- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 1999
Commission File Number: 0-27008
SCHLOTZSKY'S, INC.
(Exact name of registrant as specified in its charter)
Texas 74-2654208
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
203 Colorado Street
Austin, Texas 78701
(address of principal executive offices)
(512) 236-3600
(Registrant's telephone number)
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 the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
Class Shares Outstanding at August 1, 1999
Common Stock, no par value 7,417,714
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
INDEX
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets --
June 30, 1999 and December 31, 1998 2
Consolidated Statements of
Income - Three and Six Months Ended
June 30, 1999 and June 30, 1998 3
Consolidated Statement of
Stockholders' Equity - Six Months Ended
June 30, 1999 and the year ended December 31, 1998 4
Condensed Consolidated Statements of
Cash Flows - Six Months Ended
June 30, 1999 and June 30, 1998 5
Notes to Consolidated
Financial Statements 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 8
Item 3 Quantitative and Qualitative Disclosures About
Market Risk 14
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 2. Changes in Securities 15
Item 3. Defaults Upon Senior Securities 15
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 16
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
JUNE 30, DECEMBER 31,
1999 1998
---------------- -----------------
Assets
Current assets:
Cash and cash equivalents............................................. $ 3,044,789 $ 15,384,991
Temporary cash investments............................................ 18,000 1,439,077
Royalties receivable.................................................. 1,347,116 762,141
Turnkey notes and other receivables, current portion.................. 10,668,497 14,556,424
Other receivables..................................................... 4,582,955 3,086,065
Prepaid expenses and other assets..................................... 806,033 572,996
Turnkey Program development........................................... 10,066,812 5,924,562
Notes receivable, current portion..................................... 8,170,841 4,246,574
---------------- -----------------
Total current assets.............................................. 38,705,043 45,972,830
Property, equipment and leasehold improvements, net........................ 20,840,777 18,529,746
Real estate and restaurants held for sale.................................. 10,240,253 9,215,485
Notes receivable, less current portion..................................... 11,459,129 6,875,915
Notes receivable from related parties, less current portion................ 2,804,155 2,609,775
Turnkey notes and other receivables, less current portion.................. 1,327,092 2,185,429
Intangible assets, net..................................................... 34,001,540 16,815,059
Other noncurrent assets.................................................... 1,260,448 2,023,901
---------------- -----------------
Total assets...................................................... $120,638,437 $104,228,140
---------------- -----------------
---------------- -----------------
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable-trade................................................ $ 3,798,455 $ 4,752,369
Current maturities of long-term debt.................................. 15,679,820 5,382,585
Accrued liabilities................................................... 2,757,310 9,613,593
---------------- -----------------
Total current liabilities......................................... 22,235,585 19,748,547
Deferred revenue, net................................................. 1,538,101 1,298,486
Long-term debt, less current maturities............................... 19,784,559 9,218,515
---------------- -----------------
Total liabilities................................................. 43,558,245 30,265,548
Commitments and contingencies
Stockholders' equity:
Preferred stock:
Class C--no par value; authorized--1,000,000 shares; issued--none. - -
Common stock, no par value, 30,000,000 shares authorized, 7,412,538
and 7,401,942 issued at June 30, 1999 and December 31, 1998,
respectively...................................................... 62,983 62,877
Additional paid-in capital............................................ 57,624,534 57,533,997
Retained earnings..................................................... 19,497,675 16,470,718
Treasury stock (10,000 shares) ....................................... (105,000) (105,000)
---------------- -----------------
Total stockholders' equity........................................ 77,080,192 73,962,592
---------------- -----------------
Total liabilities and stockholders' equity........................ $120,638,437 $104,228,140
---------------- ----------------
---------------- ----------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS.
2
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
------------------------------ -------------------------------
JUNE 30, JUNE 30, JUNE 30, JUNE 30,
1999 1998 1999 1998
-------------- ------------ -------------- --------------
Revenues
Royalties.................................. $ 5,559,690 $ 4,719,538 $10,573,957 $ 8,978,556
Franchise fees............................. 193,333 380,000 438,333 720,000
Developer fees............................. 1,361,545 - 1,953,770 -
Restaurant sales........................... 3,838,564 1,884,651 6,381,611 3,500,908
Brand contribution......................... 1,601,513 1,005,571 2,802,580 1,865,887
Turnkey program development................ 159,997 1,732,462 830,045 2,857,479
Other fees and revenue..................... 318,314 590,803 614,741 844,487
-------------- ------------ -------------- --------------
Total revenues....................... 13,032,956 10,313,025 23,595,037 18,767,317
Expenses
Service costs:
Royalties................................ 1,738,842 1,799,891 3,530,363 3,420,513
Franchise fees........................... 92,500 203,250 220,500 374,500
Restaurant operations:
Cost of sales............................ 1,126,487 600,974 1,895,057 1,135,326
Labor cost............................... 1,453,553 761,532 2,447,827 1,516,418
Operating expenses....................... 844,442 542,963 1,470,643 1,042,786
Turnkey development costs.................. 975,421 917,541 2,011,990 1,328,989
General and administrative................. 3,676,296 2,942,771 6,532,596 5,447,024
Depreciation and amortization.............. 702,753 447,573 1,288,020 763,389
-------------- ------------ -------------- --------------
Total expenses....................... 10,610,294 8,216,495 19,396,996 15,028,945
-------------- ------------ -------------- --------------
Income from operations............... 2,422,662 2,096,530 4,198,041 3,738,372
Other
Interest income............................ 719,024 462,243 1,483,434 1,027,874
Interest expense........................... (570,686) (45,006) (876,782) (106,356)
-------------- ------------ -------------- --------------
Income before income taxes........... 2,571,000 2,513,767 4,804,693 4,659,890
Provision for income taxes................... 948,053 943,246 1,777,736 1,747,256
-------------- ------------ -------------- --------------
Net income........................... $ 1,622,947 $ 1,570,521 $ 3,026,957 $ 2,912,634
-------------- ------------ -------------- --------------
-------------- ------------ -------------- --------------
Income per common share - basic:
Net income........................... $0.22 $0.21 $0.41 $0.40
-------------- ------------ -------------- --------------
-------------- ------------ -------------- --------------
Weighted average shares outstanding........ 7,402,147 7,389,977 7,401,749 7,358,065
-------------- ------------ -------------- --------------
-------------- ------------ -------------- --------------
Income per common share - diluted:
Net income........................... $0.22 $0.21 $0.40 $0.38
-------------- ------------ -------------- --------------
-------------- ------------ -------------- --------------
Weighted average shares outstanding........ 7,500,782 7,605,953 7,507,653 7,602,320
-------------- ------------ -------------- --------------
-------------- ------------ -------------- --------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS.
3
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(UNAUDITED)
Common Stock
---------------------------------
Stated Additional Total
Number of Capital Paid-In Retained Treasury Stockholders'
Shares Amount Capital Earnings Stock Equity
---------------- -------------- -------------- ------------- ------------ ---------------
Balance, January 1, 1998................. 7,334,416 $ 62,202 $56,664,104 $10,264,253 $ - $66,990,559
Options exercised........................ 44,089 441 399,175 - - 399,616
Warrants exercised....................... 23,437 234 224,761 - - 224,995
Treasury stock purchase (10,000 shares).. - - - - (105,000) (105,000)
Tax benefit from employee stock
transaction.............................. - - 245,957 - - 245,957
Net income............................... - - - 6,206,465 - 6,206,465
---------------- -------------- -------------- ------------- ------------ ---------------
Balance, December 31, 1998............... 7,401,942 62,877 57,533,997 16,470,718 (105,000) 73,962,592
Options exercised........................ 10,596 106 90,537 - - 90,643
Net income............................... - - - 3,026,957 - 3,026,957
---------------- -------------- -------------- ------------- ------------ ---------------
Balance, June 30, 1999................... 7,412,538 $ 62,983 $57,624,534 $19,497,675 $(105,000) $77,080,192
---------------- -------------- -------------- ------------- ------------ ---------------
---------------- -------------- -------------- ------------- ------------ ---------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS.
4
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
------------------------------------
JUNE 30, JUNE 30,
1999 1998
---------------- ---------------
Net cash used in operating activities............................................. $ (11,818,987) $ (7,254,739)
Cash flows from investing activities:
Advances on notes receivable (less payments) .................................. (3,501,622) (6,783,293)
Acquisition of intangibles..................................................... (17,553,149) (185,934)
Purchase of property, equipment and leasehold improvements..................... (2,730,742) (2,218,664)
Sale (purchase) of temporary investments....................................... 1,421,077 (1,417,906)
Other.......................................................................... 900,953 (173,412)
---------------- ---------------
Net cash used in investing activities............................................. (21,463,483) (10,779,209)
Cash flows from financing activities:
Net proceeds from issuance of debt............................................. 26,241,654 -
Principal payments on debt..................................................... (5,390,028) (23,885)
Proceeds from exercises of options and warrants................................ 90,643 524,603
---------------- ---------------
Net cash provided by financing activities......................................... 20,942,269 500,718
---------------- ---------------
Net decrease in cash and cash equivalents......................................... (12,340,202) (17,533,230)
Cash and cash equivalents at beginning of period.................................. 15,384,991 31,254,048
---------------- ---------------
Cash and cash equivalents at end of period........................................ $ 3,044,789 $ 13,720,818
---------------- ---------------
---------------- ---------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS.
5
SCHLOTZSKY'S, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
June 30, 1999
NOTE 1. -- BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management,
all adjustments, consisting of normal recurring accruals, considered
necessary for a fair presentation have been included. Operating results for
the six months ended June 30, 1999, are not necessarily indicative of the
results that may be expected for the year ended December 31, 1999. This
information should be read in connection with the consolidated financial
statements and footnotes thereto incorporated by reference in the
Schlotzsky's, Inc. Annual Report on Form 10-K for the year ended December 31,
1998, as amended.
NOTE 2. - EARNINGS PER SHARE
Basic and diluted EPS computations for the three and six months ended
June 30, 1999 and 1998 are as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
--------------------------- ---------------------------
JUNE 30, JUNE 30, JUNE 30, JUNE 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
BASIC EPS
Net income ......................................... $ 1,622,947 $ 1,570,521 $ 3,026,957 $ 2,912,634
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Weighted average common shares outstanding.......... 7,402,147 7,389,977 7,401,749 7,358,065
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Basic EPS........................................... $0.22 $0.21 $0.41 $0.40
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
DILUTED EPS
Net income ......................................... $ 1,622,947 $ 1,570,521 $ 3,026,957 $ 2,912,634
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Weighted average common shares outstanding.......... 7,402,147 7,389,977 7,401,749 7,358,065
Assumed conversion of common shares issuable
under stock option plan and exercise of warrants.. 98,635 215,976 105,904 244,255
------------- ------------- ------------- -------------
Weighted average common shares outstanding
-assuming dilution................................ 7,500,782 7,605,953 7,507,653 7,602,320
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Diluted EPS......................................... $0.22 $0.21 $0.40 $0.38
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Outstanding options that were not included in the diluted calculation because
their effect would be anti-dilutive total 612,125 and 535,000 for the three
months ended June 30, 1999 and June 30, 1998, respectively, and 613,125 and
535,000 for the six months ended June 30, 1999 and June 30, 1998,
respectively.
6
NOTE 3. - SEGMENTS
The Company and its subsidiaries are principally engaged in franchising
quick service restaurants that feature made-to-order sandwiches with unique
sourdough buns, pizzas and salads. At June 30, 1999 the Schlotzsky's system
included Company owned and franchised stores in 38 states, the District of
Columbia and 14 foreign countries.
The Company identifies segments based on management responsibility within
the corporate structure. The Turnkey Development segment includes the
development of freestanding stores with high visibility and easy access. The
Restaurant Operations includes the operation of a limited number of
Company-owned restaurants for the purpose of product development, concept
refinement, prototype testing and training and to build brand awareness. The
Franchise Operations segment of the business encompasses both the Company's
restaurant concept and licensed private label products. The Company measures
segment profit as operating profit, which is defined as income before
interest and income taxes. Segment information and a reconciliation to
income, before interest and income taxes are as follows:
TURNKEY RESTAURANT FRANCHISE
THREE MONTHS ENDED JUNE 30, 1999 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- -------------------------------------------------- ----------- ------------ ------------ --------------
Revenue from external customers $ 159,997 $ 3,838,564 $ 9,034,395 $ 13,032,956
Operating income (loss) (901,074) 187,014 3,136,722 2,422,662
Total assets $41,396,281 $26,544,299 $52,697,857 $120,638,437
TURNKEY RESTAURANT FRANCHISE
THREE MONTHS ENDED JUNE 30, 1998 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- -------------------------------------------------- ----------- ------------ ------------ --------------
Revenue from external customers $ 1,732,462 $ 1,884,651 $ 6,695,912 $ 10,313,025
Operating income (loss) 713,556 (179,379) 1,562,353 2,096,530
Total assets $31,367,811 $10,293,607 $37,095,058 $ 78,756,476
TURNKEY RESTAURANT FRANCHISE
SIX MONTHS ENDED JUNE 30, 1999 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- -------------------------------------------------- ----------- ------------ ------------ --------------
Revenue from external customers $ 830,045 $ 6,381,611 $16,383,381 $ 23,595,037
Operating income (loss) (1,379,564) 172,154 5,405,451 4,198,041
Total assets $41,396,281 $26,544,299 $52,697,857 $120,638,437
TURNKEY RESTAURANT FRANCHISE
SIX MONTHS ENDED JUNE 30, 1998 DEVELOPMENT OPERATIONS OPERATIONS CONSOLIDATED
- ------------------------------------------------- ----------- ------------ ------------ --------------
Revenue from external customers $ 2,857,479 $ 3,500,908 $12,408,930 $ 18,767,317
Operating income (loss) 1,400,237 (466,933) 2,805,068 3,738,372
Total assets $ 31,367,811 $10,293,607 $37,095,058 $ 78,756,476
7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 1999, COMPARED TO THREE MONTHS ENDED JUNE 30, 1998
REVENUES. Total revenues increased 26.4% from $10,313,000 to
$13,033,000.
Royalties increased 17.8% from $4,720,000 to $5,560,000. This
increase was due to the opening of 81 restaurants during the period from July
1, 1998 to June 30, 1999. Also driving the increase was the growing influence
of larger freestanding units, particularly the prototype units, which are the
focus of the new unit development. Furthermore, average weekly sales
increased 9.2% and same store sales increased 2.8% during the second quarter
of 1999. The Company believes its average weekly sales and same store sales
were positively impacted by the launch of its first network television
advertising campaign and the introduction of "Deli Deals-TM-", in-store menu
board offerings of a sandwich or pizza, chips and a drink for one price.
Franchise fees decreased 49.2% from $380,000 to $193,000. This
decrease was principally a result of 13 fewer store openings during the
three-month period ended June 30, 1999. The fewer number of openings is
principally the result of the Company's increasing emphasis on superior site
selection for larger freestanding stores with higher visibility and on more
highly qualified franchisees.
Developer fees increased from $0 to $1,362,000. This increase was
attributable to the sale of limited development rights to two domestic
territories during the three months ended June 30, 1999. The rights sold
entitle the developers to 1.25% out of the 6.0% royalties payable to the
Company on sales from restaurants in those territories. In return, the
developers have certain franchisee support responsibilities in the
territories.
Restaurant sales increased 103.7% from $1,885,000 to $3,839,000.
This increase was principally attributable to the addition of seven more
Company-owned units being operated in this quarter than in the corresponding
quarter of the previous year.
Private label licensing fees (brand contributions), increased 59.2%
from $1,006,000 to $1,602,000. This increase was principally the result of
more favorable terms with certain major suppliers, as well as the increasing
volume of system-wide sales and greater franchisee participation in the
Company's purchasing programs. The Company expects additional products may be
added to its private label program and alternative retail channels of
distribution of its products may be pursued, resulting in the potential for
further increases in licensing fees.
Turnkey development revenue decreased 90.8% from $1,732,000 to $160,000.
This decrease was primarily attributable to fewer transactions in the current
period compared to the second quarter of 1998. The Company has indicated that
it intends to transition away from an emphasis on Turnkey transactional
revenue during 1999.
Other fees and revenues decreased 46.2% from $591,000 to $318,000,
primarily as a result of recognition of revenue from expired licensing
contracts that were recognized in the second quarter of 1998, but which did
not recur in 1999. Additionally, other fees in 1998 included a higher level
of revenue from operating assistance agreements with certain licensees.
8
The following table reflects the growth of the franchise system for
the three months ended June 30, 1999 and 1998. The growth of the system
during 1998 and 1999 to date was principally responsible for the increased
revenue as discussed above. In 1999, restaurant closings in the system
increased principally as a result of greater emphasis on quality, service,
cleanliness and compliance audits instituted in connection with the Company's
initial network advertising campaign, and the permanent removal of
temporarily closed stores where the franchisee had not recently been actively
pursuing a new location.
SYSTEM PERFORMANCE THREE MONTHS ENDED
-------------------------------------
JUNE 30, JUNE 30,
1999 1998
----------------- ------------------
Units Opened
Domestic
Freestanding 11 25
End Cap 3 2
Other 2 3
----------------- ------------------
Total Domestic Openings 16 30
International 2 1
----------------- ------------------
Total Openings 18 31
Units Closed (15) (7)
----------------- ------------------
Net Unit Growth 3 24
----------------- ------------------
----------------- ------------------
System-wide Sales (in thousands) $ 102,451 $ 86,737
Average Weekly Sales $ 10,814 $ 9,900
Increase in Average Weekly Sales 9.2% 13.1%
Stores in Operation 758 722
Increase in Same Store Sales 2.8% 3.9%
COSTS AND EXPENSES. Royalty service costs decreased 3.4% from
$1,800,000 to $1,739,000. In addition, royalty service costs as a percentage
of royalties declined from 38.1% to 31.3%. These decreases reflected the
Company's reacquisition and buy-down of rights to a limited number of area
developer territories during 1999 and at the end of 1998. Area developers
receive approximately 42% or 21% of the royalties from stores in their
territories (depending on whether their share of royalties is 2.5% or 1.25%).
The Company expects developer service costs as a percentage of royalty
revenue to continue to decrease as the Company plans to buy-down the rights
and obligations of several more of its area developers and may re-acquire the
full development rights to a limited number of territories.
Franchise fee costs decreased 54.2% from $203,000 to $93,000,
principally as a result of 13 fewer store openings during the three-month
period ended June 30, 1999. The fewer number of openings is mainly the result
of the Company's increasing emphasis on superior site selection for larger
freestanding stores with higher visibility and on more highly qualified
franchisees.
Restaurant cost of sales, which consists of food, beverage and paper
costs, increased 87.4% from $601,000 to $1,126,000, but as a percentage of
restaurant sales decreased from 31.9% to 29.3%. Likewise, restaurant labor
costs increased 90.8% from $762,000 to $1,454,000, but as a percentage of
restaurant sales decreased from 40.4% to 37.9% compared to the same quarter
in 1998. Restaurant operating expenses increased 55.4% from $543,000 to
$844,000, but as a percentage of restaurant sales decreased from 28.8% to
22.0% for the three months ended June 30, 1999, as compared to the
corresponding period in 1998. The decreases in restaurant operations
expenses, as a percentage of restaurant sales during the current quarter of
1999 as compared to the prior period, were primarily attributable to lower
opening and preopening costs associated with fewer new store openings this
year.
Turnkey development costs increased 6.2% from $918,000 to $975,000
and as a percentage of Turnkey development revenue increased from 53.0% to
609.4%. This increase as a percentage of sales was primarily the result of
fewer revenue transactions in the current period compared to the second
quarter of 1998.
9
General and administrative expenses grew 24.9% from $2,943,000 to
$3,676,000, but as a percentage of total revenues decreased from 28.5% to
28.2%. The percentage decrease was primarily the result of the lessening pace
of additions to the corporate staff since the prior period and the fact that
revenue was increasing at a faster pace than costs. General and
administrative costs in the second quarter of 1999 included approximately
$181,000 of nonrecurring costs associated with the termination of two area
developer contracts.
Depreciation and amortization increased 55.6% from $448,000 to
$703,000, and as a percentage of total revenues increased from 4.3% to 5.4%.
The increases were principally due to the amortization of area development
territories, goodwill and other intangibles acquired during 1998 and the six
months ended June 30, 1999. In addition, depreciation increased as a result
of the seven additional stores the Company was operating in this period as
compared to the same period in the prior year.
Interest income increased 55.6% from $462,000 to $719,000. This
increase was a result of a greater level of funds outstanding in the form of
Turnkey mortgages and interim construction financing under the Turnkey
Program and an increase in notes receivables related to the sale of limited
development rights.
Interest expense increased from $45,000 to $571,000. This increase was a
result of a greater level of debt outstanding during the current period. The
Company expects interest expense may continue to trend upward as additional
debt financing may be used to fund construction of Company-owned stores,
acquisition of additional Turnkey program properties and reacquisition of
certain area developer rights.
INCOME TAX EXPENSE. Income tax expense reflected a combined federal
and state effective tax rate of 36.9% for the three months ended June 30,
1999, which was slightly lower than the effective combined tax rate of 37.5%
for the comparable period in 1998. Based on projections of taxable income,
the Company anticipates that its effective combined rate for federal and
state taxes will be approximately 37.0% for 1999.
SIX MONTHS ENDED JUNE 30, 1999, COMPARED TO SIX MONTHS ENDED JUNE 30, 1998
REVENUES. Total revenues increased 25.7% from $18,767,000 to
$23,595,000.
Royalties increased 17.8% from $8,979,000 to $10,574,000. This
increase was due to the opening of 81 stores during the period from July 1,
1998 to June 30, 1999. Also driving the increase was the growing influence of
larger freestanding units, particularly the prototype units, which are the
focus of the new unit development. Furthermore, average weekly sales
increased 8.4% and same store sales increased 1.7% during the six months
ended June 30, 1999. Royalties were only slightly impacted by 45 closings
since the end of the prior period. Many of those stores were underperforming
or had been temporarily closed prior to the Company's determination to treat
them as permanently closed.
Franchise fees decreased 39.2% from $720,000 to $438,000. This
decrease was principally a result of 26 fewer store openings during the
six-month period ended June 30, 1999. The fewer number of openings is chiefly
the result of the Company's increasing emphasis on superior site selection
for larger freestanding stores with higher visibility and on more highly
qualified franchisees.
Developer fees increased from $0 to $1,954,000. The increase was
attributable to the sale of certain limited development rights to five
domestic territories during the six months ended June 30, 1999. The rights
sold entitle the developers to a 1.25% share of the sales from restaurants in
those territories. In return, the developers have certain franchisee support
responsibilities in those territories.
Restaurant sales increased 82.3% from $3,501,000 to $6,382,000. This
increase was principally attributable to the acquisition of five stores from
franchisees, the opening of two new corporate stores, and a 9.7% increase in
same store sales for stores that were open the entirety of both six month
periods. The increase in same store sales is mainly attributable to the
rollout of national advertising and to the introduction of "Deli Deals-TM-"
Private label licensing fees (brand contributions), increased 50.2%
from $1,866,000 to $2,803,000. The increase was mainly the result of the
increasing volume of system-wide sales which generated more purchases of
private label products, and greater franchisee participation in the Company's
purchasing programs.
10
Turnkey development revenue decreased 70.9% from $2,857,000 to $830,000.
As the Company has emphasized higher quality sites and more qualified
franchisees, fewer transactions with lower margins have been completed during
the first six months in 1999. The Company remains committed to providing its
franchisees the opportunity for ownership of these sites, where practicable,
and has indicated that it intends to transition away from an emphasis on
Turnkey transactional revenue during 1999.
Other fees and revenues decreased 27.1% from $844,000 to $615,000,
primarily as a result of recognition of revenue from expired licensing
contracts that were recognized during the second quarter of 1998.
Additionally, other fees in 1998 included revenue from operating assistance
agreements with certain licensees that did not reoccur in 1999.
The following table reflects the growth of the franchise system for
the six months ended June 30, 1999 and 1998. The growth of the system during
1998 and 1999 to date was principally responsible for the increased revenue
as discussed above.
SYSTEM PERFORMANCE SIX MONTHS ENDED
-------------------------------------
JUNE 30, JUNE 30,
1999 1998
----------------- ------------------
Units Opened
Domestic
Freestanding 26 44
End Cap 5 10
Other 2 4
----------------- ------------------
Total Domestic Openings 33 58
International 2 3
----------------- ------------------
Total Openings 35 61
Units Closed (27) (12)
----------------- ------------------
Net Unit Growth 8 49
----------------- ------------------
----------------- ------------------
System-wide Sales (in thousands) $194,679 $164,781
Average Weekly Sales $ 10,371 $ 9,568
Increase in Average Weekly Sales 8.4% 12.7%
Stores in Operation 758 722
Increase in Same Store Sales 1.7% 5.2%
COSTS AND EXPENSES. Royalty service costs increased 3.2% from
$3,421,000 to $3,530,000. This increase was a result of the increase in
royalty revenue for the six months ended June 30, 1999, as compared to the
same period in the prior year. However, royalty service costs as a percentage
of royalties decreased from 38.1% to 33.4%. This decrease reflected the
reacquisition and buy-down of rights to a limited number of territories
during the period and at the end of 1998. Area developers typically receive
approximately 42% of the royalties from stores in their territories unless
the Company has bought down a portion of their development rights and
obligations, in which case they receive approximately 21% of the royalties.
Franchise fee costs decreased 41.1% from $375,000 to $221,000,
principally as a result of 26 fewer store openings during the six-month
period ended June 30, 1999. The fewer number of openings is chiefly the
result of the Company's increasing emphasis on superior site selection for
larger freestanding stores with higher visibility and on more highly
qualified franchisees.
Restaurant cost of sales, which consists of food, beverage and paper
costs, increased 67.0% from $1,135,000 to $1,895,000, but as a percentage of
restaurant sales decreased from 32.4% to 29.7%. Likewise, restaurant labor
costs increased 61.5% from $1,516,000 to $2,448,000, but as a percentage of
restaurant sales decreased from 43.3% to 38.4% compared to the same period in
1998. Restaurant operating expenses increased 41.0% from $1,043,000 to
$1,471,000, but as a percentage of restaurant sales decreased from 29.8% to
23.0% for the six months ended June 30, 1999, as compared to the
corresponding period in 1998. These percentage decreases in restaurant
operating expenses were primarily attributable to improved operating
efficiencies related to the Company-owned restaurants operated during the six
months ended June 30, 1999. In addition, the six month period ending June 30,
1998 included two new store openings which typically have certain
nonrecurring preopening and opening costs.
11
Turnkey development costs increased 51.4% from $1,329,000 to
$2,012,000 and as a percentage of Turnkey development revenue increased from
46.5% to 242.4%. This increase was primarily the result of costs which had
been capitalized in 1998 being expensed in 1999 due to certain Turnkey sites
no longer being considered for development. Further contributing to these
increases was the addition of personnel to the real estate department during
1998.
General and administrative expenses grew 19.9% from $5,447,000 to
$6,533,000, but as a percentage of total revenues decreased from 29.0% to
27.7%. The percentage decrease was a result of revenues increasing at a
faster pace than expenses. In addition, the Company hired personnel at a
slower pace in the first six months of 1999 than it did in 1998, resulting in
reduced hiring costs. The Company believes the bulk of the infrastructure is
in place to service the franchise system.
Depreciation and amortization increased 68.8% from $763,000 to
$1,288,000, and as a percentage of total revenues increased from 4.1% to
5.5%. These increases were principally due to the amortization of area
development rights and goodwill acquired in 1999, and depreciation related to
the additional Company-owned restaurants.
Interest income increased 44.3% from $1,028,000 to $1,483,000. This
increase was a result of a greater level of funds outstanding in the form of
Turnkey mortgages and interim construction financing under the Turnkey
Program and an increase in notes receivables related to the sale of limited
development rights.
Interest expense increased from $106,000 to $877,000 due to the greater
level of debt outstanding during the current period. The Company expects
interest expense may continue to trend upward as additional debt financing
may be used to fund construction of Company-owned stores, acquisition of
additional Turnkey program properties and reacquisition of certain area
developer rights.
INCOME TAX EXPENSE. Income tax expense reflected a combined federal
and state effective tax rate of 37.0% for the six months ended June 30, 1999,
which was slightly lower than the effective combined tax rate of 37.5% for
the comparable period in 1998. Based on projections of taxable income, the
Company anticipates that its effective combined rate for federal and state
taxes will be approximately 37.0% for 1999.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $11,819,000 for the first six
months of 1999. Accounts payable and accrued liabilities decreased
$7,810,000, primarily due to the payment of amounts outstanding at December
31, 1998. The majority of the amounts paid were related to properties under
development in the Turnkey Program. Net cash of $21,463,000 was used in
investing activities, primarily consisting of the purchases and development
of Company-owned restaurants and the acquisition of certain development
rights. The Company used approximately $2,731,000 to purchase and develop
seven Company-owned restaurants. In addition, the Company used approximately
$17,553,000 to buy-down the rights of several of its area developers and to
re-acquire the rights to a limited number of territories, including the
Austin, Texas territory.
During the first six months of 1999, financing activities provided net
cash of $20,942,000. The financing activities consisted primarily of the
issuance of short-term debt used for the acquisition of certain development
rights and Company-owned stores.
At June 30, 1999, the Company had approximately $35.5 million of debt
outstanding. These notes bear interest at rates ranging from the lender's
prime interest rate to 10.6% and all mature by the end of 2001. During the
first six months of 1999, the Company borrowed $15,000,000 under a new line
of credit to fund the buy-down of the rights of several of its area
developers and to re-acquire the rights to a limited number of territories.
In addition, the Company guarantees certain real estate mortgages and leases,
equipment leases and other obligations of franchisees. At June 30, 1999,
contingent liabilities totaled approximately $33,401,000.
12
The Company is subject to a number of covenants under its various debt
instruments including limitations on additional borrowings, capital
expenditures and contingent liabilities, and requirements to maintain certain
financial ratios, working capital, and net worth. The bank credit facilities
are secured by a first priority perfected security interest in certain assets
of the Company. While the Company is currently in compliance with all
financial covenants under these facilities, the term of one facility is
scheduled to expire on October 1, 1999, and the financial covenants of the
other facility become stricter effective September 30, 1999. The Company
expects to either renegotiate the terms of its existing agreements into
long-term arrangements, or to seek alternative long-term financing from other
sources. There can be no assurance, however, that the Company will be able to
effect either of these strategies on satisfactory terms, if at all. Failure
to renegotiate the terms of the existing agreements could have material
adverse consequences to the Company.
The Company continues to refine its Turnkey Program and expects that it
will have 50 to 100 sites under contract or at various stages of development
at any given time. The Company has used the net proceeds from its public
offerings and the proceeds from sites sold and contracts assigned to finance
the activity of the Turnkey Program. With the anticipated activity in the
Turnkey Program, the capital required to finance the Turnkey Program will be
significant. The tables below provide a summary of the Turnkey Program
activity for the six months ended June 30, 1999 and 1998.
Turnkey Program revenue consists of the following:
SIX MONTHS ENDED
-----------------------------------
JUNE 30, JUNE 30,
1999 1998
----------------- ---------------
Sales to investors and franchisees..................... $ 533,008 $ 8,880,614
Development and construction management fees........... 20,099 130,000
----------------- ---------------
Gross Turnkey Program revenue..................... 553,107 9,010,614
Turnkey Program project costs.......................... (20,000) (6,260,683)
----------------- ---------------
Net revenue from Turnkey Program projects......... 533,107 2,749,931
Rental income.......................................... 296,938 43,600
Interim construction interest.......................... - 88,217
Deferred revenue recognized............................ - 550,396
Revenue deferred....................................... - (574,665)
----------------- ---------------
Total Turnkey Program revenue..................... $ 830,045 $ 2,857,479
----------------- ---------------
----------------- ---------------
The following table reflects system performance of the Turnkey Program for
the six months ended June 30, 1999 and 1998:
NUMBER OF UNITS
--------------------------------
JUNE 30, JUNE 30,
1999 1998
--------------- ---------------
Sites in process at beginning of period................ 86 78
Sites beginning development during the period *........ (5) 28
Sites inventoried as Company-owned stores.............. (2) -
Sites sold - revenue recognized........................ (4) (20)
Sites sold - revenue deferred.......................... - (6)
Other.................................................. (1) -
--------------- ---------------
Sites in process at end of period...................... 74 80
--------------- ---------------
--------------- ---------------
INVESTED AT
JUNE 30, 1999
-------------------
Sites under development or to be sold.................. 9 14 $ 8,216,000
Predevelopment Site (prequalification) ................ 65 66 1,851,000
--------------- --------------- -------------------
74 80 $ 10,067,000
--------------- --------------- -------------------
--------------- --------------- -------------------
* Net of deletions for sites removed from consideration for development.
The Company has a line of credit from a financial institution which may
be used to finance Turnkey Program capital requirements. In December 1998,
the line of credit was increased to allow the Company to draw up to
$15,000,000, bears interest at the bank's prime lending rate and expires
December 2001. As of June 30, 1999, the Company had drawn approximately
$13,563,000 on this line of credit and had allowed certain area developers
and franchisees to borrow $1,430,000 under this credit facility.
13
The Company believes that cash flow from operations, together with the
proceeds of the Turnkey Program, collections from notes receivable and
borrowings under existing credit facilities described above, will be
sufficient to meet the Company's anticipated operating cash needs for the
foreseeable future. Since the net proceeds from the Turnkey Program, credit
facilities, and cash flow from operations may not be sufficient to finance
both continuing investment in Company-owned stores and Turnkey Program
properties as well as the buydowns of percentages of royalties of certain
area developers, the Company intends to seek additional funds for this
purpose from future debt financings or additional offerings of equity
securities, although there can be no assurance of the availability of such
funds on acceptable terms in the future.
YEAR 2000 COMPLIANCE
The year 2000 issue is a result of many computer programs being written
using two digits, e.g. "99", to define a year. Date-sensitive software may
recognize the year "00" as the year 1900 rather than the year 2000. This
would result in errors and miscalculations or even system failure causing
disruptions in business activities and transactions.
The Company's computer software programs utilize four digits to define
the applicable calendar year and therefore the Company believes that it has
no material internal risk concerning the Year 2000 issue. The Company has
received responses from many of its major restaurant product and equipment
suppliers indicating that they and the products they sell to the Company's
restaurant system also have no material internal risk from the Year 2000
issue. To date, none of the Company's major suppliers have indicated that
they anticipate material internal risks. The Company is continuing a process
of in-depth inquiry concerning the readiness of its major suppliers and those
of the restaurant system. The Company will assess and, where practicable,
attempt to mitigate its risks with respect to the failure of these entities
to be Year 2000 compliant. The Company plans to continue to educate its
franchise system during 1999 to prepare them to anticipate Year 2000 issues
which could affect them locally. The Company does not anticipate that its
costs associated with monitoring readiness and mitigating risks concerning
the Year 2000 issue will be material. However, even if favorable responses
are received, there can be no assurance that third parties will be Year 2000
compliant. The impact on the Company's operations, if any, from the inability
of any of its suppliers and franchisees to become Year 2000 compliant is not
reasonably estimable (except that if there is a national or regional crisis
in the financial, transportation or utility infrastructure, it would likely
adversely affect most commercial enterprises, including the Company.)
FORWARD LOOKING STATEMENTS
This report contains forward looking statements within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of
the Securities Exchange Act of 1934, as amended, that are not historical
facts. Such statements may include, but are not limited to, projections of
revenues, income and capital expenditures, plans for future operations,
financing needs or plans (including plans relating to Turnkey Program real
estate transactions, possible debt financings and transactions with area
developers), and plans relating to products or services of the Company, as
well as assumptions relating to the foregoing. These statements involve
management assumptions and are subject to risks and uncertainties such as
changes in interest rates, availability of favorable financing for the
Company or its franchisees, satisfactory completion of transactions with
franchisees and area developers, intense competition, future restaurant
openings and changes in development plans or strategies, factors associated
with Year 2000 compliance by third parties, along with factors set forth in
the Company's Annual Report on Form 10-K/A in "Business," pages 1-15. The
Company undertakes no obligation to update forward looking statements that
may be contained in this report.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Changes in short-term interest rates on loans from financial
institutions could materially affect the Company's earnings because the
underlying obligations are either variable, or fixed for such a short period
of time as to effectively become variable.
At June 30, 1999 a hypothetical 100 basis point increase in interest
rates would result in a reduction of approximately $71,000 in quarterly
pre-tax earnings. The estimated reduction is based upon the increased
interest expense of our variable rate debt and assumes no change in the
volume or composition of debt at June 30, 1999. The fair values of the
Company's bank loans are not significantly affected by changes in market
interest rates.
14
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
On August 5, 1999, the purported class action lawsuit filed against the
Company alleging securities fraud arising out of circumstances surrounding
the reissuance of its 1997 earnings release was dismissed with prejudice. A
consolidated amended complaint had been filed on August 26, 1998 by the Lone
Star Ladies Investment Club, et al. in the Federal District Court for the
Western District of Texas against the Company and four of its officers and
directors (Monica Gill, Executive Vice President and Chief Financial Officer;
John M. Rosillo, a former director; Jeffrey J. Wooley, Senior Vice President;
and John C. Wooley, President and Chairman of the Board of Directors).
ITEM 2. CHANGES IN SECURITIES.
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
The Annual Meeting of the Shareholders of the Company was held on May 28,
1999. At the meeting, the following items were voted on:
1) Election of directors, whose terms expired at the meeting.
FOR WITHHELD
------------------- -------------------
Raymond A. Rodriguez 5,772,292 42,205
Jeffrey J. Wooley 5,776,183 38,314
The following directors' terms of office were not expired and continued after
the meeting:
John L Hill, Jr.
Azie Taylor Morton
Floor Mouthaan
John C. Wooley
2) Proposal to ratify and approve the Board's selection of Grant Thornton, LLP
to serve as the Company's auditors for the 1999 fiscal year.
FOR AGAINST ABSTAIN
----------------------------------- -------------------------------- ---------------------------------
5,785,451 20,364 8,682
ITEM 5. OTHER INFORMATION
None
15
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a. Exhibits:
Exhibit
No.
-------
10.54 Credit Agreement with Texas Capital Bank, N.A.
27 Financial Data Schedule.
b. Current Reports on Form 8-K:
None
16
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SCHLOTZSKY'S, INC.
By: /s/ John C. Wooley
-------------------------------------
John C. Wooley
President and
Chief Executive Officer
By: /s/ Monica Gill
-------------------------------------
Monica Gill
Executive Vice President and
Chief Financial Officer
Austin, Texas
August 16, 1999
17