#### **SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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#### **FORM 10-Q**

 

**Quarterlyreport pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

 

**For the quarterly period endedSeptember 30, 2003**

 

**Commission File Number: 0-27008**

 

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**Schlotzsky’s,Inc.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**203 Colorado Street, Suite 600,Austin, Texas 78701**

(Address of principalexecutive offices)

 

**(512) 236-3800**

(Registrant’stelephone number)

 

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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).   Yes o  No **ý**

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**                   |   | **Shares  Outstanding at November 7, 2003** |
|-----------------------------|--------|---------------------------------------------|
| Common Stock, no  par value |   | 7,331,999                                   |

 

 

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**SCHLOTZSKY’S, INC.**

 

**Index to Form 10-Q**

**Quarter Ended September 30, 2003**

 
| **Part I**  | **FINANCIAL  INFORMATION**                                             |   |
|-------------|------------------------------------------------------------------------|--------|
|        |                                                                   |   |
| Item 1.     | Financial Statements                                                   |   |
|        |                                                                   |   |
|        | Condensed Consolidated  Balance Sheets –                          |   |
|        | September 30,  2003 and December 31, 2002                              |   |
|        |                                                                   |   |
|        | Condensed  Consolidated Statements of Income –                    |   |
|        | Three and  Nine Months Ended September 30, 2003 and September 30, 2002 |   |
|        |                                                                   |   |
|        | Condensed  Consolidated Statements of Stockholders’ Equity – |   |
|        | Nine  Months Ended September 30, 2003 and Year Ended December 31, 2002 |   |
|        |                                                                   |   |
|        | Condensed  Consolidated Statements of Cash Flows –                |   |
|        | Nine  Months Ended September 30, 2003 and September 30, 2002           |   |
|        |                                                                   |   |
|        | Notes  to Condensed Consolidated Financial Statements                  |   |
|        |                                                                   |   |
| Item 2.     | Management’s Discussion and Analysis of  Financial Condition      |   |
|        | And Results of Operations                                              |   |
|        |                                                                   |   |
| Item 3.     | Quantitative and Qualitative Disclosures About  Market Risk            |   |
|        |                                                                   |   |
| Item 4.     | Controls and Procedures                                                |   |
|        |                                                                   |   |
| **Part II** | **OTHER INFORMATION**                                                  |   |
|        |                                                                   |   |
| Item 1.     | Legal Proceedings                                                      |   |
|        |                                                                   |   |
| Item 2.     | Changes in  Securities and Use of Proceeds                             |   |
|        |                                                                   |   |
| Item 3.     | Defaults Upon Senior  Securities                                       |   |
|        |                                                                   |   |
| Item  4.    | Submission  of Matters to a Vote of Security Holders                   |   |
|        |                                                                   |   |
| Item 5.     | Other  Information                                                     |   |
|        |                                                                   |   |
| Item 6.     | Exhibits and Reports  on Form 8-K                                      |   |

 

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**PARTI**

**FINANCIAL INFORMATION**

 

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

 

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

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                |   | **September  30,  2003** |        | **December  31,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|-------------|-------------------------|--------|
|                                                                                                                                                                |   | **(Unaudited)**          |        |                    |   |
| **ASSETS**                                                                                                                                                          |   |                     |        |                    |   |
| Current  Assets:                                                                                                                                                    |   |                     |        |                    |   |
| Cash  and cash equivalents                                                                                                                                          |   | $                        | 492,325     |                    | $      | 678,895 |   |
| Accounts  receivable, net:                                                                                                                                          |   |                     |        |                    |   |
| Royalties                                                                                                                                                           |   | 848,440                  |        | 650,376                 |   |
| Brands                                                                                                                                                              |   | 1,112,883                |        | 1,269,759               |   |
| Other                                                                                                                                                               |   | 1,243,844                |        | 1,332,990               |   |
| Refundable  income taxes                                                                                                                                            |   | 4,470                    |        | 1,837,628               |   |
| Prepaids,  inventories and other assets                                                                                                                             |   | 1,043,293                |        | 1,356,516               |   |
| Real  estate held for sale                                                                                                                                          |   | 4,188,367                |        | 5,167,563               |   |
| Deferred  tax asset                                                                                                                                                 |   | 3,328,079                |        | 2,275,941               |   |
| Current  portion of notes receivable                                                                                                                                |   | 183,978                  |        | 582,926                 |   |
| Total  current assets                                                                                                                                               |   | 12,445,679               |        | 15,152,594              |   |
|                                                                                                                                                                |   |                     |        |                    |   |
| Property,  equipment and leasehold improvements, net                                                                                                                |   | 42,932,678               |        | 39,709,461              |   |
| Notes  receivable, net, less current portion                                                                                                                        |   | 7,900,817                |        | 11,349,705              |   |
| Investments                                                                                                                                                         |   | 567,549                  |        | 1,852,765               |   |
| Intangible  assets, net                                                                                                                                             |   | 62,963,482               |        | 65,308,249              |   |
| Goodwill,  net                                                                                                                                                      |   | 3,503,830                |        | 2,985,679               |   |
| Deferred  tax asset                                                                                                                                                 |   | 865,220                  |        | —                  |   |
| Other  noncurrent assets                                                                                                                                            |   | 996,280                  |        | 1,168,029               |   |
| Total  assets                                                                                                                                                       |   | $                        | 132,175,535 |                    | $      | 137,526,482 |   |
|                                                                                                                                                                |   |                     |        |                    |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                      |   |                     |        |                    |   |
| Current  Liabilities:                                                                                                                                               |   |                     |        |                    |   |
| Short-term  debt                                                                                                                                                    |   | $                        | 1,008,750   |                    | $      | — |   |
| Current  maturities of long-term debt                                                                                                                               |   | 8,761,968                |        | 7,441,120               |   |
| Accounts  payable                                                                                                                                                   |   | 5,913,118                |        | 2,841,607               |   |
| Accrued  liabilities                                                                                                                                                |   | 5,872,432                |        | 3,812,727               |   |
| Deferred  revenue, current portion                                                                                                                                  |   | 120,325                  |        | 234,552                 |   |
| Total  current liabilities                                                                                                                                          |   | 21,676,593               |        | 14,330,006              |   |
|                                                                                                                                                                |   |                     |        |                    |   |
| Long-term  debt, less current portion                                                                                                                               |   | 40,649,321               |        | 46,063,599              |   |
| Deferred  revenue, less current portion                                                                                                                             |   | 1,565,747                |        | 1,597,443               |   |
| Deferred  tax liability                                                                                                                                             |   | —                   |        | 1,216,109               |   |
| Total  liabilities                                                                                                                                                  |   | 63,891,661               |        | 63,207,157              |   |
|                                                                                                                                                                |   |                     |        |                    |   |
| Commitments  and contingencies                                                                                                                                      |   |                     |        |                    |   |
|                                                                                                                                                                |   |                     |        |                    |   |
| Stockholders’  Equity:                                                                                                                                         |   |                     |        |                    |   |
| Preferred  stock, Class C, no par value, 1,000,000 shares authorized, none issued                                                                                   |   | —                   |        | —                  |   |
| Common  stock, no par value, 30,000,000 shares authorized, 7,521,524 shares and  7,496,778 shares issued at September 30, 2003 and December 31, 2002,  respectively |   | 64,073                   |        | 63,826                  |   |
| Additional  paid-in capital                                                                                                                                         |   | 58,196,646               |        | 58,122,469              |   |
| Retained  earnings                                                                                                                                                  |   | 10,866,311               |        | 16,976,186              |   |
| Treasury  stock (189,525 shares at September 30, 2003 and December 31, 2002), at cost                                                                               |   | (843,156                 | )           | (843,156                | )      |
| Total  stockholders’ equity                                                                                                                                    |   | 68,283,874               |        | 74,319,325              |   |
| Total  liabilities and stockholders’ equity                                                                                                                    |   | $                        | 132,175,535 |                    | $      | 137,526,482 |   |

 

**Theaccompanying notes are an integral part of the condensed consolidated financialstatements.**

 

1

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

**CONDENSED CONSOLIDATED STATEMENTS OFINCOME**

**(Unaudited)**

** **
|                                 |   | **Three months ended**  |       | **Nine months ended**   |   |
|--------------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                                 |   | **September 30,  2003** |       | **September 30,  2002** |   | **September 30,  2003** |   | **September 30,  2002** |   |
| Revenue:                             |   |                    |       |                    |   |   |   |   |   |
| Royalties                            |   | $                       | 3,976,557  |                    | $      | 4,984,274 |   | $ | 12,565,675 |   | $ | 15,368,072 |   |
| Franchise  fees                      |   | 16,665                  |       | —                  |   | 19,998 |   | 62,000 |   |
| Developer  fees                      |   | 37,036                  |       | 59,369                  |   | 131,423 |   | 179,435 |   |
| Restaurant  sales                    |   | 7,937,396               |       | 7,934,927               |   | 23,550,234 |   | 24,075,180 |   |
| Brand  contribution                  |   | 1,600,807               |       | 1,820,224               |   | 4,960,869 |   | 5,694,381 |   |
| Other  fees and revenue              |   | 281,034                 |       | 294,307                 |   | 713,073 |   | 862,986 |   |
| Total  revenue                       |   | 13,849,495              |       | 15,093,101              |   | 41,941,272 |   | 46,242,054 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Expenses:                            |   |                    |       |                    |   |   |   |   |   |
| Service  costs:                      |   |                    |       |                    |   |   |   |   |   |
| Royalties                            |   | 606,787                 |       | 1,008,337               |   | 1,937,696 |   | 3,249,705 |   |
| Franchise  fees                      |   | —                  |       | —                  |   | — |   | 25,955 |   |
|                                 |   | 606,787                 |       | 1,008,337               |   | 1,937,696 |   | 3,275,660 |   |
| Restaurant  operations:              |   |                    |       |                    |   |   |   |   |   |
| Cost  of sales                       |   | 2,419,038               |       | 2,247,065               |   | 6,939,159 |   | 6,755,185 |   |
| Personnel  and benefits              |   | 3,458,048               |       | 3,305,235               |   | 10,268,276 |   | 9,767,124 |   |
| Operating  expenses                  |   | 1,996,577               |       | 1,988,932               |   | 6,100,919 |   | 5,624,926 |   |
|                                 |   | 7,873,663               |       | 7,541,232               |   | 23,308,354 |   | 22,147,235 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Equity  loss on investments          |   | 320,786                 |       | 58,624                  |   | 471,629 |   | 136,918 |   |
| General  and administrative          |   | 7,115,000               |       | 4,833,741               |   | 18,898,305 |   | 14,149,018 |   |
| Depreciation  and amortization       |   | 1,271,385               |       | 1,273,342               |   | 3,803,386 |   | 3,443,073 |   |
| Total  expenses                      |   | 17,187,621              |       | 14,715,276              |   | 48,419,370 |   | 43,151,904 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Income  (loss) from operations       |   | (3,338,126              | )          | 377,825                 |   | (6,478,098 | ) | 3,090,150 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Other:                               |   |                    |       |                    |   |   |   |   |   |
| Interest  income                     |   | 53,444                  |       | 119,195                 |   | 260,700 |   | 431,257 |   |
| Interest  expense                    |   | (954,604                | )          | (797,001                | )      | (2,980,477 | ) | (2,054,961 | ) |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Income  (loss) before income taxes   |   | (4,239,286              | )          | (299,981                | )      | (9,197,875 | ) | 1,466,446 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Provision  (credit) for income taxes |   | (1,463,000              | )          | (60,000                 | )      | (3,088,000 | ) | 590,000 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Net  income (loss)                   |   | $                       | (2,776,286 | )                       | $      | (239,981 | ) | $ | (6,109,875 | ) | $ | 876,446 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Earnings  (loss) per share-basic     |   | $                       | (0.38      | )                       | $      | (0.03 | ) | $ | (0.83 | ) | $ | 0.12 |   |
|                                 |   |                    |       |                    |   |   |   |   |   |
| Earnings  (loss) per share-diluted   |   | $                       | (0.38      | )                       | $      | (0.03 | ) | $ | (0.83 | ) | $ | 0.12 |   |

 

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

 

2

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

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
|                                                                      |   | **Common  Stock**     |   |                        |   |                            |   |                   |   |                |       |
|---------------------------------------------------------------------------|--------|-----------------------|--------|-----------------------------|--------|---------------------------------|--------|------------------------|--------|---------------------|------------|
|                                                                      |   | **Number of  Shares** |   | **Stated  Capital  Amount** |   | **Additional  Paid-in Capital** |   | **Retained  Earnings** |   | **Treasury  Stock** |       | **Total  Stockholders’ Equity** |   |
|                                                                      |   |                  |   |                        |   |                            |   |                   |   |                |       |   |   |
| Balance,  January 1, 2002                                                 |   | 7,463,990             |   | $                           | 63,498 |                            | $      | 57,986,546             |   | $                   | 17,175,234 |   | $ | (823,242 | ) | $ | 74,402,036 |   |
| Issuance  of common stock in connection with employee stock purchase plan |   | 16,467                |   | 165                         |   | 66,726                          |   | —                 |   | —              |       | 66,891 |   |
| Treasury  stock purchases (3,225 shares)                                  |   | —                |   | —                      |   | —                          |   | —                 |   | (19,914             | )          | (19,914 | ) |
| Options  exercised                                                        |   | 16,321                |   | 163                         |   | 61,889                          |   | —                 |   | —              |       | 62,052 |   |
| Tax  benefit from employee stock transactions                             |   | —                |   | —                      |   | 7,308                           |   | —                 |   | —              |       | 7,308 |   |
| Net  loss                                                                 |   | —                |   | —                      |   | —                          |   | (199,048               | )      | —              |       | (199,048 | ) |
| Balance,  December 31, 2002                                               |   | 7,496,778             |   | 63,826                      |   | 58,122,469                      |   | 16,976,186             |   | (843,156            | )          | 74,319,325 |   |
| Issuance  of common stock in connection with employee stock purchase plan |   | 24,746                |   | 247                         |   | 61,985                          |   | —                 |   | —              |       | 62,232 |   |
| Issuance  of employee stock options                                       |   | —                |   | —                      |   | 12,192                          |   | —                 |   | —              |       | 12,192 |   |
| Net  loss                                                                 |   | —                |   | —                      |   | —                          |   | (6,109,875             | )      | —              |       | (6,109,875 | ) |
| Balance,  September 30, 2003                                              |   | 7,521,524             |   | $                           | 64,073 |                            | $      | 58,196,646             |   | $                   | 10,866,311 |   | $ | (843,156 | ) | $ | 68,283,874 |   |

 

**PREFERRED STOCK**

 

Authorized 1,000,000Class C shares, no par value; no shares outstanding at September 30, 2003,December 31, 2002, or January 1, 2002.

 

**COMMON STOCK**

 

Authorized 30,000,000shares, no par value; 7,521,524 shares issued at September 30, 2003, 7,496,778shares issued at December 31, 2002, and 7,463,990 shares issued at January 1, 2002.  Shares issued include 189,525, 189,525 and186,300 shares in treasury at September 30, 2003, December 31, 2002, andJanuary 1, 2002, respectively.

 

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

 

3

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

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(Unaudited)**

** **
|                                                                                  |   | **For the  nine months ended** |       |
|---------------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                                  |   | **September  30,  2003**       |       | **September  30,  2002** |   |
| Cash  flows from operating activities:                                                |   |                           |       |   |   |
| Net  income (loss)                                                                    |   | $                              | (6,109,875 | ) | $ | 876,446 |   |
| Adjustments  to reconcile net income (loss) to cash provided by operating activities: |   |                           |       |   |   |
| Depreciation  and amortization                                                        |   | 3,803,386                      |       | 3,443,073 |   |
| Provisions  for uncollectible accounts and impairment of assets                       |   | 1,970,744                      |       | 806,841 |   |
| Credit  for deferred taxes                                                            |   | (2,454,071                     | )          | (141,703 | ) |
| Recognition  of previously deferred financing costs                                   |   | 1,868,949                      |       | — |   |
| Provision  for stock option compensation                                              |   | 12,192                         |       | — |   |
| Amortization  of deferred revenue                                                     |   | (125,601                       | )          | (220,086 | ) |
| Equity  loss on investments                                                           |   | 471,629                        |       | 136,918 |   |
| Changes  in:                                                                          |   |                           |       |   |   |
| Accounts  receivable                                                                  |   | 1,986,330                      |       | (114,497 | ) |
| Prepaid  expenses and other assets                                                    |   | 484,753                        |       | (404,504 | ) |
| Accounts  payable and accrued liabilities                                             |   | 3,953,152                      |       | (538,346 | ) |
| Net  cash provided by operating activities                                            |   | 5,861,588                      |       | 3,844,142 |   |
|                                                                                  |   |                           |       |   |   |
| Cash  flows from investing activities:                                                |   |                           |       |   |   |
| Purchase  of property, equipment and real estate held for sale                        |   | (3,271,709                     | )          | (1,659,571 | ) |
| Sale  of property, equipment and real estate held for sale                            |   | 1,713,750                      |       | 1,182,913 |   |
| Acquisition  of investments and intangible assets                                     |   | (250,351                       | )          | (2,253,614 | ) |
| Issuance  of notes receivable                                                         |   | (523,670                       | )          | (24,391 | ) |
| Repayments  of notes receivable                                                       |   | 2,733,673                      |       | 66,704 |   |
| Net  cash provided by (used in) investing activities                                  |   | 401,693                        |       | (2,687,959 | ) |
|                                                                                  |   |                           |       |   |   |
| Cash  flows from financing activities:                                                |   |                           |       |   |   |
| Sale  of stock                                                                        |   | 62,232                         |       | 133,796 |   |
| Acquisition  of treasury stock                                                        |   | —                         |       | (19,914 | ) |
| Proceeds  from issuance of debt                                                       |   | 446,292                        |       | 9,471,950 |   |
| Repayment  of debt                                                                    |   | (6,958,375                     | )          | (13,019,349 | ) |
| Net  cash used in financing activities                                                |   | (6,449,851                     | )          | (3,433,517 | ) |
|                                                                                  |   |                           |       |   |   |
| Net  decrease in cash and cash equivalents                                            |   | (186,570                       | )          | (2,277,334 | ) |
| Cash  and cash equivalents at beginning of period                                     |   | 678,895                        |       | 2,567,904 |   |
|                                                                                  |   |                           |       |   |   |
| Cash  and cash equivalents at end of period                                           |   | $                              | 492,325    |   | $ | 290,570 |   |

 

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

 

4

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

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1. – Basis of Presentation**

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, they do not includeall of the information and footnotes required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, all adjustments, consisting of normalrecurring accruals, considered necessary for a fair presentation have beenincluded.  Operating results for thethree and nine months ended September 30, 2003, are not necessarily indicativeof the results that may be expected for the year ended December 31, 2003.  This information should be read inconjunction with the consolidated financial statements and footnotes theretoincluded in the Schlotzsky’s, Inc. Annual Report on Form 10-K for the year endedDecember 31, 2002.

 

*CorporateOrganization*

 

During the quarter ended June 30, 2003, Schlotzsky’s,Inc. (“Schlotzsky’s”) formed several new wholly-owned Delaware limitedliability companies: Schlotzsky’s Franchisor, LLC (“Franchisor”); Schlotzsky’sBrand Products, LLC (“Brand Products”); and Schlotzsky’s Franchise Operations,LLC (“Franchise Operations”).  On June7, 2003, Schlotzsky’s contributed to Franchisor, subject to a pledge ascollateral under a $1 million credit facility, all of its intellectual property,including trademarks and service marks, and related economic interests in thepayments to be received pursuant to the franchise agreements and brandlicensing agreements for the Schlotzsky’s**®**Delirestaurant concept and brand, which had previously been executed bySchlotzsky’s and certain of Schlotzsky’s other subsidiaries.  Franchisor thus became the franchisor of theSchlotzsky’s Deli restaurant concept and licensor of the Schlotzsky’s Delibrand.  Franchisor concurrentlycontributed the brand licensing agreements to Brand Products.  Franchisor and Brand Products entered into amanagement agreement with Franchise Operations to manage the intellectualproperty, administer the franchise and brand license agreements and enter intonew franchise and brand agreements

 

Schlotzsky’s and its subsidiaries are referred to asthe “Company”.

 

*Reclassifications*

 

Certain reclassificationshave been made to the condensed consolidated financial statements for theperiods ended September 30, 2002, to correspond with the presentation used atSeptember 30, 2003, and for the periods then ended.

 

*Fiscal Year*

 

The Company utilizes a“4-4-5 week” quarterly reporting schedule for royalties, restaurant operationsand royalty service costs. As a result of this reporting schedule, the fiscalyear will include 53 weeks of activity for these line items once every 5-6years, further, 2003 will be such a year. The financial statements for the third quarter 2003 reflect 13 weeks ofactivity for the three months ended September 30, 2003 and September 30, 2002,and 39 weeks activity for the nine months ended September 30, 2003 andSeptember 30, 2002, but the year-end financials will reflect 53 weeks for theyear ended December 31, 2003 and 14 weeks for the three months ended December31, 2003.  The last financial period toreflect 53 weeks of activity was the year ended December 31, 1998.

 

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

 

Effective January 1,2003, the Company adopted the cost recognition provisions for stock-basedcompensation of Statement of Financial Accounting Standards (“SFAS”) No. 123under the prospective method of adoption authorized by SFAS No. 148. The amountcharged to expense during the three and nine month periods ended September 30,2003 was approximately $6,000 and  $18,000,respectively. Had the Company adopted the cost recognition provisions of SFASNo. 123 in 1995, the Company’s net income and earnings per share would havebeen reduced to the pro forma amounts shown (in thousands, except per shareamounts):

 

5

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|                                                                                                                                                              |   | **For the  three months ended** |   | **For the  nine months ended** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|--------------------------------|--------|
|                                                                                                                                                              |   | **September  30, 2003**         |   | **September  30, 2002**        |   | **September  30, 2003** |   | **September  30, 2002** |   |
| Net income (loss), as reported                                                                                                                                    |   | $                               | (2,776 | )                              | $      | (240 | ) | $ | (6,110 | ) | $ | 876 |   |
| Add:  Stock-based employee compensation expense included in net income, net of  related tax effects                                                               |   | 4                               |   | —                         |   | 12 |   | — |   |
| Add  (deduct): Total stock-based employee compensation forfitures (expense)  determined under fair value based method for all awards, net of related tax  effects |   | (45                             | )      | 59                             |   | (159 | ) | (105 | ) |
| Pro  forma net income (loss)                                                                                                                                      |   | $                               | (2,817 | )                              | $      | (181 | ) | $ | (6,257 | ) | $ | 771 |   |
|                                                                                                                                                              |   |                            |   |                           |   |   |   |   |   |
| Earnings  per share:                                                                                                                                              |   |                            |   |                           |   |   |   |   |   |
| Basic-as  reported                                                                                                                                                |   | $                               | (0.38  | )                              | $      | (0.03 | ) | $ | (0.83 | ) | $ | 0.12 |   |
| Basic-pro  forma                                                                                                                                                  |   | $                               | (0.38  | )                              | $      | (0.02 | ) | $ | (0.85 | ) | $ | 0.11 |   |
| Diluted-as  reported                                                                                                                                              |   | $                               | (0.38  | )                              | $      | (0.03 | ) | $ | (0.83 | ) | $ | 0.12 |   |
| Diluted-pro  forma                                                                                                                                                |   | $                               | (0.38  | )                              | $      | (0.02 | ) | $ | (0.85 | ) | $ | 0.10 |   |

 

**Note 3. – Restaurant Operations**

 

A summary of certainoperating information for Company-operated restaurants is presented below forthe three and nine month periods ended September 30, 2003 and 2002 (dollars inthousands).

 
|                                                        |   | **Long-term Portfolio Restaurants** |   | **Available********For Sale********Restaurants** |   |                         |   |
|-------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------------------------------|--------|------------------------------|--------|
|                                                        |   | **Schlotzsky’s  Delis**        |   | **Marketplaces**                                 |   | **Schlotzsky’s  Delis** |   | **Total** |   |
| **Three months ended September 30,  2003**                  |   |                                |   |                                             |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 3,345  |                                             | $      | 1,541                        |   | $ | 3,051 |   | $ | 7,937 |   |
|                                                        |   |                                |   |                                             |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                             |   |                         |   |   |   |
| Cost of sales                                               |   | 1,015                               |   | 529                                              |   | 875                          |   | 2,419 |   |
| Personnel and benefits                                      |   | 1,235                               |   | 781                                              |   | 1,442                        |   | 3,458 |   |
| Operating expenses                                          |   | 569                                 |   | 441                                              |   | 987                          |   | 1,997 |   |
|                                                        |   | 2,819                               |   | 1,751                                            |   | 3,304                        |   | 7,874 |   |
|                                                        |   |                                |   |                                             |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 526    |                                             | $      | (210                         | )      | $ | (253 | ) | $ | 63 |   |
|                                                        |   |                                |   |                                             |   |                         |   |   |   |
| **Three months ended September 30,  2002**                  |   |                                |   |                                             |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 3,784  |                                             | $      | 1,230                        |   | $ | 2,921 |   | $ | 7,935 |   |
|                                                        |   |                                |   |                                             |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                             |   |                         |   |   |   |
| Cost of sales                                               |   | 1,043                               |   | 377                                              |   | 827                          |   | 2,247 |   |
| Personnel and benefits                                      |   | 1,354                               |   | 625                                              |   | 1,326                        |   | 3,305 |   |
| Operating expenses                                          |   | 688                                 |   | 318                                              |   | 983                          |   | 1,989 |   |
|                                                        |   | 3,085                               |   | 1,320                                            |   | 3,136                        |   | 7,541 |   |
|                                                        |   |                                |   |                                             |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 699    |                                             | $      | (90                          | )      | $ | (215 | ) | $ | 394 |   |

 

6

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|                                                        |   | **Long-term Portfolio Restaurants** |   | **Available  For Sale  Restaurants** |   |                         |   |
|-------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------------------|--------|------------------------------|--------|
|                                                        |   | **Schlotzsky’s  Delis**        |   | **Marketplaces**                     |   | **Schlotzsky’s  Delis** |   | **Total** |   |
| **Nine months ended September 30,  2003**                   |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 10,423 |                                 | $      | 3,997                        |   | $ | 9,130 |   | $ | 23,550 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                 |   |                         |   |   |   |
| Cost of sales                                               |   | 3,021                               |   | 1,322                                |   | 2,596                        |   | 6,939 |   |
|  Personnel and benefits                                |   | 3,822                               |   | 2,093                                |   | 4,353                        |   | 10,268 |   |
| Operating expenses                                          |   | 1,869                               |   | 1,137                                |   | 3,095                        |   | 6,101 |   |
|                                                        |   | 8,712                               |   | 4,552                                |   | 10,044                       |   | 23,308 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 1,711  |                                 | $      | (555                         | )      | $ | (914 | ) | $ | 242 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| **Nine months ended September 30,  2002**                   |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 11,790 |                                 | $      | 3,823                        |   | $ | 8,462 |   | $ | 24,075 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                 |   |                         |   |   |   |
| Cost of sales                                               |   | 3,217                               |   | 1,167                                |   | 2,371                        |   | 6,755 |   |
| Personnel and benefits                                      |   | 4,108                               |   | 1,869                                |   | 3,790                        |   | 9,767 |   |
| Operating expenses                                          |   | 2,052                               |   | 933                                  |   | 2,640                        |   | 5,625 |   |
|                                                        |   | 9,377                               |   | 3,969                                |   | 8,801                        |   | 22,147 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 2,413  |                                 | $      | (146                         | )      | $ | (339 | ) | $ | 1,928 |   |

 

As of September 30, 2003and 2002, the net book value of property and equipment and intangible assetsrelated to each of the above categories was as follows (dollars in thousands):

 
|                              |   | **September  30, 2003** |   | **September  30, 2002** |   |
|-----------------------------------|--------|-------------------------|--------|-------------------------|--------|
| Long-term  Portfolio Restaurants: |   |                    |   |                    |   |
| Schlotzsky’s  Delis          |   | $                       | 14,626 |                    | $      | 16,852 |   |
| Marketplaces                      |   | 10,050                  |   | 7,660                   |   |
| Available  for Sale Restaurants   |   | 15,879                  |   | 12,077                  |   |
|                              |   | $                       | 40,555 |                    | $      | 36,589 |   |

 

**Note 4. – Segments**

 

TheCompany and its subsidiaries are principally engaged in franchising andoperating restaurants in the fast casual sector under the Schlotzsky’s Delibrand.  Schlotzsky’s Deli restaurantsoffer a menu of distinctive, high quality foods featuring our proprietarybreads, complemented by excellent customer service in a visually appealingsetting.  Our current menu includesupscale made-to-order hot sandwiches and pizza served on our proprietary bunsand crusts, wraps, chips, salads, soups, fresh baked cookies and other desserts,and beverages.  At September 30, 2003,the Schlotzsky’s Deli system included 583 Company-operated and franchisedrestaurants in 37 states, the District of Columbia and six foreigncountries.  The Company operated 39restaurants as of September 30, 2003.

 

TheCompany identifies segments based on management responsibility within thecorporate structure.  The RestaurantOperations segment includes restaurants operated for the purposes of marketleadership and redevelopment of certain markets, demonstrating profit salespotential and key operating metrics, operational leadership of the franchisesystem, product development, concept refinement, product and process testing,and training and building brand awareness. The Restaurant Operations segment also includes restaurants developedfor or acquired from franchisees which are available for sale tofranchisees.  The Franchise Operationssegment encompasses the franchising of restaurants, assisting franchisees inthe development of restaurants, providing franchisee training and operating thenational training center, communicating with franchisees, conducting regionaland national

 

7

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franchiseemeetings, developing and monitoring supplier and distributor relationships,planning and coordinating advertising and marketing programs, and the licensingof brand products for sale to the franchise system and retailers.  The Company measures segment profit asoperating income, which is defined as income before interest and incometaxes.  Segment information and areconciliation to income before interest and income taxes are as follows(dollars in thousands):

** **
| **Three months ended September 30, 2003** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|-------------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                      |   |                       |   |                      |   |             |   |
| Revenue  from external customers          |   | $                          | 7,937  |                      | $      | 5,912            |   | $ | 13,849 |   |
| Depreciation  and amortization            |   | 597                        |   | 674                       |   | 1,271            |   |
| Operating  income (loss)                  |   | (534                       | )      | (2,242                    | )      | (2,776           | )      |
|                                      |   |                       |   |                      |   |             |   |
| Total  assets                             |   | $                          | 45,829 |                      | $      | 86,347           |   | $ | 132,176 |   |

** **
| **Three months ended September 30, 2002** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|-------------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                      |   |                       |   |                      |   |             |   |
| Revenue  from external customers          |   | $                          | 7,935  |                      | $      | 7,158            |   | $ | 15,093 |   |
| Depreciation  and amortization            |   | 602                        |   | 671                       |   | 1,273            |   |
| Operating  income (loss)                  |   | (208                       | )      | 586                       |   | 378              |   |
|                                      |   |                       |   |                      |   |             |   |
| Total  assets                             |   | $                          | 37,635 |                      | $      | 98,661           |   | $ | 136,296 |   |

 

Of the RestaurantOperations depreciation and amortization for the three months ended September30, 2003, $402,000 was allocated to the long-term portfolio of restaurants($186,000 for Marketplaces and $216,000 for Schlotzsky’s Delis) and $195,000 torestaurants available for sale.  For thethree months ended September 30, 2002, $382,000 of depreciation andamortization was allocated to the long-term portfolio of restaurants ($154,000for Marketplaces and $228,000 for Schlotzsky’s Delis) and $220,000 torestaurants available for sale.

** **
| **Nine months ended September 30, 2003** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|------------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                     |   |                       |   |                      |   |             |   |
| Revenue  from external customers         |   | $                          | 23,550 |                      | $      | 18,391           |   | $ | 41,941 |   |
| Depreciation  and amortization           |   | 1,678                      |   | 2,125                     |   | 3,803            |   |
| Operating  income (loss)                 |   | (1,436                     | )      | (4,674                    | )      | (6,110           | )      |
|                                     |   |                       |   |                      |   |             |   |
| Total  assets                            |   | $                          | 45,829 |                      | $      | 86,347           |   | $ | 132,176 |   |

** **
| **Nine months ended September 30, 2002** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|------------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                     |   |                       |   |                      |   |             |   |
| Revenue  from external customers         |   | $                          | 24,075 |                      | $      | 22,167           |   | $ | 46,242 |   |
| Depreciation  and amortization           |   | 1,638                      |   | 1,805                     |   | 3,443            |   |
| Operating  income                        |   | 290                        |   | 2,800                     |   | 3,090            |   |
|                                     |   |                       |   |                      |   |             |   |
| Total  assets                            |   | $                          | 37,635 |                      | $      | 98,661           |   | $ | 136,296 |   |

 

Of the RestaurantOperations depreciation and amortization for the nine months ended September30, 2003, $1,112,000 was allocated to the long-term portfolio of restaurants($476,000 for Marketplaces and $636,000 for Schlotzsky’s Delis) and $566,000 torestaurants available for sale.  For thenine months ended September 30, 2002, $1,101,000 of depreciation andamortization was allocated to the long-term portfolio of restaurants ($451,000for Marketplaces and $650,000 for Schlotzsky’s Delis) and $537,000 torestaurants available for sale.

 

Allgeneral and administrative expenses are included in Franchise Operations for the periods presented.

 

8

----

 

**Note 5. – Debt**

 

TheCompany’s debt structure as of September 30, 2003, and December 31, 2002, is asfollows (dollars in thousands):

** **
|                                                     |   | **September  30,  2003** |   | **December  31,  2002** |       |
|----------------------------------------------------------|--------|--------------------------|--------|-------------------------|------------|
|                                                     |   | **(Unaudited)**          |   |                    |       |
|                                                     |   |                     |   |                    | ** ** |
| Short-term  debt:                                        |   | $                        | 1,009  |                    | $          | — | ** ** |
|                                                     |   |                     |   |                    | ** ** |
| Long-term  debt:                                         |   |                     |   |                    | ** ** |
| Notes  payable to former area developers                 |   | $                        | 22,601 |                    | $          | 26,306 | ** ** |
| Mortgages  on Company-operated restaurants and equipment |   | 23,590                   |   | 23,839                  | ** ** |
| Capital  leases                                          |   | 2,755                    |   | 3,029                   | ** ** |
| Other  obligations                                       |   | 465                      |   | 331                     | ** ** |
|                                                     |   | 49,411                   |   | 53,505                  |       |
| Less  current maturities of long-term debt               |   | (8,762                   | )      | (7,441                  | )          |
| Long-term  debt                                          |   | $                        | 40,649 |                    | $          | 46,064 | ** ** |

 

Short-term debt as ofSeptember 30, 2003 was comprised of a $150,000 note to a bank with interest at5.2%, due December 23, 2003 collateralized by a certificate of deposit pledgedby an officer and director of the Company; $360,000 outstanding under a$1,000,000 facility with two officers and directors of the Company withinterest at 6.0%, due January 16, 2004 and secured generally by ourintellectual property, contract rights and certain intangibles; and anobligation to a bank in the amount of approximately $298,750, with interest atthe prime rate plus 1%, which is mature and past due, and is expected to bepaid in full by the end of the year.

 

Certainof our mortgage debt require the maintenance of certain financial ratios,including debt-to-equity and working capital. We are currently in compliance with these covenants or have obtainedwaivers from the lenders

 

**Note 6. – Related Party Receivables**

 

Asof September 30, 2003, and December 31, 2002, receivables from related partieswere as follows (dollars in thousands):

** **
|                                     |   | **September  30,  2003** |       | **December  31,  2002** |       |
|------------------------------------------|--------|--------------------------|------------|-------------------------|------------|
|                                     |   | **(Unaudited)**          |       |                    |       |
|                                     |   |                     | ** ** |                    | ** ** |
| Included  in accounts receivable - other |   | $                        | 960        |                    | $          | 902 |   |
| Included  in other noncurrent assets     |   | 549                      |       | 842                     |       |
| Included  in notes receivable            |   | 2,756                    |       | 5,450                   |       |
|                                     |   |                     |       |                    |       |
| Total  related party receivables         |   | $                        | 4,265      |                    | $          | 7,194 |   |

 

9

----

 

**Note7. – Earnings Per Share**

 

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

 
|                                                                                                                             |   | **Three Months Ended**   |   | **Nine Months Ended**    |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                                                                                                             |   | **September  30,  2003** |   | **September  30,  2002** |   | **September  30,  2003** |   | **September  30,  2002** |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Basic  earnings (loss) per share                                                                                                 |   |                     |   |                     |   |   |   |   |   |
| Net  income (loss)                                                                                                               |   | $                        | (2,776 | )                        | $      | (240 | ) | $ | (6,110 | ) | $ | 876 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Weighted  average common shares outstanding                                                                                      |   | 7,332                    |   | 7,306                    |   | 7,324 |   | 7,293 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Basic  earnings (loss) per share                                                                                                 |   | $                        | (0.38  | )                        | $      | (0.03 | ) | $ | (0.83 | ) | $ | 0.12 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Diluted  earnings (loss) per share                                                                                               |   |                     |   |                     |   |   |   |   |   |
| Net  income (loss)                                                                                                               |   | $                        | (2,776 | )                        | $      | (240 | ) | $ | (6,110 | ) | $ | 876 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Weighted  average common shares outstanding                                                                                      |   | 7,332                    |   | 7, 306                   |   | 7,324 |   | 7,293 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Dilutive  stock options and warrants                                                                                             |   | —                   |   | —                   |   | — |   | 117 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Weighted  average common shares outstanding – assuming dilution                                                             |   | 7,332                    |   | 7,306                    |   | 7,324 |   | 7,410 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Diluted  earnings (loss) per share                                                                                               |   | $                        | (0.38  | )                        | $      | (0.03 | ) | $ | (0.83 | ) | $ | 0.12 |   |
|                                                                                                                             |   |                     |   |                     |   |   |   |   |   |
| Outstanding  options and warrants that were not included in the diluted calculation  because their effect would be anti-dilutive |   | 1,105                    |   | 1,148                    |   | 1,130 |   | 825 |   |

 

10

----

 

**Note 8. – Adoption of New Accounting PronouncementsIntangible Assets**

 

The Company adopted Statements of FinancialAccounting Standards (SFAS) Nos. 141, 142 and 144, concerning accounting forbusiness combinations, amortization of certain acquired intangible assets, andthe impairment or disposal of long-lived assets, respectively, as of January 1,2002.

 

Intangibleassets consist of the following (dollars in thousands):

 
|                                            |   |                             |       | **September  30, 2003** |       | **December  31, 2002**        |       |
|-------------------------------------------------|--------|----------------------------------|------------|-------------------------|------------|-------------------------------|------------|
|                                            |   |                             |       | **(Unaudited)**         |       |                          |       |
|                                            |   | **Amortization  Period (Years)** |       | **Gross   Value**       |       | **Accumulated  Amortization** |       | **Gross  Value** |   | **Accumulated  Amortization** |   |
|                                            |   |                             | ** ** |                    | ** ** |                          | ** ** |   | ** ** |   | ** ** |
| Intangible  assets subject to amortization:     |   |                             |       |                    |       |                          |       |   |   |   |   |
| Royalty  value                                  |   | 20                               |       | $                       | 2,474      |                          | $          | 867 |   | $ | 2,474 |   | $ | 779 |   |
| Developer  and franchise rights acquired        |   | 20 to 40                         |       | 59,374                  |       | 3,521                         |       | 59,384 |   | 2,492 |   |
| Restaurant  development rights                  |   | 13 to 25                         |       | 1,652                   |       | 483                           |       | 1,619 |   | 407 |   |
| Debt  issue costs                               |   | 3 to 20                          |       | 511                     |       | 184                           |       | 1,561 |   | 77 |   |
| Other  intangible assets                        |   | 5                                |       | 602                     |       | 422                           |       | 561 |   | 364 |   |
|                                            |   |                             |       | 64,613                  |       | 5,477                         |       | 65,599 |   | 4,119 |   |
|                                            |   |                             |       |                    |       |                          |       |   |   |   |   |
| Intangible  assets not subject to amortization: |   |                             |       |                    |       |                          |       |   |   |   |   |
| Original  franchise and royalty rights          |   |                             |       | 5,689                   |       | 1,860                         |       | 5,689 |   | 1,860 |   |
| Goodwill                                        |   |                             |       | 3,898                   |       | 395                           |       | 3,316 |   | 331 |   |
|                                            |   |                             |       | 9,587                   |       | 2,255                         |       | 9,005 |   | 2,191 |   |
|                                            |   |                             |       |                    |       |                          |       |   |   |   |   |
| Total  intangible assets                        |   |                             |       | $                       | 74,200     |                          | $          | 7,732 |   | $ | 74,604 |   | $ | 6,310 |   |

 

Amortization ofintangible assets totaled approximately $557,000 and $337,000 for the threemonths ended September 30, 2003, and 2002, respectively.  For the nine months ended September 30,2003, and 2002, amortization expense totaled $1,422,000 and $808,000respectively.  Estimated amortizationexpense through 2007 for intangible assets with determinable lives is asfollows (dollars in thousands):

 
| Remainder  of 2003 |   | $     | 677    |   |
|--------------------|--------|-------|--------|--------|
| 2004               |   | 1,770 |   |
| 2005               |   | 1,752 |   |
| 2006               |   | 1,743 |   |
| 2007               |   | 1,736 |   |
|               |   | $     | 7,678  |   |

 

The changes in the grossvalue of goodwill for the nine months ended September 30, 2003, are as follows(dollars in thousands):

 
|                              |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Total** |   |
|-----------------------------------|--------|----------------------------|--------|---------------------------|--------|-----------|--------|
| Balance  as of December 31, 2002  |   | $                          | 3,055  |                      | $      | 261       |   | $ | 3,316 |   |
| Goodwill  acquired                |   | 582                        |   | —                    |   | 582       |   |
| Impairment                        |   | —                     |   | —                    |   | —    |   |
| Balance  as of September 30, 2003 |   | $                          | 3,637  |                      | $      | 261       |   | $ | 3,898 |   |

 

11

----

 

 

During the first quarterthe Company, exercising its right of first refusal, acquired the operatingassets of a franchised restaurant located in suburban Atlanta, Georgia.  The Company does not intend to operate the acquiredrestaurant, but acquired these assets primarily in order to facilitate thedevelopment of a Company-operated restaurant in the trade area that had beenlicensed to the franchisee.

 

The aggregate purchaseprice paid was $215,000.  Of thepurchase price, $8,000 was assigned to property, plant and equipment and$207,000 was assigned to goodwill.  Thegoodwill was assigned to the restaurant operations segment, and is expected tobe fully deductible for tax purposes.

 

The Company acquired inthe second quarter 2000 a 50% interest in a limited liability company engagedin the operation of a Schlotzsky’s Deli restaurant.  On September 27, 2003 the limited liability company regulationswere amended transferring full control of the entity to the Company, resultingin the consolidation of the limited liability company into the Company’sfinancials effective the date of the modification.  Goodwill in the amount of $311,000 was added to the balance sheetrelated to the consolidation of this entity.

 

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

 

TheCompany has outstanding guarantees of indebtedness of others, including relatedparties, of approximately $27.5 million as of September 30, 2003. Theseguarantees include approximately $5.7 million of lease guarantees for thebenefit of franchisees, approximately $13.5 million of mortgage loan guaranteesfor the benefit of franchisees and approximately $8.3 million of loanguarantees for the benefit of related parties.

 

Thelease guarantees for thebenefit of franchisees arose primarily through our former Turnkey program, inwhich the Company developed the restaurants, leased the restaurants tofranchisees, and then sold them to a leasing company.  The guarantees range from limited guarantees, either in dollaramount or term, to full guarantees for the life of the lease.  The maximum guarantee for a single lease isapproximately $1.3 million.  Certainguarantees extend through 2018.  TheCompany may be required by the lessor to make monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. The Company has indemnification agreements with the franchisee underwhich the franchisee would be obligated to reimburse the Company for any amountspaid under such guarantees.  As of September30, 2003, the Company had accrued a liability of approximately $605,000 relatedto these guarantees, including a $574,000 provision made in the quarter endedJune 30, 2003.  The Company also has anet deferred gain related to the sale of these leases in the amount ofapproximately $342,000 as of September 30, 2003.

 

Themortgage loan guarantees for the benefit of franchisees also arose primarilythrough the Company’s former Turnkey program, in which we developed the relatedrestaurants, sold the restaurant to a franchisee, and guaranteed all or aportion of the franchisee’s mortgage loan. The guarantees range from limited guarantees, either in dollar amount orterm, to full guarantees of the mortgage. The maximum amount of a single guarantee is approximately $1.0million.  Certain guarantees extendthrough 2016.  The Company may berequired by the lender to make monthly mortgage payments if the franchisee doesnot make the required payments in a timely manner, or the Company may berequired to make up any deficiency, up to the amount of the guarantee, if therelated restaurant is sold for net proceeds less than the amount of theoutstanding mortgage.  The Company hasindemnification agreements with the franchisees under which the franchiseewould be obligated to reimburse the Company for any amount paid under suchguarantees.  In the event that theCompany purchases the loan from the lender in the event of a default, theCompany would succeed to the lender’s security interest in the relatedproperty.

 

Theloan guarantees in favor of related parties primarily arose when the Companyguaranteed certain debt of related parties for which the proceeds of the loanswere used to repay outstanding debt to the Company.  Two of the guarantees, for the benefit of our restaurant ventureand our real estate venture, are of mortgage debt totaling approximately $4.1million.  These guarantees extendthrough 2009 on one note and through 2016 on the other note.  A third guarantee, of a bank note in theamount of approximately $4.2 million as of September 30, 2003, is for thebenefit of Schlotzsky’s NAMF Funding, LLC, the advertising entity of theSchlotzsky’s Deli restaurant system, for which the Company had received aportion of the net proceeds of the loan in repayment of outstanding debt to theCompany.  This guarantee expires in2004.  In connection with the originalguarantee of the $4.3 million advertising entity bank note, which was made inJune 2003, a liability in the amount of $43,000 was accrued under the terms ofFASB Interpretation No. 45.

 

TheCompany has been called upon, from time to time, to make payments onobligations the Company has guaranteed. During the firstnine months of 2003, the Company paid approximately $534,000 in various leaseguarantees for the benefit of franchisees.

 

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Inaddition, pursuant to a guarantee of a franchisee’s debt obligation, theCompany purchased that obligation from a bank, in the amount of approximately$665,000.  Of that amount, approximately$298,750 is mature and past due, and is expected to be paid in full by the endof the year.

 

###### **Note 10. – Adopted accounting pronouncements**

 

The Company has adoptedFinancial Accounting Standards Board (“FASB”) interpretation No.45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness toOthers.”  FIN 45 elaborates on thedisclosures required of a guarantor in its financial statements, and clarifiesthat a guarantor is required to recognize, upon making a guarantee, a liabilityfor the fair value of the guarantee. FIN 45 is applicable to guarantees made or modified after December 31,2002.  As discussed below, the Companyhas guaranteed the indebtedness of others in the past, and may do so in thefuture, but the adoption of FIN 45 has not had a material impact on ourfinancial statements for the quarter or year to date ended September 30, 2003.

 

**Note 11.– Accounting pronouncements not yet adopted**

 

The FASB has issuedInterpretation No. 46, “Consolidation of Variable Interest Entities”.  FIN 46 addresses the consolidation bybusiness enterprises of variable interest entities whose equity holders havenot provided sufficient equity to allow the entity to finance its ownactivities or whose equity holders lack the essential characteristics of acontrolling financial interest.  FIN 46requires a variable interest entity to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the entity’sactivities or entitled to receive a majority of the entity’s residual returns,or both.  The provisions of FIN 46 areeffective September 30, 2003 for entities formed after February, 2003 andeffective December 31, 2003 for entities formed before February, 2003.  The Company is reviewing the provisions ofFIN 46 and awaiting further clarification by the FASB on the application of FIN46 to franchisors, but at this time the Company anticipates no material effectfrom the adoption of FIN 46.

 

**Note 12. – Commitments andContingencies**

 

*Litigation*

 

The Company is named adefendant in various legal proceedings in the normal course of itsbusiness.  The ultimate outcome of legalproceedings cannot be projected with certainty.  The following are proceedings in which the plaintiffs havealleged significant damages.  Based onits knowledge of these matters and its experience to date, the Company does notbelieve that the outcome of these proceedings will have a material impact onthe Company’s financial condition and results of operations.

 

*NewFlorida Markets, Ltd. v. Schlotzsky’s, Inc., Schlotzsky’s Franchise LimitedPartnership, Schlotzsky’s Franchisor, LLC, Schlotzsky’s Franchise Operations,LLC, Schlotzsky’s NAMF, Inc., and Schlotzsky’s NAMF Funding, LLC*,(Case No. 701140045603) wasfiled on or about June 23, 2003 with the American Arbitration Association.  Claimant is the area developer for theTampa, Orlando, and West Palm Beach development areas.  On July 14, 2003, Deli Keys, Ltd., an areadeveloper for the Miami development area, joined the arbitration as anadditional Claimant. They allege that Respondents frustrated their ability todevelop, in part because of the Company’s Turnkey program.  Claimant also alleges Respondents breachedthe Area Developer Agreements by failing to provide adequate licensing support,negotiating with license prospects, failing to establish and administer a localadvertising group, pledging royalties, changing the area developer manual, refundingfranchise fees, and forcing Claimants to purchase errors and omissionsinsurance.  Other claims include breachof the implied covenant of good faith and fair dealing, constructivetermination, and violation of the Texas Deceptive Trade Practices Act.  Claimants seek actual, compensatory, andpunitive damages of an unspecified amount, attorneys’ fees, and costs.  The case is not yet set for hearing.

 

*ComericaBank vs. James E. Wright, John D. Wright, Lorraine Wright, and Kimberly Wrightv. Schlotzsky’s, Inc. and Schlotzsky’s Real Estate, Inc.,*inthe Circuit Court for the County of Genessee, State of Michigan (Case No.02-74931), was filed on or about June 30, 2003 as a Third Party Complaint in aforeclosure action.  Third PartyPlaintiffs are principals and guarantors of J. Wright Franchise Development,LLC, a former franchisee that had operated a Schlotzsky’s Deli in Grand Blanc,Michigan and filed Chapter 11 bankruptcy. In January 2003, Schlotzsky’s RealEstate, Inc. filed suit against John and James Wright for collection of$283,872.68 due under a promissory note. In the instant case, Third Party Plaintiffs allege that they wereinduced into participating in the Company’s Turnkey program and that anemployee of the Company represented that the restaurant would attain a certainlevel of sales.  Third Party Plaintiffs’claims include fraud in the inducement, fraudulent and negligentmisrepresentation, and breach of the Michigan Franchise Investment Act.  They seek damages of an unspecified amountin excess of $25,000, attorneys’ fees, and costs.  The case is not yet set for trial.

 

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*RussellR. Kesterson and Steven P. Schmidt v. Schlotzsky’s, Inc., Ron Lynch andJane Doe Lynch, John Does I—X, Jane Does I—X, ABC Corporations I—X, XYZCompanies I—X*, (Case No. CV2002-021158) was filed onOctober 31, 2002, in the Superior Court of Maricopa County, Arizona.Plaintiffs were franchisees of the Company and owned and operated aSchlotzsky’s Deli restaurant in Phoenix, Arizona. The Complaint includes claimsof breach of contract, interference with business expectancy, interference withbusiness relationship, unfair competition and negligence. Plaintiffs allegethat a “superstore” owned by Lynch and/or our affiliates encroached on theirbusiness and allege that we failed to collect royalties from the “superstore,”creating unfair competition. Plaintiffs further state that they attempted torelocate their restaurant but that we failed to approve a proposed alternativelocation and that we induced one of their employees to work for a competingrestaurant. Plaintiffs are seeking an unspecified amount of damages, includingtreble damages, attorney’s fees, and costs. On December 3, 2002, we fileda petition styled *Schlotzsky’s, Inc.,v. Russell R. Kesterson and Steven P. Schmidt*, in the United StatesDistrict Court for the Western District of Texas, Austin Division (Civil ActionNo. AO2CA 768SS) to compel Plaintiffs to arbitrate their claims in Austin,Texas. The federal court entered an order on December 20, 2002, grantingour petition to compel arbitration in the manner provided in the franchiseagreement and enjoined Kesterson and Schmidt from pursuing any of their claimsin the lawsuit pending in Arizona. To date, we are unaware of any subsequentdemand for arbitration filed by either Kesterson or Schmidt.

 

*Robert Coshott v.Schlotzsky’s, Inc.* (Cause No. GN 1-02279), was filed onJuly 24, 2001, in the 200th Judicial District Court of Travis County,Texas. Plaintiff is the Master Licensee for Australia and New Zealand, and heopened a Schlotzsky’s Deli restaurant in Melbourne, Australia. Plaintiff bringscauses of action for fraud and/or negligent misrepresentation. Plaintiffalleges that he experienced problems with certain equipment specified orapproved by the Company, that the Company’s system and equipment did notgenerate enough finished food product to service his potential customers; thatthe Company misrepresented the level of revenue the restaurant could reasonablybe expected to achieve; that the Company delayed his ability to developrestaurants by failing to timely secure certain trademarks and trade names; andthat the Company misrepresented whether it would allow Plaintiff to franchiseSchlotzsky’s Deli restaurants in certain gas station or convenience storelocations in his territories. Plaintiff requests actual and punitive damages of$3.75 million plus lost profits and incidental and consequential damagesof an unspecified amount. The case is not yet set for trial. On July 23, 2003,Coshott also filed a Demand for Arbitration with the International Chamber ofCommerce styled *Robert Gilbert Coshott v. Schlotzsky’s, Inc.* (Case. No.TBD).  The claims in the Demand aresimilar to those brought in the above-entitled action and include additionalallegations that the Company required the purchase of goods and services fromcertain suppliers in violation of the Trade Practices Act of 1974 and that theCompany failed to disclose the existence of a predecessor Master LicenseAgreement, 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.  At present, no arbitration hearing date hasbeen set.  

 

*DaeKim, DWK Enterprises, Inc., and Aecon International, Inc. v. JohnWooley, Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership,Schlotzsky’s N.A.M.F., Inc., Schlotzsky’s National AdvertisingAssociation, Inc., and Schlotzsky’s, Brands, Inc., Schlotzsky’s BrandProducts, L.P., Schlotzsky’s Real Estate, Inc., and Schlotzsky’sRestaurants, Inc.* (Cause No. 2001-CI-13672) wasoriginally filed in the 73rd Judicial District Court of Bexar County, Texas onor about September 25, 2001 (after a similar lawsuit was filed and laterwithdrawn in Harris County, Texas) against Schlotzsky’s, Inc., JohnWooley, Schlotzsky’s Franchising Limited Partnership, and Schlotzsky’sNAMF, Inc. (collectively, “Defendants”). Plaintiffs are, or claim to be,franchisees in Houston and San Antonio Texas, and Plaintiff Kim was an areadeveloper for those markets. Plaintiffs bring causes of action for breach ofcontract, breach of fiduciary duty, breach of the duty of good faith and fairdealing, civil conspiracy, tortious interference with contract, tortiousinterference with prospective business relationship, violation of the TexasDeceptive Trade Practices and Consumer Protection Act, restraint of trade,detrimental reliance-fraud in the inducement, and defamation-businessdisparagement. They seek an unspecified amount of money damages plus exemplarydamages, attorneys’ fees, pre-judgment interest, costs, and a jury trial.Defendants, except for Mr. Wooley, who was previously dismissed from thecase, answered and asserted counterclaims alleging breach of contract and thatPlaintiffs’ claim under the Texas Deceptive Trade Practices Act is groundlessin fact or in law and brought in bad faith or for the purpose of harassment,and seeking money damages, costs of court, penalty fees, costs incurred inperforming the accounting, attorneys’ fees, and pre- and post-judgmentinterest. Defendants (except for Mr. Wooley) removed the case to federalcourt. The case was remanded to state court on April 17, 2003.  The caseis not yet set for trial.

 

*U.S. Restaurant Properties OperatingL.P. v. Schlotzsky’s, Inc.* (Cause No. 03-01758) wasfiled on February 27, 2003, in the District Court of Dallas County, B-44thJudicial District.  Plaintiff is a real estate investment company thatowns certain Schlotzsky’s Deli restaurants and leases them to franchisees. Italleges that in 1997 and 1998 we entered into several agreements where weagreed to guarantee certain lease agreements. Plaintiff states that in 1998 theparties entered into an agreement whereby Plaintiff agreed to releaseSchlotzsky’s from its guaranty obligations pertaining to six properties inwhich the tenants had defaulted,

 

14

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in exchange forSchlotzsky’s agreement to purchase seven other properties. The Companypurchased one of the properties located in Texas. Plaintiffs are seeking anorder requiring us to purchase the other six properties, two of which are inTexas, and one each in Arizona, Colorado, Indiana, and Tennessee, for a totalpurchase price of over $4.5 million. In the alternative, Plaintiff isseeking damages or an order reinstating the previously released guaranties.Plaintiff’s claims include breach of contract and a request for attorneys’fees. A trial date has been set for February 16, 2004.

 

See also the discussionunder "Legal Proceedings" in the Company's Form 10-Q filed August 14,2003 and Form 10-Q filed May 15, 2003.

 

In addition to thematters discussed above, we are defendants in various other legal proceedingsarising from our business. The ultimate outcome of these pending proceedingscannot be projected with certainty. However, based on our experience to date,we believe such proceedings will not have a material effect on our business orfinancial condition.

 

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

 

# **CRITICALACCOUNTING POLICIES**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, revenues and expensesand related disclosure of contingent liabilities.  We base our estimates on historical experience and various otherassumptions that we believe are reasonable under the circumstances.  Estimates and assumptions are reviewedperiodically.  Actual results may varyfrom these estimates.

 

Webelieve the following critical accounting policies require estimates about theeffect of matters that are inherently uncertain and require subjectivejudgments.  Changes in the estimates andjudgments could significantly impact our results of operations and financialconditions in future periods.

 

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

 

Ouraccounts and notes receivable are primarily from franchisees of theSchlotzsky’s Deli system.  We requirepersonal guarantees for all franchise accounts and, for notes receivable,generally obtain a secondary secured interest in the related property andequipment or rights.  Many of the notesreceivable are fully subordinated to the franchisee’s senior mortgagedebt.  In reviewing the adequacy of thevaluation allowances for accounts and notes receivable, we consider factorssuch as historical collection experience, the estimated value of personalguarantees and real property collateral, the franchisee’s sales and operating trends,including potential for improvement in operations, and general and localeconomic conditions that may affect the franchisee’s ability to pay.  Actual realization of amounts receivablecould differ materially from our estimates.

 

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

 

Ourreal estate held for sale consists primarily of pad sites.  As these sites are being actively marketed,they are periodically assessed for estimated net realizable value.  Factors considered in this assessment areoffers and letters of intent received on properties, discussions with localreal estate brokers, property tax and bank appraisals, sale prices of similarproperties and level of activity and interest exhibited by potential buyers.  Actual realizeability could differmaterially from our estimates.

 

•                  Determination of appropriate valuationallowances for intangible assets.

 

Amortizingintangible assets consist primarily of amounts paid to reacquire variousdeveloper and franchise rights. Annually, and whenever an event or circumstance indicating impairmentmay be present, we compare projected undiscounted cash flows to the carryingvalue of the related assets to determine if impairment has occurred.  In estimating future cash flows, we considersuch factors as current results, trends, future prospects, and other economicfactors.  Actual future cash flows coulddiffer materially from our estimates.

 

•                  Determination of appropriate valuationallowances for deferred tax assets.

 

Ourdeferred tax assets represent deferred expenses and losses that will offsetfuture income tax liability.  If theCompany is unable to generate income tax liability resulting from future netincome the value of this tax asset would be impaired.  The Company considers such factors as current trends, operatingmargins and future system growth in determining projected net income, andprojected net income is used to assess realizable value of the deferred taxasset.

 

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**RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

The following tablereflects the changes in the Schlotzsky’s Deli system for the three and ninemonths ended September 30, 2003 and 2002. Systemwide data reflects both franchised and Company-operatedrestaurants.  Percentage changes insales-related data are based on comparison to the same period in the previousfiscal year.

 
|                                         |   | **Three Months Ended**  |       | **Nine Months Ended**   |   |
|----------------------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                                         |   | **September 30,  2003** |       | **September 30,  2002** |   | **September 30,  2003** |   | **September 30,  2002** |   |
| Restaurants  Open – Beginning of Period |   | 597                     |       | 671                     |   | 643 |   | 674 |   |
| Openings  During Period –               |   |                    |       |                    |   |   |   |   |   |
| New                                          |   | 1                       |       | 1                       |   | 8 |   | 8 |   |
| Reopenings                                   |   | 1                       |       | 2                       |   | 3 |   | 8 |   |
| Total  Openings                              |   | 2                       |       | 3                       |   | 11 |   | 16 |   |
| Closings  During Period                      |   | (16                     | )          | (16                     | )      | (71 | ) | (32 | ) |
| Restaurants  Open – End of Period       |   | 583                     |       | 658                     |   | 583 |   | 658 |   |
|                                         |   |                    |       |                    |   |   |   |   |   |
| Systemwide  Sales                            |   | $                       | 81,036,000 |                    | $      | 97,987,000 |   | $ | 251,812,000 |   | $ | 300,833,000 |   |
| Decrease  in Contractual Systemwide Sales    |   | (17.3                   | )%         | (7.7                    | )%     | (16.3 | )% | (6.9 | )% |
| Decrease  in Contractual Same Store Sales    |   | (10.6                   | )%         | (6.3                    | )%     | (11.3 | )% | (5.7 | )% |
| Average  Weekly Sales                        |   | $                       | 10,570     |                    | $      | 11,357 |   | $ | 10,579 |   | $ | 11,539 |   |
| Decrease  in Average Weekly Sales            |   | (6.9                    | )%         | (2.9                    | )%     | (8.3 | )% | (2.0 | )% |

 

**THREE MONTHS ENDEDSEPTEMBER 30, 2003 AND 2002**

 

REVENUE.  Total revenue decreased 8.2% to $13,849,000from $15,093,000.

 

ROYALTIES decreased 20.2%to $3,977,000 from $4,984,000.  Thedecrease was due to a decreased number of franchised restaurants during thethree months ended September 30, 2003 compared to the comparable period in 2002,and decrease in same store contractual sales of 10.6% during the third quarterof 2003.

 

FRANCHISE FEES increasedto $17,000 from $0.

 

DEVELOPER FEES decreased37.3% to $37,000 from $59,000.  Thedecrease was primarily due to the expiration of amortization of fees receivedunder certain agreements.

 

RESTAURANT SALESincreased to $7,937,000 from $7,935,000. The increase was primarily due to an increase in the average number ofrestaurants operated by the Company during the three months ended September 30,2003, compared to the comparable period of 2002.  The increase was offset by a 9.8% decrease in same store salesduring the third quarter of 2003.  As ofSeptember 30, 2003, there were 39 Company-operated restaurants, compared to 36at September 30, 2002, of which 25 and 21, respectively, were available forsale restaurants.

 

SCHLOTZSKY’S DELI BRANDLICENSING FEES (BRAND CONTRIBUTION) decreased 12.0% to $1,601,000 from$1,820,000.  The decrease was primarilydue to the decrease in systemwide contractual sales for the quarter.  Approximately 90% of these licensing feesare derived from sales to the franchise system and the remaining 10% todistribution channels outside Schlotzsky’s Deli restaurants.

 

OTHER FEES AND REVENUEdecreased 4.4% to $281,000 from $294,000. The decrease was due to a decrease in expired franchise fees.

 

OPERATING EXPENSES. Totaloperating expenses increased 16.8% to $17,188,000 from $14,715,000.

 

SERVICE COSTS decreased39.8% to $607,000 from $1,008,000, and as a percentage of royalties andfranchise fees decreased to 15.2% from 20.4%. This decrease was due to the Company’s reacquisition of certain areadeveloper territory rights during the third quarter of 2002 and a decrease inroyalty revenue.

 

RESTAURANT OPERATIONSEXPENSES increased 4.4% to $7,874,000 from $7,541,000.  On an overall basis, expenses, as apercentage of net restaurant sales, are higher at restaurants available forsale, and the proportion of available for sale restaurants to totalCompany-operated restaurants was higher in this year’s third quarter than lastyear’s comparable period.

 

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RESTAURANT COST OF SALESincreased 7.7% to $2,419,000 from $2,247,000 and increased as a percentage ofnet restaurant sales to 30.5% from 28.3% due primarily to product testing andto an increase in beverage costs.

 

RESTAURANT PERSONNEL ANDBENEFITS COST increased 4.6% to $3,458,000 from $3,305,000 and increased as apercentage of net restaurant sales to 43.6% from 41.7%.  The increase, as a percentage of net restaurantsales, was due to the effect of lower average sales on manager salaries,inefficiencies of a restaurant opened the second quarter of 2003, and openinglabor costs at two other restaurants.

 

RESTAURANT OPERATINGEXPENSES increased 0.4% to $1,997,000 from $1,989,000 and increased as apercentage of net restaurant sales to 25.2% from 25.1%.  The increase in operating costs, as apercentage of net restaurant sales, was primarily due to opening costs on arestaurant opened the previous quarter and a restaurant under development aswell as a tax assessment on one restaurant location, offset by opening costs oftwo restaurants the prior year.

 

EQUITY LOSS ONINVESTMENTS increased to a loss of $321,000 from a loss of $59,000.  The equity investment loss represents theconsolidation of the cumulative losses of the limited liability company thatoperates a Schlotzsky’s Deli restaurant that opened in 2000.

 

GENERAL ANDADMINISTRATIVE EXPENSES increased 47.2% to $7,115,000 from $4,834,000, andincreased to 51.4% from 32.0% as a percentage of total revenue. The increasefrom the prior year quarter was principally due to increased franchisee meetingand convention expenses, increased legal and professional expenses, the accrualof separation costs, and the recognition of approximately $1,867,000 ofpreviously deferred financing costs that were recognized in the third quarterdue to the indefinite delay of a securitized debt offering.

 

DEPRECIATION ANDAMORTIZATION decreased 0.2% to $1,271,000 from $1,273,000.  The change resulted from an increase due toacquired assets offset by a decline due to certain assets being fully amortizedduring the period presented.

 

INTERESTINCOME decreased 55.5% to $53,000 from $119,000, primarily due to a decrease innotes receivable balances.

 

INTEREST EXPENSEincreased 19.8% to $955,000 from $797,000 due primarily to the incurrence ofdebt related to the Company’s acquisition of territorial rights of theCompany’s largest area developer in middle of the third quarter of 2002.

 

PROVISION FOR INCOMETAXES increased to $1,463,000 from $60,000 for the comparable period last yearprincipally due to the net loss we experienced this quarter and because theeffective rate increased. The provision reflects a combined federal and stateeffective tax benefit rate of 34.5% for the third quarter of 2003, which waslower than the effective combined tax rate of 20.0% for the comparable periodin 2002 primarily due to certain state taxes being based in part on factorsother than income.

 

NET INCOME decreased to aloss of $2,776,000 from a loss of $240,000 due to the factors discussedabove.  Earnings per share, both basicand diluted, were $(0.38) for the quarter ended September 30, 2003 compared to$(0.03) in the prior year quarter.

 

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

 

The following table ispresented for the Schlotzsky’s Delis in the Company’s long-term portfolio forthe quarter ended September 30, 2003. As of September 30, 2003, this restaurant group included ninerestaurants in the Austin area, two in College Station, Texas and one insuburban Atlanta, Georgia.  This groupincludes eleven freestanding restaurants (ten recently constructed and oneolder facility converted from another concept) and one shopping center endcaprestaurant.  In accordance with theCompany’s internal management reporting practices for consistent comparisons,line item categories have been expanded and percentages are calculated based ongross sales, instead of net sales as used elsewhere in this report.  Facility costs vary by restaurant becausesome facilities are rented and some are owned. The table provides the average percentage results for each line item forthe twelve Schlotzsky’s Deli restaurants in the long-term portfolio group as awhole, as well as the best and worst percentage performance for each line itemfor any restaurant in the group.

 

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|                                                                      |   | **Three Months  Ended  September 30,  2003** |   | **Percentage  of Gross  Sales** |   | **Best  Percentage  Performance** |   | **Worst  Percentage  Performance** |   |
|---------------------------------------------------------------------------|--------|----------------------------------------------|--------|---------------------------------|--------|-----------------------------------|--------|------------------------------------|--------|
|                                                                      |   | **(in thousands)**                           |   |                            |   |                              |   |                               |   |
| Gross  sales                                                              |   | $                                            | 3,507  |                            | 100.0  | %                                 |   |                               |   |   |
| Less-discounts                                                            |   | 162                                          |   | 4.6                             | %      | 3.0                               | %      | 5.8                                | %      |
| Net  sales                                                                |   | 3,345                                        |   | 95.4                            | %      |                              |   |                               |   |
|                                                                      |   |                                         |   |                            |   |                              |   |                               |   |
| Cost  of sales                                                            |   | 1,015                                        |   | 28.9                            | %      | 26.3                              | %      | 32.8                               | %      |
|                                                                      |   |                                         |   |                            |   |                              |   |                               |   |
| Personnel  and benefits:                                                  |   |                                         |   |                            |   |                              |   |                               |   |
| Crew  costs                                                               |   | 837                                          |   | 23.9                            | %      | 22.4                              | %      | 31.0                               | %      |
| Management  costs                                                         |   | 398                                          |   | 11.3                            | %      | 9.2                               | %      | 16.3                               | %      |
|                                                                      |   |                                         |   |                            |   |                              |   |                               |   |
| Operating  expenses:                                                      |   |                                         |   |                            |   |                              |   |                               |   |
| Advertising                                                               |   | 124                                          |   | 3.5                             | %      | 2.7                               | %      | 3.6                                | %      |
| Controllable  expenses                                                    |   | 283                                          |   | 8.1                             | %      | 5.4                               | %      | 10.0                               | %      |
| Operating  income before facility costs and depreciation and amortization |   | 688                                          |   | 19.6                            | %      | 25.3*                             | %      | 10.8                               | %*     |
|                                                                      |   |                                         |   |                            |   |                              |   |                               |   |
| Facility  costs                                                           |   | 162                                          |   | 4.6                             | %      | 1.3                               | %      | 9.6                                | %      |
|                                                                      |   |                                         |   |                            |   |                              |   |                               |   |
| Operating  income before depreciation and amortization                    |   | $                                            | 526    |                            | 15.0   | %                                 | 24.0** | %                                  | 4.5    | %** |

 

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* Represents the actualbest and worst percentage performance for a restaurant in the group.  The best and worst performance on acomposite basis would be 30.9% and 0.7%, respectively.

** Represents the actualbest and worst percentage performance for a restaurant in the group.  The best and worst performance on acomposite basis would be 29.6% and –8.9%, respectively.

 

**NINE MONTHS ENDEDSEPTEMBER 30, 2003 AND 2002**

 

REVENUE.  Total revenue decreased 9.3% to $41,941,000from $46,242,000.

 

ROYALTIES decreased 18.2%to $12,566,000 from $15,368,000.  Thedecrease was due to a decreased number of franchised restaurants during thenine month period in 2003 compared to the comparable period in 2002 and a decreasein same store contractual sales of 11.3%.

 

FRANCHISE FEES decreased67.7% to $20,000 from $62,000.  Thedecrease was principally the result of a lower fee for current year openings offranchised restaurants as compared to the same period in the prior year.  The decrease in franchise fee per restaurantopening is due to the openings in the current year being internationalrestaurants under master license agreements where our franchise fee is lower.

 

DEVELOPER FEES decreased26.8% to $131,000 from $179,000.  Thedecrease was primarily due to the expiration of amortization of fees receivedunder certain agreements.

 

RESTAURANT SALESdecreased 2.2% to $23,550,000 from $24,075,000.  The decrease was primarily due to a 8.5% decrease in same storesales during the first nine months of 2003, partially offset by an increase inthe average number of restaurants operated by the Company during the ninemonths ended September 30, 2003, compared to the comparable period of2002.  As of September 30, 2003, therewere 39 Company-operated restaurants, compared to 36 at September 30, 2002, ofwhich 25 and 21, respectively, were available for sale restaurants.

 

SCHLOTZSKY’S DELI BRANDLICENSING FEES (BRAND CONTRIBUTION) decreased 12.9% to $4,961,000 from$5,694,000.  The decrease was primarilydue to the decrease in systemwide contractual sales for the period.  Approximately 90% of these licensing feesare derived from sales to the franchise system and the remaining 10% todistribution channels outside Schlotzsky’s Deli restaurants.

 

OTHER FEES AND REVENUEdecreased 17.4% to $713,000 from $863,000. The decrease was due to a decrease in expired franchise fees.

 

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OPERATINGEXPENSES increased 12.2% to $48,419,000 from $43,152,000.

 

SERVICE COSTS decreased40.8% to $1,938,000 from $3,276,000, and as a percentage of royalties andfranchise fees declined to 15.4% from 21.3%. This decrease was primarily due tothe Company’s reacquisition of certain area developer territory rights duringthe third quarter of 2002, as well as a decrease in royalty revenue.

 

RESTAURANT OPERATIONSEXPENSES increased 5.2% to $23,308,000 from $22,147,000. The use of someCompany-operated restaurants in the long-term portfolio for product, processand equipment testing and for systemwide training also adversely impacts theiroperating performance.  On an overallbasis, costs, as a percentage of net restaurant sales, are higher atrestaurants available for sale, and the proportion of restaurants available forsale to total Company-operated restaurants was higher this year than last year.

 

RESTAURANTCOST OF SALES increased 2.7% to $6,939,000 from $6,755,000 and increased as apercentage of net restaurant sales to 29.5% from 28.1% due primarily to producttesting and an increase in beverage costs.

 

RESTAURANTPERSONNEL AND BENEFITS COST increased 5.1% to $10,268,000 from $9,767,000, andincreased as a percentage of net restaurant sales to 43.6% from 40.6%.  The increase, as a percentage of netrestaurant sales, was due to the effect of lower average sales on managersalaries, inefficiencies of a restaurant opened in the second quarter, andpreopening labor costs at two other restaurants.

 

RESTAURANTOPERATING EXPENSES increased 8.5% to $6,101,000 from $5,625,000 and increasedas a percentage of net restaurant sales to 25.9% from 23.4%.  The increase in operating costs, as apercentage of net restaurant sales, was primarily due to preopening costs on arestaurant opened the previous quarter and a restaurant under development aswell as a tax assessment on one restaurant location.

 

EQUITYLOSS ON INVESTMENTS increased to a loss of $472,000 from a loss of$137,000.  The equity investmentrepresents the Company’s 50% interest in a limited liability company thatoperates a Schlotzsky’s Deli restaurant that opened in 2000.

 

GENERAL ANDADMINISTRATIVE EXPENSES increased 33.6% to $18,898,000 from $14,149,000, andincreased to 45.1% from 30.6% as a percentage of total revenue. The increasefrom the prior year period was principally due to increased provisions foruncollectible accounts and debt guarantees, increased franchisee meeting andconvention expense, increased legal and professional expenses, accrual ofseparation costs and the recognition of previously deferred financing coststhat were recognized in the third quarter due to the uncretain timing and termsof a securitized debt offering.

 

DEPRECIATION ANDAMORTIZATION increased 10.5% to $3,803,000 from $3,443,000.  The increase was primarily due to theamortization of reacquired area developer territory rights and depreciationrelated to an increase in the average number of Company-operated restaurantsduring the first nine months of 2003 as compared to the prior year period.

 

INTEREST INCOME decreased39.4% to $261,000 from $431,000.  Thedecrease was due to the decrease in the amount of outstanding notes receivable,an increase in the nonrecognition of interest income on certain underperformingnotes receivable, and the cash receipt of $77,000 in interest on a nonaccruingnote receivable in the first nine months of 2002.

 

INTEREST EXPENSEincreased 45.0% to $2,980,000 from $2,055,000 due primarily to the incurrenceof debt related to the Company’s acquisition of territorial rights of theCompany’s largest area developer in middle of the third quarter of 2002.

 

PROVISION FOR INCOMETAXES reflected a combined federal and state effective tax benefit rate of33.6% for the nine months ended September 30, 2003, which was lower than theeffective combined tax rate 40.2% for the comparable period in 2002 primarilydue to certain state taxes being based in part on factors other than income.

 

NET INCOME decreased to aloss of $6,110,000 from income of $876,000 due to the factors discussedabove.  Earnings per share, both basicand diluted, were (0.83) for the nine months ended September 30, 2003 comparedto $0.12 in the comparable period in the prior year.

 

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**SupplementalRestaurant Operations Information – Performance of Long-term Portfolio Deli Restaurants**

 

The following table ispresented for the Schlotzsky’s Delis in the Company’s long-term portfolio forthe nine months ended September 30, 2003. As of September 30, 2003, this restaurant group included nine restaurantsin the Austin area, two in College Station, Texas and one in suburban Atlanta,Georgia.  This group includes elevenfreestanding restaurants (ten recently constructed and one older facilityconverted from another concept) and one shopping center endcap restaurant.  In accordance with the Company’s internalmanagement reporting practices for consistent comparisons, line item categorieshave been expanded and percentages are calculated based on gross sales, insteadof net sales as used elsewhere in this report. Facility costs vary by restaurant because some facilities are rented andsome are owned.  The table provides theaverage percentage results for each line item for the twelve Schlotzsky’s Delirestaurants in the long-term portfolio group as a whole, as well as the bestand worst percentage performance for each line item for any restaurant in thegroup.

 
|                                                                      |   | **Nine Months  Ended  September 30,  2002** |   | **Percentage  of Gross  Sales** |   | **Best  Percentage  Performance** |   | **Worst  Percentage  Performance** |   |
|---------------------------------------------------------------------------|--------|---------------------------------------------|--------|---------------------------------|--------|-----------------------------------|--------|------------------------------------|--------|
|                                                                      |   | **(in thousands)**                          |   |                            |   |                              |   |                               |   |
| Gross  sales                                                              |   | $                                           | 10,979 |                            | 100.0  | %                                 | 4.5    | %                                  | 6.0    | % |
| Less-discounts                                                            |   | 556                                         |   | 5.1                             | %      |                              |   |                               |   |
| Net  sales                                                                |   | 10,423                                      |   | 94.9                            | %      |                              |   |                               |   |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Cost  of sales                                                            |   | 3,021                                       |   | 27.5                            | %      | 25.8                              | %      | 29.7                               | %      |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Personnel  and benefits:                                                  |   |                                        |   |                            |   |                              |   |                               |   |
| Crew  costs                                                               |   | 2,579                                       |   | 23.5                            | %      | 22.0                              | %      | 26.4                               | %      |
| Management  costs                                                         |   | 1,243                                       |   | 11.6                            | %      | 9.4                               | %      | 16.9                               | %      |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Operating  expenses:                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Advertising                                                               |   | 565                                         |   | 5.1                             | %      | 3.6                               | %      | 5.2                                | %      |
| Controllable  expenses                                                    |   | 820                                         |   | 7.5                             | %      | 5.7                               | %      | 9.4                                | %      |
| Operating  income before facility costs and depreciation and amortization |   | 2,195                                       |   | 20.0                            | %      | 24.4                              | %*     | 13.0                               | %*     |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Facility  costs                                                           |   | 484                                         |   | 4.4                             | %      | 1.3                               | %      | 9.6                                | %      |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Operating  income before depreciation and amortization                    |   | $                                           | 1,711  |                            | 15.6   | %                                 | 23.1   | %**                                | 3.4    | %** |

 

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* Represents the actualbest and worst percentage performance for a restaurant in the group.  The best and worst performance on acomposite basis would be 29.0% and 6.3%, respectively.

** Represents the actualbest and worst percentage performance for a restaurant in the group.  The best and worst performance on acomposite basis would be 27.7% and –3.3%, respectively.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

TheCompany has outstanding guarantees of indebtedness of others, including relatedparties, of approximately $27.5 million as of September 30, 2003. Theseguarantees include approximately $5.7 million of lease guarantees for thebenefit of franchisees, approximately $13.5 million of mortgage loan guaranteesfor the benefit of franchisees and approximately $8.3 million of loanguarantees for the benefit of related parties.

 

Thelease guarantees for the benefit of franchisees arose primarily through ourformer Turnkey program, in which the Company developed the restaurants, leasedthe restaurants to franchisees, and then sold them to a leasing company.  The guarantees range from limitedguarantees, either in dollar amount or term, to full guarantees for the life ofthe lease.  The maximum guarantee for asingle lease is approximately $1.3 million. Certain guarantees extend through 2018. The Company may be required by the lessor to make monthly rentalpayments or property tax and common area maintenance payments if the franchiseedoes not make the required payments in a timely manner.  The Company has indemnification agreementswith the franchisee under which the franchisee would be obligated to reimbursethe Company for any amounts paid under such guarantees.  As of September 30, 2003, the Company hadaccrued a liability of approximately $605,000 related to these guarantees,including a $574,000 provision made in the quarter ended June 30, 2003.  The Company also has a net deferred gainrelated to the sale of these leases in the amount of approximately $342,000 asof September 30, 2003.

 

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Themortgage loan guarantees for the benefit of franchisees also arose primarilythrough the Company’s former Turnkey program, in which we developed the relatedrestaurants, sold the restaurant to a franchisee, and guaranteed all or aportion of the franchisee’s mortgage loan. The guarantees range from limited guarantees, either in dollar amount orterm, to full guarantees of the mortgage. The maximum amount of a single guarantee is approximately $1.0million.  Certain guarantees extendthrough 2016.  The Company may berequired by the lender to make monthly mortgage payments if the franchisee doesnot make the required payments in a timely manner, or the Company may berequired to make up any deficiency, up to the amount of the guarantee, if therelated restaurant is sold for net proceeds less than the amount of theoutstanding mortgage.  The Company hasindemnification agreements with the franchisees under which the franchiseewould be obligated to reimburse the Company for any amount paid under suchguarantees.  In the event that theCompany purchases the loan from the lender in the event of a default, theCompany would succeed to the lender’s security interest in the relatedproperty.

 

Theloan guarantees in favor of related parties primarily arose when the Companyguaranteed certain debt of related parties for which the proceeds of the loanswere used to repay outstanding debt to the Company.  Two of the guarantees, for the benefit of our restaurant ventureand our real estate venture, are of mortgage debt totaling approximately $4.1million.  These guarantees extendthrough 2009 on one note and through 2016 on the other note.  A third guarantee, of a bank note in theamount of approximately $4.2 million as of September 30, 2003, is for thebenefit of the advertising entity of the Schlotzsky’s Deli restaurant system,for which the Company had received a portion of the net proceeds of the loan inrepayment of outstanding debt to the Company. This guarantee expires in 2004. In connection with the original guarantee of the $4.3 millionadvertising entity bank note, which was made in June 2003, a liability in theamount of $43,000 was accrued under the terms of FASB Interpretation No. 45.

 

The Company has been called upon, from time to time,to make payments on obligations the Company has guaranteed.  During the first nine months of 2003, theCompany paid approximately$534,000 in various lease guarantees for the benefit of franchisees.  In addition, pursuant to a guarantee of afranchisee’s debt obligation, the Company purchased that obligation from abank, in the amount of approximately $665,000, of which approximately $298,750is mature and past due, and is expected to be paid in full by the end of theyear.

 

### **LIQUIDITY AND CAPITALRESOURCES**

 

Cashand cash equivalents decreased $187,000 in the nine months ended September 30,2003, and decreased $2,277,000 in the nine months ended September 30,2002.  Cash flows are impacted byoperating, investing and financing activities.

 

Operating activitiesprovided $5,862,000 of cash in the first nine months of 2003 and $3,844,000 ofcash in the first nine months of 2002.  The increase in cashprovided was the net result of a decreased use of cash for certain workingcapital accounts, increased provision for uncollectible accounts and debtguarantees, increased depreciation and amortization and a decrease in theamount of deferred revenue amortized, partially offset by a net loss for theperiod and provision (credit) for deferred taxes.

 

Investing activitiesprovided $402,000 and used $2,688,000 of cash in the first nine months of  2003 and 2002, respectively.  The decrease in cash used in 2003 comparedto 2002 was the net result of an increase in proceeds from the sale of realestate held for sale and increase in collections of notes receivable, partiallyoffset by a decrease in expenditures for intangible assets and newCompany-operated restaurants.

 

Financingactivities used $6,450,000 and $3,434,000 of cash in the first nine months of2003 and 2002, respectively.  Theincrease in cash used in the first nine months of 2003 compared to the comparable period of2002 is primarily the net result of increased repayments of debt, partiallyoffset by increased borrowings and reduced sales of common stock.

 

At September 30, 2003, wehad approximately $50,420,000 of total debt outstanding.  Scheduled maturities of debt throughSeptember 30, 2004 approximate $9,771,000 (including short-term debt).  In addition, one of our mortgages requiresthe application to the mortgage of the net cash proceeds from the sale ofcertain real estate held for sale.

 

Certain of our mortgagedebt require the maintenance of certain financial ratios, includingdebt-to-equity and working capital.  AtSeptember 30, 2003, the Company was in compliance with or had obtained waiverof such covenants.  However, any failureto remain in compliance with the restrictive covenants of the Company’smortgages in the future could have material adverse consequences to theCompany.

 

The following tablespresent certain of our obligations to make future payments, excluding interestpayments, under contracts and contingent commitments as of September 30, 2003(dollars in thousands):

 

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|                         |   | **Payments Due by Period  As of September 30, 2003** |   |
|------------------------------|--------|------------------------------------------------------|--------|
| **Contractual  Obligations** |   | **Total**                                            |   | **Less than 1  year** |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
|                         |   |                                                 |   |   |   |   |   |   |   |   |   |
| Short-term  Debt             |   | $                                                    | 1,009  |   | $ | 1,009 |   | $ | — |   | $ | — |   | $ | — |   |
| Long-term  Debt              |   | 49,411                                               |   | 8,762 |   | 29,759 |   | 2,139 |   | 8,751 |   |
| Operating  Leases            |   | 19,478                                               |   | 2,458 |   | 6,244 |   | 2,224 |   | 8,552 |   |
|                              |        |                                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **Other  Commercial  Commitments** |   | **Total  Amounts  Committed** |   | **Amount of Commitment Expiration Per Period  As of September 30, 2003** |   |
|------------------------------------|--------|-------------------------------|--------|--------------------------------------------------------------------------|--------|
| **Less than 1  year**              |   | **1-3 years**                 |   | **4-5 years**                                                            |   | **After 5 years** |   |
| Guarantees                         |   | $                             | 27,475 |                                                                     | $      | 9,750 |   | $ | 2,072 |   | $ | 2,472 |   | $ | 13,181 |   |
|                                    |        |                               |        |                                                                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

We have experienced netreductions in the number of restaurants systemwide quarterly since early 2000and have experienced negative same store contractual sales quarterly sincemid-2001.  While we have developed and implemented strategies, includingthe re-imaging of restaurants, the introduction of an enhanced menu with newitems and combinations, workforce reductions, general and administrativeexpense reductions, salary adjustments, and the resumed marketing of ourfranchise licensing program, in an effort to reverse and mitigate the impact ofthese trends, we expect that the number of restaurants will continue to declineduring the fourth quarter of 2003 and possibly thereafter.  Continuation of these trends would have amaterial adverse impact on our royalty revenue, brand contribution, cash flowand liquidity.

 

On July 31, 2003 weeffected a reduction in force eliminating 39 positions on the corporate staff,reducing the personnel employed at our corporate headquarters or as fieldpersonnel to approximately 110.  We believe that these reductions, alongwith certain salary adjustments, began to impact operating results in the thirdquarter of 2003, but were offset by separation expenses incurred during thethird quarter of 2003.  The impact of these position reductions and salaryadjustments will begin to be reflected in the fourth quarter of 2003, but wewill not see the full effect until 2004.  We have developed and areimplementing plans to significantly reduce non-compensation general andadministrative expenses and certain employee benefits in an effort to achieve areduction in total general and administrative expenses of at least$4 million on an annualized basis.

 

We plan to developadditional Company-operated restaurants in the future.  One Company-operated restaurant opened inthe Austin area in June 2003.  We also have acquired building sitesfor four additional restaurants in the Austin area and entered into a lease fora site in the Houston area. Sites for additional restaurants in Texas and othermarkets are under consideration.  However, we do not plan to pursuedevelopment of these sites until we have obtained the necessary financing tofund this growth in our Company-operated restaurants.

 

We are currently attempting to generate additionalworking capital with third party financing and are pursuing financingalternatives, including senior debt,real estate mortgages, and asset-backed financing secured by ourintellectual property and related royalty rights and agreements.  While weare in discussions with several potential lenders at this time, there can be noassurances that such financing will be available or accomplished.  Should these discussions not result in anacceptable financing, we would need to continue to seek additional financingthat would be sufficient, with our operating income, to allow us to fund ouroperating expenses and debt service.  If the Company is unable to obtainadequate financing during the fourth quarter of 2003 or is unable to negotiatewaivers or favorable payment terms with creditors, the Company's ability tofund its continuing operations and working capital needs would be materiallyadversely affected.

 

Because of the decline inrestaurant count and the debt obligation under certain seller financed debtwhich matures in 2005, the Company has increased its accounts payable during2003.  The Company has extended thepayment terms for many of its vendors, and this change in terms is primarilyresponsible for the $3,953,000 shown as changes in accounts payable.  Waivers and deferred payment terms have beennegotiated and, in some cases, are being negotiated with certain of thesecreditors.  The Company intends toimprove vendor terms once its liquidity situation improves, and plans on usingfuture financing to reduce accounts payable and improve aging of vendoraccounts.

 

Schlotzsky’s Franchisor,LLC entered into a loan agreement in November 2003 in the amount ofapproximately $2,500,000 with John C. Wooley and Jeffrey J. Wooley (the“Loan”).  The Loan is secured generallyby our intellectual property, contract rights, and other intangibles.  The Loan matures in January 2004 and has aninterest rate of 6.75%.  The proceeds ofthe Loan will be used to pay certain accounts payable and to provide additionalliquidity to the Company while we seek a longer term financing solution.  In connection with the Loan, theWooleys willreceive $1.00 as payment.  The Wooleyshave provided several additional personal guarantees in the past for otherloans and leases to the Company and its affiliates, including our advertisingfund.

 

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Management’s Discussionand Analysis of Financial Condition and Results of Operations in this Form 10-Qshould be read in conjunction with Management’s Discussion and Analysis ofFinancial Condition and Results of Operations and other material included inthe Company’s Annual Report on Form 10-K for the year ended December 31,2002.

 

**Forward-Looking Statements**

 

This report may contain“forward-looking statements” within the meaning of Section 27A of theSecurities Act, Section 21E of the Exchange Act, or the Private SecuritiesLitigation Reform Act of 1995.  Anystatements that are not statements of historical fact may be deemed forward-lookingstatements.  Forward-looking statements are not meant to predict or guaranteeactual results, performance, events, or circumstances and may not be realizedbecause they are based on our current projections, plans, objectives, beliefs,expectations, estimates, and assumptions and are subject to a number of riskfactors and uncertainties, many of which are beyond our control.  Actual results and the timing of futureevents and circumstances may differ materially from those described or impliedby the forward-looking statements as a result of these risk factors anduncertainties.  Forward-lookingstatements may include, without limitation, statements concerning earnings orother financial item projections, the plans and objectives of management,future economic performance, new restaurant development, future Schlotzsky’sDeli brand products, and assumptions underlying or relating to any otherforward-looking statement.  Factors thatcould cause actual results to differ materially from those described in the forward-looking statementsmay include, without limitation, an inabilityof the Company or our franchisees to obtain adequate financing, an inability tomake full and timely payments or satisfy other obligations to creditors andother accounts payable, increased competition within the restaurantindustry, the continued viability of restaurants during a weak economy, theresults of arbitration and litigation, an inability to sell restaurants, afailure to successfully recruit multi-unit and single-unit franchisees, failureto adequately motivate franchisees to remodel and reimage their restaurants andto fully implement the enhanced menu,and stock volatility and illiquidity.

 

Because of the risks anduncertainties related to these factors and the forward-looking statements, readers are cautioned not to place unduereliance on the forward-looking statements. There can be no assurance that any events or results described inany forward-looking statement will actually occur or be achieved.  Weundertake no obligation to publicly revise the forward-looking statements toreflect events or circumstances that arise after the date of this report or toreflect new information, future events or circumstances, changes inassumptions, or otherwise.  Readers should carefully review the riskfactors described above and in other documents filed by us with theCommission.  Readers are specificallydirected to the discussion under “Risk Factors” in our most recent annualreport on Form 10-K.

 

**ITEM 3.**** ****                                               QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

At September 30, 2003, ahypothetical 100 basis point increase in interest rates would result in adecrease of approximately $67,000 in annual pre-tax earnings.  The estimated decrease is based upon theincreased interest expense of the Company’s variable rate debt and assumes nochange in the volume or composition of debt at September 30, 2003.

 

**ITEM 4****. ****                                               CONTROLSAND PROCEDURES**

 

(a)                                  Evaluation of Disclosure Controls andProcedures.** **The term “disclosure controls and procedures”is defined in Rule 13a - 15(e) and 15d - 15(e) of the Securities Exchange Actof 1934, or the Exchange Act.  This termrefers to the controls and procedures of a company that are designed to ensurethat information required to be disclosed by a company in the reports it filesor submits under the Exchange Act is recorded, processed, summarized andreported within the required time periods. Our management, including the Chief Executive Officer and our Controllerhave evaluated the effectiveness of our disclosure controls and procedures asof the end of the period covered by this report, and they have concluded that,our disclosure controls and procedures were effective as of the end of theperiod covered by this report.

 

(b)                                 Changes in InternalControls.  We maintain a system of internalcontrols that are designed to provide reasonable assurance that our books andrecords accurately reflect, in all material respects, our transactions and thatour established policies and procedures are followed.  There were no significant changes to our internal controls thatcould significantly affect our internal controls subsequent to the date oftheir evaluation by our Chief Executive Officer and Controller, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 

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**PART II**

**OTHER INFORMATION**

 

**ITEM 1****.****  LEGALPROCEEDINGS**

 

*NewFlorida Markets, Ltd. v. Schlotzsky’s, Inc., Schlotzsky’s Franchise LimitedPartnership, Schlotzsky’s Franchisor, LLC, Schlotzsky’s Franchise Operations,LLC, Schlotzsky’s NAMF, Inc., and Schlotzsky’s NAMF Funding, LLC*,(Case No. 701140045603) wasfiled on or about June 23, 2003 with the American Arbitration Association.  Claimant is the area developer for theTampa, Orlando, and West Palm Beach development areas.  On July 14, 2003, Deli Keys, Ltd., an areadeveloper for the Miami development area, joined the arbitration as anadditional Claimant. They allege that Respondents frustrated their ability todevelop, in part because of the Company’s Turnkey program.  Claimant also alleges Respondents breachedthe Area Developer Agreements by failing to provide adequate licensing support,negotiating with license prospects, failing to establish and administer a localadvertising group, pledging royalties, changing the area developer manual,refunding franchise fees, and forcing Claimants to purchase errors andomissions insurance.  Other claimsinclude breach of the implied covenant of good faith and fair dealing,constructive termination, and violation of the Texas Deceptive Trade PracticesAct.  Claimants seek actual,compensatory, and punitive damages of an unspecified amount, attorneys’ fees,and costs.  The case is not yet set forhearing.

 

*ComericaBank vs. James E. Wright, John D. Wright, Lorraine Wright, and Kimberly Wrightv. Schlotzsky’s, Inc. and Schlotzsky’s Real Estate, Inc.,*inthe Circuit Court for the County of Genessee, State of Michigan (Case No.02-74931), was filed on or about June 30, 2003 as a Third Party Complaint in aforeclosure action.  Third PartyPlaintiffs are principals and guarantors of J. Wright Franchise Development,LLC, a former franchisee that had operated a Schlotzsky’s Deli in Grand Blanc,Michigan and filed Chapter 11 bankruptcy. In January 2003, Schlotzsky’s RealEstate, Inc. filed suit against John and James Wright for collection of$283,872.68 due under a promissory note. In the instant case, Third Party Plaintiffs allege that they wereinduced into participating in the Company’s Turnkey program and that anemployee of the Company represented that the restaurant would attain a certainlevel of sales.  Third Party Plaintiffs’claims include fraud in the inducement, fraudulent and negligentmisrepresentation, and breach of the Michigan Franchise Investment Act.  They seek damages of an unspecified amountin excess of $25,000, attorneys’ fees, and costs.  The case is not yet set for trial.

 

*RussellR. Kesterson and Steven P. Schmidt v. Schlotzsky’s, Inc., Ron Lynch andJane Doe Lynch, John Does I—X, Jane Does I—X, ABC Corporations I—X, XYZCompanies I—X*, (Case No. CV2002-021158) was filed onOctober 31, 2002, in the Superior Court of Maricopa County, Arizona.Plaintiffs were franchisees of the Company and owned and operated aSchlotzsky’s Deli restaurant in Phoenix, Arizona. The Complaint includes claimsof breach of contract, interference with business expectancy, interference withbusiness relationship, unfair competition and negligence. Plaintiffs allegethat a “superstore” owned by Lynch and/or our affiliates encroached on theirbusiness and allege that we failed to collect royalties from the “superstore,”creating unfair competition. Plaintiffs further state that they attempted torelocate their restaurant but that we failed to approve a proposed alternativelocation and that we induced one of their employees to work for a competingrestaurant. Plaintiffs are seeking an unspecified amount of damages, includingtreble damages, attorney’s fees, and costs. On December 3, 2002, we fileda petition styled *Schlotzsky’s, Inc.,v. Russell R. Kesterson and Steven P. Schmidt*, in the United StatesDistrict Court for the Western District of Texas, Austin Division (Civil ActionNo. AO2CA 768SS) to compel Plaintiffs to arbitrate their claims in Austin,Texas. The federal court entered an order on December 20, 2002, grantingour petition to compel arbitration in the manner provided in the franchiseagreement and enjoined Kesterson and Schmidt from pursuing any of their claimsin the lawsuit pending in Arizona. To date, we are unaware of any subsequentdemand for arbitration filed by either Kesterson or Schmidt.

 

*Robert Coshott v.Schlotzsky’s, Inc.* (Cause No. GN 1-02279), was filed onJuly 24, 2001, in the 200th Judicial District Court of Travis County,Texas. Plaintiff is the Master Licensee for Australia and New Zealand, and heopened a Schlotzsky’s Deli restaurant in Melbourne, Australia. Plaintiff bringscauses of action for fraud and/or negligent misrepresentation. Plaintiffalleges that he experienced problems with certain equipment specified orapproved by the Company, that the Company’s system and equipment did notgenerate enough finished food product to service his potential customers; thatthe Company misrepresented the level of revenue the restaurant could reasonablybe expected to achieve; that the Company delayed his ability to developrestaurants by failing to timely secure certain trademarks and trade names; andthat the Company misrepresented whether it would allow Plaintiff to franchiseSchlotzsky’s Deli restaurants in certain gas station or convenience storelocations in his territories. Plaintiff requests actual and punitive damages of$3.75 million plus lost profits and incidental and consequential damagesof an unspecified amount. The case is not yet set for trial. On July 23, 2003,Coshott also filed a Demand for Arbitration with the International Chamber ofCommerce styled *Robert Gilbert Coshott v. Schlotzsky’s, Inc.* (Case. No.TBD).  The claims in the Demand aresimilar to those brought in the above-entitled action and include additionalallegations that the Company required the purchase of goods and services fromcertain suppliers in violation of the Trade Practices Act of 1974 and that theCompany failed to disclose the existence of a predecessor Master LicenseAgreement, 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.  At present, no arbitration hearing date hasbeen set.  

 

*DaeKim, DWK Enterprises, Inc., and Aecon International, Inc. v. JohnWooley, Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership,Schlotzsky’s N.A.M.F., Inc., Schlotzsky’s National AdvertisingAssociation, Inc., and Schlotzsky’s, Brands, Inc.,*

 

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*Schlotzsky’sBrand Products, L.P., Schlotzsky’s Real Estate, Inc., and Schlotzsky’sRestaurants, Inc.* (Cause No. 2001-CI-13672) wasoriginally filed in the 73rd Judicial District Court of Bexar County, Texas onor about September 25, 2001 (after a similar lawsuit was filed and laterwithdrawn in Harris County, Texas) against Schlotzsky’s, Inc., JohnWooley, Schlotzsky’s Franchising Limited Partnership, and Schlotzsky’sNAMF, Inc. (collectively, “Defendants”). Plaintiffs are, or claim to be,franchisees in Houston and San Antonio Texas, and Plaintiff Kim was an areadeveloper for those markets. Plaintiffs bring causes of action for breach ofcontract, breach of fiduciary duty, breach of the duty of good faith and fairdealing, civil conspiracy, tortious interference with contract, tortiousinterference with prospective business relationship, violation of the TexasDeceptive Trade Practices and Consumer Protection Act, restraint of trade,detrimental reliance-fraud in the inducement, and defamation-businessdisparagement. They seek an unspecified amount of money damages plus exemplarydamages, attorneys’ fees, pre-judgment interest, costs, and a jury trial.Defendants, except for Mr. Wooley, who was previously dismissed from thecase, answered and asserted counterclaims alleging breach of contract and thatPlaintiffs’ claim under the Texas Deceptive Trade Practices Act is groundlessin fact or in law and brought in bad faith or for the purpose of harassment,and seeking money damages, costs of court, penalty fees, costs incurred inperforming the accounting, attorneys’ fees, and pre- and post-judgmentinterest. Defendants (except for Mr. Wooley) removed the case to federalcourt. The case was remanded to state court on April 17, 2003.  The caseis not yet set for trial.

 

*U.S. Restaurant Properties OperatingL.P. v. Schlotzsky’s, Inc.* (Cause No. 03-01758) wasfiled on February 27, 2003, in the District Court of Dallas County, B-44thJudicial District.  Plaintiff is a real estate investment company thatowns certain Schlotzsky’s Deli restaurants and leases them to franchisees. Italleges that in 1997 and 1998 we entered into several agreements where weagreed to guarantee certain lease agreements. Plaintiff states that in 1998 theparties entered into an agreement whereby Plaintiff agreed to releaseSchlotzsky’s from its guaranty obligations pertaining to six properties inwhich the tenants had defaulted, in exchange for Schlotzsky’s agreement topurchase seven other properties. The Company purchased one of the propertieslocated in Texas. Plaintiffs are seeking an order requiring us to purchase theother six properties, two of which are in Texas, and one each in Arizona,Colorado, Indiana, and Tennessee, for a total purchase price of over$4.5 million. In the alternative, Plaintiff is seeking damages or an orderreinstating the previously released guaranties. Plaintiff’s claims includebreach of contract and a request for attorneys’ fees. A trial date has been setfor February 16, 2004.

 

See also the discussionunder "Legal Proceedings" in the Company's Form 10-Q filed August 14,2003 and Form 10-Q filed May 15, 2003.

 

In addition to thematters discussed above, we are defendants in various other legal proceedingsarising from our business. The ultimate outcome of these pending proceedingscannot be projected with certainty. However, based on our experience to date,we believe such proceedings will not have a material effect on our business orfinancial condition.

 

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**ITEM 2.****     CHANGES IN SECURITIES AND USE OFPROCEEDS**

 

None.

 

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

 

None.

 

**ITEM 4.****     SUBMISSION OF MATTERS TO A VOTE OFSECURITY 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)                                                                                                                                                               |
|   |   |                                                                                                                                                                                                        |
| 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)                                                                                                        |
|   |   |                                                                                                                                                                                                        |
| 10.49  |   | Modification,  Extension and Renewal dated October 31, 2003 of that certain Promissory Note  dated April 8, 2003, between the Company as borrower and John C. Wooley and  Jeffrey J. Wooley as lenders. (5) |
|   |   |                                                                                                                                                                                                        |
| 10.50  |   | Promissory  Note dated November 14, 2003, between the Company and John C. Wooley and  Jeffery J. Wooley (5)                                                                                                 |
|   |   |                                                                                                                                                                                                        |
| 10.51  |   | Security Agreement  dated November 14, 2003, between the Company and John C. Wooley and Jeffery  J. Wooley (5)                                                                                              |
|   |   |                                                                                                                                                                                                        |
| 31.1   |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by John C.  Wooley, Chief Executive Officer.  (5)                                                                     |
|   |   |                                                                                                                                                                                                        |
| 31.2   |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by Matthew  D. Osburn, Principal Financial Officer.   (5)                                                             |
|   |   |                                                                                                                                                                                                        |
| 32.1   |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by John C.  Wooley, Chief Executive Officer.  (5)                                                                     |
|   |   |                                                                                                                                                                                                        |
| 32.2   |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Matthew  D. Osburn, Principal Financial Officer.   (5)                                                             |

 

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(1)          Incorporated by reference from the Company’s Registration Statement onForm S-1 filed on October 12, 1995, as amended.

 

(2)          Incorporated by referenced from the Company’s Registration of certainSecurities on Form 8-A filed on December 18, 1998.

 

(3)          Incorporated by reference from the Company’s Annual Report on Form 10-Kfiled on April 2, 2001.

 

(4)          Incorporated by reference from the Company’s Quarterly Report on Form10-Q filed on August 14, 2003.

 

(5)          Filed with this Quarterly Report on Form 10-Q.

 

b)             Current Reports on Form 8-K:

 

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The Registrant filed aCurrent Report on Form 8-K dated April 3, 2003, containing a press releasedated March 28, 2003, announcing the Company’s release of financial results forthe quarter and fiscal year ended December 31, 2002.

 

TheRegistrant filed a Current Report on Form 8-K dated May 15, 2003, containing apress release dated May 15, 2003, announcing the Company’s release of financialresults for the quarter ended March 31, 2003.

 

TheRegistrant filed a Current Report on Form 8-K dated June 24, 2003, containing apress release dated June 23, 2003, announcing the results of shareholder votingat the Company’s Annual Meeting of Shareholders held on June 23, 2003.

 

TheRegistrant filed a Current Report on Form 8-K dated August 4, 2003, containinga press release dated July 31, 2003, announcing a realignment and reduction inforce effected on July 31, 2003.

### ** **

TheRegistrant filed a Current Report on Form 8-K dated August 14, 2003, containinga press release dated August 14, 2003, announcing the Company’s release offinancial results for the quarter ended June 30, 2003.

 

TheRegistrant filed a Current Report on Form 8-K dated November 14, 2003,containing a press release dated November 14, 2003, announcing the Company’srelease of financial results for the quarter ended September 30, 2003.

### ** **

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### **SIGNATURES**

 

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

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

 

 

Austin,Texas

November14, 2003

 

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