shares at a price of $11.00 per share
and at any time after three years from the issuance date the preferred shares
may be redeemed at a price of $10.00 per share. Under an agreement dated
December 19, 2003, $2,450,980 of the proceeds raised will be used by the Company
to purchase 500,200 common shares from a retiring executive of the Company by
January 9, 2004. After the purchase of these shares and the payment of costs
associated with the private equity offering, stockholders' equity will increase
by approximately $4,800,000.
NOTE O - QUARTERLY FINANCIAL DATA (UNAUDITED)
Year ended November 30, 2003 First Quarter Second Quarter Third Quarter Fourth Quarter
---------------------------- ------------- -------------- ------------- --------------
Food and beverage revenue $ 10,611,962 $ 11,859,991 $ 13,168,844 $ 12,872,659
Cost of food and beverages 2,543,408 2,935,173 3,354,705 3,438,764
Operating expenses 6,746,724 7,044,553 7,505,410 7,310,055
Net earnings (loss) (502,967) 549,361 268,665 425,399
Basic earnings (loss)
per common share (0.10) 0.10 0.05 0.08
Diluted earnings (loss)
per common share (0.10) 0.10 0.05 0.08
Year ended December 1, 2002 First Quarter Second Quarter Third Quarter Fourth Quarter
--------------------------- ------------- -------------- ------------- --------------
Food and beverage revenue $ 10,437,712 $ 11,694,052 $ 12,427,270 $ 11,393,956
Cost of food and beverages 2,596,091 2,856,715 3,013,978 2,716,788
Operating expenses 6,238,786 6,686,715 7,128,753 6,806,206
Net earnings (loss) (137,939) 251,340 442,897 153,009
Basic earnings (loss)
per common share (0.03) 0.05 0.08 0.03
Diluted earnings (loss)
per common share (0.03) 0.04 0.08 0.03
F-28