##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 
 FORM 10-Q Quarterly report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934 For the quarterly period ended March 31, 2004 Commission File Number: 0-27008   Schlotzskys, Inc.  Texas
    
    74-2654208(State or other jurisdiction of
    
    (IRS Employerincorporation or organization)
    
    Identification No.)
 203 Colorado Street, Suite 600, Austin, Texas 78701
(Address of principal executive offices) (512) 236-3800
(Registrants telephone number)   Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. Yes [ü]No
[   ] Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes [   ]No [ü] Indicate the number of shares outstanding of each of the issuers
classes of common stock, as of the latest practicable date. Class
    
    Shares Outstanding at May 4, 2004Common Stock, no par value
    
    7,338,661




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SCHLOTZSKYS, INC. Index to Form 10-Q
Quarter Ended March 31, 2004 Page No.Part I
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial StatementsCondensed Consolidated Balance Sheets  March 31, 2004 and December 31, 2003
    
    
    1Condensed Consolidated Statements of Operations  Three Months Ended March 31, 2004 and March 31, 2003
    
    
    2Condensed
Consolidated Statement of Stockholders Equity  Three Months Ended March 31, 2004 and Year Ended December 31, 2003
    
    
    3Condensed Consolidated Statements of Cash Flows  Three Months Ended March 31, 2004 and March 31, 2003
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2.
    

    Managements Discussion and Analysis of Financial Condition And Results of Operations
    
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    19Item 4.
    
    Controls and Procedures
    
    
    19Part II
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    20Item 2.
    
    Changes in Securities and Use of Proceeds
    
    
    21Item 3.
    
    Defaults Upon Senior Securities
    
    
    21Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    21Item 5.
    
    Other Information
    
    
    21Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    21Modification/Extension/Renewal of Promissory NoteCertification Pursuant to Section 302Certification Pursuant to Section 302Certification Pursuant to Section 906Certification Pursuant to Section 906




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PART I
FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 March 31,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    1,133,087
    
    
    $
    1,058,300Accounts receivable, net:Royalties
    
    
    1,072,697
    
    
    
    884,098Brands
    
    
    906,654
    
    
    
    905,085Other
    
    
    1,505,071
    
    
    
    1,494,513Refundable income taxes
    
    
    9,350
    
    
    
    9,350Prepaids, inventories and other assets
    
    
    1,199,005
    
    
    
    1,250,193Real estate held for sale
    
    
    3,213,821
    
    
    
    3,208,533Current portion of:Notes receivable
    
    
    55,134
    
    
    
    50,570Notes receivable  related party
    
    
    
    
    
    
    3,500Total current assets
    
    
    9,094,819
    
    
    
    8,864,142Property, equipment and leasehold improvements, net
    
    
    41,538,565
    
    
    
    42,396,145Notes receivable, net, less current portion
    
    
    4,059,407
    
    
    
    4,121,951Notes receivable  related party, net, less current portion
    
    
    1,740,606
    
    
    
    2,613,170Investments
    
    
    1,058,683
    
    
    
    567,850Intangible assets, net
    
    
    62,284,461
    
    
    
    62,523,367Goodwill, net
    
    
    3,519,242
    
    
    
    3,519,242Other noncurrent assets
    
    
    1,140,116
    
    
    
    1,179,687Total assets
    
    $
    124,435,899
    
    
    $
    125,785,554LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Short-term debt
    
    $
    1,917,171
    
    
    $
    1,133,701Current maturities of long-term debt
    
    
    7,357,985
    
    
    
    6,564,646Accounts payable
    
    
    3,899,488
    
    
    
    5,768,117Accrued liabilities
    
    
    5,634,784
    
    
    
    5,243,563Deferred revenue, current portion
    
    
    443,215
    
    
    
    376,633Total current liabilities
    
    
    19,252,643
    
    
    
    19,086,660Long-term debt, less current portion
    
    
    42,170,770
    
    
    
    42,586,141Deferred revenue, less current portion
    
    
    1,000,579
    
    
    
    1,450,300Deferred tax liability
    
    
    
    
    
    
    Total liabilities
    
    
    62,423,992
    
    
    
    63,123,101Commitments and contingenciesStockholders 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,
7,528,186 shares and 7,521,524 shares issued at March 31,
2004 and December 31, 2003, respectively
    
    
    64,140
    
    
    
    64,073Additional paid-in capital
    
    
    58,234,642
    
    
    
    58,213,945Retained earnings
    
    
    4,556,281
    
    
    
    5,227,591Treasury stock (189,525 shares at March 31, 2004 and
December 31, 2003), at cost
    
    
    (843,156
    )
    
    
    (843,156
    )Total stockholders equity
    
    
    62,011,907
    
    
    
    62,662,453Total liabilities and stockholders equity
    
    $
    124,435,899
    
    
    $
    125,785,554
 The accompanying notes are an integral part of the condensed consolidated financial statements. 1




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SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (Unaudited)
 For the three months endedMarch 31,
    
    March 31,2004
    
    2003Revenue:Royalties
    
    $
    3,592,768
    
    
    $
    4,303,888Developer fees
    
    
    36,307
    
    
    
    50,159Restaurant sales
    
    
    7,781,785
    
    
    
    7,612,229Brand contribution
    
    
    1,416,596
    
    
    
    1,651,105Other fees and revenue
    
    
    219,996
    
    
    
    212,649Total revenue
    
    
    13,047,452
    
    
    
    13,830,030Expenses:Service costs:Royalties
    
    
    528,883
    
    
    
    663,792528,883
    
    
    
    663,792Restaurant operations:Cost of sales
    
    
    2,110,003
    
    
    
    2,171,620Personnel and benefits
    
    
    2,950,497
    
    
    
    3,365,161Operating expenses
    
    
    1,871,420
    
    
    
    1,902,2476,931,920
    
    
    
    7,439,028Equity loss on investments
    
    
    
    
    
    
    67,150General and administrative
    
    
    3,942,874
    
    
    
    5,070,715Depreciation and amortization
    
    
    1,406,008
    
    
    
    1,249,406Total expenses
    
    
    12,809,685
    
    
    
    14,490,091Income (loss) from operations
    
    
    237,767
    
    
    
    (660,061
    )Other:Interest income
    
    
    62,393
    
    
    
    103,648Interest expense
    
    
    (931,470
    )
    
    
    (1,015,905
    )Income (loss) before provision (credit) for income taxes
    
    
    (631,310
    )
    
    
    (1,572,318
    )Provision (credit) for income taxes
    
    
    40,000
    
    
    
    (506,000
    )Net income (loss)
    
    $
    (671,310
    )
    
    $
    (1,066,318
    )Earnings per share-basic
    
    $
    (0.09
    )
    
    $
    (0.15
    )Earnings per share-diluted
    
    $
    (0.09
    )
    
    $
    (0.15
    )
 The accompanying notes are an integral part of the condensed consolidated financial statements. 2




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
 (Unaudited)
 Common StockAdditional
    
    
    
    
    
    
    
    
    
    TotalNumber of
    
    Stated Capital
    
    Paid-in
    
    Retained
    
    Treasury
    
    StockholdersShares
    
    Amount
    
    Capital
    
    Earnings
    
    Stock
    
    EquityBalance, January 1, 2003
    
    
    7,496,778
    
    
    $
    63,826
    
    
    $
    58,122,469
    
    
    $
    16,976,186
    
    
    $
    (843,156
    )
    
    $
    74,319,325Issuance of common stock in
connection with employee stock
purchase plan
    
    
    24,746
    
    
    
    247
    
    
    
    76,766
    
    
    
    
    
    
    
    
    
    
    
    77,013Issuance of employee stock options
    
    
    
    
    
    
    
    
    
    
    14,710
    
    
    
    
    
    
    
    
    
    
    
    14,710Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11,748,595
    )
    
    
    
    
    
    
    (11,748,595
    )Balance, December 31, 2003
    
    
    7,521,524
    
    
    
    64,073
    
    
    
    58,213,945
    
    
    
    5,227,591
    
    
    
    (843,156
    )
    
    
    62,662,453Issuance of common stock in
connection with employee stock
purchase plan
    
    
    6,662
    
    
    
    67
    
    
    
    11,485
    
    
    
    
    
    
    
    
    
    
    
    11,552Issuance
of employee stock options
    
    
    
    
    
    
    
    
    
    
    9,212
    
    
    
    
    
    
    
    
    
    
    
    9,212Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (671,310
    )
    
    
    
    
    
    
    (671,310
    )Balance, March 31, 2004
    
    
    7,528,186
    
    
    $
    64,140
    
    
    $
    58,234,642
    
    
    $
    4,556,281
    
    
    $
    (843,156
    )
    
    $
    62,011,907
 The accompanying notes are an integral part of the condensed consolidated financial statements. 3




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SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (Unaudited)
 Three Months EndedMarch 31,
    
    March 31,2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    (671,310
    )
    
    $
    (1,066,318
    )Adjustments to reconcile net income (loss) to cash provided by
operating activities:Depreciation and amortization
    
    
    1,406,008
    
    
    
    1,249,406Provision for uncollectible accounts
    
    
    436,849
    
    
    
    383,580Provision for deferred taxes
    
    
    
    
    
    
    (536,000
    )Provision for stock option compensation
    
    
    9,212
    
    
    
    6,096Amortization of deferred revenue
    
    
    53,693
    
    
    
    (37,659
    )Equity loss on investments
    
    
    
    
    
    
    67,150Changes in:Accounts receivable
    
    
    (675,859
    )
    
    
    468,647Prepaid expenses and other assets
    
    
    190,221
    
    
    
    259,656Accounts payable and accrued liabilities
    
    
    (588,252
    )
    
    
    1,181,918Net cash provided by operating activities
    
    
    160,562
    
    
    
    1,976,476Cash flows from investing activities:Purchase of property and equipment
    
    
    (149,320
    )
    
    
    (610,456
    )Sale of property, equipment and real estate held for sale
    
    
    
    
    
    
    530,655Acquisition of investments and intangible assets
    
    
    (164,954
    )
    
    
    (209,771
    )Issuance of notes receivable
    
    
    (37,977
    )
    
    
    (8,130
    )Repayments of notes receivable
    
    
    35,139
    
    
    
    5,372Net cash used in investing activities
    
    
    (317,112
    )
    
    
    (292,330
    )Cash flows from financing activities:Sale of common stock
    
    
    11,552
    
    
    
    36,082Proceeds from issuance of debt
    
    
    1,500,000
    
    
    
    150,000Debt issuance costs
    
    
    
    
    
    
    (10,312
    )Acquisition of treasury stock
    
    
    
    
    
    
    Repayment of debt
    
    
    (1,280,215
    )
    
    
    (1,821,722
    )Net cash provided by (used in) financing activities
    
    
    231,337
    
    
    
    (1,645,952
    )Net increase (decrease) in cash and cash equivalents
    
    
    74,787
    
    
    
    38,194Cash and cash equivalents at beginning of period
    
    
    1,058,300
    
    
    
    678,895Cash and cash equivalents at end of period
    
    $
    1,133,087
    
    
    $
    717,089
 The accompanying notes are an integral part of the condensed consolidated financial statements. 4




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SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 Note 1.  Basis of Presentation The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all
adjustments, consisting of normal recurring accruals, considered necessary for
a fair presentation have been included. Operating results for the three months
ended March 31, 2004, are not necessarily indicative of the results that may be
expected for the year ended December 31, 2004. This information should be read
in conjunction with the consolidated financial statements and footnotes thereto
included in the Schlotzskys, Inc. Annual Report on Form 10-K for the year
ended December 31, 2003. Reclassifications Certain reclassifications have been made to the condensed consolidated
financial statements at March 31, 2003, and for the period then ended, to
correspond with the presentation used at March 31, 2004, and for the period
then ended. Note 2.  Stock-Based Compensation Effective January 1, 2003, the Company adopted the cost recognition
provisions for stock-based compensation of Statement of Financial Accounting
Standards (SFAS) No. 123 under the prospective method of adoption authorized
by SFAS No. 148. The amount charged to expense during the quarter ended March
31, 2004 was approximately $9,212. Had the Company adopted the cost recognition
provisions of SFAS No. 123 in 1995, the Companys net income and earnings per
share would have been reduced to the pro forma amounts shown (in thousands,
except per share amounts): For the three months endedMarch 31, 2004
    
    March 31, 2003Net income (loss), as reported
    
    $
    (671
    )
    
    $
    (1,066
    )Add: Stock-based employee
compensation expense included
in net income, net of related
tax effects
    
    
    9
    
    
    
    4Deduct: Total stock-based
employee compensation expense
determined under fair value
based method for all awards,
net of related tax effects
    
    
    (20
    )
    
    
    (69
    )Pro forma net income (loss)
    
    $
    (682
    )
    
    $
    (1,131
    )Earnings per share:Basic-as reported
    
    $
    (0.09
    )
    
    $
    (0.15
    )Basic-pro forma
    
    $
    (0.09
    )
    
    $
    (0.15
    )Diluted-as reported
    
    $
    (0.09
    )
    
    $
    (0.15
    )Diluted-pro forma
    
    $
    (0.09
    )
    
    $
    (0.15
    )
 5




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 3.  Restaurant Operations A summary of certain operating information for Company-operated
restaurants is presented below for the three-month periods ended March 31, 2004
and 2003 (dollars in thousands). Long-term PortfolioRestaurants
    
    AvailableSandwich-
    
    
    
    
    
    For SaleCafes
    
    Training
    
    Restaurants
    
    TotalThree months ended March 31, 2004Restaurant sales
    
    $
    4,994
    
    
    $
    634
    
    
    $
    2,154
    
    
    $
    7,782Restaurant operations:Cost of sales
    
    
    1,353
    
    
    
    176
    
    
    
    581
    
    
    
    2,110Personnel and benefits
    
    
    1,718
    
    
    
    289
    
    
    
    944
    
    
    
    2,951Operating expenses
    
    
    903
    
    
    
    249
    
    
    
    719
    
    
    
    1,8713,974
    
    
    
    714
    
    
    
    2,244
    
    
    
    6,932Operating income (loss) before depreciation
and amortization
    
    $
    1,020
    
    
    $
    (80
    )
    
    $
    (90
    )
    
    $
    850Three months ended March 31, 2003Restaurant sales
    
    $
    4,474
    
    
    $
    657
    
    
    $
    2,481
    
    
    $
    7,612Restaurant operations:Cost of sales
    
    
    1,275
    
    
    
    195
    
    
    
    702
    
    
    
    2,172Personnel and benefits
    
    
    1,782
    
    
    
    349
    
    
    
    1,234
    
    
    
    3,365Operating expenses
    
    
    829
    
    
    
    248
    
    
    
    825
    
    
    
    1,9023,886
    
    
    
    792
    
    
    
    2,761
    
    
    
    7,439Operating income (loss) before depreciation
and amortization
    
    $
    588
    
    
    $
    (135
    )
    
    $
    (280
    )
    
    $
    173
 The classification of restaurants has changed from the previous year due
to reorganization within the Company. The long-term portfolio of Schlotzskys
Delis now consists of all but one of the former Long-term delis, two former
Marketplace restaurants and two former Available for Sale restaurants. The
Training classification consists of one former Marketplace, one former
Long-term Schlotzskys Deli and two former Available for Sale restaurants. Note 4.  Segments The Company is principally engaged in franchising and operating
restaurants in the fast casual sector under the Schlotzskys brand.
Schlotzskys restaurants offer a menu of distinctive, high quality foods
featuring our proprietary breads, complemented by excellent customer service in
a visually appealing setting. Our current menu includes upscale made-to-order
hot sandwiches and pizza served on our proprietary buns and crusts, wraps,
chips, salads, soups, fresh baked cookies and other desserts, and beverages.
At March 31, 2004, the Schlotzskys system included 537 Company-operated and
franchised restaurants in 37 states, the District of Columbia and six foreign
countries. The Company operated 36 restaurants as of March 31, 2004. The Company identifies segments based on management responsibility within
the corporate structure. The Restaurant Operations segment includes
restaurants operated for the purposes of market leadership and redevelopment of
certain markets, demonstrating sales potential and key operating metrics,
operational leadership of the franchise system, product development, concept
refinement, product and process testing, training and building brand awareness
and restaurants available for sale. The Franchise Operations segment
encompasses the franchising of restaurants, assisting franchisees in the
development of restaurants, providing franchisee training and operating the
national training center, communicating with franchisees, conducting regional
and national franchisee meetings, developing and monitoring supplier and
distributor relationships, planning and coordinating advertising and marketing
programs, and the licensing of brand products for sale to the franchise system
and retailers. The Company measures segment profit as operating income, which
is defined as income before interest and income taxes. Segment information and
a reconciliation to income before interest and income taxes are as follows
(dollars in thousands): 6




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Restaurant
    
    FranchiseThree months ended March 31, 2004
    
    Operations
    
    Operations
    
    ConsolidatedRevenue from external customers
    
    $
    7,782
    
    
    $
    5,265
    
    
    $
    13,047Depreciation and amortization
    
    
    757
    
    
    
    649
    
    
    
    1,406Operating income (loss)
    
    
    93
    
    
    
    145
    
    
    
    238Total assets
    
    $
    41,387
    
    
    $
    83,049
    
    
    $
    124,436
 Restaurant

    
    FranchiseThree months ended March 31, 2003
    
    Operations
    
    Operations
    
    ConsolidatedRevenue from external customers
    
    $
    7,612
    
    
    $
    6,218
    
    
    $
    13,830Depreciation and amortization
    
    
    521
    
    
    
    728
    
    
    
    1,249Operating income (loss)
    
    
    (348
    )
    
    
    (312
    )
    
    
    (660
    )Total assets
    
    $
    41,595
    
    
    $
    93,784
    
    
    $
    135,379
 Of the Restaurant Operations depreciation and amortization for the three
months ended March 31, 2004, $458,000 was allocated to the long-term portfolio
of restaurants ($82,000 for Training restaurants and $376,000 for
Sandwich-cafes) and $299,000 to restaurants available for sale. For the three
months ended March 31, 2003, $369,000 of depreciation and amortization was
allocated to the long-term portfolio of restaurants ($76,000 for Training
restaurants and $293,000 for Sandwich-cafes) and $152,000 to restaurants
available for sale. Note 5.  Debt The Companys debt structure as of March 31, 2004, and December 31, 2003,
is as follows (dollars in thousands): March 31,
    
    December 31,2004
    
    2003(Unaudited)Short-term debt
    
    $
    1,917
    
    
    $
    1,134Long-term debt:Notes payable to former area developers
    
    $
    21,450
    
    
    $
    21,851Mortgages on Company-operated restaurants and equipment
    
    
    21,136
    
    
    
    21,589Capital leases
    
    
    2,562
    
    
    
    2,659Notes payable to shareholders
    
    
    2,500
    
    
    
    2,500Obligations secured by royalty and licensing contracts.
    
    
    1,500
    
    
    
    Other obligations
    
    
    381
    
    
    
    55149,529
    
    
    
    49,150Less current maturities of long-term debt
    
    
    (7,358
    )
    
    
    (6,564
    )Long-term debt
    
    $
    42,171
    
    
    $
    42,586
 7




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 6.  Related Party Receivables As of March 31, 2004, and December 31, 2003, receivables from related
parties were as follows (dollars in thousands): March 31,
    
    December 31,2004
    
    2003(Unaudited)Included in accounts receivable - other
    
    $
    0
    
    
    $
    23Included in other noncurrent assets
    
    
    751
    
    
    
    939Included in notes receivable
    
    
    1,741
    
    
    
    2,617Total related party receivables
    
    $
    2,492
    
    
    $
    3,579
 Note 7.  Earnings Per Share Basic earnings per share are computed by dividing reported earnings
available to common stockholders by weighted average common shares outstanding.
Diluted earnings per share give effect to dilutive potential common shares.
Earnings per share are calculated as follows (in thousands, except per share
data): For the three months endedMarch 31,
    
    March 31,2004
    
    2003Basic earnings per shareNet income (loss)
    
    $
    (671
    )
    
    $
    (1,066
    )Weighted average common shares outstanding
    
    
    7,339
    
    
    
    7,320Basic earnings per share
    
    $
    (0.09
    )
    
    $
    (0.15
    )Diluted earnings per shareNet income (loss)
    
    $
    (671
    )
    
    $
    (1,066
    )Weighted average common shares outstanding
    
    
    7,339
    
    
    
    7,320Dilutive stock options and warrants
    
    
    
    
    
    
    Weighted average common shares outstanding 
assuming dilution
    
    
    7,339
    
    
    
    7,320Diluted earnings per share
    
    $
    (0.09
    )
    
    $
    (0.15
    )Outstanding options and warrants that were
not included in the diluted calculation
because their effect would be anti-dilutive.
    
    
    883
    
    
    
    1,142
 8




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 8.  Intangible Assets Intangible assets consist of the following (dollars in thousands): March 31, 2004
    
    December 31, 2003(Unaudited)AmortizationPeriod
    
    Gross
    
    Accumulated
    
    Gross
    
    Accumulated(Years)
    
    Value
    
    Amortization
    
    Value
    
    AmortizationIntangible assets subject to amortization:Royalty value
    
    
    20
    
    
    $
    2,474
    
    
    $
    926
    
    
    $
    2,474
    
    
    $
    897Developer and franchise rights acquired
    
    
    40
    
    
    
    59,474
    
    
    
    4,212
    
    
    
    59,374
    
    
    
    3,867Restaurant development rights
    
    
    13 to 25
    
    
    
    1,653
    
    
    
    654
    
    
    
    1,653
    
    
    
    568Debt issue costs
    
    
    3 to 20
    
    
    
    688
    
    
    
    238
    
    
    
    529
    
    
    
    211Other intangible assets
    
    
    5
    
    
    
    652
    
    
    
    455
    
    
    
    646
    
    
    
    43864,941
    
    
    
    6,485
    
    
    
    64,676
    
    
    
    5,981Intangible assets not subject to amortization:Original franchise and royalty rights
    
    
    
    
    
    
    5,689
    
    
    
    1,860
    
    
    
    5,689
    
    
    
    1,860Goodwill
    
    
    
    
    
    
    3,850
    
    
    
    331
    
    
    
    3,850
    
    
    
    3319,539
    
    
    
    2,191
    
    
    
    9,539
    
    
    
    2,191Total intangible assets
    
    
    
    
    
    $
    74,480
    
    
    $
    8,676
    
    
    $
    74,215
    
    
    $
    8,172
 Amortization of intangible assets totaled approximately $504,000 and
$426,000 for the three months ended March 31, 2004 and 2003, respectively.
Estimated amortization expense through 2008 for intangible assets with
determinable lives is as follows (dollars in thousands): Remainder of 2004
    
    $
    1,3592005
    
    
    1,7152006
    
    
    1,6402007
    
    
    1,6402008
    
    
    1,638$
    7,992
 The changes in the gross value of goodwill for the quarter ended March 31,
2004, are as follows (dollars in thousands): Restaurant
    
    FranchiseOperations
    
    Operations
    
    TotalBalance as of December 31, 2003
    
    $
    3,589
    
    
    $
    261
    
    
    $
    3,850Goodwill acquired
    
    
    
    
    
    
    
    
    
    
    Impairment
    
    
    
    
    
    
    
    
    
    
    Balance as of March 31, 2004
    
    $
    3,589
    
    
    $
    261
    
    
    $
    3,850
 9




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 9.  Off-balance Sheet Arrangements The Company has outstanding guarantees of indebtedness of others,
including related parties, of approximately $24.6 million as of March 31, 2004.
These guarantees include approximately $4.8 million of lease guarantees for
the benefit of franchisees, approximately $13.8 million of mortgage loan
guarantees for the benefit of franchisees and approximately $6.0 million of
loan guarantees for the benefit of related parties. The lease guarantees for the benefit of franchisees arose primarily
through our former Turnkey program, in which the Company developed the
restaurants, leased the restaurants to franchisees, and then 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 the lease. The
maximum guarantee for a single lease is approximately $1.2 million. Certain
lease guarantees extend through 2018. The Company may be required by the
lessor to make monthly rental payments or property tax and common area
maintenance payments if the franchisee does not make the required payments in a
timely manner. The Company has indemnification agreements with the franchisee
under which the franchisee would be obligated to reimburse the Company for any
amounts paid under such guarantees. As of March 31, 2004, the Company had
accrued a liability of approximately $320,000 related to these guarantees. The
Company also has a net deferred gain related to the sale of these leases in the
amount of approximately $342,000 as of March 31, 2004. The mortgage loan guarantees for the benefit of franchisees also arose
primarily through the Companys former Turnkey program, in which we developed
the related restaurants, sold the restaurant to a franchisee, and guaranteed
all or a portion of the franchisees mortgage loan. The guarantees range from
limited guarantees, either in dollar amount or term, to full guarantees of the
mortgage. The maximum amount of a single guarantee is approximately $1.1
million. Certain loan guarantees extend through 2016. The Company may be
required by the lender to make monthly mortgage payments if the franchisee does
not make the required payments in a timely manner, or the Company may be
required to make up any deficiency, up to the amount of the guarantee, if the
related restaurant is sold for net proceeds less than the amount of the
outstanding mortgage. The Company has indemnification agreements with the
franchisees under which the franchisee would be obligated to reimburse the
Company for any amount paid under such guarantees. In the event that the
Company purchases the loan from the lender in the event of a default, the
Company would succeed to the lenders security interest in the related
property. The loan guarantees in favor of related parties primarily arose when we
guaranteed certain debt of related parties for which the proceeds of the loans
were used to repay outstanding debt to us. One of the guarantees, for the
benefit of our real estate venture, is of mortgage debt, totaling approximately
$2.0 million. This guarantee extends through 2009. Another guarantee, in the
amount of approximately $4.1 million at March 31, 2004, was for the benefit of
NAMF, the advertising entity of the Schlotzskys restaurant system, for which
we received the net proceeds of the loan in repayment of outstanding debt to
us. This guarantee was released in May 2004. We have been called upon, from time to time, to make payments on obligations we
have guaranteed on behalf of franchisees under the former Turnkey program. We
will make additional payments in the future to the extent that franchised
stores developed under the Turnkey program default on obligations that we have
guaranteed. During the first quarter of 2004, the Company paid approximately
$288,000 in various lease guarantees for the benefit of franchisees. Note 10.  Adopted Accounting Pronouncements The Financial Accounting Standards Board (FASB) has issued Interpretation No.
46(R), Consolidation of Variable Interest Entities in December 2003. FIN
46(R) addresses the consolidation by business enterprises of variable interest
entities whose equity holders have not provided sufficient equity to allow the
entity to finance its own activities or whose equity holders lack the essential
characteristics of a controlling financial interest. FIN 46(R) requires a
variable interest entity to be consolidated by a company if that company is
subject to a majority of the risk of loss from the entitys activities or
entitled to receive a majority of the entitys residual returns, or both.
Adoption of FIN 46(R) was required after December 15, 2003 for public companies
that have interests in variable interest or special purpose entities, and
for all public companies for periods ended after March 15, 2004. Adoption of
FIN 46(R) had no material impact on the Companys consolidated financial
position, results of operations, or cash plans. 10




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##### Table of Contents



Note 11.  Deferred Tax Assets The Company records deferred tax assets and liabilities based on the
difference between the financial statement and income tax basis of assets and
liabilities using the enacted statutory tax rate. Deferred income tax expenses
or credits are based on the changes in the asset or liability from period to
period. The recorded deferred tax assets are reviewed for impairment on a
quarterly basis by reviewing the Companys internal estimates for future net
income. If the Company determines it to be more likely than not that the
recovery of the asset is in question in the immediate, foreseeable future, the
Company records a valuation allowance. As of December 31, 2003 the Company had
recorded a full valuation allowance against its net deferred tax asset. The
results of operations for the quarter ended March 31, 2004 reflect a valuation
allowance recorded against net deferred tax assets generated during the
quarter. The Company will continue to record valuation allowances against
additional deferred tax assets until such time that recoverability of such
assets is demonstrated. Note 12.  Commitments and Contingencies Litigation New Florida Markets, Ltd. and Deli Keys, Ltd. v. Schlotzskys, Inc.,
Schlotzskys Franchise Limited Partnership, Schlotzskys Franchisor, LLC,
Schlotzskys Franchise Operations, LLC, Schlotzskys NAMF, Inc., and
Schlotzskys NAMF Funding, LLC(Case No. 701140045603), was filed on or about
June 23, 2003 with the American Arbitration Association. Claimant is the area
developer for the Tampa, Orlando, and West Palm Beach development areas. On
July 14, 2003, Deli Keys, Ltd., an area developer for the Miami development
area, joined the arbitration as an additional Claimant. They alleged that
Respondents frustrated their ability to develop, in part because of the
Companys Turnkey program under which Respondents developed a number of
restaurants during the period 1995 until 2000 in which Respondents were
involved in acquiring sites, building restaurants for franchisees and, in
certain instances, guaranteeing franchise debts or leases. Claimant also
alleged Respondents breached the Area Developer Agreements by failing to
provide adequate licensing support, negotiating with license prospects, failing
to establish and administer a local advertising group, pledging royalties,
changing the area developer manual, refunding franchise fees, and forcing
Claimants to purchase errors and omissions insurance. Other claims included
breach of the implied covenant of good faith and fair dealing, constructive
termination, and violation of the Texas Deceptive Trade Practices Act.
Claimants sought actual, compensatory, and punitive damages of an unspecified
amount, attorneys fees, and costs. On May 9, 2004 the Company and Claimants
settled all claims and entered into a binding settlement agreement. Robert Coshott v. Schlotzskys, Inc.(Cause No. GN 1-02279), was filed on
July 24, 2001, in the 200th Judicial District Court of Travis County, Texas.
Plaintiff is the Master Licensee for Australia and New Zealand, and he opened a
Schlotzskys Deli restaurant in Melbourne, Australia. Plaintiff brings causes
of action for fraud and/or negligent misrepresentation. Plaintiff alleges that
he experienced problems with certain equipment specified or approved by the
Company, that the Companys system and equipment did not generate enough
finished food product to service his potential customers; that the Company
misrepresented the level of revenue the restaurant could reasonably be expected
to achieve; that the Company delayed his ability to develop restaurants by
failing to timely secure certain trademarks and trade names; and that the
Company misrepresented whether it would allow Plaintiff to franchise
Schlotzskys Deli restaurants in certain gas station or convenience store
locations in his territories. Plaintiff requests actual and punitive damages of
$3.75 million plus lost profits and incidental and consequential damages of an
unspecified amount. On July 23, 2003, Coshott also filed a Demand for
Arbitration with the International Chamber of Commerce styled Robert Gilbert
Coshott v. Schlotzskys, Inc.(Case. No. 12 838/JNK). The claims in the Demand
are similar to those brought in the above-entitled action and include
additional allegations that the Company required the purchase of goods and
services from certain suppliers in violation of the Trade Practices Act of 1974
and that the Company failed to disclose the existence of a predecessor Master
License Agreement, in violation of the Fair Trading Act of 1987 (New South)
Wales, breach of contract, and equitable estoppel. Claimant seeks unspecified
actual, compensatory and punitive damages, lost profits, attorneys fees,
prejudgment interest, and costs. On February 26, 2004, the Company obtained a
declaratory judgment in the state court case declaring that Plaintiff had
waived any right to arbitrate his claim by filing suit against the Company in
state court in Texas. The state court case is not yet set for trial. Dae Kim, DWK Enterprises, 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 Advertising Association,
Inc., and Schlotzskys, Brands, Inc., Schlotzskys Brand Products, L.P.,
Schlotzskys Real Estate, Inc., and Schlotzskys Restaurants, Inc.(Cause No.
2001-CI-13672) was originally filed in the 73rd Judicial District Court of
Bexar County, Texas on or about September 25, 2001 (after a similar lawsuit was
filed and later withdrawn in Harris County, Texas) against Schlotzskys, Inc.,
John Wooley, Schlotzskys Franchising Limited Partnership, and Schlotzskys
NAMF, Inc. (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 bring causes of action for breach of 11




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##### Table of Contents



contract, breach of fiduciary duty, breach of the duty of good faith and fair
dealing, civil conspiracy, tortious interference with contract, tortious
interference with prospective business relationship, violation of the Texas
Deceptive Trade Practices and Consumer Protection Act, restraint of trade,
detrimental reliance-fraud in the inducement, and defamation-business
disparagement. They seek an unspecified amount of money damages plus exemplary
damages, attorneys fees, pre-judgment interest, costs, and a jury trial.
Defendants, except for Mr. Wooley who was previously dismissed from the case,
answered and asserted counterclaims alleging breach of contract and that
Plaintiffs claim under the Texas Deceptive Trade Practices Act is groundless
in fact or in law and brought in bad faith or for the purpose of harassment,
and seek money damages, costs of court, penalty fees, costs incurred in
performing the accounting, attorneys fees, and pre- and post-judgment
interest. Defendants (except for Mr. Wooley) removed the case to federal court.
The case was remanded to state court on April 17, 2003. The case is not yet
set for trial. U.S. Restaurant Properties Operating L.P. v. Schlotzskys, Inc.(Cause No.
03-01758) was filed on February 27, 2003, in the District Court of Dallas
County, B-44th Judicial District. Plaintiff is a real estate investment
company that owns certain Schlotzskys restaurants and leases them to
franchisees. It alleges that in 1997 and 1998 we entered into several
agreements where we agreed to guarantee certain lease agreements. Plaintiff
claims that in 1998 the parties entered into an agreement whereby Plaintiff
agreed to release Schlotzskys from its guaranty obligations pertaining to six
properties in which the tenants had defaulted, in exchange for Schlotzskys
agreement to purchase six other properties. Plaintiff is seeking an order
requiring us to purchase six properties for a total purchase price of over
$4.5 million. In the alternative, Plaintiff is seeking damages or an order
reinstating the previously released guaranties. Plaintiffs claims include
breach of contract and a request for attorneys fees. The trial date has been
scheduled for September 20, 2004. In addition to the matters discussed above, we are defendants in various
other legal proceedings arising from our business. The ultimate outcome of
these pending proceedings cannot be projected with certainty. However, based on
our experience to date, we believe any such proceeding will not have a material
effect on our business or financial condition. 12




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##### Table of Contents



ITEM 2.
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues
and expenses and related disclosure of contingent liabilities. We base our
estimates on historical experience and various other assumptions that we
believe are reasonable under the circumstances. Estimates and assumptions are
reviewed periodically. Actual results may vary from these estimates. We believe the following critical accounting policies require estimates
about the effect of matters that are inherently uncertain and require
subjective judgments. Changes in the estimates and judgments, or the
assumptions underlying these estimates and judgments, could significantly
impact our results of operations and financial condition in future periods.  
    
    Determination of the appropriate valuation allowances
for accounts and notes receivable.Our accounts and notes receivable are primarily from franchisees of
the Schlotzskys system. We require personal guarantees for all
franchise accounts and, for notes receivable, generally obtain a
secondary secured interest in the related property and equipment or
rights. Many of the notes receivable are fully subordinated to the
franchisees senior mortgage debt. In reviewing the adequacy of
the valuation allowances for accounts and notes receivable, we
consider factors such as historical collection experience, the
estimated value of personal guarantees and real property
collateral, the franchisees sales and operating trends, including
potential for improvement in operations, and general and local
economic conditions that may affect the franchisees ability to
pay. Actual realization of amounts receivable could differ
materially from our estimates. As of March 31, 2004, the Company
has approximately $4.2 million due in unreserved principal and
interest from Schlotzskys franchisees.
    
    Determination of appropriate valuation allowances for
real estate held for sale.Our real estate held for sale consists primarily of pad sites. As
these sites are being actively marketed, they are periodically
assessed for estimated net realizable value. Factors considered in
this assessment are offers and letters of intent received on
properties, discussions with local real estate brokers, property
tax and bank appraisals, sale prices of similar properties and
level of activity and interest exhibited by potential buyers.
Actual proceeds from the sale of real estate could differ
materially from our estimates. As of March 31, 2004, net of
impairment allowances, the Company has $3.2 million in held for
sale real estate assets.
    
    Determination of appropriate valuation allowances for
intangible assets.Amortizing intangible assets consist primarily of amounts paid to
reacquire various developer and franchise rights. Annually, and
whenever an event or circumstance indicating impairment may be
present, we compare projected undiscounted cash flows to the
carrying value of the related assets to determine if impairment has
occurred. In estimating future cash flows, we consider such
factors as current results, trends, future prospects, and other
economic factors. Actual future cash flows could differ materially
from our estimates. As of March 31, 2004, net of accumulated
amortization and impairment allowances, the Company has
approximately $55.3 million in reacquired developer and franchise
rights.
    
    Determination of appropriate valuation allowances for
deferred tax assets.Our deferred tax assets represent expenses and losses that will
offset future income tax liability. If the Company is unable to
generate income tax liability resulting from future net income the
value of this tax asset would be impaired. The Company considers
such factors as current trends, operating margins and future system growth in determining projected
net income, and projected net income is used to assess realizable
value of the deferred tax asset. As of March 31, 2004, the Company
has recorded a valuation allowance against $5.1 million of deferred
tax assets and will continue to record valuation allowances against
additional deferred tax assets until such time that recoverability
of such assets is demonstrated. 13




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##### Table of Contents



RESULTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 2004 AND 2003 REVENUE. Total revenue decreased 5.7% to $13,047,000 from $13,830,000. ROYALTIES decreased 16.5% to $3,593,000 from $4,304,000. The decrease was
due to a decreased number of franchised restaurants in 2004 compared to 2003,
and a decrease in same store contractual sales by franchised restaurants of
7.8%. The following table presents additional data concerning the domestic
franchised restaurant system: Restaurant Data For the three months endedMarch 31,
    
    March 31,2004
    
    2003Restaurants opened:Domestic New
    
    
    
    
    
    
    Re-openings
    
    
    
    
    
    
    1Total domestic openings
    
    
    
    
    
    
    1Domestic closings
    
    
    (24
    )
    
    
    (25
    )Operating domestic restaurants at end of quarter
    
    
    479
    
    
    
    566Average weekly sales for domestic franchised restaurants
    
    $
    10,388
    
    
    $
    10,301Change in same store sales for domestic franchised
restaurants
    
    
    (7.8
    %)
    
    
    (11.9
    %)
 DEVELOPER FEES decreased 28.0% to $36,000 from $50,000. The decrease is
primarily attributed to the expiration of amortization of deferred revenue
related to developer agreements. RESTAURANT SALES increased 2.2% to $7,782,000 from $7,612,000. The
increase was primarily due to the addition of two Company-operated restaurants, partially offset by a 4.1% decrease in comparable
store sales, and a decrease in the average number of restaurants operated by
the Company in the first quarter of 2004, compared to the first quarter of
2003. As of March 31, 2004, there were 36 Company-operated restaurants
compared to 37 at March 31, 2003, of which 17 and 20, respectively, were
available for sale. SCHLOTZSKYS BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 14.2% to
$1,417,000 from $1,651,000. The decrease was primarily due to the effect of
the decrease in franchise restaurant sales for the quarter, partially offset by an
increase in sales through retail channels. OTHER FEES AND REVENUE increased 3.3% to $220,000 from $213,000. OPERATING EXPENSES. SERVICE COSTS decreased 20.3% to $529,000 from
$664,000. This decrease is primarily due to a decrease in royalty and
franchise fee revenue. RESTAURANT OPERATIONS EXPENSES decreased 6.8% to $6,932,000 from
$7,439,000. RESTAURANT COST OF SALES decreased 2.9% to $2,110,000 from $2,172,000 and
decreased as a percentage of net restaurant sales to 27.1% from 28.5%
primarily due to operational improvements and menu price increases, which
were partially offset by higher commodity costs. RESTAURANT PERSONNEL AND BENEFITS COST decreased 12.3% to $2,950,000 from
$3,365,000 and decreased as a percentage of net restaurant sales to 37.9%
from 44.2%. The decrease, as a percentage of net restaurant sales, was
primarily due to a decreased number of restaurant managers and
operational improvements. RESTAURANT OPERATING EXPENSES decreased 1.6% to $1,871,000 from
$1,902,000 and decreased as a percentage of net restaurant sales to 24.0%
from 25.0%. The decrease in operating costs, as a percentage of net 14




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restaurant sales, was due to decreased facility costs as a result of the
decreased number of Company-operated restaurants and increased average sales per Company-operated restaurant. EQUITY
LOSS ON INVESTMENTS was zero, as compared to a loss of $67,000 in the
comparable period from 2003. GENERAL AND ADMINISTRATIVE EXPENSES decreased 22.2% to $3,943,000 from
$5,071,000, and decreased as a percentage of total revenue to 30.2% from 36.7%.
The decline is a result of a reduction in force that occurred in July 2003
and cost-control measures enacted by the Company in 2004, such as forgoing a
national franchisee convention during 2004 and reducing insurance coverage
expense and travel costs. DEPRECIATION AND AMORTIZATION increased 12.6% to $1,406,000 from
$1,249,000. The increase was primarily due to an increase in the assets
related to Company-operated restaurants and a change in the mix of depreciation
periods of unamortized assets. INTEREST INCOME decreased 40.4% to $62,000 from $104,000. The decrease
was primarily due to repayment of notes receivable during 2003. INTEREST EXPENSE decreased 8.3% to $931,000 from $1,016,000 due to lower
interest rates on certain notes. PROVISION (CREDIT) FOR INCOME TAXES in 2004, reflects the net expense
after the impairment of deferred tax assets generated during the quarter. NET INCOME was a loss of $671,000 for the quarter compared to net loss of
$1,066,000 in the previous years quarter due to the factors discussed above.
Diluted earnings per share were $(0.09) for the quarter ended March 31, 2004,
and $(0.15) for the quarter ended March 31, 2003. Supplemental
Restaurant Operations Information  Performance of Long-Term
Portfolio Restaurants The following table is presented for the Company-operated restaurants in
the Companys long-term portfolio for the quarter ended March 31, 2004. As of
March 31, 2004, this restaurant group included ten restaurants in the Austin
area, two in Houston, Texas, two in College Station, Texas and one in suburban
Atlanta, Georgia. This group includes 14 freestanding restaurants and one
shopping center end-cap restaurant. In accordance with the Companys internal
management reporting practices for consistent comparisons, line item categories
have been expanded and percentages are calculated based on gross sales, instead
of net sales as used elsewhere in this report. Facility costs vary by
restaurant because some facilities are rented and some are owned. The table
provides the average percentage results for each line item for the 15
Schlotzskys restaurants in the long-term portfolio group as a whole, as well
as the best and worst percentage performance for each line item for any
restaurant in the group. Three MonthsEnded
    
    Percentage
    
    Best
    
    WorstMarch 31, 2004
    
    of Gross
    
    Percentage
    
    Percentage(in thousands)
    
    Sales
    
    Performance (1)
    
    Performance (1)Gross sales
    
    $
    5,130
    
    
    
    100.0
    %Less-discounts
    
    
    136
    
    
    
    2.7
    %
    
    
    1.9
    %
    
    
    3.5
    %Net sales
    
    
    4,994
    
    
    
    97.3
    %Cost of sales
    
    
    1,353
    
    
    
    26.4
    %
    
    
    24.1
    %
    
    
    31.0
    %Personnel and benefits:Crew costs
    
    
    1,130
    
    
    
    22.0
    %
    
    
    19.6
    %
    
    
    25.7
    %Management costs
    
    
    589
    
    
    
    11.5
    %
    
    
    8.7
    %
    
    
    19.3
    %Operating expenses:Advertising (2)
    
    
    222
    
    
    
    4.3
    %
    
    
    3.1
    %
    
    
    4.7
    %Controllable expenses
    
    
    398
    
    
    
    7.8
    %
    
    
    5.9
    %
    
    
    10.5
    %Operating income
before facility
costs and
depreciation and
amortization
    
    
    1,302
    
    
    
    25.4
    %
    
    
    32.8
    %
    
    
    11.1
    %Facility costs
    
    
    282
    
    
    
    5.5
    %
    
    
    1.4
    %
    
    
    15.8
    %Operating income
before
depreciation and
amortization
    
    $
    1,020
    
    
    
    19.9
    %
    
    
    30.8
    %
    
    
    -4.7
    %
  (1)
    
    Represents the actual best and worst percentage performance among
restaurants in this group for this income statement category.(2)
    
    Stores contribute 4% of sales to the NAMF marketing fund, but
vendor rebates will reduce this rate periodically, and some stores
spend additional amounts on advertising. 15




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OFF-BALANCE SHEET ARRANGEMENTS The Company has outstanding guarantees of indebtedness of others,
including related parties, of approximately $24.6 million as of March 31, 2004.
These guarantees include approximately $4.8 million of lease guarantees for
the benefit of franchisees, approximately $13.8 million of mortgage loan
guarantees for the benefit of franchisees and approximately $6.0 million of
loan guarantees for the benefit of related parties. The lease guarantees for the benefit of franchisees arose primarily
through our former Turnkey program, in which we developed the restaurants,
leased the restaurants to franchisees, and then 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 the lease. The maximum guarantee for
a single lease is approximately $1.2 million. Certain guarantees extend
through 2018. We may be required by the lessor to make monthly rental payments
or property tax and common area maintenance payments if the franchisee does not
make the required payments in a timely manner. We have indemnification
agreements with the franchisee under which the franchisee would be obligated to
reimburse us for any amounts paid under such guarantees. As of March 31, 2004,
we had accrued a liability of approximately $320,000 related to these
guarantees. We also have a net deferred gain related to the sale of these
leases in the amount of approximately $342,000 as of March 31, 2004. The mortgage loan guarantees for the benefit of franchisees also arose
primarily through our former Turnkey program, in which we developed the related
restaurants, sold the restaurant to a franchisee, and guaranteed all or a
portion of the franchisees mortgage or equipment loan. The guarantees range
from limited guarantees, either in dollar amount or term, to full guarantees of
the mortgage. The maximum amount of a single guarantee is approximately $1.1
million. Certain loan guarantees extend through 2016. We may be required by
the lender to make monthly mortgage payments if the franchisee does not make
the required payments 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 net proceeds less than the amount of the outstanding mortgage. We
have indemnification agreements with the franchisees under which the franchisee
would be obligated to reimburse us for any amount paid under such guarantees.
In the event that we purchase the loan from the lender in the event of a
default, we would succeed to the lenders security interest in the related
property. The loan guarantees in favor of related parties primarily arose when we
guaranteed certain debt of related parties for which the proceeds of the loans
were used to repay outstanding debt to us. One of the guarantees, for the
benefit of our real estate venture, is of mortgage debt, totaling approximately
$2.0 million. This guarantee extends through 2009. Another guarantee, in the
amount of approximately $4.1 million, was for the benefit of NAMF, the
advertising entity of the Schlotzskys restaurant system, for which we received
the net proceeds of the loan in repayment of outstanding debt to us. This
guarantee was released in May 2004. We have been called upon, from time to time, to make payments on
obligations we have guaranteed. During the first quarter of 2004, we paid
approximately $288,000 in various lease guarantees for the benefit of
franchisees. In addition, pursuant to a guarantee of a franchisees debt
obligation, we purchased that obligation from a bank, in the amount of
approximately $665,000, in August 2003 of which $299,000 was outstanding and
secured with an agreed judgment at March 31, 2004. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents increased $75,000 in the three months ended
March 31, 2004 and increased $38,000 in the three months ended March 31, 2003.
Cash and cash equivalents are impacted by operating, investing and financing
activities. Operating activities provided $161,000 of cash in the first quarter of
2004 and $1,976,000 of cash in the first quarter of 2003. The decrease in cash
provided in the first quarter of 2004 compared to the first quarter of 2003 was
primarily the net result of extending vendor terms and deferring vendor payments in the first
quarter of 2003
and reducing vendor payables in the first quarter of 2004. Investing activities used $317,000 of cash in the quarter ended March 31,
2004 and used $292,000 of cash in the quarter ended March 31, 2003. The
increase in cash used in the quarter ended March 31, 2004 compared to the
comparable period of 2003 was the net result of no real estate sales in 2004
as compared to one in 2003. Financing activities provided $231,000 of cash in the first quarter of
2004 and used $1,646,000 of cash in the first quarter of 2003. The decrease in
cash used in the first quarter of 2004 compared to the first quarter of 2003 is
primarily due to decreased net repayments of debt due to the modification of
terms of certain payables. At
March 31, 2004, we had approximately $51,446,000 of total debt
outstanding. Scheduled maturities of debt through March 31, 2005
approximate $9,275,000 (including short-term debt). 16




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Schlotzskys Franchisor, LLC entered into a loan agreement in November
2003 in the amount of approximately $2,500,000 with John C. Wooley and Jeffrey
J. Wooley (the Loan) and the Loan was extended in January 2004. The Loan and
other previous personal guarantees provided by the Wooleys on our behalf were
initially secured by a first lien on our intellectual property, contract
rights, and other intangibles before they were subordinated as discussed below.
The Loan matures in December 2006 and has an annual interest rate of 2.5% over
prime. The proceeds of the Loan were used to pay certain accounts payable and
to provide us with additional liquidity while we seek longer term financing.
In connection with the Loan, the Wooleys received $1.00 in excess of their
costs. In December 2003, we negotiated modifications to the debt held by NS
Associates, Ltd., a former area developer, of approximately $18.0 million (the
NS Loan). These modifications decreased the monthly payments under the NS
Loan from $520,000 to $120,000 for 12 months, after which payments increase to
$420,000 a month. The term of the NS Loan was extended from June 2005 to
December 2006. In addition, the interest on the balance was fixed at 3% for 12
months and then fluctuates thereafter at four points over the prime rate. In
exchange, NS Associates received a first lien on our intellectual property,
contract rights, and other intangibles. John C. Wooley and Jeffrey J. Wooley
agreed to subordinate their first lien securing, among other things, the Loan
to repayment of the NS Loan. In addition, NS Associates agreed to subordinate
its security interest to any new lender who provides up to $3,000,000 in senior
debt to the Company. We are subject to certain covenants under the terms of
the NS Loan. If we fail to satisfy the terms of those covenants, it would
constitute a default under the terms of the NS Loan, and NS Associates would
have the right to accelerate the maturity of its debt. The Company borrowed
$1,500,000 of this senior debt during the first quarter of 2004 and borrowed an
additional $550,000 during April, 2004. The Company is seeking the funding of
an additional $950,000 of this senior debt. Certain of our mortgage debt requires the maintenance of financial ratios,
including debt-to-equity and working capital ratios. At March 31, 2004, the
Company was in compliance with or had obtained a waiver of such covenants.
However, any failure to remain in compliance with the restrictive covenants of
the Companys mortgages in the future could have material adverse consequences
to the Company. In addition, one of our mortgages requires the application to
the mortgage of the net cash proceeds from the sale of certain real estate held
for sale. The following tables present certain of our obligations and commitments to
make future payments, excluding interest payments, under contracts and
contingent commitments as of March 31, 2004 (dollars in thousands): Payments Due by PeriodAs of March 31, 2004Less than 1Contractual Obligations
    
    Total

    
    year
    
    1-3 years
    
    4-5 years
    
    After 5 yearsShort-Term Debt
    
    $
    1,917
    
    
    $
    1,917
    
    
    $
    
    
    
    $
    
    
    
    $
    Long-Term Debt
    
    
    49,529
    
    
    
    7,358
    
    
    
    28,221
    
    
    
    4,796
    
    
    
    9,154Operating Leases
    
    
    18,231
    
    
    
    2,420
    
    
    
    4,251
    
    
    
    2,478
    
    
    
    9,082
 Amount of Commitment Expiration Per PeriodTotal
    
    As of March 31, 2004Other Commercial
    
    Amounts
    
    Less than 1Commitments
    
    Committed
    
    year
    
    1-3 years
    
    4-5 years
    
    After 5 yearsGuarantees
    
    $
    24,578
    
    
    $
    9,638
    
    
    $
    1,585
    
    
    $
    6,510
    
    
    $
    6,845
 We have experienced net reductions in the number of franchised restaurants
quarterly since early 2000 and have experienced decreased royalty collections
quarterly since mid-2001. In addition to the net decline in restaurants, we
have also experienced declines in same store sales for franchised restaurants
since mid-2001. This decline in same store sales has led to a decrease in
royalty collections from our franchisees. We believe this decline has
resulted from increased competition, a reduction in advertising funds
available to the franchise system due to these sales declines,
changes in consumer preferences regarding low-carb diets, and recent
increases in gasoline prices. We have developed and implemented
strategies, including the re-imaging of restaurants, the introduction of an
enhanced menu with new items and combinations, and the resumed marketing of our
franchise licensing program, in an effort to reverse and mitigate the impact of
these trends. We expect that the number of restaurants will continue to
decline, however, during the second and third quarter of 2004 and possibly thereafter.
Continuation of these trends could result in additional guarantee expenses and would have a material adverse impact on our
royalty revenue, brand contribution, cash flow and liquidity. On July 31, 2003 we effected a reduction in force and developed and
implemented plans to significantly reduce non-compensation general and
administrative expenses and certain employee benefits in an effort to achieve a
reduction in total general and administrative expenses. These reductions, along
with certain salary adjustments, began to impact operating results in the third
quarter of 2003, but were offset by separation expenses incurred during the
same quarter. The impact of these position reductions and salary adjustments
are more fully reflected in the first quarter of 2004, and we anticipate a
significant effect during the rest of 2004. 17




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We may develop additional Company-operated restaurants in the future and
plan to convert existing Company-operated restaurants to the Sandwich-Café
format. We also have acquired building sites for four additional restaurants
in the Austin area and entered into a lease for a site in the Houston area.
Sites for additional restaurants in Texas and other markets are under
consideration. However, future development of these sites and conversion of
existing restaurants is limited until we have obtained additional financing to
fund this growth in our Company-operated restaurants. We made improvements to our operations of the Company-operated restaurants
in 2003, and these changes have resulted in the improvement in restaurant
results seen between the first quarter of 2004 and the first quarter of 2003.
We modified internal reporting procedures and focused our restaurant managers
on improving daily and weekly results, which improved our operating
accountability. In addition, we moved franchisee training, product research
and development, and operations experimentation from our core stores into four
stores that are located in different regions of the country, rather than having
all training occur in a few stores in Texas. The refinement of the
Sandwich-Café operating procedures also enhanced operations at certain
Company-operated restaurants as the training for the new menus was completed. We
will need additional financing to meet existing and future cash
requirements. We are currently attempting to generate additional working capital with
third party financing and are pursuing financing alternatives, including senior
debt, real estate mortgages, asset-backed financing secured by our intellectual
property and related royalty rights and agreements, and equity
financing. We expect the terms of such financing to be more expensive
and with more onerous terms than the financing the Company has received
in recent years. While we are in discussions with several potential lenders or investors at this
time, there can be no assurances that such financing will be available or
accomplished. Should these discussions not result in an acceptable financing,
we would need to continue to seek additional financing that would be
sufficient, with our operating income, to allow us to fund our operating
expenses and debt service. If we are unable to obtain funding of the $950,000
in senior debt and other sufficient financing during the second quarter of 2004
or are unable to negotiate waivers, debt forgiveness or favorable payment terms with creditors,
our ability to fund continuing operations and working capital needs could be
materially adversely affected, and we might violate certain financial covenants
to which we are subject under certain third party agreements, including loan
agreements. FORWARD-LOOKING STATEMENTS This report may contain forward-looking statements within the meaning of
Section 27A of the Securities Act, Section 21E of the Exchange Act, or the
Private Securities Litigation Reform Act of 1995. Any statements that are not
statements of historical fact may be deemed forward-looking statements.
Forward-looking statements are not meant to predict or guarantee actual
results, performance, events, or circumstances and may not be realized because
they are based on our current projections, plans, objectives, beliefs,
expectations, estimates, and assumptions and are subject to a number of risk
factors and uncertainties, many of which are beyond our control. Actual
results and the timing of future events and circumstances may differ materially
from those described or implied by the forward-looking statements as a result
of these risk factors and uncertainties. Forward-looking statements may
include, without limitation, statements concerning earnings or other financial
item projections, the plans and objectives of management, future economic
performance, new restaurant development, future Schlotzskys brand products,
and assumptions underlying or relating to any other forward-looking statement.
Factors that could cause actual results to differ materially from those
described in the forward-looking statements may include, without limitation, an
inability to obtain adequate financing for the development of new
Company-operated restaurants and other purposes, increased competition within
the restaurant industry, a reduction in the number of franchised Schlotzskys
restaurants, a decline in the sales at franchised restaurants, changing
consumer preferences, government regulation, the results of arbitration and
litigation, an inability to sell restaurants, a failure to successfully recruit
multi-unit and single-unit franchisees, and stock volatility and illiquidity. Because of the risks and uncertainties related to these factors and the
forward-looking statements, readers are cautioned not to place undue reliance
on the forward-looking statements. There can be no assurance that any events
or results described in any forward-looking statement will actually occur or be
achieved. We undertake no obligation to publicly revise the forward-looking
statements to reflect events or circumstances that arise after the date of this
report or to reflect new information, future events or circumstances, changes
in assumptions, or otherwise. Readers should carefully review the risk factors
described above and in other documents filed by us with the Commission.
Readers are specifically directed to the discussion under Risk Factors in our
most recent annual report on Form 10-K. 18




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Changes in short-term interest rates on loans from financial institutions
could materially affect the Companys earnings because the interest rates
charged on certain underlying obligations are variable. At March 31, 2004, a hypothetical 100 basis point increase in interest
rates would result in a decrease of approximately $56,000 in annual pre-tax
earnings. The estimated decrease is based upon the increased interest expense
of the Companys variable rate debt and assumes no change in the volume or
composition of debt at March 31, 2004. 
 ITEM 4. CONTROLS AND PROCEDURES The term disclosure controls and procedures is defined in Rules
13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange
Act. This term refers to the controls and procedures of a company that are
designed to ensure that information required to be disclosed by a company in
the reports that it files or submits under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified by the
Securities and Exchange Commission. Our management, including our Chief
Executive Officer and Principal Financial Officer, has evaluated the
effectiveness of our disclosure controls and procedures as of the end of the
period covered by this quarterly report. Based upon that evaluation, our Chief
Executive Officer and Principal Financial Officer have concluded that our
disclosure controls and procedures were effective as of the end of the period
covered by this quarterly report. There
were no changes to our internal control over financial reporting during our
last fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting. 19




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PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS New Florida Markets, Ltd. and Deli Keys, Ltd. v. Schlotzskys, Inc.,
Schlotzskys Franchise Limited Partnership, Schlotzskys Franchisor, LLC,
Schlotzskys Franchise Operations, LLC, Schlotzskys NAMF, Inc., and
Schlotzskys NAMF Funding, LLC(Case No. 701140045603), was filed on or about
June 23, 2003 with the American Arbitration Association. Claimant is the area
developer for the Tampa, Orlando, and West Palm Beach development areas. On
July 14, 2003, Deli Keys, Ltd., an area developer for the Miami development
area, joined the arbitration as an additional Claimant. They alleged that
Respondents frustrated their ability to develop, in part because of the
Companys Turnkey program under which Respondents developed a number of
restaurants during the period 1995 until 2000 in which Respondents were
involved in acquiring sites, building restaurants for franchisees and, in
certain instances, guaranteeing franchise debts or leases. Claimant also
alleged Respondents breached the Area Developer Agreements by failing to
provide adequate licensing support, negotiating with license prospects, failing
to establish and administer a local advertising group, pledging royalties,
changing the area developer manual, refunding franchise fees, and forcing
Claimants to purchase errors and omissions insurance. Other claims included
breach of the implied covenant of good faith and fair dealing, constructive
termination, and violation of the Texas Deceptive Trade Practices Act.
Claimants sought actual, compensatory, and punitive damages of an unspecified
amount, attorneys fees, and costs. On May 9, 2004 the Company and Claimants
settled all claims and entered into a binding settlement agreement. Robert Coshott v. Schlotzskys, Inc.(Cause No. GN 1-02279), was filed on
July 24, 2001, in the 200th Judicial District Court of Travis County, Texas.
Plaintiff is the Master Licensee for Australia and New Zealand, and he opened a
Schlotzskys Deli restaurant in Melbourne, Australia. Plaintiff brings causes
of action for fraud and/or negligent misrepresentation. Plaintiff alleges that
he experienced problems with certain equipment specified or approved by the
Company, that the Companys system and equipment did not generate enough
finished food product to service his potential customers; that the Company
misrepresented the level of revenue the restaurant could reasonably be expected
to achieve; that the Company delayed his ability to develop restaurants by
failing to timely secure certain trademarks and trade names; and that the
Company misrepresented whether it would allow Plaintiff to franchise
Schlotzskys Deli restaurants in certain gas station or convenience store
locations in his territories. Plaintiff requests actual and punitive damages of
$3.75 million plus lost profits and incidental and consequential damages of an
unspecified amount. On July 23, 2003, Coshott also filed a Demand for
Arbitration with the International Chamber of Commerce styled Robert Gilbert
Coshott v. Schlotzskys, Inc.(Case. No. 12 838/JNK). The claims in the Demand
are similar to those brought in the above-entitled action and include
additional allegations that the Company required the purchase of goods and
services from certain suppliers in violation of the Trade Practices Act of 1974
and that the Company failed to disclose the existence of a predecessor Master
License Agreement, in violation of the Fair Trading Act of 1987 (New South)
Wales, breach of contract, and equitable estoppel. Claimant seeks unspecified
actual, compensatory and punitive damages, lost profits, attorneys fees,
prejudgment interest, and costs. On February 26, 2004, the Company obtained a
declaratory judgment in the state court case declaring that Plaintiff had
waived any right to arbitrate his claim by filing suit against the Company in
state court in Texas. The state court case is not yet set for trial. Dae Kim, DWK Enterprises, 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 Advertising Association,
Inc., and Schlotzskys, Brands, Inc., Schlotzskys Brand Products, L.P.,
Schlotzskys Real Estate, Inc., and Schlotzskys Restaurants, Inc.(Cause No.
2001-CI-13672) was originally filed in the 73rd Judicial District Court of
Bexar County, Texas on or about September 25, 2001 (after a similar lawsuit was
filed and later withdrawn in Harris County, Texas) against Schlotzskys, Inc.,
John Wooley, Schlotzskys Franchising Limited Partnership, and Schlotzskys
NAMF, Inc. (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 bring causes of action for breach of contract, breach
of fiduciary duty, breach of the duty of good faith and fair dealing, civil
conspiracy, tortious interference with contract, tortious interference with
prospective business relationship, violation of the Texas Deceptive Trade
Practices and Consumer Protection Act, restraint of trade, detrimental
reliance-fraud in the inducement, and defamation-business disparagement. They
seek an unspecified amount of money damages plus exemplary damages, attorneys
fees, pre-judgment interest, costs, and a jury trial. Defendants, except for
Mr. Wooley who was previously dismissed from the case, answered and asserted
counterclaims alleging breach of contract and that Plaintiffs claim under the
Texas Deceptive Trade Practices Act is groundless in fact or in law and brought
in bad faith or for the purpose of harassment, and seek money damages, costs
of court, penalty fees, costs incurred in performing the accounting, attorneys
fees, and pre- and post-judgment interest. Defendants (except for Mr. Wooley)
removed the case to federal court. The case was remanded to state court on
April 17, 2003. The case is not yet set for trial. 20




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U.S. Restaurant Properties Operating L.P. v. Schlotzskys, Inc.(Cause No.
03-01758) was filed on February 27, 2003, in the District Court of Dallas
County, B-44th Judicial District. Plaintiff is a real estate investment
company that owns certain Schlotzskys restaurants and leases them to
franchisees. It alleges that in 1997 and 1998 we entered into several
agreements where we agreed to guarantee certain lease agreements. Plaintiff
claims that in 1998 the parties entered into an agreement whereby Plaintiff
agreed to release Schlotzskys from its guaranty obligations pertaining to six
properties in which the tenants had defaulted, in exchange for Schlotzskys
agreement to purchase six other properties. Plaintiff is seeking an order
requiring us to purchase six properties, for a total purchase price of over
$4.5 million. In the alternative, Plaintiff is seeking damages or an order
reinstating the previously released guaranties. Plaintiffs claims include
breach of contract and a request for attorneys fees. The trial date has been
scheduled for September 20, 2004. In addition to the matters discussed above, we are defendants in various
other legal proceedings arising from our business. The ultimate outcome of
these pending proceedings cannot be projected with certainty. However, based on
our experience to date, we believe any such proceeding will not have a material
affect on our business or financial condition. 
 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:a)
    
    
    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)10.54
    
    
    Modification, Extension and Renewal of Promissory Note dated
April 16, 2004, of that certain Promissory Note dated April 8, 2003,
as previously amended, between the Company, as borrower, and John C.
Wooley and Jeffrey J. Wooley, as lenders. (5)31.1
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, signed by John C. Wooley, Chief Executive Officer. (5)
 21




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31.2
    
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, signed by Matthew D. Osburn, principal financial
officer. (5)32.1
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, signed by John C. Wooley, Chief Executive Officer. (5)32.2
    
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, signed by Matthew D. Osburn, principal financial
officer. (5)
   (1)
    
    Incorporated by reference from the Companys Registration
Statement on Form S-1 filed on October 12, 1995, as amended.(2)
    
    Incorporated by reference 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)
    
    Incorporated by reference from the Companys Annual Report on
Form 10-K filed on March 30, 2004.(5)
    
    Filed with this Quarterly Report on Form 10-Q.  b)
    
    Current Reports on Form 8-K:The Registrant furnished a Current Report on Form 8-K dated January 9,
2004, containing a press release dated January 9, 2004, announcing the
modification and extension of certain debt with NS Associates I, Ltd.The Registrant filed a Current Report on Form 8-K dated March 31, 2004,
containing a press release dated March 30, 2004, announcing the Companys
release of financial results for the quarter and fiscal year ended
December 31, 2003.The Registrant furnished a Current Report on Form 8-K dated May 13, 2004,
containing a press release dated May 13, 2004, announcing the Companys
release of financial results for the quarter ended March 31, 2004. 22




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SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized. SCHLOTZSKYS, INC.By:
    /s/ John C. WooleyJohn C. WooleyDirector, President and
Chief Executive Officer
(Principal Executive Officer) By:
    /s/ Matthew D. OsburnMatthew D. OsburnVice President, Controller and
Assistant Treasurer
(Principal Financial Officer) Austin, Texas
May 13, 2004 23