** **

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

** **

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** **

**FORM 10-Q**

** **

**Quarterly report pursuant toSection 13 or 15(d)of the Securities Exchange Act of 1934**

** **

**For the quarterly period endedMarch 31, 2003**

** **

**Commission File Number: 0-27008**

 

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**Schlotzsky’s, Inc.**

(Exactname of registrant as specified in its charter)

 

| **Texas**                                                        |   | **74-2654208**                      |
|------------------------------------------------------------------|--------|-------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (IRS  Employer  Identification No.) |

 

**203 Colorado Street, Austin, Texas78701**

(Addressof principal executive offices)

 

**(512) 236-3600**

(Registrant’stelephone number)

 

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** **

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes  ý    No  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes  o     No  ý

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date.

 

| **Class**                   |   | **Shares  Outstanding at May 1, 2003** |
|-----------------------------|--------|----------------------------------------|
| Common  Stock, no par value |   | 7,319,887                              |

 

 

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**SCHLOTZSKY’S, INC.**

** **

**Index to Form 10-Q**

**Quarter Ended March 31, 2003**

 
| **Part I**  | **FINANCIAL INFORMATION**                                                                                                                 |   |
|-------------|-------------------------------------------------------------------------------------------------------------------------------------------|--------|
|        |                                                                                                                                      |   |
| Item 1.     | Financial  Statements                                                                                                                     |   |
|        |                                                                                                                                      |   |
|        | Condensed  Consolidated Balance Sheets –March 31, 2003  and December 31, 2002                                                        |   |
|        |                                                                                                                                      |   |
|        | Condensed  Consolidated Statements of Income –  Three Months Ended March 31, 2003 and March 31, 2002                                 |   |
|        |                                                                                                                                      |   |
|        | Condensed  Consolidated Statement of Stockholders’ Equity –  Three Months Ended March 31, 2003 and Year Ended December 31, 2002 |   |
|        |                                                                                                                                      |   |
|        | Condensed  Consolidated Statements of Cash Flows –  Three Months Ended March 31, 2003 and March 31, 2002                             |   |
|        |                                                                                                                                      |   |
|        | Notes  to Condensed Consolidated Financial Statements                                                                                     |   |
|        |                                                                                                                                      |   |
| Item 2.     | Management’s Discussion and Analysis of  Financial Condition And Results of Operations                                               |   |
|        |                                                                                                                                      |   |
| Item 3.     | Quantitative and Qualitative Disclosures About  Market Risk                                                                               |   |
|        |                                                                                                                                      |   |
| Item 4.     | Controls and Procedures                                                                                                                   |   |
|        |                                                                                                                                      |   |
| **Part II** | **OTHER INFORMATION**                                                                                                                     |   |
|        |                                                                                                                                      |   |
| Item 1.     | Legal Proceedings                                                                                                                         |   |
|        |                                                                                                                                      |   |
| Item  2.    | Changes in Securities and Use of  Proceeds                                                                                                |   |
|        |                                                                                                                                      |   |
| Item  3.    | Defaults Upon Senior Securities                                                                                                           |   |
|        |                                                                                                                                      |   |
| Item  4.    | Submission of Matters to a Vote of  Security Holders                                                                                      |   |
|        |                                                                                                                                      |   |
| Item 5.     | Other Information                                                                                                                         |   |
|        |                                                                                                                                      |   |
| Item  6.    | Exhibits and Reports on Form 8-K                                                                                                          |   |

 

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**PART I**

**FINANCIAL INFORMATION**

 

**ITEM 1****.  FINANCIAL STATEMENTS**

** **

**SCHLOTZSKY’S, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCESHEETS**

 
|                                                                                                                                                           |   | **March 31,  2003** |        | **December  31,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|-------------|-------------------------|--------|
|                                                                                                                                                           |   | **(Unaudited)**     |        |                    |   |
| **ASSETS**                                                                                                                                                     |   |                |        |                    |   |
| Current Assets:                                                                                                                                                |   |                |        |                    |   |
| Cash and cash equivalents                                                                                                                                      |   | $                   | 717,089     |                    | $      | 678,895 |   |
| Accounts receivable, net:                                                                                                                                      |   |                |        |                    |   |
| Royalties                                                                                                                                                      |   | 835,764             |        | 650,376                 |   |
| Brands                                                                                                                                                         |   | 1,065,141           |        | 1,269,759               |   |
| Other                                                                                                                                                          |   | 1,081,154           |        | 1,332,990               |   |
| Refundable income taxes                                                                                                                                        |   | 1,438,668           |        | 1,837,628               |   |
| Prepaids, inventories and other assets                                                                                                                         |   | 1,039,370           |        | 1,356,516               |   |
| Real estate held for sale                                                                                                                                      |   | 4,637,178           |        | 5,167,563               |   |
| Current portion of:                                                                                                                                            |   |                |        |                    |   |
| Notes receivable                                                                                                                                               |   | 564,758             |        | 582,926                 |   |
| Deferred tax asset                                                                                                                                             |   | 2,275,941           |        | 2,275,941               |   |
| Total current assets                                                                                                                                           |   | 13,655,063          |        | 15,152,594              |   |
|                                                                                                                                                           |   |                |        |                    |   |
| Property, equipment and leasehold improvements, net                                                                                                            |   | 39,445,259          |        | 39,709,461              |   |
| Notes receivable, net, less current portion                                                                                                                    |   | 11,188,247          |        | 11,349,705              |   |
| Investments                                                                                                                                                    |   | 1,785,615           |        | 1,852,765               |   |
| Intangible assets, net                                                                                                                                         |   | 64,885,628          |        | 65,308,249              |   |
| Goodwill, net                                                                                                                                                  |   | 3,192,678           |        | 2,985,679               |   |
| Other noncurrent assets                                                                                                                                        |   | 1,226,388           |        | 1,168,029               |   |
| Total assets                                                                                                                                                   |   | $                   | 135,378,878 |                    | $      | 137,526,482 |   |
|                                                                                                                                                           |   |                |        |                    |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                 |   |                |        |                    |   |
| Current Liabilities:                                                                                                                                           |   |                |        |                    |   |
| Short–term debt                                                                                                                                           |   | $                   | 150,000     |                    | $      | — |   |
| Current maturities of long–term debt                                                                                                                      |   | 8,493,224           |        | 7,441,120               |   |
| Accounts payable                                                                                                                                               |   | 3,479,872           |        | 2,841,607               |   |
| Accrued liabilities                                                                                                                                            |   | 4,356,379           |        | 3,812,727               |   |
| Deferred revenue, current portion                                                                                                                              |   | 231,114             |        | 234,552                 |   |
| Total current liabilities                                                                                                                                      |   | 16,710,589          |        | 14,330,006              |   |
|                                                                                                                                                           |   |                |        |                    |   |
| Long–term debt, less current portion                                                                                                                      |   | 43,139,773          |        | 46,063,599              |   |
| Deferred revenue, less current portion                                                                                                                         |   | 1,553,222           |        | 1,597,443               |   |
| Deferred tax liability                                                                                                                                         |   | 680,109             |        | 1,216,109               |   |
| Total liabilities                                                                                                                                              |   | 62,083,693          |        | 63,207,157              |   |
|                                                                                                                                                           |   |                |        |                    |   |
| Commitments and contingencies                                                                                                                                  |   |                |        |                    |   |
|                                                                                                                                                           |   |                |        |                    |   |
| Stockholders’ Equity:                                                                                                                                     |   |                |        |                    |   |
| Preferred stock, Class C, no par value, 1,000,000 shares authorized, none  issued                                                                              |   | —              |        | —                  |   |
| Common stock, no par value, 30,000,000 shares authorized, 7,508,190  shares and 7,496,778 shares issued at March 31, 2003 and December 31, 2002,  respectively |   | 63,952              |        | 63,826                  |   |
| Additional paid–in capital                                                                                                                                |   | 58,164,521          |        | 58,122,469              |   |
| Retained earnings                                                                                                                                              |   | 15,909,868          |        | 16,976,186              |   |
| Treasury stock (189,525 shares at March 31, 2003 and December 31,  2002), at cost                                                                              |   | (843,156            | )           | (843,156                | )      |
| Total stockholders’ equity                                                                                                                                |   | 73,295,185          |        | 74,319,325              |   |
| Total liabilities and stockholders’ equity                                                                                                                |   | $                   | 135,378,878 |                    | $      | 137,526,482 |   |

 

**The accompanying notes are an integral part of the condensedconsolidated financial statements.**

 

1

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**SCHLOTZSKY’S, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFINCOME**

**(Unaudited)**

** **
|                                                     |   | **For the three months ended** |       |
|----------------------------------------------------------|--------|--------------------------------|------------|
|                                                     |   | **March 31,  2003**            |       | **March 31,  2002** |   |
| Revenue:                                                 |   |                           |       |   |   |
| Royalties                                                |   | $                              | 4,303,888  |   | $ | 5,119,487 |   |
| Franchise fees                                           |   | —                         |       | 20,000 |   |
| Developer fees                                           |   | 50,159                         |       | 60,033 |   |
| Restaurant sales                                         |   | 7,612,229                      |       | 7,870,891 |   |
| Brand contribution                                       |   | 1,651,105                      |       | 1,883,027 |   |
| Other fees and revenue                                   |   | 212,649                        |       | 292,385 |   |
| Total revenue                                            |   | 13,830,030                     |       | 15,245,823 |   |
|                                                     |   |                           |       |   |   |
| Expenses:                                                |   |                           |       |   |   |
| Service costs:                                           |   |                           |       |   |   |
| Royalties                                                |   | 663,792                        |       | 1,135,268 |   |
| Franchise fees                                           |   | —                         |       | 10,000 |   |
|                                                     |   | 663,792                        |       | 1,145,268 |   |
| Restaurant operations:                                   |   |                           |       |   |   |
| Cost of sales                                            |   | 2,171,620                      |       | 2,196,134 |   |
| Personnel and benefits                                   |   | 3,365,161                      |       | 3,169,311 |   |
| Operating expenses                                       |   | 1,902,247                      |       | 1,766,899 |   |
|                                                     |   | 7,439,028                      |       | 7,132,344 |   |
| Equity loss on investments                               |   | 67,150                         |       | 30,220 |   |
| General and administrative                               |   | 5,070,715                      |       | 4,479,886 |   |
| Depreciation and amortization                            |   | 1,249,406                      |       | 1,083,294 |   |
| Total expenses                                           |   | 14,490,091                     |       | 13,871,012 |   |
|                                                     |   |                           |       |   |   |
| Income (loss) from operations                            |   | (660,061                       | )          | 1,374,811 |   |
|                                                     |   |                           |       |   |   |
| Other:                                                   |   |                           |       |   |   |
| Interest income                                          |   | 103,648                        |       | 217,443 |   |
| Interest expense                                         |   | (1,015,905                     | )          | (602,525 | ) |
|                                                     |   |                           |       |   |   |
| Income (loss) before provision (credit) for income taxes |   | (1,572,318                     | )          | 989,729 |   |
|                                                     |   |                           |       |   |   |
| Provision (credit) for income taxes                      |   | (506,000                       | )          | 362,000 |   |
|                                                     |   |                           |       |   |   |
| Net income (loss)                                        |   | $                              | (1,066,318 | ) | $ | 627,729 |   |
|                                                     |   |                           |       |   |   |
| Earnings per share–basic                            |   | $                              | (0.15      | ) | $ | 0.09 |   |
|                                                     |   |                           |       |   |   |
| Earnings per share–diluted                          |   | $                              | (0.15      | ) | $ | 0.08 |   |

 

**The accompanying notes are anintegral part of the condensed consolidated financial statements.**

 

2

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**SCHLOTZSKY’S, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
|                                                                      |   | **Common  Stock**     |   | **Additional**              |   |                 |   |                   |   | **Total**           |       |
|---------------------------------------------------------------------------|--------|-----------------------|--------|-----------------------------|--------|----------------------|--------|------------------------|--------|---------------------|------------|
|                                                                      |   | **Number of  Shares** |   | **Stated  Capital  Amount** |   | **Paid-in  Capital** |   | **Retained  Earnings** |   | **Treasury  Stock** |       | **Stockholders’  Equity** |   |
|                                                                      |   |                  |   |                        |   |                 |   |                   |   |                |       |   |   |
| Balance, January 1, 2002                                                  |   | 7,463,990             |   | $                           | 63,498 |                 | $      | 57,986,546             |   | $                   | 17,175,234 |   | $ | (823,242 | ) | $ | 74,402,036 |   |
| Issuance of common stock in connection with employee stock purchase  plan |   | 16,467                |   | 165                         |   | 66,726               |   | —                 |   | —              |       | 66,891 |   |
| Treasury stock purchases (3,225 shares)                                   |   | —                |   | —                      |   | —               |   | —                 |   | (19,914             | )          | (19,914 | ) |
| Options exercised                                                         |   | 16,321                |   | 163                         |   | 61,889               |   | —                 |   | —              |       | 62,052 |   |
| Tax benefit from employee stock transactions                              |   | —                |   | —                      |   | 7,308                |   | —                 |   | —              |       | 7,308 |   |
| Net loss                                                                  |   | —                |   | —                      |   | —               |   | (199,048               | )      | —              |       | (199,048 | ) |
| Balance, December 31, 2002                                                |   | 7,496,778             |   | 63,826                      |   | 58,122,469           |   | 16,976,186             |   | (843,156            | )          | 74,319,325 |   |
| Issuance of common stock in connection with employee stock purchase  plan |   | 12,634                |   | 126                         |   | 35,956               |   | —                 |   | —              |       | 36,082 |   |
| Issuance of employee stock options                                        |   | —                |   | —                      |   | 6,096                |   | —                 |   | —              |       | 6,096 |   |
| Net loss                                                                  |   | —                |   | —                      |   | —               |   | (1,066,318             | )      | —              |       | (1,066,318 | ) |
| Balance, March 31, 2003                                                   |   | 7,509,412             |   | $                           | 63,952 |                 | $      | 58,164,521             |   | $                   | 15,909,868 |   | $ | (843,156 | ) | $ | 73,295,185 |   |

** **

**PREFERRED STOCK**

 

Authorized 1,000,000 Class Cshares, no par value; no shares outstanding at March 31, 2003, December 31,2002, or January 1, 2002.

 

**COMMON STOCK**

 

Authorized 30,000,000 shares,no par value; 7,509,412 shares issued at March 31, 2003, 7,496,778 sharesissued at December 31, 2002, and 7,463,990 shares issued at January 1,2002.  Shares issued include 189,525,189,525 and 186,300 shares in treasury at March 31, 2003, December 31, 2002,and January 1, 2002, respectively.

** **

**The accompanying notes are anintegral part of the condensed consolidated financial statements.**

 

3

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**SCHLOTZSKY’S, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(Unaudited)**

** **
|                                                                                  |   | **Three  Months Ended** |       |
|---------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                                  |   | **March 31,  2003**     |       | **March 31,  2002** |   |
| Cash flows from operating activities:                                                 |   |                    |       |   |   |
| Net income (loss)                                                                     |   | $                       | (1,066,318 | ) | $ | 627,729 |   |
| Adjustments to reconcile net income (loss) to cash provided by  operating activities: |   |                    |       |   |   |
| Depreciation and amortization                                                         |   | 1,249,406               |       | 1,083,294 |   |
| Provision for uncollectible accounts                                                  |   | 383,580                 |       | 225,603 |   |
| Provision for deferred taxes                                                          |   | (536,000                | )          | — |   |
| Provision for stock option compensation                                               |   | 6,096                   |       | — |   |
| Amortization of deferred revenue                                                      |   | (37,659                 | )          | (103,805 | ) |
| Equity loss on investments                                                            |   | 67,150                  |       | 30,220 |   |
| Changes in:                                                                           |   |                    |       |   |   |
| Accounts receivable                                                                   |   | 468,647                 |       | (605,666 | ) |
| Prepaid expenses and other assets                                                     |   | 259,656                 |       | 72,373 |   |
| Accounts payable and accrued liabilities                                              |   | 1,181,918               |       | 743,356 |   |
| Net cash provided by operating activities                                             |   | 1,976,476               |       | 2,073,104 |   |
|                                                                                  |   |                    |       |   |   |
| Cash flows from investing activities:                                                 |   |                    |       |   |   |
| Purchase of property and equipment                                                    |   | (610,456                | )          | (674,937 | ) |
| Sale of property, equipment and real estate held for sale                             |   | 530,655                 |       | 814,403 |   |
| Acquisition of investments and intangible assets                                      |   | (209,771                | )          | (4,797 | ) |
| Issuance of notes receivable                                                          |   | (8,130                  | )          | (8,130 | ) |
| Repayments of notes receivable                                                        |   | 5,372                   |       | 21,284 |   |
| Net cash provided by (used in) investing activities                                   |   | (292,330                | )          | 147,843 |   |
|                                                                                  |   |                    |       |   |   |
| Cash flows from financing activities:                                                 |   |                    |       |   |   |
| Sale of common stock                                                                  |   | 36,082                  |       | 43,861 |   |
| Proceeds from issuance of debt                                                        |   | 150,000                 |       | — |   |
| Debt issuance costs                                                                   |   | (10,312                 | )          | (42,737 | ) |
| Acquisition of treasury stock                                                         |   | —                  |       | (19,914 | ) |
| Repayment of debt                                                                     |   | (1,821,722              | )          | (2,433,192 | ) |
| Net cash used in financing activities                                                 |   | (1,645,952              | )          | (2,451,982 | ) |
|                                                                                  |   |                    |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                  |   | 38,194                  |       | (231,055 | ) |
| Cash and cash equivalents at beginning of period                                      |   | 678,895                 |       | 2,567,904 |   |
|                                                                                  |   |                    |       |   |   |
| Cash and cash equivalents at end of period                                            |   | $                       | 717,089    |   | $ | 2,336,849 |   |

** **

**The accompanying notes are anintegral part of the condensed consolidated financial statements.**

 

4

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**SCHLOTZSKY’S, INC. AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

** **

**Note 1. – Basis of Presentation**

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith generally accepted accounting principles for interim financial informationand with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Inthe opinion of management, all adjustments, consisting of normal recurringaccruals, considered necessary for a fair presentation have been included.  Operating results for the three months endedMarch 31, 2003, are not necessarily indicative of the results that may beexpected for the year ended December 31, 2003. This information should be read in conjunction with the consolidatedfinancial statements and footnotes thereto included in the Schlotzsky’s, Inc.Annual Report on Form 10-K for the year ended December 31, 2002.

 

**Reclassifications**

 

Certain reclassificationshave been made to the condensed consolidated financial statements at March 31,2002, and for the period then ended, to correspond with the presentation usedat March 31, 2003, and for the period then ended.

 

**Note 2. – Stock-Based Compensation**

 

Effective January 1, 2003, the Company adopted thecost recognition provisions for stock-based compensation of Statement ofFinancial Accounting Standards (“SFAS”) No. 123 under the prospective method ofadoption authorized by SFAS No. 148. The amount charged to expense during thequarter ended March 31, 2003 was approximately $6,000. Had the Company adoptedthe cost recognition provisions of SFAS No. 123 in 1995, the Company’s netincome and earnings per share would have been reduced to the pro forma amountsshown (in thousands, except per share amounts):

 
|                                                                                                                                               |   | **For the  three months ended** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                                                                                                               |   | **March 31,  2003**             |   | **March 31,  2002** |   |
| Net income  (loss), as reported                                                                                                                    |   | $                               | (1,066 | ) | $ | 628 |   |
| Add: Stock–based  employee compensation expense included in net income, net of related tax  effects                                           |   | 4                               |   | — |   |
| Deduct: Total  stock–based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |   | (69                             | )      | (77 | ) |
| Pro forma net  income (loss)                                                                                                                       |   | $                               | (1,131 | ) | $ | 551 |   |
|                                                                                                                                               |   |                            |   |   |   |
| Earnings per  share:                                                                                                                               |   |                            |   |   |   |
| Basic–as  reported                                                                                                                            |   | $                               | (0.15  | ) | $ | 0.09 |   |
| Basic–pro forma                                                                                                                               |   | $                               | (0.15  | ) | $ | 0.08 |   |
| Diluted–as  reported                                                                                                                          |   | $                               | (0.15  | ) | $ | 0.08 |   |
| Diluted–pro  forma                                                                                                                            |   | $                               | (0.15  | ) | $ | 0.07 |   |

 

5

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**Note 3. – Restaurant Operations**

 

A summary of certainoperating information for Company-operated restaurants is presented below forthe three-month periods ended March 31, 2003 and 2002 (dollars in thousands).

 
|                                                         |   | **Long-term Portfolio  Restaurants** |   | **Available  For Sale  Restaurants** |   |                         |   |
|--------------------------------------------------------------|--------|--------------------------------------|--------|--------------------------------------|--------|------------------------------|--------|
|                                                         |   | **Schlotzsky’s  Delis**         |   | **Marketplaces**                     |   | **Schlotzsky’s  Delis** |   | **Total** |   |
| **Three months ended March 31, 2003**                        |   |                                 |   |                                 |   |                         |   |   |   |
| Restaurant sales                                             |   | $                                    | 3,490  |                                 | $      | 1,162                        |   | $ | 2,960 |   | $ | 7,612 |   |
|                                                         |   |                                 |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                       |   |                                 |   |                                 |   |                         |   |   |   |
| Cost of sales                                                |   | 967                                  |   | 370                                  |   | 835                          |   | 2,172 |   |
| Personnel and benefits                                       |   | 1,295                                |   | 615                                  |   | 1,455                        |   | 3,365 |   |
| Operating expenses                                           |   | 631                                  |   | 314                                  |   | 957                          |   | 1,902 |   |
|                                                         |   | 2,893                                |   | 1,299                                |   | 3,247                        |   | 7,439 |   |
|                                                         |   |                                 |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciation and amortization |   | $                                    | 597    |                                 | $      | (137                         | )      | $ | (287 | ) | $ | 173 |   |
|                                                         |   |                                 |   |                                 |   |                         |   |   |   |
| **Three months ended March 31, 2002**                        |   |                                 |   |                                 |   |                         |   |   |   |
| Restaurant sales                                             |   | $                                    | 3,976  |                                 | $      | 1,275                        |   | $ | 2,620 |   | $ | 7,871 |   |
|                                                         |   |                                 |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                       |   |                                 |   |                                 |   |                         |   |   |   |
| Cost of sales                                                |   | 1,073                                |   | 390                                  |   | 733                          |   | 2,196 |   |
| Personnel and benefits                                       |   | 1,370                                |   | 613                                  |   | 1,186                        |   | 3,169 |   |
| Operating expenses                                           |   | 680                                  |   | 294                                  |   | 793                          |   | 1,767 |   |
|                                                         |   | 3,123                                |   | 1,297                                |   | 2,712                        |   | 7,132 |   |
|                                                         |   |                                 |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciation and amortization |   | $                                    | 853    |                                 | $      | (22                          | )      | $ | (92 | ) | $ | 739 |   |

 

**Note 4. – Segments**

 

The Company isprincipally engaged in franchising and operating restaurants in the fast casualsector under the Schlotzsky’s® Deli brand. Schlotzsky’s Deli restaurants offera menu of distinctive, high quality foods featuring our proprietary breads,complemented by excellent customer service in a visually appealing setting.  Our current menu includes upscalemade-to-order hot sandwiches and pizza served on our proprietary buns andcrusts, wraps, chips, salads, soups, fresh baked cookies and other desserts,and beverages.  At March 31, 2003, theSchlotzsky’s Deli system included 619 Company-operated and franchisedrestaurants in 37 states, the District of Columbia and six foreigncountries.  The Company operated 37restaurants as of March 31, 2003.

** **

The Company identifies segments based on managementresponsibility within the corporate structure. The Restaurant Operations segment includes restaurants operated for thepurposes of market leadership and redevelopment of certain markets,demonstrating sales potential and key operating metrics, operational leadershipof the franchise system, product development, concept refinement, product andprocess testing, training and building brand awareness and restaurantsavailable for sale.  The FranchiseOperations segment encompasses the franchising of restaurants, assistingfranchisees in the development of restaurants, providing franchisee trainingand operating the national training center, communicating with franchisees,conducting regional and national franchisee meetings, developing and monitoringsupplier and distributor relationships, planning and coordinating advertisingand marketing programs, and the licensing of brand products for sale to thefranchise system and retailers.  TheCompany measures segment profit as operating income, which is defined as incomebefore interest and income taxes. Segment information and a reconciliation to income before interest andincome taxes are as follows (dollars in thousands):

 

6

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| **Three months ended March 31, 2003** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|---------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                  |   |                       |   |                      |   |             |   |
| Revenue from external customers       |   | $                          | 7,612  |                      | $      | 6,218            |   | $ | 13,830 |   |
| Depreciation and amortization         |   | 521                        |   | 728                       |   | 1,249            |   |
| Operating income (loss)               |   | (348                       | )      | (312                      | )      | (660             | )      |
|                                  |   |                       |   |                      |   |             |   |
| Total assets                          |   | $                          | 41,595 |                      | $      | 93,784           |   | $ | 135,379 |   |

** **
| **Three months ended March 31, 2002** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|---------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                  |   |                       |   |                      |   |             |   |
| Revenue from external customers       |   | $                          | 7,871  |                      | $      | 7,375            |   | $ | 15,246 |   |
| Depreciation and amortization         |   | 505                        |   | 578                       |   | 1,083            |   |
| Operating income                      |   | 234                        |   | 1,141                     |   | 1,375            |   |
|                                  |   |                       |   |                      |   |             |   |
| Total assets                          |   | $                          | 36,202 |                      | $      | 76,851           |   | $ | 113,053 |   |

** **

Of the Restaurant Operationsdepreciation and amortization for the three months ended March 31, 2003,$342,000 was allocated to the long-term portfolio of restaurants ($137,000 forMarketplaces and $205,000 for Schlotzsky’s Delis) and $179,000 to restaurantsavailable for sale.  For the threemonths ended March 31, 2002, $360,000 of depreciation and amortization wasallocated to the long-term portfolio of restaurants ($148,000 for Marketplacesand $212,000 for Schlotzsky’s Delis) and $145,000 to restaurants available forsale.

** **

**Note 5. – Debt**

 

The Company’s debt structure as of March 31, 2003, and December 31,2002, is as follows (dollars in thousands):

** **
|                                                    |   | **March 31,  2003** |   | **December  31,  2002** |   |
|---------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                                    |   | **(Unaudited)**     |   |                    |   |
|                                                    |   |                |   |                    |   |
| Short-term debt                                         |   | $                   | 150    |                    | $      | 0 |   |
|                                                    |   |                |   |                    |   |
| Long-term debt:                                         |   |                |   |                    |   |
| Notes payable to former area developers                 |   | $                   | 25,214 |                    | $      | 26,306 |   |
| Mortgages on Company-operated restaurants and equipment |   | 22,979              |   | 23,839                  |   |
| Capital leases                                          |   | 2,939               |   | 3,029                   |   |
| Other obligations                                       |   | 501                 |   | 331                     |   |
|                                                    |   | 51,633              |   | 53,505                  |   |
|                                                    |   |                |   |                    |   |
| Less current maturities of long-term debt               |   | (8,493              | )      | (7,441                  | )      |
| Long-term debt                                          |   | $                   | 43,140 |                    | $      | 46,064 |   |

 

7

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**Note 6. – Related Party Receivables**

 

As ofMarch 31, 2003, and December 31, 2002, receivables from related parties were asfollows (dollars in thousands):

** **
|                                    |   | **March 31,  2003** |   | **December  31,  2002** |       |
|-----------------------------------------|--------|---------------------|--------|-------------------------|------------|
|                                    |   | **(Unaudited)**     |   |                    |       |
|                                    |   |                |   |                    |       |
| Included in accounts receivable - other |   | $                   | 821    |                    | $          | 902 | ** ** |
| Included in other noncurrent assets     |   | 876                 |   | 842                     | ** ** |
| Included in notes receivable            |   | 5,457               |   | 5,450                   | ** ** |
|                                    |   | $                   | 7,154  |                    | $          | 7,194 |   |

** **

**Note 7. – Earnings Per Share**

 

Basic earnings per share arecomputed by dividing reported earnings available to common stockholders byweighted average common shares outstanding. Diluted earnings per share give effect to dilutive potential commonshares.  Earnings per share arecalculated as follows (in thousands, except per share data):

 
|                                                                                                                            |   | **For the  three months ended** |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                                                                                            |   | **March 31,  2003**             |   | **March 31,  2002** |   |
|                                                                                                                            |   |                            |   |   |   |
| Basic earnings per share                                                                                                        |   |                            |   |   |   |
| Net income (loss)                                                                                                               |   | $                               | (1,066 | ) | $ | 628 |   |
|                                                                                                                            |   |                            |   |   |   |
| Weighted average common shares outstanding                                                                                      |   | 7,320                           |   | 7,285 |   |
|                                                                                                                            |   |                            |   |   |   |
| Basic earnings per share                                                                                                        |   | $                               | (0.15  | ) | $ | 0.09 |   |
|                                                                                                                            |   |                            |   |   |   |
| Diluted earnings per share                                                                                                      |   |                            |   |   |   |
| Net income (loss)                                                                                                               |   | $                               | (1,066 | ) | $ | 628 |   |
|                                                                                                                            |   |                            |   |   |   |
| Weighted average common shares outstanding                                                                                      |   | 7,320                           |   | 7,285 |   |
|                                                                                                                            |   |                            |   |   |   |
| Dilutive stock options and warrants                                                                                             |   | —                          |   | 198 |   |
|                                                                                                                            |   |                            |   |   |   |
| Weighted average common shares outstanding – assuming dilution                                                             |   | 7,320                           |   | 7,483 |   |
|                                                                                                                            |   |                            |   |   |   |
| Diluted earnings per share                                                                                                      |   | $                               | (0.15  | ) | $ | 0.08 |   |
|                                                                                                                            |   |                            |   |   |   |
| Outstanding options and warrants that were not included in the diluted  calculation because their effect would be anti-dilutive |   | 1,142                           |   | 639 |   |

 

8

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**Note 8. – Intangible Assets**

 

The Company adoptedStatements of Financial Accounting Standards (SFAS) Nos. 141, 142 and 144,concerning accounting for business combinations, amortization of certainacquired intangible assets, and the impairment or disposal of long-livedassets, respectively, as of January 1, 2002.

 

Intangible assets consist ofthe following (dollars in thousands):

 
|                                           |   | **Amortization**    |       | **March 31,  2003** |       | **December  31, 2002**        |       |
|------------------------------------------------|--------|---------------------|------------|---------------------|------------|-------------------------------|------------|
|                                           |   | **Period  (Years)** |       | **Gross  Value**    |       | **Accumulated  Amortization** |       | **Gross  Value** |   | **Accumulated  Amortization** |   |
|                                           |   |                | ** ** | **(Unaudited)**     | ** ** |                          | ** ** |   | ** ** |
| Intangible assets subject to amortization:     |   |                |       |                |       |                          |       |   |   |   |   |
| Royalty value                                  |   | 20                  |       | $                   | 2,474      |                          | $          | 809 |   | $ | 2,474 |   | $ | 779 |   |
| Developer and franchise rights acquired        |   | 40                  |       | 59,374              |       | 2,838                         |       | 59,384 |   | 2,492 |   |
| Restaurant development rights                  |   | 13  to 25           |       | 1,619               |       | 423                           |       | 1,619 |   | 407 |   |
| Debt issue costs                               |   | 3  to 20            |       | 1,573               |       | 95                            |       | 1,561 |   | 77 |   |
| Other intangible assets                        |   | 5                   |       | 562                 |       | 380                           |       | 561 |   | 364 |   |
|                                           |   |                |       | 65,602              |       | 4,545                         |       | 65,599 |   | 4,119 |   |
|                                           |   |                |       |                |       |                          |       |   |   |   |   |
| Intangible assets not subject to amortization: |   |                |       |                |       |                          |       |   |   |   |   |
| Original franchise and royalty rights          |   |                |       | 5,689               |       | 1,860                         |       | 5,689 |   | 1,860 |   |
| Goodwill                                       |   |                |       | 3,523               |       | 331                           |       | 3,316 |   | 331 |   |
|                                           |   |                |       | 9,212               |       | 2,191                         |       | 9,005 |   | 2,191 |   |
|                                           |   |                |       |                |       |                          |       |   |   |   |   |
| Total intangible assets                        |   |                |       | $                   | 74,814     |                          | $          | 6,736 |   | $ | 74,604 |   | $ | 6,310 |   |

 

Amortization of intangibleassets totaled approximately $426,000 and $212,000 for the three months endedMarch 31, 2003 and 2002, respectively. Estimated amortization expense through 2007 for intangible assets withdeterminable lives is as follows (dollars in thousands):

 
| Remainder of 2003 |   | $     | 1,331  |   |
|-------------------|--------|-------|--------|--------|
| 2004              |   | 1,754 |   |
| 2005              |   | 1,715 |   |
| 2006              |   | 1,711 |   |
| 2007              |   | 1,687 |   |
|              |   | $     | 8,198  |   |

 

The changes in the grossvalue of goodwill for the quarter ended March 31, 2003, are as follows (dollarsin thousands):

 
|                            |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Total** |   |
|---------------------------------|--------|----------------------------|--------|---------------------------|--------|-----------|--------|
| Balance as of December 31, 2002 |   | $                          | 3,055  |                      | $      | 261       |   | $ | 3,316 |   |
| Goodwill acquired               |   | 207                        |   | —                    |   | 207       |   |
| Impairment                      |   | —                     |   | —                    |   | —    |   |
| Balance as of March 31, 2003    |   | $                          | 3,262  |                      | $      | 261       |   | $ | 3,523 |   |

 

During the first quarter the Company, exercising itsright of first refusal, acquired the operating assets of a franchisedrestaurant located in suburban Atlanta, Georgia.  TheCompany acquired these assets primarily in order to facilitate the developmentof a Company-operated restaurant in the trade area licensed to thefranchisee.  The Company does not intendto operate the acquired restaurant.

 

The aggregate purchase price paid was $215,000.  $8,000 of the purchase price was assigned to property, plant andequipment and $207,000 was assigned to goodwill.  The goodwill was assigned to the restaurant operations segment,and is expected to be fully deductible for tax purposes.

 

**Note 9. –Off-balance Sheet Arrangements**

 

The Company has outstandingguarantees of indebtedness of others, including related parties, ofapproximately $27.6 million as of March 31, 2003.  These guarantees include approximately $6.1 million of leaseguarantees for the benefit of franchisees, approximately $15.7 million ofmortgage loan guarantees for the benefit of franchisees and approximately $5.8million of loan guarantees for the benefit of related parties.

 

9

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The lease guarantees for thebenefit of franchisees arose primarily through our former Turnkey program, inwhich the Company developed the restaurants, leased the restaurants tofranchisees, and then sold them to a leasing company.   The guarantees range from limited guarantees, either in dollaramount or term, to full guarantees for the life of the lease.  The maximum guarantee for a single lease isapproximately $1.3 million.  Certainguarantees extend through 2018.  TheCompany may be required by the lessor to make monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. The Company has indemnification agreements with the franchisee underwhich the franchisee would be obligated to reimburse the Company for anyamounts paid under such guarantees.  Asof March 31, 2003, the Company had accrued a liability of approximately $32,000related to these guarantees.  TheCompany also has a net deferred gain related to the sale of these leases in theamount of approximately $342,000 as of March 31, 2003.

 

The mortgage loan guaranteesfor the benefit of franchisees also arose primarily through the Company’sformer Turnkey program, in which we developed the related restaurants, sold therestaurant to a franchisee, and guaranteed all or a portion of the franchisee’smortgage loan.  The guarantees rangefrom limited guarantees, either in dollar amount or term, to full guarantees ofthe mortgage.  The maximum amount of asingle guarantee is approximately $1.1 million.  Certain guarantees extend through 2016.  The Company may be required by the lender to make monthlymortgage payments if the franchisee does not make the required payments in atimely manner, or the Company may be required to make up any deficiency, up tothe amount of the guarantee, if the related restaurant is sold for net proceedsless than the amount of the outstanding mortgage.  The Company has indemnification agreements with the franchiseesunder which the franchisee would be obligated to reimburse the Company for anyamount paid under such guarantees.  Inthe event that the Company purchases the loan from the lender in the event of adefault, the Company would succeed to the lender’s security interest in therelated property.

 

The loan guarantees in favorof related parties primarily arose when the Company guaranteed certain debt ofrelated parties for which the proceeds of the loans were used to repayoutstanding debt to the Company.  Two ofthe guarantees, for the benefit of our restaurant venture and our real estateventure, are of mortgage debt totaling approximately $4.1 million.  These guarantees extend through 2009 on onenote and through 2016 on the other note. A third guarantee, in the amount of approximately $1.7 million, is forthe benefit of the advertising entity of the Schlotzsky’s Deli restaurant system,for which the Company had received the net proceeds of the loan in repayment ofoutstanding debt to the Company.  Thisguarantee expires in 2004.

 

The Company has been calledupon, from time to time, to make payments on obligations the Company has guaranteed.  During the first quarter of 2003, theCompany paid approximately $169,000 in various lease guarantees for the benefitof franchisees.  In addition, pursuantto a guarantee of a franchisee’s debt obligation, the Company expects topurchase that obligation from a bank, in the amount of approximately $665,000,in August 2003.

 

10

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**ITEM 2****.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**CRITICALACCOUNTING POLICIES**

 

The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses and related disclosure ofcontingent liabilities.  We base ourestimates on historical experience and various other assumptions that arebelieved to be reasonable under the circumstances.  Estimates and assumptions are reviewed periodically.  Actual results may vary from theseestimates.

 

We believe the followingcritical accounting policies require estimates about the effect of matters thatare inherently uncertain and require subjective judgments.  Changes in the estimates and judgments couldsignificantly impact our results of operations and financial conditions infuture periods.

 

•                  Determination of the appropriate valuationallowances for accounts and notes receivable.

 

Our accounts and notesreceivable are primarily from franchisees of the Schlotzsky’s Deli system.  We require personal guarantees for allfranchise accounts and, for notes receivable, generally obtain a secondarysecured interest in the related property and equipment or rights.  Many of the notes receivable are fullysubordinated to the franchisee’s senior mortgage debt.  In reviewing the adequacy of the valuationallowances for accounts and notes receivable, we consider factors such ashistorical collection experience, the estimated value of personal guaranteesand real property collateral, the franchisee’s sales and operating trends,including potential for improvement in operations, and general and localeconomic conditions that may affect the franchisee’s ability to pay.  Actual realization of amounts receivable coulddiffer materially from our estimates.

 

•                  Determination of appropriate valuationallowances for real estate held for sale.

 

Our real estate held for saleconsists primarily of pad sites.  Asthese sites are being actively marketed, they are periodically assessed forestimated net realizable value.  Factorsconsidered in this assessment are offers and letters of intent received onproperties, discussions with local real estate brokers, property tax and bankappraisals, sale prices of similar properties and level of activity andinterest exhibited by potential buyers. Actual realizeability could differ materially from our estimates.

 

•                  Determination of appropriate valuationallowance for intangible assets.

 

Amortizing intangible assetsconsist primarily of amounts paid to reacquire various developer and franchiserights.  Annually, and whenever an eventor circumstances indicating impairment may be present, we compare projectedundiscounted cash flows to the carrying value of the related assets todetermine if impairment has occurred. In estimating future cash flows, we consider such factors as currentresults, trends, future prospects, and other economic factors.  Actual future cash flows could differmaterially from our estimates.

 

11

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**RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

The following table reflectsthe changes in the Schlotzsky’s Deli system for the three months ended March31, 2003 and 2002.  Systemwide datareflects both franchised and Company-operated restaurants.  Percentage changes in sales-related data arebased on comparison to the same period in the previous fiscal year.

 
|                                         |   | **Three Months Ended** |       |
|----------------------------------------------|--------|------------------------|------------|
|                                         |   | **March 31, 2003**     |       | **March 31, 2002** |   |
| Restaurants Open – Beginning of Period  |   | 643                    |       | 674 |   |
| Openings During Period –                |   |                   |       |   |   |
| New                                          |   | —                 |       | 2 |   |
| Reopenings                                   |   | 1                      |       | 4 |   |
| Total Openings                               |   | 1                      |       | 6 |   |
| Closings During Period                       |   | (25                    | )          | (8 | ) |
| Restaurants Open – End of Period        |   | 619                    |       | 672 |   |
|                                         |   |                   |       |   |   |
| Systemwide Contractual Sales                 |   | $                      | 85,513,000 |   | $ | 100,201,000 |   |
| Decrease in Systemwide Contractual Sales     |   | (14.7                  | )%         | (6.5 | )% |
| Decrease in Same Store Contractual Sales     |   | (11.7                  | )%         | (5.4 | )% |
| Average Weekly Contractual Sales             |   | $                      | 10,430     |   | $ | 11,485 |   |
| Decrease in Average Weekly Contractual Sales |   | (9.2                   | )%         | (1.1 | )% |

 

Systemwide contractual sales,same store contractual sales and average weekly contractual sales, all based oncontractual sales as defined in our franchise agreements, represent net salesunder generally accepted accounting principles, plus the amounts of anydiscounts for employee or manager meals. Contractual sales are used in this chart, and throughout this report,because these sales are the basis of our royalty income and contractual salesare the only sales amounts reported to us by the franchisees.

 

**THREE MONTHS ENDED MARCH 31, 2003 AND 2002**

 

REVENUE.  Total revenue decreased 9.3% to $13,830,000from $15,246,000.

 

ROYALTIES decreased 15.9% to$4,304,000 from $5,119,000.  Thedecrease was due to a decreased number of franchised restaurants in 2003compared to 2002, an increased percentage of systemwide sales generated byCompany-operated restaurants, which do not pay royalties, and a decrease insame store contractual sales of 11.7%, partially offset by a continuing shiftin restaurant mix towards units with higher volumes.

 

FRANCHISE FEES decreased tozero from $20,000.  The decrease was theresult of no openings of franchised restaurants during the three-month periodended March 31, 2003.

 

DEVELOPER FEES decreased16.7% to $50,000 from $60,000.  Thedecrease is primarily attributed to the expiration of amortization on certaindevelopment agreements.

 

RESTAURANT SALES decreased3.3% to $7,612,000 from $7,871,000.  Thedecrease was primarily due to a 9.0% decrease in same store sales, partiallyoffset by an increase in the average number of restaurants operated by theCompany in the first quarter of 2003, compared to the first quarter of 2002.      As of March 31, 2003, there were 37Company-operated restaurants, compared to 33 at March 31, 2002, of which 23 and18, respectively, were available for sale.

 

SCHLOTZSKY’S DELI BRANDLICENSING FEES (BRAND CONTRIBUTION) decreased 12.3% to $1,651,000 from$1,883,000.  The decrease was primarilydue to the effect of the decrease in systemwide sales for the quarter,partially offset by more favorable terms with certain major suppliers and anincrease in sales through retail channels.

 

OTHER FEES AND REVENUEdecreased 27.1% to $213,000 from $292,000. The decrease was due primarily to reduced rental income.

 

OPERATING EXPENSES.  SERVICE COSTS decreased 42.0% to $664,000from $1,145,000, and as a percentage of royalties and franchise fees declinedto 15.4% from 22.3%.  This decrease isdue to the Company’s reacquisition of certain area developer territory rightsduring 2002, as well as a decrease in royalty and franchise fee revenue.

 

12

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RESTAURANT OPERATIONSEXPENSES increased 4.3% to $7,439,000 from $7,132,000.

 

RESTAURANT COST OF SALESdecreased 1.1% to $2,172,000 from $2,196,000 and increased as a percentage ofnet restaurant sales to 28.5% from 27.9% primarily due to increased bun mix andbeverage costs.

 

RESTAURANT PERSONNEL ANDBENEFITS COST increased 6.2% to $3,365,000 from $3,169,000 and increased as apercentage of net restaurant sales to 44.2% from 40.3%.  The increase, as a percentage of netrestaurant sales, was primarily due to an increased number of restaurantmanagers and increased workers compensation insurance cost.

 

RESTAURANT OPERATING EXPENSESincreased 7.6% to $1,902,000 from $1,767,000 and increased as a percentage ofnet restaurant sales to 25.0% from 22.4%. The increase in operating costs, as a percentage of net restaurantsales, was due to increased facility costs as a result of the increased numberof Company-operated restaurants and reduced fixed expense leverage due todecreased average sales per restaurant.

 

The use of someCompany-operated restaurants in the long-term portfolio for product, processand equipment testing and for systemwide training also adversely impacts theiroperating performance.

 

EQUITY LOSS ON INVESTMENTSincreased 123.3% to a loss of $67,000 from a loss of $30,000.  The equity investment represents theCompany’s 50% interest in a limited liability company that operates aSchlotzsky’s® Deli restaurant.

 

GENERAL AND ADMINISTRATIVEEXPENSES increased 13.2% to $5,071,000 from $4,480,000, and increased to 36.7%from 29.4% as a percentage of total revenue. The increase from the prior yearquarter was due to increased franchisee meeting expenses, an increase in theprovision for uncollectible accounts, and increases in repairs and maintenance,professional fees, insurance, recruiting and relocation costs, and charitablecontributions.

 

DEPRECIATION AND AMORTIZATIONincreased 15.3% to $1,249,000 from $1,083,000. The increase was primarily due to the amortization of reacquired areadeveloper territory rights and depreciation related to an increase in theaverage number of Company-operated restaurants during the quarter.

 

INTEREST INCOME decreased52.1% to $104,000 from $217,000.  Thedecrease was due to a decrease in the weighted average interest rate, and thenonrecognition of interest income on certain underperforming notes receivable,and cash receipt of $77,000 in interest on a nonaccruing note receivable in theprior year quarter.

 

INTEREST EXPENSE increased68.5% to $1,016,000 from $603,000 due to increased debt levels partially offsetby  lower average interest rates.

 

PROVISION (CREDIT) FOR INCOMETAXES reflected a combined federal and state effective tax rate of 32.2% forthe first quarter of 2003, which was lower than the effective combined tax rateof 36.6% for the comparable period in 2002.

 

NET INCOME was a loss of$1,066,000 for the quarter compared to net income of  $628,000 in theprevious year’s quarter due to the factors discussed above.  Diluted earnings per share were ($0.15) forthe quarter ended March 31, 2003, and $0.08 for the quarter ended March 31,2002.

 

**SupplementalRestaurant Operations Information – Performance of Long-term Portfolio DeliRestaurants**

 

The following table ispresented for the Schlotzsky’s Delis in the Company’s long-term portfolio forthe quarter ended March 31, 2003.  As ofMarch 31, 2003, this restaurant group included eight restaurants in the Austinarea, two in College Station, Texas and one in suburban Atlanta, Georgia.  This group includes ten freestandingrestaurants (nine recently constructed and one older facility converted fromanother concept) and one shopping center endcap restaurant.  In accordance with the Company’s internalmanagement reporting practices for consistent comparisons, line item categorieshave been expanded and percentages are calculated based on gross sales, insteadof net sales as used elsewhere in this report. Facility costs vary by restaurant because some facilities are rented andsome are owned.  The table provides theaverage percentage results for each line item for the eleven Schlotzsky’s Delirestaurants in the long-term portfolio group as a whole, as well as the bestand worst percentage performance for each line item for any restaurant in the group.

 

13

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|                                                                      |   | **Three Months  Ended  March 31, 2003  (in thousands)** |   | **Percentage  of Gross  Sales** |   | **Best  Percentage  Performance** |   | **Worst  Percentage  Performance** |   |
|---------------------------------------------------------------------------|--------|---------------------------------------------------------|--------|---------------------------------|--------|-----------------------------------|--------|------------------------------------|--------|
| Gross sales                                                               |   | $                                                       | 3,689  |                            | 100.0  | %                                 |   |                               |   |   |
| Less-discounts                                                            |   | 199                                                     |   | 5.4                             |   | 4.6                               | %      | 6.6                                | %      |
| Net sales                                                                 |   | 3,490                                                   |   | 94.6                            |   |                              |   |                               |   |
|                                                                      |   |                                                    |   |                            |   |                              |   |                               |   |
| Cost of sales                                                             |   | 967                                                     |   | 26.2                            |   | 25.3                              |   | 27.7                               |   |
|                                                                      |   |                                                    |   |                            |   |                              |   |                               |   |
| Personnel and benefits:                                                   |   |                                                    |   |                            |   |                              |   |                               |   |
| Crew costs                                                                |   | 863                                                     |   | 23.4                            |   | 20.8                              |   | 24.9                               |   |
| Management costs                                                          |   | 432                                                     |   | 11.7                            |   | 8.9                               |   | 18.8                               |   |
|                                                                      |   |                                                    |   |                            |   |                              |   |                               |   |
| Operating expenses:                                                       |   |                                                    |   |                            |   |                              |   |                               |   |
| Advertising                                                               |   | 207                                                     |   | 5.6                             |   | 3.4                               |   | 6.0                                |   |
| Controllable expenses                                                     |   | 256                                                     |   | 6.9                             |   | 5.7                               |   | 9.2                                |   |
| Operating income before facility costs and depreciation and  amortization |   | 765                                                     |   | 20.7                            |   | 25.7                              | *      | 11.1                               | *      |
|                                                                      |   |                                                    |   |                            |   |                              |   |                               |   |
| Facility costs                                                            |   | 168                                                     |   | 4.6                             |   | 1.5                               |   | 10.1                               |   |
|                                                                      |   |                                                    |   |                            |   |                              |   |                               |   |
| Operating income before depreciation and amortization                     |   | $                                                       | 597    |                            | 16.2   |                              |   |                               |   |   |

 

----

*  Represents the actual best and worst percentage performance for arestaurant in the group.  The best andworst performance on a composite basis would be 31.2% and 6.9%, respectively.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

We have outstandingguarantees of indebtedness of others, including related parties, ofapproximately $27.6 million as of March 31, 2003.  These guarantees include approximately $6.1 million of leaseguarantees for the benefit of franchisees, approximately $15.7 million ofmortgage loan guarantees for the benefit of franchisees and approximately $5.8million of loan guarantees for the benefit of related parties.

 

The lease guarantees for thebenefit of franchisees arose primarily through our former Turnkey program, inwhich we developed the restaurants, leased the restaurants to franchisees, andthen sold them to a leasing company. The guarantees range from limited guarantees,either in dollar amount or term, to full guarantees for the life of thelease.  The maximum guarantee for asingle lease is approximately $1.3 million. Certain guarantees extend through 2018. We may be required by the lessor to make monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. We have indemnification agreements with the franchisee under which thefranchisee would be obligated to reimburse us for any amounts paid under suchguarantees.  As of March 31, 2003, wehad accrued a liability of approximately $32,000 related to theseguarantees.  We also have a net deferredgain related to the sale of these leases in the amount of approximately $342,000as of March 31, 2003.

 

The mortgage loan guaranteesfor the benefit of franchisees also arose primarily through our former Turnkeyprogram, in which we developed the related restaurants, sold the restaurant toa franchisee, and guaranteed all or a portion of the franchisee’s mortgageloan.  The guarantees range from limitedguarantees, either in dollar amount or term, to full guarantees of themortgage. The maximum amount of a single guarantee is approximately $1.1million.  Certain guarantees extend through2016.  We may be required by the lenderto make monthly mortgage payments if the franchisee does not make the requiredpayments in a timely manner, or we may be required to make up any deficiency,up to the amount of the guarantee, if the related restaurant is sold for netproceeds less than the amount of the outstanding mortgage.  We have indemnification agreements with thefranchisees under which the franchisee would be obligated to reimburse us forany amount paid under such guarantees. In the event that we purchase the loan from the lender in the event of adefault, we would succeed to the lender’s security interest in the relatedproperty.

 

The loan guarantees in favorof related parties primarily arose when we guaranteed certain debt of relatedparties for which the proceeds of the loans were used to repay outstanding debtto us.  Two of the guarantees, for thebenefit of our

 

14

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restaurant venture and our real estateventure, are of mortgage debt  totalingapproximately $4.1 million.  Theseguarantees extend through 2009 on one note and through 2016 on the othernote.  A third guarantee, in the amountof approximately $1.7 million, is for the benefit of the advertising entity ofthe Schlotzsky’s Deli restaurant system, for which we had received the netproceeds of the loan in repayment of outstanding debt to us.  This guarantee expires in 2004.

 

We have been called upon,from time to time, to make payments on obligations we have guaranteed.  During the first quarter of 2003, we paidapproximately $169,000 in various lease guarantees  for the benefit of franchisees. In addition, pursuant to a guarantee of a franchisee’s debt obligation,we expect to purchase that obligation from a bank, in the amount ofapproximately $665,000, in August 2003.

 

### **LIQUIDITY AND CAPITAL RESOURCES**

 

Cash and cash equivalentsincreased $38,000 in the three months ended March 31, 2003, and decreased$231,000 in the three months ended March 31, 2002.  Cash and cash equivalents are impacted by operating, investingand financing activities.

 

Operating activities provided$1,976,000 of cash in the first quarter of 2003 and $2,073,000 of cash in thefirst quarter of 2002.  The decrease incash provided in the first quarter of 2003 compared to the first quarter of2002 was the net result of reduced net income and a provision for deferredtaxes, partially offset by increased cash provided by certain working capitalaccounts,  increased depreciation andamortization, an increased provision for uncollectible amounts, and a decreasein the amount of deferred revenue amortized.

 

Investing activities used$292,000 of cash in the quarter ended March 31, 2003 and provided $148,000 ofcash in the quarter ended March 31, 2002. The increase in cash used in the quarter ended March 31, 2003 comparedto the comparable period of 2002 was the net result of an increase inexpenditures for intangible assets, partially offset by decreased proceeds fromthe sale of real estate held for sale and a decrease in expenditures forproperty and equipment.

 

Financing activities used$1,646,000 and $2,452,000 of cash in the first quarter of 2003 and 2002,respectively.  The decrease in cash usedin the first quarter of 2003 compared to the first quarter of 2002 is primarilydue to decreased net repayments of debt.

 

At March 31, 2003, we hadapproximately $51,783,000 of total debt outstanding.  Scheduled maturities of debt through March 31, 2004 approximate$8,409,000 (including short-term debt). During the quarter ended March 31, 2003, we repaid approximately$1,822,000 of debt and borrowed $150,000 on a short-term basis.  This short-term debt was collateralized by acertificate of deposit pledged by one of our officers.  Subsequent to the end of the quarter, wearranged a $1,000,000 four-month facility with two of our officers, secured byour intellectual property, contract rights and certain intangibles.

 

Certain of our mortgage debtrequire the maintenance of certain financial ratios, including debt-to-equityand working capital.  While we arecurrently in compliance with these covenants, or have obtained waivers, anyfailure to comply in the future could have material adverse consequences to us.

 

The following tables presentcertain of our obligations and commitments to make future payments, excludinginterest payments, under contracts and contingent commitments as of March 31,2003 (dollars in thousands).

 
|                         |   | **Payments Due by Period** |   |
|------------------------------|--------|----------------------------|--------|
| **Contractual  Obligations** |   | **Total**                  |   | **Less than 1  year** |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
| Short-term Debt              |   | $                          | 150    |   | $ | 150 |   | $ | — |   | $ | — |   | $ | — |   |
| Long-term Debt               |   | 51,633                     |   | 8,493 |   | 31,035 |   | 4,364 |   | 7,741 |   |
| Operating Leases             |   | 20,700                     |   | 2,421 |   | 6,671 |   | 2,478 |   | 9,080 |   |
|                              |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                             |   | **Total**              |   | **Amount of Commitment Expiration Per Period** |   |
|----------------------------------|--------|------------------------|--------|------------------------------------------------|--------|
| **Other Commercial Commitments** |   | **Amounts  Committed** |   | **Less than 1  year**                          |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
| Guarantees                       |   | $                      | 27,598 |                                           | $      | 5,937 |   | $ | 4,778 |   | $ | 2,726 |   | $ | 14,157 |   |
|                                  |        |                        |        |                                                |        |  |  |  |  |  |  |  |  |  |  |  |

 

15

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We plan to develop additionalCompany-operated restaurants.  Tworestaurants are under construction in the Austin area and are expected to openlater in 2003.  We have received alending commitment for one of these restaurants.  We have also acquired building sites for three additionalrestaurants in the Austin area and entered into a lease for a site in theHouston area.  Sites for additionalrestaurants in Texas and in other markets are under consideration.

 

We will require additionalfinancing in the second quarter of 2003 to execute our growth strategy for Company-operatedrestaurants, to refinance certain existing debt and for operatingpurposes.  We are pursuing financingalternatives, including asset-backed financing secured by our intellectualproperty and related royalty rights and agreements, as well as real estatemortgages.  There can be no assurancesthat such financing can be arranged in acceptable amounts and on acceptableterms.  Failure to obtain such financingin the second quarter of 2003 would require us to significantly modify ourgrowth strategies for Company-operated restaurants and to reduce our operatingcosts and capital expenditures.

 

Our Board of Directors hasauthorized the repurchase of up to 1,000,000 shares of our outstanding CommonStock.  In 1998, 10,000 shares wererepurchased for $105,000.  In 2001 and2002, we had repurchased an additional 179,525 shares at a total cost ofapproximately $738,000.

 

**FORWARD-LOOKINGSTATEMENTS**

 

This report may contain “forward-looking statements” within the meaning ofSection 27A of the Securities Act, Section 21E of the Exchange Act, or thePrivate Securities Litigation Reform Act of 1995.  Any statements that are not statements of historical fact may bedeemed forward-looking statements.  Forward-looking statements are not meantto predict or guarantee actual results, performance, events, or circumstancesand may not be realized because they are based on our current projections,plans, objectives, beliefs, expectations, estimates, and assumptions and aresubject to a number of risk factors and uncertainties, many of which are beyondour control.  Actual results and thetiming of future events and circumstances may differ materially from thosedescribed or implied by the forward-looking statements as a result of theserisk factors and uncertainties.  Forward-lookingstatements may include, without limitation, statements concerning earnings orother financial item projections, the plans and objectives of management,future economic performance, new restaurant development, future Schlotzsky’s®Deli brand products, and assumptions underlying or relating to any otherforward-looking statement.  Factors thatcould cause actual results to differ materially from those described in the forward-looking statementsmay include, without limitation, an inabilityto obtain adequate financing for the development of new Company-operatedrestaurants and other purposes, increased competition within therestaurant industry, the continued viability of restaurants during a weakeconomy, changing consumer preferences, government regulation, the results ofarbitration and litigation, an inability to sell restaurants, a failure tosuccessfully recruit multi-unit and single-unit franchisees, and stock volatility and illiquidity.

 

Because of the risks and uncertainties related to thesefactors and the forward-looking statements, readers are cautioned not to placeundue reliance on the forward-looking statements.  There can be no assurance that any events or results described inany forward-looking statement will actually occur or be achieved.  We undertake no obligation to publiclyrevise the forward-looking statements to reflect events or circumstances thatarise after the date of this report or to reflect new information, futureevents or circumstances, changes in assumptions, or otherwise.  Readers should carefully review the riskfactors described above and in other documents filed by us with theCommission.  Readers are specificallydirected to the discussion under “Risk Factors” in our most recent annualreport on Form 10-K.

 

16

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**ITEM 3****.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Changes in short-terminterest rates on loans from financial institutions could materially affect theCompany’s earnings because the interest rates charged on certain underlyingobligations are variable.

 

At March 31, 2003, ahypothetical 100 basis point increase in interest rates would result in adecrease of approximately $81,000 in annual pre-tax earnings.  The estimated decrease is based upon theincreased interest expense of the Company’s variable rate debt and assumes nochange in the volume or composition of debt at March 31, 2003.

 

**ITEM 4****.  CONTROLS ANDPROCEDURES**

 

(a)   Evaluation of Disclosure Controls and Procedures.** **Theterm “disclosure controls and procedures” is defined in Rule 13a-14(c) of theSecurities Exchange Act of 1934, or the Exchange Act.  This term refers to the controls and procedures of a company thatare designed to ensure that information required to be disclosed by a companyin the reports it files under the Exchange Act is recorded, processed,summarized and reported within the required time periods.  Our Chief Executive Officer and our ChiefFinancial Officer have evaluated the effectiveness of our disclosure controlsand procedures as of a date within 90 days before the filing of this quarterlyreport, and they have concluded that as of that date, our disclosure controlsand procedures were effective at ensuring that required information will bedisclosed on a timely basis in our reports filed under the Exchange Act.

 

(b)   Changes in Internal Controls.  We maintain a system of internalcontrols that are designed to provide reasonable assurance that our books andrecords accurately reflect, in all material respects, our transactions and thatour established policies and procedures are followed.  There were no significant changes to our internal controls or inother factors that could significantly affect our internal controls subsequentto the date of their evaluation by our Chief Executive Officer and ChiefFinancial Officer, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

17

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**PART II**

**OTHER INFORMATION**

 

**ITEM 1.  LEGAL****PROCEEDINGS**

 

*Russell R. Kesterson and Steven P.Schmidt v. Schlotzsky’s, Inc., Ron Lynch and Jane Doe Lynch, John DoesI—X, Jane Does I—X, ABC Corporations I—X, XYZ Companies I—X,* (Case No. CV2002-021158) was filed onOctober 31, 2002, in the Superior Court of Maricopa County, Arizona.Plaintiffs were franchisees of the Company and owned and operated aSchlotzsky’s Deli restaurant in Phoenix, Arizona. The Complaint includes claimsof breach of contract, interference with business expectancy, interference withbusiness relationship, unfair competition and negligence. Plaintiffs allegethat a “superstore” owned by Lynch and/or our affiliates encroached on theirbusiness and allege that we failed to collect royalties from the “superstore,”creating unfair competition. Plaintiffs further state that they attempted torelocate their restaurant but that we failed to approve a proposed alternativelocation and that we induced their employee to work for a competing restaurant.Plaintiffs are seeking an unspecified amount of damages, including trebledamages, attorney’s fees, and costs. On December 3, 2002, we filed apetition styled *Schlotzsky’s, Inc., v. Russell R. Kesterson and Steven P. Schmidt,*in the United States District Court for the Western District of Texas, AustinDivision (Civil Action No. AO2CA 768SS) to compel Plaintiffs to arbitrate theirclaims in Austin, Texas. The federal court entered an order onDecember 20, 2002, granting our petition to compel arbitration in themanner provided in the franchise agreement and enjoined Kesterson and Schmidtfrom pursuing any of their claims in the lawsuit pending in Arizona. To date,we are unaware of any subsequent demand for arbitration filed by eitherKesterson or Schmidt.

 

*Kimberly L.E. Garland v.Schlotzsky’s, Inc., Schenck & Associates, John C. Wooley, DarrellW. Kolinek, Kelly R. Arnold, Joyce Cates, Brian Wieters, David B. Gerstner, andJeffrey P. Noeldner*,(Case No. 01-CV-2377), was filed on or about December 26, 2001 in theUnited States District Court for the District of Minnesota. Plaintiff is aprincipal and guarantor under a franchise agreement between the Company andHoly Buns, L.L.C., a former franchisee in Apple Valley, Minnesota (“FranchiseAgreement”). Plaintiff alleges fraudulent and negligent misrepresentation andomission and violations of the Minnesota Franchise Act, Minnesota UniformDeceptive Trade Practices Act, and the Texas Deceptive Trade Practices andConsumer Protection Act against the Company and five of its current and formeremployees (John Wooley, Darrell Kolinek, Kelly Arnold, Joyce Cates, and BrianWieters), her Area Developer (Jeffrey Noeldner), her accountant (DavidGerstner), and his accounting firm (Schenck & Associates). Plaintiffclaims that the defendants engaged in a fraudulent scheme to sell her aSchlotzsky’s franchise and Schlotzsky’s Deli restaurant in Apple Valley,Minnesota (constructed through the Company’s Turnkey Program) that they knewwas not financially viable. Plaintiff seeks an unspecified amount of moneydamages plus attorneys’ fees, costs, and interest. We have denied theallegations in our answer and filed a motion, which is still pending, todismiss or stay the case pending arbitration in the manner provided in theFranchise Agreement. The Court ordered the parties to appear for a settlementconference on May 19, 2003. The case is not yet set for trial.

 

*Robert Coshott v.Schlotzsky’s, Inc.*,(Cause No. GN 1-02279), was filed on July 24, 2001, in the 200th JudicialDistrict Court of Travis County, Texas. Plaintiff is the Master Licensee forAustralia and New Zealand, and he opened a Schlotzsky’s Deli restaurant inMelbourne, Australia. Plaintiff brings causes of action for fraud and/ornegligent misrepresentation. Plaintiff alleges that he experienced problemswith certain equipment specified or approved by the Company, that the Company’ssystem and equipment did not generate enough finished food product to servicehis potential customers; that the Company misrepresented the level of revenuethe restaurant could reasonably be expected to achieve; that the Companydelayed his ability to develop restaurants by failing to timely secure certaintrademarks and trade names; and that the Company misrepresented whether itwould allow Plaintiff to franchise Schlotzsky’s Deli restaurants in certain gasstation or convenience store locations in his territories. Plaintiff requestsactual and punitive damages of $3.75 million plus lost profits andincidental and consequential damages of an unspecified amount. The case is not yetset for trial.

 

*Dae Kim, DWKEnterprises, Inc., and Aecon International, Inc. v. John Wooley,Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership,Schlotzsky’s N.A.M.F., Inc., Schlotzsky’s National AdvertisingAssociation, Inc., and Schlotzsky’s, Brands, Inc., Schlotzsky’s BrandProducts, L.P., Schlotzsky’s Real Estate, Inc., and Schlotzsky’sRestaurants, Inc.,*(Cause No. 2001-CI-13672), was originally filed in the 73rd Judicial DistrictCourt of Bexar County, Texas on or about September 25, 2001 (after asimilar lawsuit was filed and later withdrawn in Harris County, Texas) againstSchlotzsky’s, Inc., John Wooley, Schlotzsky’s Franchising LimitedPartnership, and Schlotzsky’s NAMF, Inc. (collectively, “Defendants”).Plaintiffs are, or claim to be, franchisees in Houston and San Antonio Texas,and Plaintiff Kim was an area developer for those markets. Plaintiffs bringcauses of action for breach of contract, breach of fiduciary duty, breach ofthe duty of good faith and fair dealing, civil conspiracy, tortiousinterference with contract, tortious interference with prospective businessrelationship, violation of the Texas Deceptive Trade Practices and ConsumerProtection Act, restraint of trade, detrimental reliance-fraud in theinducement, and defamation-business disparagement. They seek an unspecifiedamount of money damages plus exemplary damages, attorneys’ fees, pre-judgmentinterest, costs, and a jury trial. Defendants, except for Mr. Wooley, whowas previously dismissed from the case, answered and asserted

 

18

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counter claims alleging breach of contract andthat Plaintiffs’ claim under the Texas Deceptive Trade Practices Act isgroundless in fact or in law and brought in bad faith or for the purpose ofharassment, and seeking money damages, costs of court, penalty fees, costsincurred in performing the accounting, attorneys’ fees, and pre- andpost-judgment interest. Defendants (except for Mr. Wooley) removed thecase to federal court. The case was remanded to state court on April 17,2003.  The case is not yet set fortrial.

 

*U.S. Restaurant PropertiesOperating L.P. v. Schlotzsky’s, Inc.*was filed on February 27, 2003, in theDistrict Court of Dallas County, B-44th Judicial District (Cause No. 03-01758).  Plaintiff is a real estate investmentcompany that owns certain Schlotzsky’s Deli restaurants, and leases them tofranchisees. It alleges that in 1997 and 1998 we entered into several writtenguaranty agreements where we agreed to guarantee certain lease agreements.Plaintiff states that in 1998 the Parties entered into an agreement wherebyPlaintiff agreed to release Schlotzsky’s from its guaranty obligationspertaining to six properties in which the tenants had defaulted, in exchangefor Schlotzsky’s agreement to purchase seven other properties. The Companypurchased one of the properties located in Texas. Plaintiffs are seeking anorder requiring us to purchase the other six properties, two of which are inTexas, and one each in Arizona, Colorado, Indiana, and Tennessee, for a totalpurchase price of over $4.5 million. In the alternative, Plaintiff isseeking damages or an order reinstating the previously released guaranties.Plaintiff’s claims include breach of contract and a request for attorneys’fees. A trial date has been set for February 16, 2004.

 

In addition to the mattersdiscussed above, we are defendants in various other legal proceedings arisingfrom our business. The ultimate outcome of these pending proceedings cannot beprojected with certainty. However, based on our experience to date, we believesuch proceedings will not have a material effect on our business or financialcondition.

 

**ITEM 2.  CHANGES****IN SECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM 3.  DEFAULTS****UPON SENIOR SECURITIES**

 

None.

 

**ITEM 4.  SUBMISSION****OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None.

 

**ITEM 5.  OTHER****INFORMATION**

 

None.

 

**ITEM 6.  EXHIBITS****AND REPORTS ON FORM 8-K**

 

Exhibits:

 
| 3.1    |   | Articles of Incorporation  of the Company, as amended.  (1)                                                                                                |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                            |
| 3.2    |   | Statement of Resolutions  Regarding the Designation, Preferences and Rights of Class C Series A Junior  Participating Preferred Stock of the Company.  (2) |
|   |   |                                                                                                                                                            |
| 3.3    |   | Bylaws of the Company, as  amended.  (4)                                                                                                                   |
|   |   |                                                                                                                                                            |
| 4.1    |   | Specimen stock certificate  evidencing the Common Stock of the Company.   (1)                                                                              |
|   |   |                                                                                                                                                            |
| 4.2    |   | Rights Agreement dated  December 18, 1998 between the Company and Harris Trust and Savings Bank.  (2)                                                      |
|   |   |                                                                                                                                                            |
| 4.3    |   | Warrant Certificate dated  February 15, 2001 from the Company to Triad Media Ventures LLC.  (3)                                                            |
|   |   |                                                                                                                                                            |
| 10.43  |   | Note and Security Agreement  dated March 27, 2003, between the Company and American Bank of Commerce. (4)                                                       |
|   |   |                                                                                                                                                            |
| 10.44  |   | Promissory Note dated April  8, 2003, between the Company and John C. Wooley and Jeffrey J. Wooley. (4)                                                         |
|   |   |                                                                                                                                                            |
| 10.45  |   | Security Agreement dated  April 8, 2003 between the Company and John C. Wooley and Jeffrey J. Wooley.  (4)                                                      |

 

19

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| Additional Exhibits: |
|----------------------|
|                 |
|                 | 99.1 |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, signed by John C. Wooley,  Chief Executive Officer.  (4) |
|                 |   |   |   |
|                 | 99.2 |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, signed by Richard H. Valade,  Chief Financial Officer.  (4) |
|                      |
|                 | (1) |   | Incorporated by reference  from the Company’s Registration Statement on Form S-1 filed on October 12,  1995, as amended. |
|                 |   |   |   |
|                 | (2) |   | Incorporated by referenced  from the Company’s Registration of certain Securities on Form 8-A filed on  December 18, 1998. |
|                 |   |   |   |
|                 | (3) |   | Incorporated by reference  from the Company’s Annual Report on Form 10-K filed on April 2, 2001. |
|                 |   |   |   |
|                 | (4) |   | Filed with this Quarterly  Report on Form 10-Q. |
|                 |   |   |   |
| b)                   | Current Reports on Form  8-K: |
|                 |   |
|                 | The Registrant filed a  Current Report on Form 8-K dated April 2, 2003, containing a press release  dated March 28, 2003, announcing the Company’s financial results for the  quarter and fiscal year ended December 31, 2002. |

 

20

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|   | SCHLOTZSKY’S, INC. |
|--------|-------------------------|
|   |                    |   |
|   | By:                     |  /s/ John C. Wooley |
|   |                    |   |
|   |                    | John C. Wooley |
|   |                    | Chairman of the Board, |
|   |                    | President and Chief Executive Officer |
|   |                    | (Principal Executive Officer) |
|   |                    |   |
|   | By:                     |  /s/ Richard H. Valade |
|   |                    |   |
|   |                    | Richard H. Valade |
|   |                    | Executive Vice President, |
|   |                    | Treasurer and Chief Financial Officer |
|   |                    | (Principal Financial Officer) |
|   |                    |   |
|   | By:                     |  /s/ Matthew D. Osburn |
|   |                    |   |
|   |                    | Matthew D. Osburn |
|   |                    | Controller and Assistant Treasurer |
|   |                    | (Principal Accounting Officer) |

 

Austin, Texas

May 15, 2003

 

21

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**CERTIFICATION**

 

I, John C. Wooley, certify that:

 

1. I have reviewed this quarterly report onForm 10-Q of Schlotzsky’s, Inc.;

 

2.Based on my knowledge, this quarterly report does not contain any untruestatement of a material fact or omit to state a material fact necessary to makethe statements made, in light of the circumstances under which such statementswere made, not misleading with respect to the period covered by this quarterlyreport;

 

3.Based on my knowledge, the financial statements, and other financialinformation included in this quarterly report, fairly present in all materialrespects the financial condition, results of operations and cash flows of theregistrant as of, and for, the periods presented in this quarterly report;

 

4.The registrant’s other certifying officer and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

 

a)designed such disclosure controls and procedures to ensure that materialinformation relating to the registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this quarterly report is being prepared;

 

b)evaluated the effectiveness of the registrant’s disclosure controls andprocedures as of a date within 90 days prior to the filing date of thisquarterly report (the “Evaluation Date”); and

 

c)presented in this quarterly report our conclusions about the effectiveness ofthe disclosure controls and procedures based on our evaluation as of theEvaluation Date;

 

5.The registrant’s other certifying officer and I have disclosed, based on ourmost recent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)all significant deficiencies in the design or operation of internal controlswhich could adversely affect the registrant’s ability to record, process,summarize and report financial data and have identified for the registrant’sauditors any material weaknesses in internal controls; and

 

b)any fraud, whether or not material, that involves management or other employeeswho have a significant role in the registrant’s internal controls; and

 

6.The registrant’s other certifying officer and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

 

Date: May 15, 2003
|   | By:    | /s/ John C. Wooley                     |   |
|--------|--------|----------------------------------------|--------|
|   |   |                                   |
|   |   | John C. Wooley                         |
|   |   | Chairman of the Board,                 |
|   |   | President and Chief  Executive Officer |
|   |   | (Principal Executive  Officer)         |

 

22

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**CERTIFICATION**

 

I, Richard H. Valade, certify that:

 

1. I have reviewed this quarterly report onForm 10-Q of Schlotzsky’s, Inc.;

 

2.Based on my knowledge, this quarterly report does not contain any untruestatement of a material fact or omit to state a material fact necessary to makethe statements made, in light of the circumstances under which such statementswere made, not misleading with respect to the period covered by this quarterlyreport;

 

3.Based on my knowledge, the financial statements, and other financialinformation included in this quarterly report, fairly present in all materialrespects the financial condition, results of operations and cash flows of theregistrant as of, and for, the periods presented in this quarterly report;

 

4.The registrant’s other certifying officer and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

 

a)designed such disclosure controls and procedures to ensure that materialinformation relating to the registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this quarterly report is being prepared;

 

b)evaluated the effectiveness of the registrant’s disclosure controls andprocedures as of a date within 90 days prior to the filing date of thisquarterly report (the “Evaluation Date”); and

 

c)presented in this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.The registrant’s other certifying officer and I have disclosed, based on ourmost recent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)all significant deficiencies in the design or operation of internal controlswhich could adversely affect the registrant’s ability to record, process,summarize and report financial data and have identified for the registrant’sauditors any material weaknesses in internal controls; and

 

b)any fraud, whether or not material, that involves management or other employeeswho have a significant role in the registrant’s internal controls; and

 

6.The registrant’s other certifying officer and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

 

Date: May 15, 2003
|   | By:    | /s/ Richard H. Valade                  |   |
|--------|--------|----------------------------------------|--------|
|   |   |                                   |
|   |   | Richard H. Valade                      |
|   |   | Executive Vice President,              |
|   |   | Treasurer and Chief  Financial Officer |
|   |   | (Principal Financial  Officer)         |

 

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