##### 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 June 30, 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 þ No
o Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes o No þ 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 November 5, 2004Common Stock, no par value
    
    7,341,079




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SCHLOTZSKYS, INC. Index to Form 10-Q
Quarter Ended June 30, 2004  
 Page No.Part I            FINANCIAL INFORMATIONItem 1. Financial StatementsCondensed Consolidated Balance Sheets -
June 30, 2004 and December 31, 2003
    
    
    1Condensed Consolidated Statements of Income -
Three and Six Months Ended June 30, 2004 and June 30, 2003
    
    
    2Condensed Consolidated Statement of Stockholders Equity -
Six Months Ended June 30, 2004 and Year Ended December 31, 2003
    
    
    3Condensed Consolidated Statements of Cash Flows -
Six Months Ended June 30, 2004 and June 30, 2003
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition
And Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4. Controls and Procedures
    
    
    26Part II            OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    27Item 2. Changes in Securities and Use of Proceeds
    
    
    28Item 3. Defaults Upon Senior Securities
    
    
    28Item 4. Submission of Matters to a Vote of Security Holders
    
    
    28Item 5. Other Information
    
    
    28Item 6. Exhibits and Reports on Form 8-K
    
    
    28Bylaws of the CompanyEmployment AgreementCertification Pursuant to Section 302 - CEOCertification Pursuant to Section 302 - CFOCertification Pursuant to Section 906 - CEOCertification Pursuant to Section 906 - CFO




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##### Table of Contents



PART I
FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 June 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    514,193
    
    
    $
    1,058,300Accounts receivable, net:Royalties
    
    
    827,569
    
    
    
    884,098Brands
    
    
    742,244
    
    
    
    905,085Other
    
    
    350,842
    
    
    
    1,494,513Refundable income taxes
    
    
    
    
    
    
    9,350Prepaids, inventories and other assets
    
    
    1,023,879
    
    
    
    1,250,193Real estate held for sale
    
    
    3,050,000
    
    
    
    3,208,533Current Portion of:Notes receivable
    
    
    11,349
    
    
    
    50,570Notes receivable  related party
    
    
    
    
    
    
    3,500Total current assets
    
    
    6,520,076
    
    
    
    8,864,142Property, equipment and leasehold improvements, net
    
    
    23,712,634
    
    
    
    42,396,145Notes receivable, net, less current portion
    
    
    3,144,990
    
    
    
    4,121,951Notes receivable  related party, net, less current portion
    
    
    1,230,275
    
    
    
    2,613,170Investments
    
    
    267,850
    
    
    
    567,850Intangible assets, net
    
    
    6,153,543
    
    
    
    62,523,367Goodwill, net
    
    
    
    
    
    
    3,519,242Other noncurrent assets
    
    
    1,056,642
    
    
    
    1,179,687Total assets
    
    $
    42,086,010
    
    
    $
    125,785,554LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Short-term debt
    
    $
    1,681,971
    
    
    $
    1,133,701Current maturities of long-term debt
    
    
    45,441,286
    
    
    
    6,564,646Accounts payable
    
    
    4,160,576
    
    
    
    5,768,117Accrued liabilities
    
    
    9,931,731
    
    
    
    5,243,563Deferred revenue, current portion
    
    
    523,420
    
    
    
    376,633Total current liabilities
    
    
    61,738,984
    
    
    
    19,086,660Long-term debt, less current portion
    
    
    4,160,062
    
    
    
    42,586,141Deferred revenue, less current portion
    
    
    964,439
    
    
    
    1,450,300Deferred tax liability
    
    
    
    
    
    
    Total liabilities
    
    
    66,863,485
    
    
    
    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 June 30,
2004 and December 31, 2003, respectively
    
    
    64,140
    
    
    
    64,073Additional paid-in capital
    
    
    58,243,854
    
    
    
    58,213,945Retained earnings
    
    
    (82,242,313
    )
    
    
    5,227,591Treasury stock (189,525 shares at June 30, 2004 and
December 31, 2003, respectively), at cost
    
    
    (843,156
    )
    
    
    (843,156
    )Total stockholders equity
    
    
    (24,777,475
    )
    
    
    62,662,453Total liabilities and stockholders equity
    
    $
    42,086,010
    
    
    $
    125,785,554
 The accompanying notes are an integral part of the condensed consolidated financial statements. 1




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
 Three months ended
    
    Six months endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenue:Royalties
    
    $
    3,617,959
    
    
    $
    4,285,230
    
    
    $
    7,210,727
    
    
    $
    8,589,118Franchise fees
    
    
    
    
    
    
    3,333
    
    
    
    
    
    
    
    3,333Developer fees
    
    
    35,935
    
    
    
    44,228
    
    
    
    72,242
    
    
    
    94,387Restaurant sales
    
    
    7,668,137
    
    
    
    8,000,609
    
    
    
    15,449,922
    
    
    
    15,612,838Brand contribution
    
    
    1,167,860
    
    
    
    1,708,957
    
    
    
    2,584,457
    
    
    
    3,360,062Other fees and revenue
    
    
    207,443
    
    
    
    219,390
    
    
    
    427,438
    
    
    
    432,039Total revenue
    
    
    12,697,334
    
    
    
    14,261,747
    
    
    
    25,744,786
    
    
    
    28,091,777Expenses:Service costs:Royalties
    
    
    533,660
    
    
    
    667,118
    
    
    
    1,062,543
    
    
    
    1,330,910Franchise fees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    533,660
    
    
    
    667,118
    
    
    
    1,062,543
    
    
    
    1,330,910Restaurant operations:Cost of sales
    
    
    2,135,821
    
    
    
    2,348,501
    
    
    
    4,245,824
    
    
    
    4,520,121Personnel and benefits
    
    
    2,901,252
    
    
    
    3,445,067
    
    
    
    5,851,749
    
    
    
    6,810,228Operating expenses
    
    
    1,975,162
    
    
    
    2,202,095
    
    
    
    3,846,581
    
    
    
    4,104,3427,012,235
    
    
    
    7,995,663
    
    
    
    13,944,154
    
    
    
    15,434,691Equity loss on investments
    
    
    300,000
    
    
    
    83,693
    
    
    
    300,000
    
    
    
    150,843Impairment of franchising assets
    
    
    59,938,180
    
    
    
    
    
    
    
    59,938,180
    
    
    
    Restaurant impairment
    
    
    17,376,156
    
    
    
    
    
    
    
    17,376,156
    
    
    
    General and administrative
    
    
    12,134,279
    
    
    
    6,712,589
    
    
    
    16,077,154
    
    
    
    11,783,304Depreciation and amortization
    
    
    1,311,916
    
    
    
    1,282,595
    
    
    
    2,717,924
    
    
    
    2,532,001Total expenses
    
    
    98,606,426
    
    
    
    16,741,658
    
    
    
    111,416,111
    
    
    
    31,231,749Income (loss) from operations
    
    
    (85,909,092
    )
    
    
    (2,479,911
    )
    
    
    (85,671,325
    )
    
    
    (3,139,972
    )Other:Interest income
    
    
    62,638
    
    
    
    103,609
    
    
    
    125,031
    
    
    
    207,257Interest expense
    
    
    (932,140
    )
    
    
    (1,009,968
    )
    
    
    (1,863,610
    )
    
    
    (2,025,873
    )Income (loss) before provision
(credit) for income
taxes
    
    
    (86,778,594
    )
    
    
    (3,386,270
    )
    
    
    (87,409,904
    )
    
    
    (4,958,588
    )Provision (credit) for income taxes
    
    
    20,000
    
    
    
    (1,119,000
    )
    
    
    60,000
    
    
    
    (1,625,000
    )Net income (loss)
    
    $
    (86,798,594
    )
    
    $
    (2,267,270
    )
    
    $
    (87,469,904
    )
    
    $
    (3,333,588
    )Earnings per share-basic
    
    $
    (11.83
    )
    
    $
    (0.31
    )
    
    $
    (11.92
    )
    
    $
    (0.46
    )Earnings per share-diluted
    
    $
    (11.83
    )
    
    $
    (0.31
    )
    
    $
    (11.92
    )
    
    $
    (0.46
    )
 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 Stock
    
    Additional
    
    
    
    
    
    
    
    
    
    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
    
    
    
    
    
    
    
    
    
    
    18,424
    
    
    
    
    
    
    
    
    
    
    
    18,424Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (87,469,904
    )
    
    
    
    
    
    
    (87,469,904
    )Balance, June 30, 2004
    
    
    7,528,186
    
    
    $
    64,140
    
    
    $
    58,243,854
    
    
    
    (82,242,313
    )
    
    $
    (843,156
    )
    
    $
    (24,777,475
    )
 The accompanying notes
are an integral part of the condensed consolidated financial statements. 3




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 For the six months endedJune 30,
    
    June 30,2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    (87,469,904
    )
    
    $
    (3,333,588
    )Adjustments to reconcile net income (loss) to cash provided by
operating activities:Depreciation and amortization
    
    
    2,717,924
    
    
    
    2,532,001Provision for deferred taxes
    
    
    
    
    
    
    (1,683,020
    )Provision for stock option compensation
    
    
    18,424
    
    
    
    12,192Provision for uncollectible accounts
    
    
    3,434,752
    
    
    
    1,539,563Provision for impairment of assets
    
    
    77,314,336
    
    
    
    Amortization of deferred revenue
    
    
    97,758
    
    
    
    (91,064
    )Equity loss on investments
    
    
    300,000
    
    
    
    150,844Changes in:Accounts receivable
    
    
    (652,966
    )
    
    
    1,058,418Prepaid expenses and other assets
    
    
    349,359
    
    
    
    341,617Accounts payable and accrued liabilities
    
    
    3,844,045
    
    
    
    3,728,710Net cash provided by operating activities
    
    
    (46,272
    )
    
    
    4,255,673Cash flows from investing activities:Purchase of property, equipment and real estate held for sale
    
    
    (171,576
    )
    
    
    (3,025,961
    )Sale of property, equipment and real estate held for sale
    
    
    2,536
    
    
    
    1,195,824Acquisition of investments and intangible assets
    
    
    (43,426
    )
    
    
    (236,692
    )Issuance of notes receivable
    
    
    (25,107
    )
    
    
    (198,740
    )Repayments on notes receivable
    
    
    43,124
    
    
    
    2,378,643Net cash provided by (used in) investing activities
    
    
    (194,449
    )
    
    
    113,074Cash flows from financing activities:Sale of stock
    
    
    11,552
    
    
    
    36,082Acquisition of treasury stock
    
    
    
    
    
    
    Proceeds from issuance of debt
    
    
    2,607,500
    
    
    
    710,000Debt issuance costs
    
    
    (247,103
    )
    
    
    (858,745
    )Repayment of debt
    
    
    (2,675,335
    )
    
    
    (4,154,752
    )Net cash used in financing activities
    
    
    (303,386
    )
    
    
    (4,267,415
    )Net increase (decrease) in cash and cash equivalents
    
    
    (544,107
    )
    
    
    101,332Cash and cash equivalents at beginning of period
    
    
    1,058,300
    
    
    
    678,895Cash and cash equivalents at end of period
    
    $
    514,193
    
    
    $
    780,227
 The accompanying notes are an integral part of the condensed consolidated financial statements. 4




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##### Table of Contents



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
and six months ended June 30, 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. On August 3, 2004 (the Petition Date), Schlotzskys, Inc. (the
Company) and its subsidiaries filed a voluntary petition for relief (the
Filing) under Chapter 11 of Title 11 of the United States Code in the United
States Bankruptcy Court for the Western District of Texas (the Bankruptcy
Court), San Antonio division. The cases have been assigned No. 04-54504. The
Company is operating its business and managing its property as a debtor in
possession of its assets and the Companys existing directors and officers
continue to oversee operation of the Companys business as a
debtor-in-possession. Financial Statement Presentation The accompanying condensed consolidated financial statements have been
prepared assuming that the Company will continue to operate as a going concern,
which contemplates continuity of operations, timely payment by franchisees and
licensees, control of operating expenses and the professional fees associated
with reorganizing the Company, and the realization of asset sales and
liquidation of liabilities and commitments. The Filing and related
circumstances raise substantial doubts about the Companys ability to continue
as a going concern and accordingly such realization of assets and liquidation
of liabilities are subject to uncertainty. In connection with its plan of
reorganization, the Company may liquidate or settle liabilities for amounts
other than those reflected in the Condensed Consolidated Financial Statements.
In addition, a plan of reorganization could materially change the amounts and
classifications reported in the consolidated historical financial statements,
which do not give effect to any adjustments to the carrying value of assets or
amounts of liabilities that might be necessary as a consequence of a plan of
reorganization. Pursuant to the Bankruptcy Code, schedules have been and will continue to
be filed by the Company with the Bankruptcy Court setting forth the assets and
liabilities of the Company. Differences between amounts recorded by the
Company and claims filed by creditors will be investigated and resolved as part
of the Chapter 11 Cases. The Company has received approval from the Bankruptcy Court to pay or
otherwise honor certain of its pre-petition obligations, including employee
wages, salaries, benefits and other employee obligations and certain other
pre-petition claims. Reclassifications and Required Accounting Issues Discussion Certain reclassifications have been made to the condensed consolidated
financial statements for the periods ended June 30, 2003, to correspond with
the presentation used at June 30, 2004, and for the periods then ended. Quarterly Financials Not Reviewed by Independent Accountants Due to the constraints of operating as a debtor-in-possession and the need
to negotiate cash collateral orders with its secured creditors the Company is
unable to control the timing and amount of payments to its professionals. Due
to the uncertainty of the payment of professional fees, the Company has been
unable to secure a review of this Form 10-Q by its independent accountants, thus
it was unreviewed by independent accountants at the time of filing. Note 2.  Review of Accounting for Reacquired Area Developer Rights The Company has received from the Securities and Exchange Commission
(the Commission)
comments to the Companys Annual Report on Form 10-K for the year ended
December 31, 2003. This action has led to discussions between the Company, the
Commission, and the Companys auditors concerning the appropriateness of
capitalizing as intangible assets those payments made over the past eight years
to area developers to modify or cancel their area developer contracts.
Although the Company continues to believe the classification as intangible
assets is proper, the Company has not resolved this issue with the Commission at the time of filing this Form 10-Q. Were the Company
to restate its financials to reflect expensing the payments to area developers
at the time the transactions were executed, approximately $60.1 million in
repurchase expense would be recognized between 1996 and 2004, and $4.7 million
in amortization expense would be reversed off the income statement during that
same period. Additionally, see Note 14 for information regarding the Companys treatment of these intangible assets during the
second quarter of 2004. 5




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Note 3.  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 three and six-month
periods ended June 30, 2004 were approximately $9,000 and $18,000,
respectively. 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 ended
    
    For the six months endedJune 30, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003Net income (loss), as reported
    
    $
    (86,799
    )
    
    $
    (2,267
    )
    
    $
    (87,470
    )
    
    $
    (3,334
    )Add: Stock-based employee
compensation expense included
in net income, net of related
tax effects
    
    
    9
    
    
    
    4
    
    
    
    18
    
    
    
    8Deduct: Total stock-based
employee compensation expense
determined under fair value
based method for all awards,
net of related tax effects
    
    
    (24
    )
    
    
    (45
    )
    
    
    (44
    )
    
    
    (114
    )Pro forma net income (loss)
    
    $
    (86,814
    )
    
    $
    (2,308
    )
    
    $
    (87,496
    )
    
    $
    (3,440
    )Earnings per share:Basic-as reported
    
    $
    (11.83
    )
    
    $
    (0.31
    )
    
    $
    (11.92
    )
    
    $
    (0.46
    )Basic-pro forma
    
    $
    (11.83
    )
    
    $
    (0.32
    )
    
    $
    (11.92
    )
    
    $
    (0.47
    )Diluted-as reported
    
    $
    (11.83
    )
    
    $
    (0.31
    )
    
    $
    (11.92
    )
    
    $
    (0.46
    )Diluted-pro forma
    
    $
    (11.83
    )
    
    $
    (0.32
    )
    
    $
    (11.92
    )
    
    $
    (0.47
    )
 6




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 4.  Restaurant Operations A summary of certain operating information for Company-operated restaurants is
presented below for the three and six month periods ended June 30, 2004 and
2003 (dollars in thousands). The Company reviewed its 36 Company-operated
restaurant units and determined it would close 18 underperforming units during
the third and fourth quarters of 2004. Closure of these units was completed in
October 2004. The results shown below do not reflect the impairment of
certain intangible or real estate assets or recognition of liabilities related
to the 18 closed restaurants. Retained
    
    Closed
    
    TotalThree months ended June 30, 2004Restaurant sales
    
    $
    5,324
    
    
    $
    2,344
    
    
    $
    7,668Restaurant operations:Cost of sales
    
    
    1,478
    
    
    
    658
    
    
    
    2,136Personnel and benefits
    
    
    1,836
    
    
    
    1,065
    
    
    
    2,901Operating expenses
    
    
    1,030
    
    
    
    945
    
    
    
    1,9754,344
    
    
    
    2,668
    
    
    
    7,012Operating income (loss) before depreciation
and amortization
    
    $
    980
    
    
    $
    (324
    )
    
    $
    656Three months ended June 30, 2003Restaurant sales
    
    $
    5,375
    
    
    $
    2,626
    
    
    $
    8,001Restaurant operations:Cost of sales
    
    
    1,590
    
    
    
    759
    
    
    
    2,349Personnel and benefits
    
    
    2,156
    
    
    
    1,289
    
    
    
    3,445Operating expenses
    
    
    1,036
    
    
    
    1,166
    
    
    
    2,2024,782
    
    
    
    3,214
    
    
    
    7,996Operating income (loss) before depreciation
and amortization
    
    $
    593
    
    
    $
    (588
    )
    
    $
    5
 Retained
    
    Closed
    
    TotalSix months ended June 30, 2004Restaurant sales
    
    $
    10,715
    
    
    $
    4,735
    
    
    $
    15,450Restaurant operations:Cost of sales
    
    
    2,931
    
    
    
    1,315
    
    
    
    4,246Personnel and benefits
    
    
    3,731
    
    
    
    2,121
    
    
    
    5,852Operating expenses
    
    
    2,009
    
    
    
    1,837
    
    
    
    3,8468,671
    
    
    
    5,273
    
    
    
    13,944Operating income (loss) before depreciation
and amortization
    
    $
    2,044
    
    
    $
    (538
    )
    
    $
    1,506Six months ended June 30, 2003Restaurant sales
    
    $
    10,504
    
    
    $
    5,109
    
    
    $
    15,613Restaurant operations:Cost of sales
    
    
    3,047
    
    
    
    1,473
    
    
    
    4,520Personnel and benefits
    
    
    4,184
    
    
    
    2,626
    
    
    
    6,810Operating expenses
    
    
    1,999
    
    
    
    2,106
    
    
    
    4,1059,230
    
    
    
    6,205
    
    
    
    15,435Operating income (loss) before depreciation
and amortization
    
    $
    1,274
    
    
    $
    (1,096
    )
    
    $
    178
 7




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 4.  Restaurant Operations-Continued As of June 30, 2004 and 2003, the net book value of property and equipment
and intangible assets related to each of the above categories was as follows
(dollars in thousands): June 30, 2004
    
    June 30, 2003Retained
    
    $
    13,824
    
    
    $
    24,201Closed
    
    
    7,571
    
    
    
    13,282$
    21,395
    
    
    $
    37,483
 The assets remaining related to the closed restaurants are the estimated
liquidation value of the real estate where the restaurants were located. Note 5.  Segments The Company and its subsidiaries are 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 June 30, 2004, the Schlotzskys system included
Company-operated and franchised restaurants in 37 states, the District of
Columbia and six foreign countries. The Company operated 36 restaurants as of
June 30, 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, and training and building brand
awareness. The Restaurant Operations segment also includes restaurants
developed for or acquired from franchisees which are available for sale to
franchisees. 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): Restaurant Operations
    
    FranchiseThree months ended June 30, 2004
    
    Retained
    
    Closed
    
    Operations
    
    ConsolidatedSales
    
    $
    5,324
    
    
    $
    2,344
    
    
    $
    5,029
    
    
    $
    12,697Depreciation and amortization
    
    
    397
    
    
    
    294
    
    
    
    621
    
    
    
    1,312Impairment
    
    
    9,408
    
    
    
    7,968
    
    
    
    59,938
    
    
    
    77,314Operating income (loss)
    
    
    (8,825
    )
    
    
    (7,938
    )
    
    
    (69,146
    )
    
    
    (85,909
    )Total assets
    
    
    13,824
    
    
    
    7,571
    
    
    
    20,691
    
    
    
    42,086
 Restaurant Operations
    
    FranchiseThree months ended June 30, 2003
    
    Retained
    
    Closed
    
    Operations
    
    ConsolidatedSales
    
    $
    5,375
    
    
    $
    2,626
    
    
    $
    6,261
    
    
    $
    14,262Depreciation and amortization
    
    
    365
    
    
    
    194
    
    
    
    724
    
    
    
    1,283Operating income (loss)
    
    
    228
    
    
    
    (782
    )
    
    
    (1,926
    )
    
    
    (2,480
    )Total assets
    
    $
    24,201
    
    
    $
    13,282
    
    
    $
    96,344
    
    
    $
    133,827
 8




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 5.  Segments-Continued Of the Restaurant Operations depreciation and amortization for the three
months ended June 30, 2004, $397,000 was allocated to the retained restaurants
and $294,000 to the restaurants that were closed in the third and fourth quarters of 2004.
For the three months ended June 30, 2003, $365,000 of depreciation and
amortization was allocated to the retained restaurants and $194,000 to
restaurants that were closed in the third and fourth quarters of 2004 or prior. Restaurant Operations
    
    FranchiseSix months ended June 30, 2004
    
    Retained
    
    Closed
    
    Operations
    
    ConsolidatedSales
    
    $
    10,715
    
    
    
    4,735
    
    
    $
    10,295
    
    
    $
    25,745Depreciation and amortization
    
    
    797
    
    
    
    650
    
    
    
    1,271
    
    
    
    2,718Impairment
    
    
    9,408
    
    
    
    7,968
    
    
    
    59,938
    
    
    
    77,314Operating income (loss)
    
    
    (8,161
    )
    
    
    (9,156
    )
    
    
    (68,354
    )
    
    
    (85,671
    )Total assets
    
    
    13,824
    
    
    
    7,571
    
    
    
    20,691
    
    
    
    42,086
 Restaurant Operations
    
    FranchiseSix months ended June 30, 2003
    
    Retained
    
    Closed
    
    Operations
    
    ConsolidatedSales
    
    $
    10,504
    
    
    
    5,109
    
    
    $
    12,479
    
    
    $
    28,092Depreciation and amortization
    
    
    704
    
    
    
    376
    
    
    
    1,452
    
    
    
    2,532Impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Operating income (loss)
    
    
    570
    
    
    
    (1,472
    )
    
    
    (2,238
    )
    
    
    (3,140
    )Total assets
    
    $
    24,201
    
    
    $
    13,282
    
    
    $
    96,344
    
    
    $
    133,827
 Of the Restaurant Operations depreciation and amortization for the six
months ended June 30, 2004, $797,000 was allocated to the retained restaurants
and $650,000 to the restaurants that were closed in the third and fourth
quarters of 2004. For the six months ended June 30, 2003, $704,000 of
depreciation and amortization was allocated to the retained restaurants and
$376,000 to the restaurants that were closed in the third and fourth quarters of
2004 or prior. All general and administrative expenses are included in Franchise Operations
for the periods presented. 9




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 6.  Debt The Companys debt structure as of June 30, 2004, and December 31, 2003,
is as follows (dollars in thousands): June 30, 2004
    
    December 31, 2003(Unaudited)Short-term debt:
    
    $
    1,682
    
    
    $
    1,134Long-term debt:Notes payable to former area developers
    
    $
    21,171
    
    
    $
    21,851Mortgages on Company-operated restaurants and equipment
    
    
    20,685
    
    
    
    21,589Capital leases
    
    
    2,462
    
    
    
    2,659Notes payable to shareholders
    
    
    2,344
    
    
    
    2,500Obligations secured by royalty and licensing contracts
    
    
    2,608
    
    
    
    Other obligations
    
    
    331
    
    
    
    55149,601
    
    
    
    49,150Less current maturities of long-term debt
    
    
    (45,441
    )
    
    
    (6,654
    )Long-term debt
    
    $
    4,160
    
    
    $
    42,586
 As of June 30, 2004, the Company was in default of the financial covenants
specified in its debt agreements. Under these debt agreements, such defaults
result in the debt becoming immediately due and payable. Related to these
defaults, approximately $35.8 million in long-term debt was reclassified as a
current maturity of long-term debt as of June 30, 2004. Note 7.  Related Party Receivables As of June 30, 2004 and December 31, 2003, receivables from related
parties were as follows (dollars in thousands): June 30, 2004
    
    December 31, 2003(Unaudited)Included in accounts receivable  other
    
    $
    
    
    
    $
    23Included in other noncurrent assets
    
    
    253
    
    
    
    939Included in notes receivable
    
    
    1,230
    
    
    
    2,617Total related party receivables
    
    $
    1,483
    
    
    $
    3,579
 10




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 8.  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): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Basic earnings per shareNet income (loss)
    
    $
    (86,799
    )
    
    $
    (2,267
    )
    
    $
    (87,470
    )
    
    $
    (3,334
    )Weighted average common shares outstanding
    
    
    7,339
    
    
    
    7,320
    
    
    
    7,339
    
    
    
    7,320Basic earnings per share
    
    $
    (11.83
    )
    
    $
    (0.31
    )
    
    $
    (11.92
    )
    
    $
    (0.46
    )Diluted earnings per shareNet income (loss)
    
    $
    (86,799
    )
    
    $
    (2,267
    )
    
    $
    (87,470
    )
    
    $
    (3,334
    )Weighted average common shares outstanding
    
    
    7,339
    
    
    
    7,320
    
    
    
    7,339
    
    
    
    7,320Dillutive stock options and warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Weighted average common shares outstanding -
assuming dilution
    
    
    7,339
    
    
    
    7,320
    
    
    
    7,339
    
    
    
    7,320Diluted earnings per share
    
    $
    (11.83
    )
    
    $
    (0.31
    )
    
    $
    (11.92
    )
    
    $
    (0.46
    )Outstanding options and warrants that were
not included in the diluted calculation
because their effect would be
anti-dilutive
    
    
    883
    
    
    
    1,142
    
    
    
    883
    
    
    
    1,142
 11




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 9.  Intangible Assets Intangible assets consist of the following (dollars in thousands): June 30, 2004
    
    December 31, 2003(Unaudited)AmortizationPeriod
    
    Gross
    
    Accumulated
    
    Gross
    
    Accumulated(Years)
    
    Value
    
    Amortization
    
    Value
    
    AmortizationIntangible assets subject to amortization:Royalty value
    
    
    20
    
    
    $
    2,385
    
    
    $
    956
    
    
    $
    2,474
    
    
    $
    897Developer and franchise rights acquired
    
    
    20 to 40
    
    
    
    4,558
    
    
    
    4,558
    
    
    
    59,374
    
    
    
    3,867Restaurant development rights
    
    
    13 to 25
    
    
    
    951
    
    
    
    718
    
    
    
    1,653
    
    
    
    568Debt issue costs
    
    
    3 to 20
    
    
    
    747
    
    
    
    264
    
    
    
    529
    
    
    
    211Other intangible assets
    
    
    5
    
    
    
    652
    
    
    
    472
    
    
    
    646
    
    
    
    4389,293
    
    
    
    6,968
    
    
    
    64,676
    
    
    
    5,981Intangible assets not subject to
amortization:Original franchise and royalty rights
    
    
    
    
    
    
    5,689
    
    
    
    1,860
    
    
    
    5,689
    
    
    
    1,860Goodwill
    
    
    
    
    
    
    331
    
    
    
    331
    
    
    
    3,850
    
    
    
    3316,020
    
    
    
    2,191
    
    
    
    9,539
    
    
    
    2,191Total intangible assets
    
    
    
    
    
    $
    15,313
    
    
    $
    9,159
    
    
    $
    74,215
    
    
    $
    8,172
 Amortization of intangible assets totaled approximately $483,000 and
$439,000 for the three months ended June 30, 2004, and 2003, respectively. For
the six months ended June 30, 2004, and 2003, amortization expense totaled
$987,000 and $865,000 respectively. Estimated amortization expense through
2007 for intangible assets with determinable lives is as follows (dollars in
thousands): Remainder of 2004
    
    $
    1322005
    
    
    2332006
    
    
    1602007
    
    
    1592008
    
    
    158$
    842
 The changes in the gross value of goodwill for the six months ended June 30,
2004, are as follows (dollars in thousands): Restaurant
    
    FranchiseOperations
    
    Operations
    
    TotalBalance as of December 31, 2003
    
    $
    3,589
    
    
    $
    261
    
    
    $
    3,850Goodwill acquired
    
    
    
    
    
    
    
    
    
    
    Impairment
    
    
    (3,299
    )
    
    
    (220
    )
    
    
    (3,519
    )Balance as of June 30, 2004
    
    $
    290
    
    
    $
    41
    
    
    $
    331
 12




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 10.  Off-balance Sheet Arrangements The Company has outstanding guarantees of indebtedness of others,
including related parties, of approximately $20.5 million as of June 30, 2004.
These guarantees include approximately $4.7 million of lease guarantees for the
benefit of franchisees, approximately $13.8 million of mortgage loan guarantees
for the benefit of franchisees and approximately $2.0 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
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 June 30, 2004, the Company had
accrued a liability of approximately $982,000 related to these guarantees.
This accrual is due to a management determination that it would no longer be
able to attempt to rehabilitate franchisees restaurants through direct
financial assistance. The Company also has a net deferred gain related to the
sale of these leases in the amount of approximately $342,000 as of June 30,
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 $1.0
million. Certain 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. As of June 30, 2004,
the Company had accrued $1,761,000 for certain mortgage guarantees that were
called but not yet paid. 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. The Company has been called upon, from time to time, to make payments on
obligations the Company has guaranteed. During the first six months of 2004,
the Company paid approximately $362,000 in various lease guarantees for the
benefit of franchisees. As of the date of the bankruptcy filing, the Company
has suspended payments of guarantee obligations. The status of these various
guarantees likely will be addressed during the proceeding in the Bankruptcy
Court. 13




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##### Table of Contents



SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 11.  Commitments and Contingencies Litigation The Companys filing for Chapter 11 protection in federal bankruptcy court
generally stayed all litigation pending as of August 3, 2004, although parties
in some cases may either request that the bankruptcy judge lift the stay and
allow the litigation to proceed or remove the case to the bankruptcy court to
be heard by the judge in the bankruptcy proceeding. New Florida Markets, Ltd. and Deli Keys, Ltd. v. Schlotzskys, Inc.,
Schlotzskys Franchising 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 around June
23, 2003 with the American Arbitration Association. Claimants are the area
developers for the Tampa, Orlando, Miami and West Palm Beach development areas.
They alleged that Respondents frustrated their ability to develop their areas
and breached the Area Developer Agreements, in addition to other claims. On
May 9, 2004 the Respondents and Claimants settled all claims and entered into a
binding settlement agreement. The Company was not able to make a required
settlement payment on June 15, 2004, and around July 27, 2004, the claimants
filed New Florida Markets, Ltd. and Deli Keys Ltd. v. Schlotzskys, Inc.,
Schlotzskys Franchising Limited Partnership, Schlotzskys Franchisor, LLC,
Schlotzskys Franchise Operations, LLC, Schlotzskys N.A.M.F. Inc. and
Schlotzskys N.A.M.F. Funding, LLC, in the Circuit Court of
the 11th Judicial
Circuit in and for Dade County, Florida, General Civil Division, Case No.
04-16303 seeking enforcement of the settlement agreement. On October 21, 2004,
the Court granted a Motion to Dismiss the NAMF entities but allowed Plaintiffs
20 days to amend the complaint to state a cause of action against the NAMF
entities that would not be barred by the bankruptcy or the binding terms of
settlement, which provided that Plaintiffs exclusive remedy for a breach was
against Schlotzskys, Inc. or the subsidiary that was to sign the note.
Because of uncertainties inherent in this type of matter, no outcome can be
confidently predicted with respect to the foregoing matter and no estimate of
the possible loss or range of possible loss can be made. 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 brought causes
of action for fraud and/or negligent misrepresentation. Plaintiff alleged 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 requested 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. On June 21, 2004, the parties were informed by the
International Court of Arbitration that the case is considered withdrawn as of
June 1, 2004 for failure to pay the required advance on costs. The state court
case is not yet set for trial. Because of uncertainties inherent in this type
of matter, no outcome can be confidently predicted with respect to the
foregoing matter and no estimate of the possible loss or range of possible loss
can be made. 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 brought causes of action for breach of contract, breach of fiduciary
duty, breach of the duty of good faith and fair dealing, civil conspiracy,
tortuous interference with contract, tortuous interference with prospective
business relationship, violation of the Texas Deceptive Trade Practices and
Consumer Protection Acts, restraint of trade, detrimental reliance-fraud in the
inducement, and defamation-business disparagement. They seek 14




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) 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. Because of uncertainties
inherent in this type of matter, no outcome can be confidently predicted with
respect to the foregoing matter and no estimate of the possible loss or range
of possible loss can be made. 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, although the Chapter 11 proceeding is expected to stay the
trial date. On June 25, 2004, Plaintiff filed U.S. Restaurant Properties
Operating L.P. v. Schlotzskys, Inc.(Cause No. 04-05858-D), in the District
Court of Dallas County, 95th Judicial District. Plaintiff alleges that
Defendant owes unpaid balance on certain guaranty pool agreements allegedly
defaulted by Defendant beginning in May 2004. Because of uncertainties
inherent in this type of matter, no outcome can be confidently predicted with
respect to the foregoing matter and no estimate of the possible loss or range
of possible loss can be made. John Wooley and Jeffrey Wooley vs. Schlotzskys Franchisor, LLC,Cause No.
GN402261, was filed on July 20, 2004 in the 98th Judicial District Court of
Travis County, Texas, and John Wooley and Jeffrey Wooley v. Schlotzskys, Inc.,
Cause No. GN402596, was filed on August 12, 2004 in the
250th Judicial District
Court of Travis County, Texas. John Wooley and Jeffrey Wooley, former officers
and directors of the Company, with John Wooley currently being the largest
shareholder of the Company, filed a request for a Temporary Restraining Order
on July 20, 2004 to request the Court to order the Company not to take any
actions with regard to Schlotzskys Franchisor, LLC, a subsidiary of the
Company. The Wooleys asserted that any action taken with regard to
Schlotzskys Franchisor would harm them with regard to a loan they made to
Franchisor in November 2003 for approximately $2.5 million. The Court rejected
their request, and no further action has been taken to date by the Wooleys in
the first listed lawsuit. On August 12, 2004, the Wooleys filed the second
listed lawsuit above and requested that the Court order the Company to hold its
annual shareholder meeting by August 30, 2004. The Wooleys subsequently filed
a motion for non-suit in the state court case and then filed a motion with the
bankruptcy court asking that the judge lift the automatic stay with regard to
the annual meeting and grant the Wooleys permission to pursue their claim for
injunctive relief in state court. In addition, the Wooleys have filed several
other motions with the bankruptcy court challenging certain actions the Company
has taken during the bankruptcy proceeding and objecting to requests made by
the Company with regard to its retention of professionals during the bankruptcy
process. Because of uncertainties inherent in this type of matter, no outcome
can be confidently predicted with respect to the foregoing matter and no
estimate of the possible loss or range of possible loss can be made. In addition to the matters discussed above, we are defendants in various
other legal proceedings arising from our business. Due to the bankruptcy
filing, the early stages of some of the proceedings, and the general
uncertainty surrounding the outcome of any litigation, it is not possible for
the Company to provide any certain or meaningful analysis, projections, or
expectations with respect to the proceedings discussed above. Note 12.  Impairment of Real Estate Investments and Real Estate Held for Sale At the start of the second quarter, 2004, the Company was developing four
real estate pad sites as future Company-operated Schlotzskys restaurants, and
had capitalized costs related to those sites, such as interest expense, site
work and acquisition costs. Additionally, the Company had five pad sites held for
sale, generally recorded on the books at historical cost. In June 2004 the
Company discontinued all real estate development activity and began marketing
all nine real estate sites for sale on an expedited basis. An impairment
charge of $4.4 million was booked in June 2004 to write-off capitalized
development costs and to adjust the value of the assets to the expected net
cash proceeds from a sale of the real estate on an expedited basis. 15




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SCHLOTZSKYS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED)
(Unaudited) Note 13.  Discontinued Operations When a restaurant is closed or held for sale, the Company makes an
evaluation as to whether its results should be reflected as discontinued
operations in accordance with Statement of Financial Accounting Standard 144 -
Accounting for the Impairment or Disposal of Long-Lived Assets. In the second quarter ended June 30, 2004, the Company recorded a non-cash
impairment charge of $8.0 million for the write-down of buildings, leasehold
improvements, equipment and goodwill to fair value for eighteen of the
Companys restaurants it intends to close. The Company determined a weighted
fair value for its restaurant assets by estimating the sales price of the real
estate value of the closed restaurants as determined through discussions with
real estate brokers and potential investors, or determined there was no fair
value related to the restaurant if the location was leased. This approach
differs from prior periods in that previous testing, including that done at
December 31, 2003, was primarily based on the projected cash flow generated by
the restaurants, not their sale value. The Company closed those ten
restaurants and five others in July 2004 and three others in October 2004,
during the fourth quarter. Three of the closed restaurants are located in
Georgia, three in North Carolina, two in Tennessee, two in Mississippi, three
in Texas and one each in Arizona, Arkansas, Minnesota, New York and Utah. In
the third quarter 2004, the Company will record a charge of approximately
$1,139,000 for the expected liability from rejection of the leases for eight of
the closed restaurants and one location, which never opened, under Section 502
(B)(6) of the Bankruptcy Code. Note 14.  Impairment of Area Developer Rights The Company reviews its intangible assets for impairment on an annual basis, or
when a change in circumstances indicates that the carrying amount may not be
recoverable. At the end of the second quarter of 2004, the Company tested its
assets for impairment due to the events leading up to the August 3, 2004
bankruptcy filing. The Company determined, due to the likelihood that all
existing area developer contracts would be rejected during the bankruptcy
proceedings and the Company would terminate the area developer program, that
the previously acquired area developer rights had no fair value and an
impairment charge of $55.5 million was recorded during the second quarter of
2004. Note 15.  Impairment of Restaurant Goodwill, Intangible assets, and Property,
Plant, and Equipment At the end of the second quarter of 2004, the Company tested its restaurant
assets for impairment due to the events leading up to the August 3, 2004
bankruptcy filing. The Company determined a weighted fair value for the 18
Company-operated locations it intends to continue to operate by projecting a
range of sale scenarios determined through discussions with investment bankers,
real estate brokers and potential investors. This approach differs from prior
periods in that previous testing, including that done at December 31, 2003, was
primarily based on the cash flow generated by the restaurants, not their sale
value. An impairment charge of $2.0 million of goodwill, approximately
$500,000 of intangible assets, and $6.9 million of Property, Plant, and
Equipment was indicated based on the weighted fair value of the operating
restaurants. Note 16.  Employment Contracts On June 17, 2004, the Board of Directors terminated John C. Wooley from
his position as President and Chief Executive Officer of the Company and
Jeffrey J. Wooley from his position as Senior Vice President of the Company.
At the time of termination, the Wooleys had active employment contracts and
those contracts required salary and benefits continuation for four years and
that certain bonus advances be deemed earned upon termination. In June 2004,
the Company accrued expenses of $2,629,000 related to the future salaries and
benefits obligation and expensed $527,000 related to the bonus advances. 16




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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 could
significantly impact our results of operations and financial conditions 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.
    
    Determination of appropriate valuation allowance 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.Recoverability of intangible assets is primarily dependent on the
continuing collection of franchise royalties. To the extent that
there is doubt about the ability of the Company to successfully
reorganize and emerge from Chapter 11 these assets may be
unrecoverable. After our impairment of area developer contracts,
approximately $5.9 million remained worth of intangible assets
relating to the franchising business remained on the balance sheet at
June 30, 2004. Recent Events On June 17, 2004, the Board of Directors terminated John C. Wooley from
his position as President and Chief Executive Officer of the Company and
Jeffrey J. Wooley from his position as Senior Vice President of the Company.
They had served as senior management of the Company since 1981. That same day,
David Samuel (Sam) Coats was named President and Chief Executive Officer of
the Company. Subsequently, John and Jeff Wooley were removed from various
positions with the subsidiaries of the Company. On June 24, 2004, the Board
appointed Sam Coats to the Board of Directors and the Company announced that it
had retained Trinity Capital, LLC (Trinity), a specialty investment banking
firm focused on the multi-unit retail and food and beverage industries, to
serve as financial advisor to the Company. Trinity had been retained by the
Company in March 2004 on a limited basis to obtain waivers of certain covenants
from specific lenders and to seek financing for the Company. The June 24
engagement expanded the scope of their engagement to include restructuring,
corporate finance and other advisory services. On June 30, 2004, both John and Jeff Wooley voluntarily resigned from
their positions as members of the Board of Directors of the Company. They both
remained on the Board of Schlotzskys N.A.M.F., Inc., (NAMF) a Texas
not-for-profit, non-member corporation that collects payments from Schlotzskys
franchisees to use for advertising and marketing purposes. The Board of the
Company asked them to resign from NAMF but they have refused to do so to date. On July 6, 2004, the Company reduced its workforce and eliminated
approximately 20 percent of corporate staff, or 19 positions, within
Schlotzskys, Inc. and Schlotzskys Franchise Operations, LLC, a subsidiary of
Schlotzskys, Inc. Eight of the 17




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##### Table of Contents



people terminated were at the vice president or director level. On August
2, 2004, the Company terminated nine additional employees. Beginning on July
9, 2004 and continuing through July 26, 2004, the Company closed 15
Company-operated restaurants located in various states. In October 2004, three
additional Company-operated restaurants were closed; two were in Mississippi
and one was in Texas. None of these stores had been profitable prior to the
closing. On August 3, 2004, the Company filed for Chapter 11 as discussed in Note
1. Consequences of the Chapter 11 Filing As a consequence of the Filing, all pending claims against the Company are
stayed automatically by Section 362 of the Bankruptcy Code, and absent further
order of the Bankruptcy Court, no party may take any action to recover any
pre-petition claims, enforce any lien against or obtain possession of any
property from the Company. In addition, pursuant to Section 365 of the
Bankruptcy Code, the Company may reject or assume pre-petition executory
contracts and unexpired leases. The non-debtor parties to these contracts or
leases may file claims with the Bankruptcy Court in accordance with the Chapter
11 reorganization process. As provided by the Bankruptcy Code, the Company initially will have the
exclusive right for 120 days following the Petition Date to propose a plan of
reorganization. If the Company fails to file a plan of reorganization during
such period or any extension thereof, or if such plan is not accepted by the
requisite numbers of creditors and equity holders entitled to vote on the plan
within 180 days after the Petition Date or any extension thereof, other parties
in interest may be permitted to propose their own plan or plans of
reorganization for the Company. The Company is unable to predict at this time
what the treatment of creditors and equity holders of the Company will be under
any proposed plan or plans of reorganization, although discussions with
potential buyers have indicated that the recovery of unsecured creditors and
equity holders may be minimal or non-existent. The Bankruptcy Court may confirm a plan of reorganization only upon making
certain findings required by the Bankruptcy Code, and a plan may be confirmed
over the dissent of non-accepting creditors and equity security holders if
certain requirements of the Bankruptcy Code are met. The payment rights and
other entitlements of pre-petition creditors and the Companys stockholders may
be substantially altered by any plan of reorganization confirmed in the Chapter
11 Cases. There can be no assurance that there will be sufficient assets to
satisfy the Companys pre-petition liabilities in whole or that the Companys
equity securities will have any continuing value. Under a plan of
reorganization, pre-petition creditors could receive less than 100% of the face
value of their claims and the Companys equity securities could be cancelled.
In addition, the Company has not yet proposed a plan of reorganization. It is
not possible to predict the outcome of the Chapter 11 Cases, the terms and
provisions of any plan of reorganization, or the effect of the Chapter 11
reorganization process on the claims of the creditors of the Company or the
interests of the Companys equity security holders. The Company, with the agreement of certain secured creditors, has been
able to use franchising revenue to fund the operations to date during the
Chapter 11 proceedings. The Company is currently operating under a temporary
cash collateral order approved by the Bankruptcy Court that expires on November
17, 2004. It is attempting to finance its unmet capital needs after November
17, 2004 through some combination of real estate sales or securing the
permission of certain creditors to use franchising revenue to meet the
operating needs of the Company. If necessary, the Company would seek
debtor-in-possession financing at that time, although there is no guarantee
that such financing could be obtained. There can be no assurance that
additional capital will be available on terms acceptable to the Company, or at
all. Failure to raise sufficient additional capital or to secure the agreement
of certain secured creditors to use franchising revenue to fund the operations
would have a material adverse effect on the Companys ability to operate as a
going concern or to restructure under Chapter 11. In addition, the ability of the Company to continue as a going concern
(including its ability to meet post-petition obligations of the Company) and
the appropriateness of using the going concern basis for its financial
statements are dependent upon, among other things, any orders entered by the
Bankruptcy Court concerning matters outside of the ordinary course of business,
and obtaining confirmation of a plan of reorganization or a sale of assets
under the Bankruptcy Code. If the assets of the Company are sold under Section
363 of the Bankruptcy Code, the Company itself likely would not continue as a going
concern. The consolidated financial statements contain no adjustments related
to this uncertainty. On August 12, 2004, the Companys securities were delisted from the NASDAQ
National Market. The Companys common stock currently trades on the NASD
Over-the-Counter-Market under the symbol BUNZQ.PK. Background of Filing The Schlotzskys franchise system has been declining in store count since
2000 and has had negative same store sales since 2001, resulting in declining
royalty and license fees to the Company. Since 1999, the Company has
repurchased certain area developer rights, and often these repurchase
agreements had some component of seller financing, which resulted in a
significant debt service burden to the Company. Additionally, the Company
guaranteed over $25 million of franchisee lease and mortgage liabilities during
the 1997-2000 time period as part of the Turnkey program, in which the
Company developed restaurant sites and then sold 18




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##### Table of Contents



them to franchisees. The Company, as a franchisor, also was subject to
significant amounts of litigation over various matters by both the franchisees
and area developers. While significant expenses related to litigation and
guarantees had been incurred over the last four years, the Company anticipated
that it would continue to incur material cash expenses related to litigation
and guarantees in future periods. From approximately August 2002 to June 2004, the Company attempted to
secure financing with favorable repayment terms that would allow it to retire
the area developer obligations and provide additional operating capital, but
was unable to secure such financing. The Company was able, starting in
January 2003, to extend vendor payment terms and secure limited amounts of
financing, but these financing facilities were repayable in full in less than
two years, and called for amortizing payments beginning in mid-2004. Because
of the cash required to repay the short-term financing, the area developer
notes, and guarantee and litigation costs, as well as expenses incurred in
attempting to secure additional financing, the Company was unable to pay its
obligations in a timely and consistent manner and was incurring additional
liabilities it was unable to pay as well. The Company and its subsidiaries
filed a voluntary petition for relief under the Bankruptcy Code on August 3,
2004. Financial Statement Presentation The accompanying condensed consolidated financial statements have been
prepared assuming that the Company will continue to operate as a going concern,
which contemplates continuity of operations, timely payment for services by
customers, control of operating costs and expenses and the realization of asset
sales and liquidation of liabilities and commitments. The bankruptcy filing
and related circumstances, including the closure of 18 stores, the Companys
default on certain pre-petition debt, the losses from operations, as well as
current competitive conditions within this retail space and the possibility
that the assets of the Company will be sold in a Section 363 sale, raise
substantial doubts about the Companys ability to continue as a going concern,
accordingly, such realization of assets and liquidation of liabilities are
subject to uncertainty. In connection with its plan of reorganization, the
Company may liquidate or settle liabilities for amounts other than those
reflected in the Condensed Consolidated Financial Statements. Further, a plan
of reorganization could materially change the amounts and classifications
reported in the consolidated historical financial statements, which do not give
effect to any adjustments to the carrying value of assets or amounts of
liabilities that might be necessary as a consequence of a plan of
reorganization. Pursuant to the Bankruptcy Code, schedules will be filed by the Company
with the Bankruptcy Court setting forth the assets and liabilities of the
Company. Differences between amounts recorded by the Company and claims filed
by creditors will be investigated and resolved as part of the
Chapter 11 cases. The Company has received approval from the Bankruptcy Court to pay or
otherwise honor certain of its pre-petition obligations, including employee
wages, salaries, benefits and other employee obligations and certain other
pre-petition claims. As part of the Filing, the Company anticipates it will reject certain
leases and guarantees as allowed by the Bankruptcy Code. The Company will
record an accrual of approximately $1.2 million, in the third quarter, for the
estimated maximum amount of allowable claims under the Bankruptcy Code for the
15 restaurants closed in July 2004 whose leases were rejected. 19




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##### Table of Contents



RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2004 AND 2003 REVENUE.
Total revenue decreased 11.0% to $12,697,000 from $14,262,000. ROYALTIES decreased 15.6% to $3,618,000 from $4,285,000. 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 5.1%. The following table presents additional data concerning the domestic
franchised restaurant system: For the three months endedJune 30,
    
    June 30,Restaurant Data
    
    2004
    
    2003Restaurants opened:Domestic -New
    
    
    1
    
    
    
    Re-openings
    
    
    3
    
    
    
    1Total domestic openings
    
    
    4
    
    
    
    1Domestic closings
    
    
    (11
    )
    
    
    (28
    )Operating domestic restaurants at end of quarter
    
    
    471
    
    
    
    538Average weekly sales for domestic franchised restaurants
    
    $
    10,195
    
    
    $
    10,511Change in same store sales for domestic franchised
restaurants
    
    
    (5.1
    %)
    
    
    (12.3
    %)
 No FRANCHISE FEES were recognized, as compared to $3,000 in the comparable
period from 2003. DEVELOPER FEES decreased 18.2% to $36,000 from $44,000. The decrease was
primarily due to the expiration of amortization on certain agreements. RESTAURANT SALES decreased 4.2% to $7,668,000 from $8,001,000. The
decrease was primarily due to a 7.7% decrease in same store sales, and a
decrease in the average number of restaurants operated by the Company during
the second quarter of 2004, compared to the second quarter of 2003, partially
offset by the opening of a high-volume unit at the end of the second
quarter of
2003. As of June 30, 2004, there were 36 Company-operated restaurants,
compared to 38 at June 30, 2003. SCHLOTZSKYS BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 31.7% to
$1,168,000 from $1,709,000. The decrease was primarily due to the decrease in
systemwide sales for the quarter. OTHER FEES AND REVENUE decreased 5.5% to $207,000 from $219,000. The
decrease was due to a decrease in expired franchise fees. OPERATING EXPENSES. Total operating expenses increased to $98,606,000 from
$16,742,000. SERVICE COSTS decreased 19.9% to $534,000 from $667,000, and as a
percentage of royalties and franchise fees decreased to 14.8% from 15.6%. This
decrease was primarily due to a decrease in royalty revenue. RESTAURANT OPERATIONS EXPENSES decreased 12.3% to $7,012,000 from
$7,996,000.  RESTAURANT COST OF SALES decreased 9.1% to $2,136,000 from $2,349,000 and
decreased as a percentage of net restaurant sales to 27.9% from 29.4% due
primarily to operating efficiencies.RESTAURANT PERSONNEL AND BENEFITS COST decreased 15.8% to $2,901,000 from
$3,445,000 and decreased as a percentage of net restaurant sales to 37.8%
from 43.1%. The decrease, as a percentage of net restaurant sales, was
due to reduction in the average number of managers at each location and
improved labor scheduling.RESTAURANT OPERATING EXPENSES decreased 10.3% to $1,975,000 from
$2,202,000 and decreased as a percentage of net restaurant sales to 25.8%
from 27.5%. The decrease in operating costs, as a percentage of net
restaurant sales, was primarily due to previous years preopening costs on
a restaurant opened during the comparable quarter of the previous year and
a restaurant under development, as well as a tax assessment on one
restaurant location. 20




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##### Table of Contents



EQUITY LOSS ON INVESTMENTS was $300,000, as compared to a loss of $84,000
in the comparable period from 2003. The Company recorded a loss on its
investment in an international master licensee due to an anticipated decrease
in future efforts to expand the presence of Schlotzskys restaurants outside
the United States. IMPAIRMENT OF FRANCHISING ASSETS was $59,938,000 for the quarter in the
current year, as compared to no expense in the same period in the prior year.
An impairment charge of $55,515,000 was booked to reflect the planned
termination of the Companys area developer program and the related decrease in
the fair value of repurchased area developer rights. An additional $4,423,000
in impairment expense was recognized in the second quarter of 2004 to reflect
impairment of certain held-for-sale and investment in real estate. RESTAURANT IMPAIRMENT was $17,376,000 for the quarter in the current year,
as compared to no expense in the same period in the prior year. $7,968,000 of
this expense reflects the impairment of certain leasehold improvements,
buildings, equipment, and franchise rights related to Company-operated
restaurants that the Company determined to close in the second quarter of 2004.
$9,408,000 of this expense relates to stores that are expected to continue
operating, but whose fair value, given the Companys intent to market and sell
the stores in the immediate future, was lower than the book value of the
restaurants. GENERAL
AND ADMINISTRATIVE EXPENSES increased 80.8% to $12,134,000 from
$6,713,000. This increase was primarily due to a $3.2 million accrual related
to the termination of executive employment contracts, $2.1 million in accrued
guarantee costs recognized in the second quarter of 2004, and an increase in
bad debt expense of approximately $1.4 million as compared to the same period
in 2003, offset by savings due to overhead and salary expense reductions
implemented in the second half of 2003. DEPRECIATION AND AMORTIZATION increased 2.3% to $1,312,000 from
$1,283,000. The increase was primarily due to the opening of a
Company-operated restaurant in the second quarter of 2003, net of the
retirement of certain assets. INTEREST INCOME decreased 39.4% to $63,000 from $104,000. INTEREST EXPENSE decreased 7.7% to $932,000 from $1,010,000 due primarily
to improvement in terms on the seller-financed debt related to the
reacquisition of the territorial rights of the Companys largest area
developer. PROVISION (CREDIT) FOR INCOME TAXES, reflects the net expense after the
impairment of deferred tax assets generated during the quarter. The Company
began impairing its deferred tax assets in the second half of 2003. NET INCOME decreased to a loss of $86,799,000 from a loss of $2,267,000
due to the factors discussed above. Earnings per share, both basic and
diluted, were $(11.83) for the quarter ended June 30, 2004 compared to $(0.31)
in the prior year quarter. SIX MONTHS ENDED JUNE 30, 2004 AND 2003 REVENUE. Total revenue decreased 8.4% to $25,745,000 from $28,092,000. ROYALTIES decreased 16.0% to $7,211,000 from $8,589,000. The decrease was
due to a decreased number of franchised restaurants during the six-month period
in 2004 compared to 2003, and a decrease in same store contractual sales by
franchised restaurants of 6.2%. The following table presents additional data concerning the domestic
franchised restaurant system: For the six months endedJune 30,
    
    June 30,Restaurant Data
    
    2004
    
    2003Restaurants opened:Domestic -New
    
    
    1
    
    
    
    Re-openings
    
    
    5
    
    
    
    2Total domestic openings
    
    
    6
    
    
    
    2Domestic closings
    
    
    (37
    )
    
    
    (53
    )Operating domestic restaurants at end of quarter
    
    
    471
    
    
    
    538Average weekly sales for domestic franchised restaurants
    
    $
    10,080
    
    
    $
    10,342Change in same store sales for domestic franchised
restaurants
    
    
    (6.2
    %)
    
    
    (12.0
    %)
 21




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##### Table of Contents



FRANCHISE FEES were zero, as compared to $3,000 in the comparable period
from 2003. DEVELOPER FEES decreased 23.4% to $72,000 from $94,000. The decrease was
primarily due to the expiration of amortization on certain agreements. RESTAURANT SALES decreased 1.0% to $15,450,000 from $15,613,000. The
decrease was primarily due to a 7.4% decrease in same store sales during the
first six months of 2004, and a decrease in the average number of restaurants
operated by the Company during the six months ended June 30, 2004, compared to
the comparable period of 2003, partially offset by a change in the store mix.
As of June 30, 2004, there were 36 Company-operated restaurants compared to 38
at June 30, 2003. SCHLOTZSKYS BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 23.1% to
$2,584,000 from $3,360,000. The decrease was primarily due to the decrease in
systemwide sales for the period. OTHER FEES AND REVENUE decreased 1.2% to $427,000 from $432,000. The
decrease was due to a decrease in expired franchise fees. OPERATING EXPENSES increased to $111,416,000 from $31,232,000. SERVICE COSTS decreased 20.1% to $1,063,000 from $1,331,000, and as a
percentage of royalties and franchise fees declined to 14.7% from 15.5%. This
decrease was primarily due to a decrease in royalty revenue. RESTAURANT OPERATIONS EXPENSES decreased 9.7% to $13,944,000 from
$15,435,000. The use of certain Company-operated restaurants for product,
process and equipment testing and for systemwide training also adversely
impacts their operating performance. The decrease is mainly attributed to a
change in the store mix.  RESTAURANT COST OF SALES decreased 6.1% to $4,246,000 from $4,520,000 and
decreased as a percentage of net restaurant sales to 27.5% from 29.0% due
primarily to operating efficiencies.RESTAURANT PERSONNEL AND BENEFITS COST decreased 14.1 % to $5,852,000 from
$6,810,000, and decreased as a percentage of net restaurant sales to 37.9%
from 43.6%. The decrease, as a percentage of net restaurant sales, was
due to reduction in the average number of managers at each location and
operating efficiencies.RESTAURANT OPERATING EXPENSES decreased 6.3% to $3,847,000 from $4,104,000
and decreased as a percentage of net restaurant sales to 24.9% from 26.3%.
The decrease in operating costs, as a percentage of net restaurant sales,
was primarily due to the change in the store mix and the previous years
preopening costs on a restaurant opened during the quarter and a
restaurant under development as well as a tax assessment on one restaurant
location. EQUITY LOSS ON INVESTMENTS was $300,000, as compared to a loss of $151,000
in the comparable period from 2003. The Company recorded a loss on its
investment in an international master licensee due to an anticipated decrease
in future efforts to expand the presence of Schlotzskys restaurants outside
the United States. IMPAIRMENT OF FRANCHISING ASSETS was $59,938,000 in the current year, as
compared to no expense in the same period in the prior year. An impairment
charge of $55,515,000 was booked to reflect the planned termination of the
Companys area developer program and the related decrease in the fair value of
repurchased area developer rights. An additional $4,423,000 in impairment
expense was recognized in the second quarter of 2004 to reflect impairment of
certain held-for-sale and investment in real estate. RESTAURANT IMPAIRMENT was $17,376,000 in the current year, as compared to
no expense in the same period in the prior year. $7,968,000 of this expense
reflects the impairment of certain leasehold improvements, buildings,
equipment, and franchise rights related to Company-operated restaurants that
the Company determined to close in the second quarter of 2004. $9,408,000 of
this expense relates to stores that are expected to continue operating, but
whose fair value given the Companys intent to market and sell the stores in
the immediate future, was lower than the book value of the restaurants. GENERAL AND ADMINISTRATIVE EXPENSES increased 36.4% to $16,077,000 from
$11,783,000. This increase was primarily due to a $3.2 million accrual related
to the termination of executive employment contracts, $2.1 million in accrued
guarantee costs recognized in the second quarter of 2004, and an increase in
bad debt expense of approximately $1.9 million as compared to the same period
in 2003, offset by savings due to overhead and salary expense reductions
implemented in the second half of 2003. DEPRECIATION AND AMORTIZATION increased 7.3% to $2,718,000 from
$2,532,000. The increase was primarily due to the opening of additional
Company restaurants in 2003. 22




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INTEREST INCOME decreased 39.6% to $125,000 from $207,000. The decrease
was due to the decrease in the amount of performing notes receivable. INTEREST EXPENSE decreased 8.0% to $1,864,000 from $2,026,000 due
primarily to improved terms on the seller financed debt related to the
reacquisition of the territorial rights the Companys largest area developer. PROVISION (CREDIT) FOR INCOME TAXES reflects the net expense after the
impairment of deferred tax assets generated during the six months ended June
30, 2004. The Company began impairing its deferred tax assets in the second
half of 2003. NET INCOME decreased to a loss of $87,470,000 for the six months ended
June 30, 2004 from a loss of $3,334,000 for the comparable prior year period
due to the factors discussed above. Earnings per share, both basic and
diluted, were $(11.92) for the six months ended June 30, 2004 compared to
$(0.46) in the comparable period in the prior year. OFF-BALANCE SHEET ARRANGEMENTS On August 9, 2004, the Company filed a motion with the Bankruptcy Court to
discharge certain Area Developer contracts and remove area developers from the
Schlotzskys, Inc. franchising model. The Company has outstanding guarantees of indebtedness of others,
including related parties, of approximately $20.5 million as of June 30, 2004.
These guarantees include approximately $4.7 million of lease guarantees for the
benefit of franchisees, approximately $13.8 million of mortgage loan guarantees
for the benefit of franchisees and approximately $2.0 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
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 June 30, 2004, the Company had
accrued a liability of approximately $982,000 related to these guarantees.
This accrual is due to a management determination that it would no longer be
able to attempt to rehabilitate franchisees restaurants through direct
financial assistance. The Company also has a net deferred gain related to the
sale of these leases in the amount of approximately $342,000 as of June 30,
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 $1.0
million. Certain 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. As of June 30, 2004,
the Company had accrued $1,761,000 for certain mortgage guarantees that were
due but not yet paid. 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 the Company. One of the guarantees, for
the benefit of the Companys 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 the Company. This guarantee was released in May 2004. The Company has been called upon, from time to time, to make payments on
obligations the Company has guaranteed. During the first six months of 2004,
the Company paid approximately $362,000 in various lease guarantees for the
benefit of franchisees. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents decreased $544,000 in the six months ended June
30, 2004, and increased $101,000 in the six months ended June 30, 2003. Cash
flows are impacted by operating, investing and financing activities. 23




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Operating activities used $46,000 of cash in the first six months of 2004
and provided $4,256,000 of cash in the first six months of 2003. The Company
reported a loss of $87,470,000 for the first six months of 2004, and much of
this loss was related to expenses the Company incurred but did not pay in the
quarter, such as $3.2 million in executive compensation, or non-cash expenses,
such as $83.3 million in depreciation, impairment, and bad debt expense.
Without these expenses, the cash used by operations resulted from an increase
in accounts receivable mostly offset by an increase in accounts payable. Investing used $194,000 and provided $113,000 of cash in the first six
months of 2004 and 2003, respectively. The cashed used in 2004 resulted from
remodels at Company owned-restaurants and expenditures to protect trademarks. Financing activities used $303,000 and $4,267,000 of cash in the first six
months of 2004 and 2003, respectively. The decrease in cash used in the first
six months of 2004 compared to the comparable period of 2003 is primarily the
net result of increased borrowings and decreased debt payment in the first six
months of 2004, partially offset by decreases in debt issuance costs. At June 30, 2004, we had approximately $51,283,000 of total debt
outstanding. Scheduled maturities of debt through June 30, 2005 currently
approximate $47,123,000, including short-term debt and debt classified as
current due to violations of the terms debt agreements. Certain of our mortgage debt require the maintenance of certain financial
ratios, including debt-to-equity and working capital. As of June 30, 2004, the
Company was in default of many of the financial covenants specified in its debt
agreements. While the Company has not sought waivers of these covenant
violations, the Bankruptcy Filing stays, to date, any actions by these lenders to
accelerate collections of these debts. Under these debt agreements, such
defaults result in the debt becoming immediately due and payable. Related to
these defaults, approximately $35.8 million in long-term debt was reclassified
as a current maturity of long-term debt as of June 30, 2004. The following
tables present certain of our obligations to make future payments, excluding
interest payments, under contracts and contingent commitments as of June 30,
2004 (dollars in thousands): Payments Due by PeriodAs of June 30, 2004Less than 1Contractual Obligations
    
    Total
    
    year
    
    1-3 years
    
    4-5 years
    
    After 5 yearsShort-term
Debt
    
    $
    1,682
    
    
    $
    1,682
    
    
    $
    
    

    
    $
    
    
    
    $
    Long-term
Debt
    
    
    49,601
    
    
    
    45,441
    
    
    
    2,515
    
    
    
    278
    
    
    
    1,367Operating
Leases
    
    
    17,622
    
    
    
    2,420
    
    
    
    4,034
    
    
    
    2,351
    
    
    
    8,817
 Amount of Commitment Expiration Per PeriodAs of June 30, 2004TotalAmounts
    
    Less than 1Other CommercialCommitments
    
    Committed
    
    year
    
    1-3 years
    
    4-5 years
    
    After 5 yearsGuarantees
    
    $
    20,464
    
    
    $
    8,894
    
    
    $
    4,112
    
    
    $
    3,324
    
    
    $
    4,134
 We have experienced net reductions in the number of restaurants systemwide
quarterly since 2000 and have experienced negative same store contractual sales
quarterly since mid-2001. While we have been developing and implementing
strategies to reverse these trends, we expect that the number of restaurants
will continue to decline in the near term, particularly due to the Companys
inability to support certain franchisees that were able to remain open due to
the Companys payment on lease and mortgage guarantees which were suspended
after the Filing. Continuation of these trends will have a negative impact on
our royalty revenue and brand contribution, which in turn would impact our cash
flow and liquidity. On July 6, 2004 and August 2, 2004 we effected a reduction in force
eliminating 32 positions on the corporate staff, reducing the personnel
employed at our corporate headquarters or as field personnel to approximately
70. These reductions will begin to impact operating results in the third
quarter of 2004. The effects of these position reductions will
continue in the fourth quarter of 2004. We also have developed and have
implemented plans to reduce non-compensation general and administrative
expense, and expect certain guarantees and litigation liabilities and expenses
to be discharged during the Bankruptcy process. These reductions in expense
likely will be offset by additional legal and professional fees incurred during
the Bankruptcy process. The Company is currently operating under a temporary cash collateral order
approved by the Bankruptcy Court that expires on November 17, 2004. The
Company is attempting to finance its cash needs after November 17, 2004 through
some combination of real estate sales or securing the permission of certain
creditors to continue to use collateralized franchising revenue to meet the
operating needs of the Company. There can be no assurance that additional
capital will be available on terms acceptable to the 24




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Company, or at all. Failure to raise sufficient additional capital would
have a material adverse effect on the Companys ability to operate as a going
concern or to restructure in Chapter 11. On June 24, 2004, the Company announced that it had retained Trinity
Capital, LLC, a specialty investment banking firm focused on the multi-unit
retail and food and beverage industries, to serve as financial advisor to the
Company. Through its financial advisor, the Company is exploring its
restructuring alternatives involving strategic investors. The Company
considers additional investment critical to successfully reorganizing the
Company and emerging from bankruptcy, and there can be no assurance that
additional capital can be secured on terms acceptable to the Company. Managements Discussion and Analysis of Financial Condition and Results of
Operations in this Form 10-Q should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations and
other material included in the Companys Annual Report on Form 10-K for the
year ended December 31, 2003. 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,
the ability of the Company to develop one or more plans of reorganization with
respect to the Chapter 11 proceeding and receiving approval from the Court and
other interested third parties, an inability of the Company or our franchisees
to obtain adequate financing, increased competition within the restaurant
industry, 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. It is possible that the equity of the Company will be restructured
in a manner that will substantially reduce or eliminate any remaining value.
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. 25




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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 June 30, 2004, a hypothetical 100 basis point increase in interest
rates would result in a decrease of approximately $74,000 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 June 30, 2004. 
 ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures. The term
disclosure controls and procedures is defined in
Rule 13a-15(e) or 15d-15(e) of the
Securities Exchange Act of 1934, (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 it files under
the Exchange Act is recorded, processed, summarized and reported within the
required time periods. Our Chief Executive Officer and our Chief Financial
Officer have evaluated the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this
report, and they have concluded that as of that date, our disclosure controls
and procedures were effective at ensuring that required information will be
disclosed on a timely basis in our reports filed under the Exchange Act. (b) Changes in Internal Controls. We maintain a system of internal
controls that are designed to provide reasonable assurance that our books and
records accurately reflect, in all material respects, our transactions and that
our established policies and procedures are followed. There were no
changes to our internal controls over financial reporting that
occurred during the Companys last fiscal quarter that has
materially affected, or is reasonably likely to materially affect,
the Companys internal controls over financial reporting. 26




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##### Table of Contents



PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS The Companys filing for Chapter 11 protection in federal bankruptcy court
generally stayed all litigation pending as of August 3, 2004, although parties
in some cases may either request that the bankruptcy judge lift the stay and
allow the litigation to proceed or remove the case to the bankruptcy court to
be heard by the judge in the bankruptcy proceeding. New Florida Markets, Ltd. and Deli Keys, Ltd. v. Schlotzskys, Inc.,
Schlotzskys Franchising 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 around June
23, 2003 with the American Arbitration Association. Claimants are the area
developers for the Tampa, Orlando, Miami and West Palm Beach development areas.
They alleged that Respondents frustrated their ability to develop their areas
and breached the Area Developer Agreements, in addition to other claims. On
May 9, 2004 the Respondents and Claimants settled all claims and entered into a
binding settlement agreement. The Company was not able to make a required
settlement payment on June 15, 2004, and around July 27, 2004, the claimants
filed New Florida Markets, Ltd. and Deli Keys Ltd. v. Schlotzskys, Inc.,
Schlotzskys Franchising Limited Partnership, Schlotzskys Franchisor, LLC,
Schlotzskys Franchise Operations, LLC, Schlotzskys N.A.M.F. Inc. and
Schlotzskys N.A.M.F. Funding, LLC, in the Circuit Court of
the 11th Judicial
Circuit in and for Dade County, Florida, General Civil Division, Case No.
04-16303 seeking enforcement of the settlement agreement. On October 21, 2004,
the Court granted a Motion to Dismiss the NAMF entities but allowed Plaintiffs
20 days to amend the complaint to state a cause of action against the NAMF
entities that would not be barred by the bankruptcy or the binding terms of
settlement, which provided that Plaintiffs exclusive remedy for a breach was
against Schlotzskys, Inc. or the subsidiary that was to sign the note. 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 brought causes
of action for fraud and/or negligent misrepresentation. Plaintiff alleged 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 requested 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. On June 21, 2004, the parties were informed by the
International Court of Arbitration that the case is considered withdrawn as of
June 1, 2004 for failure to pay the required advance on costs. 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 brought causes of action for breach of contract,
breach of fiduciary duty, breach of the duty of good faith and fair dealing,
civil conspiracy, tortuous interference with contract, tortuous interference
with prospective business relationship, violation of the Texas Deceptive Trade
Practices and Consumer Protection Acts, 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. 27




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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, although the Chapter 11 proceeding is expected to stay the
trial date. On June 25, 2004, Plaintiff filed U.S. Restaurant Properties
Operating L.P. v. Schlotzskys, Inc.(Cause No. 04-05858-D), in the District
Court of Dallas County, 95th Judicial District. Plaintiff alleges that
Defendant owes unpaid balance on certain guaranty pool agreements allegedly
defaulted by Defendant beginning in May 2004. John Wooley and Jeffrey Wooley vs. Schlotzskys Franchisor, LLC,Cause No.
GN402261, was filed on July 20, 2004 in the 98th Judicial District Court of
Travis County, Texas, and John Wooley and Jeffrey Wooley v. Schlotzskys, Inc.,
Cause No. GN402596, was filed on August 12, 2004 in the
250th Judicial District
Court of Travis County, Texas. John Wooley and Jeffrey Wooley, former officers
and directors of the Company, with John Wooley currently being the largest
shareholder of the Company, filed a request for a Temporary Restraining Order
on July 20, 2004 to request the Court to order the Company not to take any
actions with regard to Schlotzskys Franchisor, LLC, a subsidiary of the
Company. The Wooleys asserted that any action taken with regard to
Schlotzskys Franchisor would harm them with regard to a loan they made to
Franchisor in November 2003 for approximately $2.5 million. The Court rejected
their request, and no further action has been taken to date by the Wooleys in
the first listed lawsuit. On August 12, 2004, the Wooleys filed the second
listed lawsuit above and requested that the Court order the Company to hold its
annual shareholder meeting by August 30, 2004. The Wooleys subsequently filed
a motion for non-suit in the state court case and then filed a motion with the
bankruptcy court asking that the judge lift the automatic stay with regard to
the annual meeting and grant the Wooleys permission to pursue their claim for
injunctive relief in state court. In addition, the Wooleys have filed several
other motions with the bankruptcy court challenging certain actions the Company
has taken during the bankruptcy proceeding and objecting to requests made by
the Company with regard to its retention of professionals during the bankruptcy
process. In addition to the matters discussed above, we are defendants in various
other legal proceedings arising from our business. Due to the bankruptcy
filing, the early stages of some of the proceedings, and the general
uncertainty surrounding the outcome of any litigation, it is not possible for
the Company to provide any certain or meaningful analysis, projections, or
expectations with respect to the proceedings discussed above. 
 ITEM 2. UNREGISTERED SALES OF EQUITY 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  a)
    
    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) 28




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##### Table of Contents



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)10.55
    
    Employment Agreement dated as of June 17, 2004 between the Company and Sam Coats (4)*31.1
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002, signed by David Samuel Coats, Chief Executive Officer. (4)31.2
    
    Certification pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002, signed by Matthew D. Osburn, Chief Financial Officer. (4)32.1
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002, signed by David Samuel Coats, Chief Executive Officer. (4)32.2
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002, signed by Matthew D. Osburn, Chief Financial Officer. (4)*
    
    Indicates a management contract or compensatory plan or arrangement.(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 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 filed 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. The Registrant filed a Current Report on Form 8-K dated June 17, 2004,
containing a press release dated June 17, 2004, announcing the removal by the
Board of Directors of the Company of certain senior management and the election
of a new interim Chief Executive Officer. The Registrant filed a Current Report on Form 8-K dated August 3, 2004,
containing a press release dated August 3, 2004, announcing the Chapter 11
bankruptcy filings by the Company and certain of its subsidiaries. 29




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. SCHLOTZSKYS, INC.By:
    
    /s/ David Samuel CoatsDavid Samuel CoatsPresident and Chief Executive OfficerBy:
    
    /s/ Matthew D. OsburnMatthew D. OsburnVice President, Controller andAssistant Treasurer(Principal Financial Officer)
 Austin, Texas
November 11, 2004 30