**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

 

**Quarterly report pursuant to Section 13 or 15(d)**

**of the Securities Exchange Act of 1934**

 

**For the quarterlyperiod ended June 30, 2003**

 

**Commission FileNumber: 0-27008**

 

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**Schlotzsky’s, Inc.**

(Exact name of registrant as specified in its charter)

 

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

 

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

(Address of principal executive offices)

 

**(512) 236-3800**

(Registrant’s telephone number)

 

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Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ýNo o

 

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

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.

 

| **Class**                  |   | **Shares Outstanding at August 6, 2003** |
|----------------------------|--------|-----------------------------------------------|
| Common Stock, no par value |   | 7,331,999                                     |

 

 

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**SCHLOTZSKY’S, INC.**

 

**Index to Form 10-Q**

**Quarter EndedJune 30, 2003**

 
| **Part I**  | **FINANCIAL INFORMATION** |
|-------------|---------------------------|
|        |                      |
|        | Item 1.                   | Financial Statements |
|        |                      |   |
|        |                      | Condensed Consolidated Balance Sheets –  June 30, 2003 and December 31, 2002 |
|        |                      |   |
|        |                      | Condensed Consolidated Statements of Income  –  Three and Six Months Ended June 30, 2003 and June 30, 2002 |
|        |                      |   |
|        |                      | Condensed Consolidated Statement of  Stockholders’ Equity –  Six Months Ended June 30, 2003 and Year Ended December 31, 2002 |
|        |                      |   |
|        |                      | Condensed Consolidated Statements of Cash  Flows –  Six Months Ended June 30, 2003 and June 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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**PART I**

**FINANCIAL INFORMATION**

 

**ITEM 1.                  FINANCIALSTATEMENTS**

 

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

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                    |   | **June 30,  2003** |        | **December 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|-------------|-----------------------------|--------|
|                                                                                                                                                                    |   | **(Unaudited)**         |        |                        |   |
| **ASSETS**                                                                                                                                                              |   |                    |        |                        |   |
| Current Assets:                                                                                                                                                         |   |                    |        |                        |   |
| Cash and cash equivalents                                                                                                                                               |   | $                       | 780,227     |                        | $      | 678,895 |   |
| Accounts receivable, net:                                                                                                                                               |   |                    |        |                        |   |
| Royalties                                                                                                                                                               |   | 828,866                 |        | 650,376                     |   |
| Brands                                                                                                                                                                  |   | 1,072,845               |        | 1,269,759                   |   |
| Other                                                                                                                                                                   |   | 1,416,015               |        | 1,332,990                   |   |
| Refundable income taxes                                                                                                                                                 |   | 170,180                 |        | 1,837,628                   |   |
| Prepaids, inventories and other assets                                                                                                                                  |   | 1,282,396               |        | 1,356,516                   |   |
| Real estate held for sale                                                                                                                                               |   | 3,963,230               |        | 5,167,563                   |   |
| Current portion of notes receivable                                                                                                                                     |   | 782,192                 |        | 582,926                     |   |
| Deferred tax asset                                                                                                                                                      |   | 2,557,027               |        | 2,275,941                   |   |
| Total current assets                                                                                                                                                    |   | 12,852,978              |        | 15,152,594                  |   |
|                                                                                                                                                                    |   |                    |        |                        |   |
| Property, equipment and leasehold  improvements, net                                                                                                                    |   | 41,009,134              |        | 39,709,461                  |   |
| Notes receivable, net, less current portion                                                                                                                             |   | 8,654,581               |        | 11,349,705                  |   |
| Investments                                                                                                                                                             |   | 1,701,922               |        | 1,852,765                   |   |
| Intangible assets, net                                                                                                                                                  |   | 65,332,296              |        | 65,308,249                  |   |
| Goodwill, net                                                                                                                                                           |   | 3,192,342               |        | 2,985,679                   |   |
| Deferred tax asset                                                                                                                                                      |   | 165,739                 |        | —                      |   |
| Other noncurrent assets                                                                                                                                                 |   | 918,051                 |        | 1,168,029                   |   |
| Total assets                                                                                                                                                            |   | $                       | 133,827,043 |                        | $      | 137,526,482 |   |
|                                                                                                                                                                    |   |                    |        |                        |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                           |   |                    |        |                        |   |
| Current Liabilities:                                                                                                                                                    |   |                    |        |                        |   |
| Short-term debt                                                                                                                                                         |   | $                       | 1,375,000   |                        | $      | — |   |
| Current maturities of long-term debt                                                                                                                                    |   | 8,630,571               |        | 7,441,120                   |   |
| Accounts payable                                                                                                                                                        |   | 4,407,075               |        | 2,841,607                   |   |
| Accrued liabilities                                                                                                                                                     |   | 5,955,883               |        | 3,812,727                   |   |
| Deferred revenue, current portion                                                                                                                                       |   | 224,584                 |        | 234,552                     |   |
| Total current liabilities                                                                                                                                               |   | 20,593,113              |        | 14,330,006                  |   |
|                                                                                                                                                                    |   |                    |        |                        |   |
| Long-term debt, less current portion                                                                                                                                    |   | 40,669,395              |        | 46,063,599                  |   |
| Deferred revenue, less current portion                                                                                                                                  |   | 1,530,524               |        | 1,597,443                   |   |
| Deferred tax liability                                                                                                                                                  |   | —                  |        | 1,216,109                   |   |
| Total liabilities                                                                                                                                                       |   | 62,793,032              |        | 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, 7,509,412 shares and 7,496,778 shares issued at June 30,  2003 and December 31, 2002, respectively |   | 63,952                  |        | 63,826                      |   |
| Additional paid-in capital                                                                                                                                              |   | 58,170,617              |        | 58,122,469                  |   |
| Retained earnings                                                                                                                                                       |   | 13,642,598              |        | 16,976,186                  |   |
| Treasury stock (189,525 shares at  June 30, 2003 and December 31, 2002, respectively), at cost                                                                |   | (843,156                | )           | (843,156                    | )      |
| Total stockholders’ equity                                                                                                                                         |   | 71,034,011              |        | 74,319,325                  |   |
| Total liabilities and stockholders’ equity                                                                                                                         |   | $                       | 133,827,043 |                        | $      | 137,526,482 |   |

 

**The accompanying notes are an integral partof the condensed consolidated financial statements.**

 

1

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

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited)**

 
|                                                      |   | **Three months ended**  |       | **Six months ended**    |   |
|-----------------------------------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                                                      |   | **June 30,  2003** |       | **June 30,  2002** |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Revenue:                                                  |   |                    |       |                    |   |   |   |   |   |
| Royalties                                                 |   | $                       | 4,285,230  |                    | $      | 5,264,312 |   | $ | 8,589,118 |   | $ | 10,383,799 |   |
| Franchise fees                                            |   | 3,333                   |       | 42,000                  |   | 3,333 |   | 62,000 |   |
| Developer fees                                            |   | 44,228                  |       | 60,034                  |   | 94,387 |   | 120,067 |   |
| Restaurant sales                                          |   | 8,000,609               |       | 8,269,362               |   | 15,612,838 |   | 16,140,254 |   |
| Brand contribution                                        |   | 1,708,957               |       | 1,991,130               |   | 3,360,062 |   | 3,874,157 |   |
| Other fees and revenue                                    |   | 219,390                 |       | 276,294                 |   | 432,039 |   | 568,679 |   |
| Total revenue                                             |   | 14,261,747              |       | 15,903,132              |   | 28,091,777 |   | 31,148,956 |   |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Expenses:                                                 |   |                    |       |                    |   |   |   |   |   |
| Service costs:                                            |   |                    |       |                    |   |   |   |   |   |
| Royalties                                                 |   | 667,118                 |       | 1,106,100               |   | 1,330,910 |   | 2,241,368 |   |
| Franchise fees                                            |   | —                  |       | 15,955                  |   | — |   | 25,955 |   |
|                                                      |   | 667,118                 |       | 1,122,055               |   | 1,330,910 |   | 2,267,323 |   |
| Restaurant operations:                                    |   |                    |       |                    |   |   |   |   |   |
| Cost of sales                                             |   | 2,348,501               |       | 2,311,986               |   | 4,520,121 |   | 4,508,120 |   |
| Personnel and benefits                                    |   | 3,445,067               |       | 3,292,578               |   | 6,810,228 |   | 6,461,889 |   |
| Operating expenses                                        |   | 2,202,095               |       | 1,869,095               |   | 4,104,342 |   | 3,635,994 |   |
|                                                      |   | 7,995,663               |       | 7,473,659               |   | 15,434,691 |   | 14,606,003 |   |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Equity loss on investments                                |   | 83,693                  |       | 48,074                  |   | 150,843 |   | 78,294 |   |
| General and administrative                                |   | 6,712,589               |       | 4,835,390               |   | 11,783,304 |   | 9,315,277 |   |
| Depreciation and amortization                             |   | 1,282,595               |       | 1,086,438               |   | 2,532,001 |   | 2,169,731 |   |
| Total expenses                                            |   | 16,741,658              |       | 14,565,616              |   | 31,231,749 |   | 28,436,628 |   |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Income (loss) from operations                             |   | (2,479,911              | )          | 1,337,516               |   | (3,139,972 | ) | 2,712,328 |   |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Other:                                                    |   |                    |       |                    |   |   |   |   |   |
| Interest income                                           |   | 103,609                 |       | 94,618                  |   | 207,257 |   | 312,061 |   |
| Interest expense                                          |   | (1,009,968              | )          | (655,436                | )      | (2,025,873 | ) | (1,257,962 | ) |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Income (loss) before provision (credit) for  income taxes |   | (3,386,270              | )          | 776,698                 |   | (4,958,588 | ) | 1,766,427 |   |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Provision (credit) for income taxes                       |   | (1,119,000              | )          | 288,000                 |   | (1,625,000 | ) | 650,000 |   |
|                                                      |   |                    |       |                    |   |   |   |   |   |
| Net income (loss)                                         |   | $                       | (2,267,270 | )                       | $      | 488,698 |   | $ | (3,333,588 | ) | $ | 1,116,427 |   |
| Earnings per share-basic                                  |   | $                       | (0.31      | )                       | $      | 0.07 |   | $ | (0.46 | ) | $ | 0.15 |   |
| Earnings per share-diluted                                |   | $                       | (0.31      | )                       | $      | 0.07 |   | $ | (0.46 | ) | $ | 0.15 |   |

 

**The accompanyingnotes are an integral part of the condensed consolidated financial statements.**

 

2

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

**CONDENSEDCONSOLIDATED STATEMENT OF STOCKHOLDERS’ 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 |   | 12,634                |   | 126                        |   | 35,956                           |   | —                 |   | —              |       | 36,082 |   |
| Issuance of employee stock options                                        |   | —                |   | —                     |   | 12,192                           |   | —                 |   | —              |       | 12,192 |   |
| Net loss                                                                  |   | —                |   | —                     |   | —                           |   | (3,333,588             | )      | —              |       | (3,333,588 | ) |
| Balance, June 30, 2003                                               |   | 7,509,412             |   | $                          | 63,952 |                             | $      | 58,170,617             |   | $                   | 13,642,598 |   | $ | (843,156 | ) | $ | 71,034,011 |   |

 

**PREFERRED STOCK**

 

Authorized1,000,000 Class C shares, no par value; no shares outstanding at June 30,2002, December 31, 2001, or January 1, 2001.

 

**COMMON STOCK**

 

Authorized30,000,000 shares, no par value; 7,509,412 shares issued at June 30, 2003,7,496,778 shares issued at December 31, 2002, and 7,463,990 shares issuedat January 1, 2002.  Shares issuedinclude 189,525, 189,525 and 186,300 shares in treasury at June 30, 2003,December 31, 2002, and January 1, 2002, respectively.

 

**The accompanyingnotes are an integral part of the condensed consolidated financial statements.**

 

3

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

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
|                                                                                  |   | **For the  six months ended** |       |
|---------------------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                                  |   | **June 30,  2003**       |       | **June 30,  2002** |   |
| Cash flows from operating activities:                                                 |   |                          |       |   |   |
| Net income (loss)                                                                     |   | $                             | (3,333,588 | ) | $ | 1,116,427 |   |
| Adjustments to reconcile net income (loss)  to cash provided by operating activities: |   |                          |       |   |   |
| Depreciation and amortization                                                         |   | 2,532,001                     |       | 2,169,731 |   |
| Provision for deferred taxes                                                          |   | (1,683,020                    | )          | — |   |
| Provision for stock option compensation                                               |   | 12,192                        |       | — |   |
| Provision for uncollectible accounts                                                  |   | 1,539,563                     |       | 425,779 |   |
| Amortization of deferred revenue                                                      |   | (91,064                       | )          | (158,217 | ) |
| Equity loss on investments                                                            |   | 150,844                       |       | 78,294 |   |
| Changes in:                                                                           |   |                          |       |   |   |
| Accounts receivable                                                                   |   | 1,058,418                     |       | 129,515 |   |
| Prepaid expenses and other assets                                                     |   | 341,617                       |       | (415,847 | ) |
| Accounts payable and accrued liabilities                                              |   | 3,728,710                     |       | 179,357 |   |
| Net cash provided by operating activities                                             |   | 4,255,673                     |       | 3,525,039 |   |
|                                                                                  |   |                          |       |   |   |
| Cash flows from investing activities:                                                 |   |                          |       |   |   |
| Purchase of property, equipment and real  estate held for sale                        |   | (3,025,961                    | )          | (1,356,779 | ) |
| Sale of property, equipment and real estate  held for sale                            |   | 1,195,824                     |       | 814,403 |   |
| Acquisition of investments and intangible  assets                                     |   | (236,692                      | )          | (478,468 | ) |
| Issuance of notes receivable                                                          |   | (198,740                      | )          | (16,260 | ) |
| Repayments on notes receivable                                                        |   | 2,378,643                     |       | 42,912 |   |
| Net cash provided by (used in) investing activities                                   |   | 113,074                       |       | (994,192 | ) |
|                                                                                  |   |                          |       |   |   |
| Cash flows from financing activities:                                                 |   |                          |       |   |   |
| Sale of stock                                                                         |   | 36,082                        |       | 85,191 |   |
| Acquisition of treasury stock                                                         |   | —                        |       | (19,914 | ) |
| Proceeds from issuance of debt                                                        |   | 710,000                       |       | — |   |
| Debt issuance costs                                                                   |   | (858,745                      | )          | (253,789 | ) |
| Repayment of debt                                                                     |   | (4,154,752                    | )          | (3,928,504 | ) |
| Net cash used in financing activities                                                 |   | (4,267,415                    | )          | (4,117,016 | ) |
|                                                                                  |   |                          |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                 |   | 101,332                       |       | (1,586,169 | ) |
| Cash and cash equivalents at beginning of  period                                     |   | 678,895                       |       | 2,567,904 |   |
|                                                                                  |   |                          |       |   |   |
| Cash and cash equivalents at end of period                                            |   | $                             | 780,227    |   | $ | 981,735 |   |

 

**The accompanyingnotes are an integral part of the condensed consolidated financial statements.**

 

4

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

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1. – Basis of Presentation**

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.  In the opinion ofmanagement, all adjustments, consisting of normal recurring accruals,considered necessary for a fair presentation have been included.  Operating results for the three months andsix months ended June 30, 2003, are not necessarily indicative of theresults 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 yearended December 31, 2002.

 

*Corporate Organization*

 

During thequarter ended June 30, 2003, Schlotzsky’s, Inc. (“Schlotzsky’s”) formedseveral new wholly-owned Delaware limited liability companies: Schlotzsky’sFranchisor, LLC (“Franchisor”); Schlotzsky’s Brand Products, LLC (“BrandProducts”); and Schlotzsky’s Franchise Operations, LLC (“FranchiseOperations”).  On June 7, 2003,Schlotzsky’s contributed to Franchisor, subject to a pledge as collateral undera $1 million credit facility, all of its intellectual property, includingtrademarks and service marks, and related economic interests in the payments tobe received pursuant to the franchise agreements and brand licensing agreementsfor the Schlotzsky’s®****Deli restaurantconcept and brand, which had previously been executed by Schlotzsky’s andcertain of Schlotzsky’s other subsidiaries. Franchisor thus became the franchisor of the Schlotzsky’s Delirestaurant concept and licensor of the Schlotzsky’s Deli brand.  Franchisor concurrently contributed thebrand licensing agreements to Brand Products. Franchisor and Brand Products entered into a management agreement withFranchise Operations to manage the intellectual property, administer thefranchise and brand license agreements and enter into new franchise and brandagreements

 

Schlotzsky’sand its subsidiaries are referred to as the “Company”.

 

*Reclassifications*

 

Certainreclassifications have been made to the condensed consolidated financialstatements for the periods ended June 30, 2002, to correspond with thepresentation used at June 30, 2003, and for the periods then ended.

 

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

 

EffectiveJanuary 1, 2003, the Company adopted the cost recognition provisions forstock-based compensation of Statement of Financial Accounting Standards(“SFAS”) No. 123 under the prospective method of adoption authorized by SFASNo. 148. The amount charged to expense during the three and six month periodsended June 30, 2003 were approximately $6,000 and $12,000, respectively.Had the Company adopted the cost recognition provisions of SFAS No. 123 in1995, the Company’s net income and earnings per share would have been reducedto the pro forma amounts shown (in thousands, except per share amounts):

 
|                                                                                                                                          |   | **For the  three months ended** |   | **For the  six months ended** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                                                                                                          |   | **June 30,  2003**         |   | **June 30,  2002**       |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Net income (loss), as reported                                                                                                                |   | $                               | (2,267 | )                             | $      | 489 |   | $ | (3,334 | ) | $ | 1,116 |   |
| Add: Stock-based employee compensation  expense included in net income, net of related tax effects                                            |   | 4                               |   | —                        |   | 8 |   | — |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (45                             | )      | (87                           | )      | (114 | ) | (164 | ) |
| Pro forma net income (loss)                                                                                                                   |   | $                               | (2,308 | )                             | $      | 402 |   | $ | (3,440 | ) | $ | 952 |   |
|                                                                                                                                          |   |                            |   |                          |   |   |   |   |   |
| Earnings per share:                                                                                                                           |   |                            |   |                          |   |   |   |   |   |
| Basic-as reported                                                                                                                             |   | $                               | (0.31  | )                             | $      | 0.07 |   | $ | (0.46 | ) | $ | 0.15 |   |
| Basic-pro forma                                                                                                                               |   | $                               | (0.32  | )                             | $      | 0.06 |   | $ | (0.47 | ) | $ | 0.13 |   |
| Diluted-as reported                                                                                                                           |   | $                               | (0.31  | )                             | $      | 0.07 |   | $ | (0.46 | ) | $ | 0.15 |   |
| Diluted-pro forma                                                                                                                             |   | $                               | (0.32  | )                             | $      | 0.05 |   | $ | (0.47 | ) | $ | 0.13 |   |

 

5

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**Note 3. – Restaurant Operations**

A summary ofcertain operating information for Company-operated restaurants is presentedbelow for the three and six month periods ended June 30, 2003 and 2002(dollars in thousands).

 
|                                                        |   | **Long-term Portfolio Restaurants** |   | **Available  For Sale  Restaurants** |   |                         |   |
|-------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------------------|--------|------------------------------|--------|
|                                                        |   | **Schlotzsky’s  Delis**        |   | **Marketplaces**                     |   | **Schlotzsky’s  Delis** |   | **Total** |   |
| **Three months ended June 30, 2003**                   |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 3,589  |                                 | $      | 1,293                        |   | $ | 3,119 |   | $ | 8,001 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                 |   |                         |   |   |   |
| Cost of sales                                               |   | 1,039                               |   | 424                                  |   | 886                          |   | 2,349 |   |
| Personnel and benefits                                      |   | 1,292                               |   | 697                                  |   | 1,456                        |   | 3,445 |   |
| Operating expenses                                          |   | 669                                 |   | 382                                  |   | 1,151                        |   | 2,202 |   |
|                                                        |   | 3,000                               |   | 1,503                                |   | 3,493                        |   | 7,996 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 589    |                                 | $      | (210                         | )      | $ | (374 | ) | $ | 5 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| **Three months ended June 30, 2002**                   |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 4,031  |                                 | $      | 1,317                        |   | $ | 2,921 |   | $ | 8,269 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                 |   |                         |   |   |   |
| Cost of sales                                               |   | 1,101                               |   | 400                                  |   | 812                          |   | 2,313 |   |
| Personnel and benefits                                      |   | 1,384                               |   | 630                                  |   | 1,278                        |   | 3,292 |   |
| Operating expenses                                          |   | 685                                 |   | 320                                  |   | 864                          |   | 1,931 |   |
|                                                        |   | 3,170                               |   | 1,350                                |   | 2,954                        |   | 7,474 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 861    |                                 | $      | (33                          | )      | $ | (33 | ) | $ | 795 |   |

 
|                                                        |   | **Long-term Portfolio Restaurants** |   | **Available  For Sale  Restaurants** |   |                         |   |
|-------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------------------|--------|------------------------------|--------|
|                                                        |   | **Schlotzsky’s  Delis**        |   | **Marketplaces**                     |   | **Schlotzsky’s  Delis** |   | **Total** |   |
| **Six months ended June 30, 2003**                     |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 7,079  |                                 | $      | 2,455                        |   | $ | 6,079 |   | $ | 15,613 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                 |   |                         |   |   |   |
| Cost of sales                                               |   | 2,006                               |   | 794                                  |   | 1,721                        |   | 4,521 |   |
| Personnel and benefits                                      |   | 2,587                               |   | 1,312                                |   | 2,911                        |   | 6,810 |   |
| Operating expenses                                          |   | 1,300                               |   | 696                                  |   | 2,108                        |   | 4,104 |   |
|                                                        |   | 5,893                               |   | 2,802                                |   | 6,740                        |   | 15,435 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 1,186  |                                 | $      | (347                         | )      | $ | (661 | ) | $ | 178 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| **Six months ended June 30, 2002**                     |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant sales                                            |   | $                                   | 8,007  |                                 | $      | 2,592                        |   | $ | 5,541 |   | $ | 16,140 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Restaurant operations:                                      |   |                                |   |                                 |   |                         |   |   |   |
| Cost of sales                                               |   | 2,174                               |   | 790                                  |   | 1,544                        |   | 4,508 |   |
| Personnel and benefits                                      |   | 2,754                               |   | 1,244                                |   | 2,464                        |   | 6,462 |   |
| Operating expenses                                          |   | 1,364                               |   | 614                                  |   | 1,658                        |   | 3,636 |   |
|                                                        |   | 6,292                               |   | 2,648                                |   | 5,666                        |   | 14,606 |   |
|                                                        |   |                                |   |                                 |   |                         |   |   |   |
| Operating income (loss) before depreciationand amortization |   | $                                   | 1,715  |                                 | $      | (56                          | )      | $ | (125 | ) | $ | 1,534 |   |

 

6

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As ofJune 30, 2003 and 2002, the net book value of property and equipment andintangible assets related to each of the above categories was as follows(dollars in thousands):

 
|                            |   | **June 30,  2003** |   | **June 30,  2002** |   |
|---------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                            |   |                    |   |                    |   |
| Long-term Portfolio Restaurants |   |                    |   |                    |   |
| Schlotzsky’s  Delis   |   | $                       | 14,837 |                    | $      | 15,630 |   |
| Marketplaces                    |   | 10,050                  |   | 7,543                   |   |
| Available for Sale Restaurants  |   | 12,596                  |   | 11,844                  |   |
|                            |   | $                       | 37,483 |                    | $      | 35,017 |   |

 

**Note 4. – Segments**

 

The Companyand its subsidiaries are principally engaged in franchising and operatingrestaurants in the fast casual sector under the Schlotzsky’s Deli brand.  Schlotzsky’s Deli restaurants offer a menuof distinctive, high quality foods featuring our proprietary breads,complemented by excellent customer service in a visually appealing setting.  Our current menu includes upscalemade-to-order hot sandwiches and pizza served on our proprietary buns andcrusts, wraps, chips, salads, soups, fresh baked cookies and other desserts,and beverages.  At June 30, 2003,the Schlotzsky’s Deli system included 597 Company-operated and franchisedrestaurants in 37 states, the District of Columbia and six foreigncountries.  The Company operated 38restaurants as of June 30, 2003.

 

The Companyidentifies segments based on management responsibility within the corporatestructure.  The Restaurant Operationssegment includes restaurants operated for the purposes of market leadership andredevelopment of certain markets, demonstrating sales potential and keyoperating metrics, operational leadership of the franchise system, productdevelopment, concept refinement, product and process testing, and training andbuilding brand awareness.  TheRestaurant Operations segment also includes restaurants developed for oracquired from franchisees which are available for sale to franchisees.  The Franchise Operations segment encompassesthe franchising of restaurants, assisting franchisees in the development ofrestaurants, providing franchisee training and operating the national trainingcenter, communicating with franchisees, conducting regional and nationalfranchisee meetings, developing and monitoring supplier and distributorrelationships, planning and coordinating advertising and marketing programs,and the licensing of brand products for sale to the franchise system andretailers.  The Company measures segmentprofit as operating income, which is defined as income before interest andincome taxes.  Segment information and areconciliation to income before interest and income taxes are as follows(dollars in thousands):

 
| **Three months ended June 30, 2003** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|-------------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                      |   |                       |   |                      |   |             |   |
| Revenue from external customers           |   | $                          | 8,001  |                      | $      | 6,261            |   | $ | 14,262 |   |
| Depreciation and amortization             |   | 559                        |   | 724                       |   | 1,283            |   |
| Operating income (loss)                   |   | 5                          |   | (2,485                    | )      | (2,480           | )      |
|                                      |   |                       |   |                      |   |             |   |
| Total assets                              |   | $                          | 37,483 |                      | $      | 96,344           |   | $ | 133,827 |   |

 
| **Three months ended June 30, 2002** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|-------------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                      |   |                       |   |                      |   |             |   |
| Revenue from external customers           |   | $                          | 8,269  |                      | $      | 7,634            |   | $ | 15,903 |   |
| Depreciation and amortization             |   | 531                        |   | 555                       |   | 1,086            |   |
| Operating income                          |   | 264                        |   | 1,074                     |   | 1,338            |   |
|                                      |   |                       |   |                      |   |             |   |
| Total assets                              |   | $                          | 37,292 |                      | $      | 75,576           |   | $ | 112,868 |   |

 

7

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Of theRestaurant Operations depreciation and amortization for the three months endedJune 30, 2003, $367,000 was allocated to the long-term portfolio ofrestaurants ($153,000 for Marketplaces and $214,000 for Schlotzsky’s Delis) and$192,000 to restaurants available for sale. For the three months ended June 30, 2002, $359,000 of depreciationand amortization was allocated to the long-term portfolio of restaurants($149,000 for Marketplaces and $210,000 for Schlotzsky’s Delis) and $172,000 torestaurants available for sale.

 
| **Six months ended June 30, 2003** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|-----------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                    |   |                       |   |                      |   |             |   |
| Revenue from external customers         |   | $                          | 15,613 |                      | $      | 12,479           |   | $ | 28,092 |   |
| Depreciation and amortization           |   | 1,080                      |   | 1,452                     |   | 2,532            |   |
| Operating income (loss)                 |   | 179                        |   | (3,319                    | )      | (3,140           | )      |
|                                    |   |                       |   |                      |   |             |   |
| Total assets                            |   | $                          | 37,483 |                      | $      | 96,344           |   | $ | 133,827 |   |

 
| **Six months ended June 30, 2002** |   | **Restaurant  Operations** |   | **Franchise  Operations** |   | **Consolidated** |   |
|-----------------------------------------|--------|----------------------------|--------|---------------------------|--------|------------------|--------|
|                                    |   |                       |   |                      |   |             |   |
| Revenue from external customers         |   | $                          | 16,140 |                      | $      | 15,009           |   | $ | 31,149 |   |
| Depreciation and amortization           |   | 1,036                      |   | 1,134                     |   | 2,170            |   |
| Operating income                        |   | 498                        |   | 2,214                     |   | 2,712            |   |
|                                    |   |                       |   |                      |   |             |   |
| Total assets                            |   | $                          | 37,292 |                      | $      | 75,576           |   | $ | 112,868 |   |

 

Of theRestaurant Operations depreciation and amortization for the six months endedJune 30, 2003, $709,000 was allocated to the long-term portfolio ofrestaurants ($290,000 for Marketplaces and $419,000 for Schlotzsky’s Delis) and$371,000 to restaurants available for sale. For the six months ended June 30, 2002, $720,000 of depreciationand amortization was allocated to the long-term portfolio of restaurants($297,000 for Marketplaces and $423,000 for Schlotzsky’s Delis) and $316,000 torestaurants available for sale.

 

All general and administrative expenses are included in Franchise Operations for theperiods presented.

 

8

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**Note 5. – Debt**

 

The Company’sdebt structure as of June 30, 2003, and December 31, 2002, is asfollows (dollars in thousands):

 
|                                                     |   | **June 30,  2003** |   | **December 31,  2002** |   |
|----------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                     |   | **(Unaudited)**         |   |                        |   |
|                                                     |   |                    |   |                        |   |
| Short-term debt:                                         |   | $                       | 1,375  | ** **                  | $      | **—** | ** ** |
|                                                     |   |                    |   |                        |   |
| Long-term debt:                                          |   |                    |   |                        |   |
| Notes payable to former area developers                  |   | $                       | 23,909 |                        | $      | 26,306 |   |
| Mortgages on Company-operated restaurants  and equipment |   | 22,060                  |   | 23,839                      |   |
| Capital leases                                           |   | 2,848                   |   | 3,029                       |   |
| Other obligations                                        |   | 484                     |   | 331                         |   |
|                                                     |   | 49,301                  |   | 53,505                      |   |
| Less current maturities of long-term debt                |   | (8,631                  | )      | (7,441                      | )      |
| Long-term debt                                           |   | $                       | 40,670 |                        | $      | 46,064 |   |

 

Short-termdebt as of June 30, 2003 was comprised of a $150,000 note to a bank withinterest at 5.2%, due August 25, 2003 collateralized by a certificate ofdeposit pledged by an officer and director of the Company; $560,000 outstandingunder a $1,000,000 facility with two officers and directors of the Company withinterest at 6.0%, due October 31, 2003 and secured by our intellectualproperty, contract rights and certain intangibles; and a $665,000 note payableto a bank with interest at the prime rate plus 1%, due August 28, 2003.

 

Certain of ourmortgage debt require the maintenance of certain financial ratios, includingdebt-to-equity and working capital.  Weare currently in compliance with these covenants or have obtained waivers fromthe lenders.

 

**Note 6. – Related Party Receivables**

 

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

** **
|                                         |   | **June 30,  2003** |       | **December 31,  2002** |       |
|----------------------------------------------|--------|-------------------------|------------|-----------------------------|------------|
|                                         |   | **(Unaudited)**         |       |                        |       |
|                                         |   |                    | ** ** |                        | ** ** |
| Included in accounts receivable – other |   | $                       | 889        |                        | $          | 902 |   |
| Included in other noncurrent assets          |   | 549                     |       | 842                         |       |
| Included in notes receivable                 |   | 3,097                   |       | 5,450                       |       |
|                                         |   |                    | ** ** |                        | ** ** |
| Total related party receivables              |   | $                       | 4,535      |                        | $          | 7,194 |   |

 

9

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**Note7. – Earnings Per Share**

 

Basic earningsper share are computed by dividing reported earnings available to commonstockholders by weighted average common shares outstanding.  Diluted earnings per share give effect todilutive potential common shares. Earnings per share are calculated as follows (in thousands, except pershare data):

 
|                                                                                                                             |   | **Three  Months Ended** |   | **Six Months  Ended**   |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                                                                                                                             |   | **June 30,  2003** |   | **June 30,  2002** |   | **June 30,  2003** |   | **June 30,  2002** |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Basic earnings per share                                                                                                         |   |                    |   |                    |   |   |   |   |   |
| Net income (loss)                                                                                                                |   | $                       | (2,267 | )                       | $      | 489 |   | $ | (3,334 | ) | $ | 1,116 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Weighted average common shares outstanding                                                                                       |   | 7,320                   |   | 7,288                   |   | 7,320 |   | 7,287 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Basic earnings per share                                                                                                         |   | $                       | (0.31  | )                       | $      | 0.07 |   | $ | (0.46 | ) | $ | 0.15 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Diluted earnings per share                                                                                                       |   |                    |   |                    |   |   |   |   |   |
| Net income (loss)                                                                                                                |   | $                       | (2,267 | )                       | $      | 489 |   | $ | (3,334 | ) | $ | 1,116 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Weighted average common shares outstanding                                                                                       |   | 7,320                   |   | 7,288                   |   | 7,320 |   | 7,287 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Dilutive stock options and warrants                                                                                              |   | —                  |   | 154                     |   | — |   | 176 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Weighted average common shares outstanding  – assuming dilution                                                             |   | 7,320                   |   | 7,442                   |   | 7,320 |   | 7,463 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Diluted earnings per share                                                                                                       |   | $                       | (0.31  | )                       | $      | 0.07 |   | $ | (0.46 | ) | $ | 0.15 |   |
|                                                                                                                             |   |                    |   |                    |   |   |   |   |   |
| Outstanding options and warrants that were  not included in the diluted calculation because their effect would be  anti-dilutive |   | 1,142                   |   | 687                     |   | 1,142 |   | 663 |   |

 

10

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**Note 8. – Intangible Assets**

 

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

 

Intangible assets consist ofthe following (dollars in thousands):

 
|                                            |   |                              |       | **June 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      |                          | $          | 839 |   | $ | 2,474 |   | $ | 779 |   |
| Developer and franchise rights acquired         |   | 20 to 40                          |       | 59,374                  |       | 3,185                         |       | 59,384 |   | 2,492 |   |
| Restaurant development rights                   |   | 13 to 25                          |       | 1,619                   |       | 451                           |       | 1,619 |   | 407 |   |
| Debt issue costs                                |   | 3 to 20                           |       | 2,431                   |       | 110                           |       | 1,561 |   | 77 |   |
| Other intangible assets                         |   | 5                                 |       | 589                     |       | 399                           |       | 561 |   | 364 |   |
|                                            |   |                              |       | 66,487                  |       | 4,984                         |       | 65,599 |   | 4,119 |   |
|                                            |   |                              |       |                    |       |                          |       |   |   |   |   |
| Intangible assets not subject to  amortization: |   |                              |       |                    |       |                          |       |   |   |   |   |
| Original franchise and royalty rights           |   |                              |       | 5,689                   |       | 1,860                         |       | 5,689 |   | 1,860 |   |
| Goodwill                                        |   |                              |       | 3,523                   |       | 331                           |       | 3,316 |   | 331 |   |
|                                            |   |                              |       | 9,212                   |       | 2,191                         |       | 9,005 |   | 2,191 |   |
|                                            |   |                              |       |                    |       |                          |       |   |   |   |   |
| Total intangible assets                         |   |                              |       | $                       | 75,699     |                          | $          | 7,175 |   | $ | 74,604 |   | $ | 6,310 |   |

 

Amortizationof intangible assets totaled approximately $439,000 and $260,000 for the threemonths ended June 30, 2003, and 2002, respectively.  For the six months ended June 30, 2003,and 2002, amortization expense totaled $865,000 and $472,000 respectively.  Estimated amortization expense through 2007for intangible assets with determinable lives is as follows (dollars inthousands):

 
| Remainder of 2003 |   | $     | 912    |   |
|-------------------|--------|-------|--------|--------|
| 2004              |   | 1,808 |   |
| 2005              |   | 1,747 |   |
| 2006              |   | 1,729 |   |
| 2007              |   | 1,720 |   |
|              |   | $     | 7,916  |   |

 

The changes in the gross valueof goodwill for the six months ended June 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                    |   | 207                        |   | —                    |   | 207       |   |
| Impairment                           |   | —                     |   | —                    |   | —    |   |
| Balance as of June 30, 2003     |   | $                          | 3,262  |                      | $      | 261       |   | $ | 3,523 |   |

 

11

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During thefirst quarter the Company, exercising its right of first refusal, acquired theoperating assets of a franchised restaurant located in suburban Atlanta, Georgia.  The Company does not intend to operate theacquired restaurant, but acquired these assets primarily in order to facilitatethe development of a Company-operated restaurant in the trade area that hadbeen licensed to the franchisee.

 

The aggregatepurchase price paid was $215,000.  Ofthe purchase 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.

 

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

 

The Company has outstandingguarantees of indebtedness of others, including related parties, ofapproximately $29.2 million as of June 30, 2003. These guarantees includeapproximately $6.3 million of lease guarantees for the benefit of franchisees,approximately $14.5 million of mortgage loan guarantees for the benefit offranchisees and approximately $8.4 million of loan guarantees for the benefitof related parties.

 

The lease guarantees for thebenefit of franchisees arose primarily through our former Turnkey program, inwhich the Company developed the restaurants, leased the restaurants tofranchisees, and then sold them to a leasing company.  The guarantees range from limited guarantees, either in dollar amount or term,to full guarantees for the life of the lease. The maximum guarantee for a single lease is approximately $1.3million.  Certain guarantees extend through2018.  The Company may be required bythe lessor to make monthly rental payments or property tax and common areamaintenance payments if the franchisee does not make the required payments in atimely manner.  The Company hasindemnification agreements with the franchisee under which the franchisee wouldbe obligated to reimburse the Company for any amounts paid under suchguarantees.  As of June 30, 2003,the Company had accrued a liability of approximately $598,000 related to theseguarantees, including a $574,000 provision made in the quarter endedJune 30, 2003.  The Company alsohas a net deferred gain related to the sale of these leases in the amount ofapproximately $342,000 as of June 30, 2003.

 

The mortgage loan guaranteesfor the benefit of franchisees also arose primarily through the Company’sformer Turnkey program, in which we developed the related restaurants, sold therestaurant to a franchisee, and guaranteed all or a portion of the franchisee’smortgage loan.  The guarantees rangefrom limited guarantees, either in dollar amount or term, to full guarantees ofthe mortgage.  The maximum amount of asingle guarantee is approximately $1.0 million.  Certain guarantees extend through 2016.  The Company may be required by the lender to make monthlymortgage payments if the franchisee does not make the required payments in a timelymanner, or the Company may be required to make up any deficiency, up to theamount of the guarantee, if the related restaurant is sold for net proceedsless than the amount of the outstanding mortgage.  The Company has indemnification agreements with the franchiseesunder which the franchisee would be obligated to reimburse the Company for anyamount paid under such guarantees.  Inthe event that the Company purchases the loan from the lender in the event of adefault, the Company would succeed to the lender’s security interest in therelated property.

 

The loan guarantees in favorof related parties primarily arose when the Company guaranteed certain debt ofrelated parties for which the proceeds of the loans were used to repayoutstanding debt to the Company.  Two ofthe guarantees, for the benefit of our restaurant venture and our real estateventure, are of mortgage debt totaling approximately $4.1 million.  These guarantees extend through 2009 on onenote and through 2016 on the other note. A third guarantee, of a bank note in the amount of approximately $4.3million, is for the benefit of the advertising entity of the Schlotzsky’s Delirestaurant system, for which the Company had received a portion of the netproceeds of the loan in repayment of outstanding debt to the Company.  This guarantee expires in 2004.  In connection with the guarantee of the $4.3million guarantee of the advertising entity bank note, which was made inJune 2003, a liability in the amount of $43,000 was accrued under the termsof FASB Interpretation No. 45.

 

The Company has been calledupon, from time to time, to make payments on obligations the Company hasguaranteed.  During the first six monthsof 2003, the Company paid approximately $346,000 in various lease guarantees forthe benefit of franchisees.  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.

 

12

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**Note 10. – Commitments and Contingencies**

 

*Litigation*

 

The Company isnamed a defendant 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.

 

*New Florida Markets, Ltd. v. Schlotzsky’s,Inc., Schlotzsky’s Franchise Limited Partnership, Schlotzsky’s Franchisor, LLC,Schlotzsky’s Franchise Operations, LLC, Schlotzsky’s NAMF, Inc., andSchlotzsky’s NAMF Funding, LLC*, (Case No. 701140045603) was filed onor 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., anarea developer 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 for hearing.

 

*Comerica Bank vs. James E. Wright, John D.Wright, Lorraine Wright, and Kimberly Wright v. Schlotzsky’s, Inc. andSchlotzsky’s Real Estate, Inc., In the Circuit Court for the County ofGenessee, State of Michigan* (Case No. 02-74931), wasfiled 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 restaurant in Grand Blanc,Michigan and filed Chapter 11 bankruptcy. In January 2003, Schlotzsky’sReal Estate, Inc. had filed suit against John and James Wright, for collectionof $283,872.68 due under a promissory note. In the instant case, Third Party Plaintiffs allege that they wereinduced into participating in the Turnkey program and that an employee of theCompany represented that the restaurant would attain a certain level of sales.  Third Party Plaintiffs’ claims include fraudin the inducement, fraudulent and negligent misrepresentation, and breach ofthe Michigan Franchise Investment Act. They seek damages of an unspecified amount in excess of $25,000,attorneys’ fees, and costs.  The case isnot yet set for trial.

 

*Russell R. Kesterson and Steven P. Schmidt v.Schlotzsky’s, Inc., Ron Lynch and Jane Doe Lynch, John Does I—X, Jane DoesI—X, ABC Corporations I—X, XYZ Companies I—X*, (CaseNo. CV2002-021158) was filed on October 31, 2002, in the SuperiorCourt of Maricopa County, Arizona. Plaintiffs were franchisees of the Companyand owned and operated a Schlotzsky’s Deli restaurant in Phoenix, Arizona. TheComplaint includes claims of breach of contract, interference with business expectancy,interference with business relationship, unfair competition and negligence.Plaintiffs allege that a “superstore” owned by Lynch and/or our affiliatesencroached on their business and allege that we failed to collect royaltiesfrom the “superstore,” creating unfair competition. Plaintiffs further statethat they attempted to relocate their restaurant but that we failed to approvea proposed alternative location and that we induced one of their employees towork for a competing restaurant. Plaintiffs are seeking an unspecified amountof damages, including treble damages, attorney’s fees, and costs. OnDecember 3, 2002, we filed a petition styled *Schlotzsky’s, Inc., v. Russell R. Kesterson and Steven P. Schmidt*,in the United States District Court for the Western District of Texas, AustinDivision (Civil Action No. AO2CA 768SS) to compel Plaintiffs to arbitrate theirclaims in Austin, Texas. The federal court entered an order onDecember 20, 2002, granting our petition to compel arbitration in the mannerprovided in the franchise agreement and enjoined Kesterson and Schmidt frompursuing any of their claims in the lawsuit pending in Arizona. To date, we areunaware of any subsequent demand for arbitration filed by either Kesterson orSchmidt.

 

*Kimberly L.E. Garland v.Schlotzsky’s, Inc., Schenck & Associates, John C. Wooley, DarrellW. Kolinek, Kelly R. Arnold, Joyce Cates, Brian Wieters, David B. Gerstner, andJeffrey P. Noeldner* (Case No. 01-CV-2377) wasfiled on or about December 26, 2001 in the United States District Courtfor the District of Minnesota. Plaintiff, a principal of a former franchisee inApple Valley, Minnesota, brought suit against the Company and five of itscurrent and former employees (John Wooley, Darrell Kolinek, Kelly Arnold, JoyceCates, and Brian Wieters, collectively the “Schlotzsky’s Parties”), her AreaDeveloper (Jeffrey Noeldner), her accountant (David Gerstner), and hisaccounting firm (Schenck & Associates). Plaintiff claimed she wasfraudulently induced into developing a Schlotzsky’s Deli restaurant through theCompany’s Turnkey program, and that Defendants should have advised her

 

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that franchisees’ financialprojections were unrealistic.  Herclaims included fraudulent and negligent misrepresentation and omission andviolations of the Minnesota Franchise Act, Minnesota Uniform Deceptive TradePractices Act, and the Texas Deceptive Trade Practices and Consumer ProtectionAct. Defendants filed motions to dismiss or stay the case pending arbitrationas required in the Franchise Agreement. Prior to a hearing on the motions, theparties were ordered to appear for a settlement conference on May 19,2003.  Without conceding the facts thatformed the basis of any claims, the parties entered into a settlementagreement.  Plaintiff agreed toterminate the franchise agreement, exit the system, and pay $5,500 inmediator’s fees.  In exchange, Schenck& Associates and Gerstner agreed to pay $90,000, the Schlotzsky’s Partiesand Noeldner paid $11,525, and their insurer contributed $218,975 in settlementto Plaintiff.  The parties agreed todismiss all of their respective claims, with prejudice.

 

*Robert Coshott v.Schlotzsky’s, Inc.* (Cause No. GN 1-02279), wasfiled on July 24, 2001, in the 200th Judicial District Court of TravisCounty, Texas. Plaintiff is the Master Licensee for Australia and New Zealand,and he opened a Schlotzsky’s Deli restaurant in Melbourne, Australia. Plaintiffbrings causes 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 InternationalChamber of Commerce styled *Robert Gilbert Coshott v. Schlotzsky’s, Inc.*(Case. No. TBD).  The claims in theDemand are similar to those brought in the above-entitled action and includeadditional allegations that the Company required the purchase of goods andservices from certain suppliers in violation of the Trade Practices Act of 1974that that the Company failed to disclose the existence of a predecessor MasterLicense Agreement, in violation of the Fair Trading Act of 1987 (New South)Wales, breach of contract, and equitable estoppel.  Claimant seeks unspecified actual, compensatory and punitivedamages, lost profits, attorneys’ fees, prejudgment interest, and costs.  At present, no arbitration hearing date hasbeen set.  

 

*Dae Kim, DWK Enterprises, Inc., andAecon International, Inc. v. John Wooley, Schlotzsky’s, Inc.,Schlotzsky’s Franchising Limited Partnership, Schlotzsky’s N.A.M.F., Inc.,Schlotzsky’s National Advertising Association, Inc., and Schlotzsky’s,Brands, Inc., Schlotzsky’s Brand Products, L.P., Schlotzsky’s RealEstate, Inc., and Schlotzsky’s Restaurants, Inc.*(Cause No. 2001-CI-13672) was originally filed in the 73rd Judicial DistrictCourt of Bexar County, Texas on or about September 25, 2001 (after asimilar lawsuit was filed and later withdrawn in Harris County, Texas) againstSchlotzsky’s, Inc., John Wooley, Schlotzsky’s Franchising LimitedPartnership, and Schlotzsky’s NAMF, Inc. (collectively, “Defendants”).Plaintiffs are, or claim to be, franchisees in Houston and San Antonio Texas,and Plaintiff Kim was an area developer for those markets. Plaintiffs bringcauses of action for breach of contract, breach of fiduciary duty, breach ofthe duty of good faith and fair dealing, civil conspiracy, tortiousinterference with contract, tortious interference with prospective businessrelationship, violation of the Texas Deceptive Trade Practices and ConsumerProtection Act, restraint of trade, detrimental reliance-fraud in theinducement, and defamation-business disparagement. They seek an unspecifiedamount of money damages plus exemplary damages, attorneys’ fees, pre-judgment interest,costs, and a jury trial. Defendants, except for Mr. Wooley, who waspreviously dismissed from the case, answered and asserted counterclaimsalleging breach of contract and that Plaintiffs’ claim under the TexasDeceptive Trade Practices Act is groundless in fact or in law and brought inbad faith or for the purpose of harassment, and seeking money damages, costs ofcourt, penalty fees, costs incurred in performing the accounting, attorneys’fees, and pre- and post-judgment interest. Defendants (except forMr. Wooley) removed the case to federal court. The case was remanded tostate court on April 17, 2003.  The case is not yet set for trial.

 

*U.S. RestaurantProperties Operating L.P. v. Schlotzsky’s, Inc.*(Cause No. 03-01758) was filed on February 27, 2003, in the DistrictCourt of Dallas County, B-44th Judicial District.  Plaintiff is a realestate investment company that owns certain Schlotzsky’s Deli restaurants andleases them to franchisees. It alleges that in 1997 and 1998 we entered into severalagreements where we agreed to guarantee certain lease agreements. Plaintiffstates that in 1998 the parties entered into an agreement whereby Plaintiffagreed to release Schlotzsky’s from its guaranty obligations pertaining to sixproperties in which the tenants had defaulted, in exchange for Schlotzsky’sagreement to purchase seven other properties. The Company purchased one of theproperties located in Texas. Plaintiffs are seeking an order requiring us topurchase the other six properties, two of which are in Texas, and one each inArizona, 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.

 

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In addition tothe matters discussed above, we are defendants in various other legalproceedings arising from our business. The ultimate outcome of these pendingproceedings cannot be projected with certainty. However, based on ourexperience to date, we believe such proceedings will not have a material effecton our business or financial condition.

 

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**ITEM 2****.****                  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**CRITICALACCOUNTING POLICIES**

 

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

 

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

 

•                  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, generallyobtain a secondary secured interest in the related property and equipment orrights.  Many of the notes receivableare fully subordinated to the franchisee’s senior mortgage debt.  In reviewing the adequacy of the valuationallowances for accounts and notes receivable, we consider factors such ashistorical collection experience, the estimated value of personal guaranteesand real property collateral, the franchisee’s sales and operating trends,including potential for improvement in operations, and general and localeconomic conditions that may affect the franchisee’s ability to pay.  Actual realization of amounts 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 potentialbuyers.  Actual realizeability coulddiffer materially from our estimates.

 

•                  Determination of appropriate valuationallowance 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.

 

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**RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

The followingtable reflects the changes in the Schlotzsky’s Deli system for the three andsix months ended June 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** |       | **Six Months  Ended**   |   |
|-----------------------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                                          |   | **June 30,  2003** |       | **June 30,  2002** |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Restaurants Open – Beginning of Period   |   | 619                     |       | 672                     |   | 643 |   | 674 |   |
| Openings During Period –                 |   |                    |       |                    |   |   |   |   |   |
| New                                           |   | 7                       |       | 5                       |   | 7 |   | 7 |   |
| Reopenings                                    |   | 1                       |       | 2                       |   | 2 |   | 6 |   |
| Total Openings                                |   | 8                       |       | 7                       |   | 9 |   | 13 |   |
| Closings During Period                        |   | (30                     | )          | (8                      | )      | (55 | ) | (16 | ) |
| Restaurants Open – End of Period         |   | 597                     |       | 671                     |   | 597 |   | 671 |   |
|                                          |   |                    |       |                    |   |   |   |   |   |
| Systemwide Contractual  Sales            |   | $                       | 85,263,000 |                    | $      | 102,645,000 |   | $ | 170,776,000 |   | $ | 202,848,000 |   |
| Decrease in Systemwide Contractual Sales      |   | (16.9                   | )%         | (6.5                    | )%     | (15.8 | )% | (6.5 | )% |
| Decrease in Same Store Contractual Sales      |   | (11.9                   | )%         | (5.5                    | )%     | (11.7 | )% | (5.4 | )% |
| Average Weekly Contractual Sales              |   | $                       | 10,773     |                    | $      | 11,800 |   | $ | 10,595 |   | $ | 11,635 |   |
| Decrease in Average Weekly Contractual  Sales |   | (8.7                    | )%         | (1.7                    | )%     | (8.9 | )% | (1.5 | )% |

 

Systemwidecontractual sales, same store contractual sales and average weekly contractualsales, all based on contractual sales as defined in our franchise agreements,represent net sales under generally accepted accounting principles, plus theamounts of any discounts for employee or manager meals.  Contractual sales are used in this chart,and throughout this report, because these sales are the basis of our royaltyincome and contractual sales are the only sales amounts reported to us by thefranchisees

 

**THREEMONTHS ENDED JUNE 30, 2003 AND 2002**

 

REVENUE.  Total revenue decreased 10.3% to $14,261,000from $15,903,000.

 

ROYALTIESdecreased 18.6% to $4,285,000 from $5,264,000. The decrease was due to a decreased number of franchised restaurants in2003 compared to 2002, a decrease in same store contractual sales of 11.9%, andan increasing percentage of systemwide sales generated by Company-operatedrestaurants, which do not pay royalties, partially offset by a continuing shiftin restaurant mix towards units with higher volume.

 

FRANCHISE FEESdecreased 92.9% to $3,000 from $42,000. The decrease was principally the result of a lower fee for currentquarter openings of franchised restaurants as compared to the same period inthe prior year.  The decrease infranchise fee per restaurant opening is due to the openings in the currentquarter being international restaurants under master license agreements whereour franchise fee is lower.

 

DEVELOPER FEESdecreased 26.7% to $44,000 from $60,000. The decrease was primarily due to the expiration of amortization oncertain agreements.

 

RESTAURANTSALES decreased 3.3% to $8,000,000 from $8,269,000.  The decrease was primarily due to a 11.9% decrease in same storesales partially offset by an increase in the average number of restaurantsoperated by the Company during the second quarter of 2003, compared to thesecond quarter of 2002.  As ofJune 30, 2003, there were 38 Company-operated restaurants, compared to 35at June 30, 2002, of which 23 and 20, respectively, were available forsale.

 

SCHLOTZSKY’S®DELI BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 14.2% to $1,709,000from $1,991,000.  The decrease wasprimarily due to the decrease in systemwide sales for the quarter.

 

OTHER FEES ANDREVENUE decreased 20.7% to $219,000 from $276,000.  The decrease was due to a decrease in expired franchise fees.

 

OPERATINGEXPENSES. Total operating expenses increased 14.9% to $16,742,000 from$14,566,000.

 

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SERVICE COSTSdecreased 40.6% to $667,000 from $1,122,000, and as a percentage of royaltiesand franchise fees decreased to 15.6% from 21.1%.  This decrease was primarily due to the Company’s reacquisition ofcertain area developer territory rights during the third quarter of 2002, aswell as a decrease in royalty revenue.

 

RESTAURANTOPERATIONS EXPENSES increased 7.0% to $7,996,000 from $7,474,000.  On an overall basis, expenses, as apercentage of net restaurant sales, are higher at restaurants available forsale, and the proportion of restaurants available for sale to totalCompany-operated restaurants was higher this year than last year.

 

RESTAURANTCOST OF SALES increased 1.6% to $2,349,000 from $2,312,000 and increased as apercentage of net restaurant sales to 29.4% from 28.0% due primarily to anincrease in beverage costs.

 

RESTAURANTPERSONNEL AND BENEFITS COST increased 4.6% to $3,445,000 from $3,293,000 andincreased as a percentage of net restaurant sales to 43.1% from 39.8%.  The increase, as a percentage of netrestaurant sales, was due to the effect of lower average sales on managersalaries and preopening labor costs.

 

RESTAURANTOPERATING EXPENSES increased 17.8% to $2,202,000 from $1,869,000 and increasedas a percentage of net restaurant sales to 27.5% from 22.6%.  The increase in operating costs, as apercentage of net restaurant sales, was primarily due to preopening costs on arestaurant opened during the quarter and a restaurant under development as wellas a tax assessment on one restaurant location.

 

EQUITY LOSS ONINVESTMENTS increased 75.0% to a loss of $84,000 from a loss of $48,000.  The equity investment represents theCompany’s 50% interest in a limited liability company that operates a Schlotzsky’sDeli restaurant that opened in 2000.

 

GENERAL ANDADMINISTRATIVE EXPENSES increased 38.8% to $6,713,000 from $4,835,000, andincreased to 47.1% from 30.4% as a percentage of total revenue. The increasefrom the prior year quarter was principally due to increased provisions foruncollectible accounts and debt guarantees, increased franchisee meeting andconvention expenses, and increased legal and professional expenses.

 

DEPRECIATIONAND AMORTIZATION increased 18.1% to $1,283,000 from $1,086,000.  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 quarter.

 

INTERESTINCOME increased 9.5% to $104,000 from $95,000.

 

INTERESTEXPENSE increased 54.2% to $1,010,000 from $655,000 due primarily to theseller-financed debt related to the reacquisition of the territorial rights ofthe Company’s largest area developer.

 

PROVISION FORINCOME TAXES reflected a combined federal and state effective tax benefit rateof 33.0% for the second quarter of 2003, which was lower than the effectivecombined tax rate of 37.1% for the comparable period in 2002 primarily due tocertain state taxes being based in part on factors other than income.

 

NET INCOMEdecreased to a loss of $2,267,000 from income of $489,000 due to the factorsdiscussed above.  Earnings per share,both basic and diluted, were $(0.31) for the quarter ended June 30, 2003compared to $0.07 in the prior year quarter.

 

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

 

The followingtable is presented for the Schlotzsky’s Delis in the Company’s long-termportfolio for the quarter ended June 30, 2003.  As of June 30, 2003, this restaurant group included eightrestaurants in the Austin area, two in College Station, Texas and one insuburban Atlanta, Georgia.  This groupincludes ten freestanding restaurants, six of which are recently constructed,and one shopping center endcap restaurant. In accordance with the Company’s internal management reporting practicesfor consistent comparisons, line item categories have been expanded andpercentages are calculated based on gross sales, instead of net sales as usedelsewhere in this report.  Facilitycosts vary by restaurant because some facilities are rented and some areowned.  The table provides the averagepercentage results for each line item for the eleven Schlotzsky’s Delirestaurants in the long-term portfolio group as a whole, as well as the bestand worst percentage performance for each line item for any restaurant in thegroup.

 

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|                                                                      |   | **Three Months  Ended  June 30, 2003** |   | **Percentage  of Gross  Sales** |   | **Best  Percentage  Performance** |   | **Worst  Percentage  Performance** |   |
|---------------------------------------------------------------------------|--------|---------------------------------------------|--------|---------------------------------|--------|-----------------------------------|--------|------------------------------------|--------|
|                                                                      |   | **(in thousands)**                          |   |                            |   |                              |   |                               |   |
| Gross sales                                                               |   | $                                           | 3,784  |                            | 100.0  | %                                 |   |                               |   |   |
| Less-discounts                                                            |   | 195                                         |   | 5.2                             | %      | 4.6                               | %      | 6.1                                | %      |
| Net sales                                                                 |   | 3,589                                       |   | 94.8                            | %      |                              |   |                               |   |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Cost of sales                                                             |   | 1,039                                       |   | 27.4                            | %      | 25.4                              | %      | 30.9                               | %      |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Personnel and benefits:                                                   |   |                                        |   |                            |   |                              |   |                               |   |
| Crew costs                                                                |   | 874                                         |   | 23.1                            | %      | 21.4                              | %      | 25.1                               | %      |
| Management costs                                                          |   | 418                                         |   | 11.0                            | %      | 8.9                               | %      | 15.7                               | %      |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Operating expenses:                                                       |   |                                        |   |                            |   |                              |   |                               |   |
| Advertising                                                               |   | 234                                         |   | 6.2                             | %      | 3.8                               | %      | 6.3                                | %      |
| Controllable expenses                                                     |   | 273                                         |   | 7.3                             | %      | 5.4                               | %      | 9.1                                | %      |
| Operating income before facility costs and  depreciation and amortization |   | 751                                         |   | 19.8                            | %      | 25.1                              | %*     | 13.2                               | %*     |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Facility costs                                                            |   | 162                                         |   | 4.2                             | %      | 1.2                               | %      | 9.4                                | %      |
|                                                                      |   |                                        |   |                            |   |                              |   |                               |   |
| Operating income before depreciation and  amortization                    |   | $                                           | 589    |                            | 15.6   | %                                 | 23.3   | %                                  | 3.8    | % |

 

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* Represents the actual bestand worst percentage performance for a restaurant in the group.  The best and worst performance on acomposite basis would be 30.4% and 6.7%, respectively.

 

**SIXMONTHS ENDED JUNE 30, 2003 AND 2002**

 

REVENUE.  Total revenue decreased 9.8% to $28,092,000from $31,149,000.

 

ROYALTIESdecreased 17.3% to $8,589,000 from $10,384,000.  The decrease was due to a decreased number of franchisedrestaurants during the six month period in 2003 compared to 2002 and a decreasein same store contractual sales of 11.7%, partially offset by a continuingshift in restaurant mix towards units with higher volume.

 

FRANCHISE FEESdecreased 95.2% to $3,000 from $62,000. The decrease was principally the result of a lower fee for current yearopenings of franchised restaurants as compared to the same period in the prioryear.  The decrease in franchise fee perrestaurant opening is due to the openings in the current quarter beinginternational restaurants under master license agreements where our franchisefee is lower.

 

DEVELOPER FEESdecreased 21.7% to $94,000 from $120,000. The decrease was primarily due to the expiration of amortization oncertain agreements.

 

RESTAURANTSALES decreased 3.3% to $15,613,000 from $16,140,000.  The decrease was primarily due to a 11.7% decrease in same storesales during the first six months of 2003, partially offset by an increase inthe average number of restaurants operated by the Company during the six monthsended June 30, 2003, compared to the comparable period of 2002.  As of June 30, 2003, there were 38Company-operated restaurants, compared to 35 at June 30, 2002, of which 23and 20, respectively, were available for sale.

 

SCHLOTZSKY’S®DELI BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 13.3% to $3,360,000 from$3,874,000.  The decrease was primarilydue to the decrease in systemwide sales for the period.

 

OTHER FEES ANDREVENUE decreased 24.1% to $432,000 from $569,000.  The decrease was due to a decrease in expired franchise fees.

 

OPERATINGEXPENSES increased 9.8% to $31,232,000 from $28,437,000.

 

SERVICE COSTSdecreased 41.3% to $1,331,000 from $2,267,000, and as a percentage of royaltiesand franchise fees declined to 15.5% from 21.7%. This decrease was primarilydue to the Company’s reacquisition of certain area developer territory rightsduring the third quarter of 2002, as well as a decrease in royalty revenue.

 

RESTAURANTOPERATIONS EXPENSES increased 5.7% to $15,435,000 from $14,606,000. The use ofsome Company-operated restaurants in the long-term portfolio for product,process and equipment testing and for systemwide training also adversely

 

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impacts their operatingperformance.  On an overall basis,costs, as a percentage of net restaurant sales, are higher at restaurantsavailable for sale, and the proportion of restaurants available for sale tototal Company-operated restaurants was higher this year than last year.

 

RESTAURANTCOST OF SALES increased 0.3% to $4,520,000 from $4,508,000 and increased as apercentage of net restaurant sales to 29.0% from 27.9% due primarily to anincrease in beverage costs.

 

RESTAURANTPERSONNEL AND BENEFITS COST increased 5.4% to $6,810,000 from $6,462,000, andincreased as a percentage of net restaurant sales to 43.6% from 40.0%.  The increase, as a percentage of netrestaurant sales, was due to the effect of lower average sales on managersalaries and preopening labor costs.

 

RESTAURANTOPERATING EXPENSES increased 12.9% to $4,104,000 from $3,636,000 and increased asa percentage of net restaurant sales to 26.3% from 22.5%.  The increase in operating costs, as apercentage of net restaurant sales, was primarily due to preopening costs on arestaurant opened during the quarter and a restaurant under development as wellas a tax assessment on one restaurant location.

 

EQUITY LOSS ONINVESTMENTS increased 93.6% to a loss of $151,000 from a loss of $78,000.  The equity investment represents theCompany’s 50% interest in a limited liability company that operates a Schlotzsky’sDeli restaurant that opened in 2000.

 

GENERAL ANDADMINISTRATIVE EXPENSES increased 26.5% to $11,783,000 from $9,315,000, andincreased to 41.9% from 29.9% as a percentage of total revenue. The increasefrom the prior year quarter was principally due increased provisions foruncollectible accounts and debt guarantees, increased franchisee meeting andconvention expense, and increased legal and professional expenses.

 

DEPRECIATIONAND AMORTIZATION increased 16.7% to $2,532,000 from $2,170,000.  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 six months of 2003 as compared to the prior year period.

 

INTERESTINCOME decreased 33.7% to $207,000 from $312,000.  The decrease was due to the decrease in the amount of outstandingnotes receivable, the nonrecognition of interest income on certainunderperforming notes receivable, a decrease in average interest rate the cashreceipt of $77,000 in interest on a nonaccruing note receivable in the firstsix months of 2002.

 

INTERESTEXPENSE increased 61.0% to $2,026,000 from $1,258,000 due primarily to theseller financed debt related to the reacquisition of the territorial rights theCompany’s largest area developer.

 

PROVISION FORINCOME TAXES reflected a combined federal and state effective tax benefit rateof 32.8% for the six months ended June 30, 2003, which was lower than theeffective combined tax rate of 36.8% for the comparable period in 2002primarily due to certain state taxes being based in part on factors other thanincome.

 

NET INCOMEdecreased to a loss of $3,334,000 from income of $1,116,000 due to the factorsdiscussed above.  Earnings per share,both basic and diluted, were ($0.46) for the six months ended June 30,2003 compared to $0.15 in the comparable period in the prior year.

 

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

 

The followingtable is presented for the Schlotzsky’s Delis in the Company’s long-termportfolio for the six months ended June 30, 2003.  As of June 30, 2003, this restaurantgroup included eight restaurants in the Austin area, two in College Station,Texas and one in suburban Atlanta, Georgia. This group includes ten freestanding restaurants, six recentlyconstructed, and one shopping center endcap restaurant.  In accordance with the Company’s internalmanagement reporting practices for consistent comparisons, line item categorieshave been expanded and percentages are calculated based on gross sales, insteadof net sales as used elsewhere in this report. Facility costs vary by restaurant because some facilities are rented andsome are owned.  The table provides theaverage percentage results for each line item for the eleven Schlotzsky’s Delirestaurants in the long-term portfolio group as a whole, as well as the bestand worst percentage performance for each line item for any restaurant in thegroup.

 

20

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|                                                                      |   | **Six Months  Ended  June 30, 2003** |   | **Percentage  of Gross  Sales** |   | **Best  Percentage  Performance** |   | **Worst  Percentage  Performance** |   |
|---------------------------------------------------------------------------|--------|-------------------------------------------|--------|---------------------------------|--------|-----------------------------------|--------|------------------------------------|--------|
|                                                                      |   | **(in thousands)**                        |   |                            |   |                              |   |                               |   |
| Gross sales                                                               |   | $                                         | 7,473  |                            | 100.0  | %                                 |   |                               |   |   |
| Less-discounts                                                            |   | 394                                       |   | 5.3                             | %      | 4.7                               | %      | 6.3                                | %      |
| Net sales                                                                 |   | 7,079                                     |   | 94.7                            | %      |                              |   |                               |   |
|                                                                      |   |                                      |   |                            |   |                              |   |                               |   |
| Cost of sales                                                             |   | 2,006                                     |   | 26.8                            | %      | 25.6                              | %      | 29.3                               | %      |
|                                                                      |   |                                      |   |                            |   |                              |   |                               |   |
| Personnel and benefits:                                                   |   |                                      |   |                            |   |                              |   |                               |   |
| Crew costs                                                                |   | 1,742                                     |   | 23.3                            | %      | 21.6                              | %      | 25.4                               | %      |
| Management costs                                                          |   | 845                                       |   | 11.3                            | %      | 9.3                               | %      | 17.4                               | %      |
|                                                                      |   |                                      |   |                            |   |                              |   |                               |   |
| Operating expenses:                                                       |   |                                      |   |                            |   |                              |   |                               |   |
| Advertising                                                               |   | 442                                       |   | 5.9                             | %      | 3.6                               | %      | 6.1                                | %      |
| Controllable expenses                                                     |   | 536                                       |   | 7.2                             | %      | 5.8                               | %      | 9.1                                | %      |
| Operating income before facility costs and  depreciation and amortization |   | 1,508                                     |   | 20.2                            | %      | 24.1                              | %*     | 12.3                               | %*     |
|                                                                      |   |                                      |   |                            |   |                              |   |                               |   |
| Facility costs                                                            |   | 322                                       |   | 4.3                             | %      | 1.3                               | %      | 9.6                                | %      |
|                                                                      |   |                                      |   |                            |   |                              |   |                               |   |
| Operating income before depreciation and  amortization                    |   | $                                         | 1,186  |                            | 15.9   | %                                 | 22.6   | %                                  | 2.6    | % |

 

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* Represents the actual bestand worst percentage performance for a restaurant in the group.  The best and worst performance on acomposite basis would be 33.3% and 3.5%, respectively.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

The Company has outstandingguarantees of indebtedness of others, including related parties, ofapproximately $29.2 million as of June 30, 2003. These guarantees includeapproximately $6.3 million of lease guarantees for the benefit of franchisees,approximately $14.5 million of mortgage loan guarantees for the benefit offranchisees and approximately $8.4 million of loan guarantees for the benefitof related parties.

 

The lease guarantees for thebenefit of franchisees arose primarily through our former Turnkey program, inwhich the Company developed the restaurants, leased the restaurants tofranchisees, and then sold them to a leasing company.  The guarantees range from limited guarantees, either in dollaramount or term, to full guarantees for the life of the lease.  The maximum guarantee for a single lease isapproximately $1.3 million.  Certainguarantees extend through 2018.  TheCompany may be required by the lessor to make monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. The Company has indemnification agreements with the franchisee underwhich the franchisee would be obligated to reimburse the Company for anyamounts paid under such guarantees.  Asof June 30, 2003, the Company had accrued a liability of approximately$598,000 related to these guarantees, including a $574,000 provision made inthe quarter ended June 30, 2003. The Company also has a net deferred gain related to the sale of theseleases in the amount of approximately $342,000 as of June 30, 2003.

 

The mortgage loan guaranteesfor the benefit of franchisees also arose primarily through the Company’sformer Turnkey program, in which we developed the related restaurants, sold therestaurant to a franchisee, and guaranteed all or a portion of the franchisee’smortgage loan.  The guarantees rangefrom limited guarantees, either in dollar amount or term, to full guarantees ofthe mortgage.  The maximum amount of asingle guarantee is approximately $1.0 million.  Certain guarantees extend through 2016.  The Company may be required by the lender to make monthlymortgage payments if the franchisee does not make the required payments in atimely manner, or the Company may be required to make up any deficiency, up tothe amount of the guarantee, if the related restaurant is sold for net proceedsless than the amount of the outstanding mortgage.  The Company has indemnification agreements with the franchiseesunder which the franchisee would be obligated to reimburse the Company for anyamount paid under such guarantees.  Inthe event that the Company purchases the loan from the lender in the event of adefault, the Company would succeed to the lender’s security interest in therelated property.

 

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The loan guarantees in favorof related parties primarily arose when the Company guaranteed certain debt ofrelated parties for which the proceeds of the loans were used to repayoutstanding debt to the Company.  Two ofthe guarantees, for the benefit of our restaurant venture and our real estateventure, are of mortgage debt totaling approximately $4.1 million.  These guarantees extend through 2009 on onenote and through 2016 on the other note. A third guarantee, of a bank note in the amount of approximately $4.3million, is for the benefit of the advertising entity of the Schlotzsky’s Delirestaurant system, for which the Company had received a portion of the netproceeds of the loan in repayment of outstanding debt to the Company.  This guarantee expires in 2004.  In connection with the guarantee of the $4.3million guarantee of the advertising entity bank note, which was made inJune 2003, a liability in the amount of $43,000 was accrued under theterms of FASB Interpretation No. 45.

 

The Company has been calledupon, from time to time, to make payments on obligations the Company hasguaranteed.  During the first six monthsof 2003, the Company paid approximately $346,000 in various lease guaranteesfor the benefit of franchisees.  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.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Cash and cashequivalents increased $101,000 in the six months ended June 30, 2003, anddecreased $1,586,000 in the six months ended June 30, 2002.  Cash flows are impacted by operating,investing and financing activities.

 

Operatingactivities provided $4,256,000 of cash in the first six months of 2003 and$3,525,000 of cash in the first six 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.

 

Investingactivities provided $113,000 and used $994,000 of cash in the first six monthsof  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 $4,267,000 and $4,117,000 of cash in the first six months of2003 and 2002, respectively.  Theincrease in cash used in the first six months of 2003 compared to thecomparable period of 2002 is primarily the net result of increased repaymentsof debt, partially offset by increased borrowings and reduced sales of commonstock.

 

AtJune 30, 2003, we had approximately $50,676,000 of total debtoutstanding.  Scheduled maturities ofdebt through June 30, 2004 approximate $10,006,000 (including short-termdebt).  In addition, one of ourmortgages requires the application to the mortgage of the net cash proceedsfrom the sale of certain real estate held for sale.

 

Certain of ourmortgage debt require the maintenance of certain financial ratios, includingdebt-to-equity and working capital.  AtJune 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 the Company.

 

22

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The followingtables present certain of our obligations to make future payments, excludinginterest payments, under contracts and contingent commitments as ofJune 30, 2003 (dollars in thousands):

 
|                         |   | **Payments Due by Period  As of June 30, 2003** |   |
|------------------------------|--------|------------------------------------------------------|--------|
| **Contractual  Obligations** |   | **Total**                                            |   | **Less than 1  year** |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
| Short-term Debt              |   | $                                                    | 1,375  |   | $ | 1,375 |   | $ | — |   | $ | — |   | $ | — |   |
| Long-term Debt               |   | 49,301                                               |   | 8,631 |   | 28,913 |   | 4,247 |   | 7,510 |   |
| Operating Leases             |   | 20,112                                               |   | 2,490 |   | 6,454 |   | 3,013 |   | 8,817 |   |
|                              |        |                                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                               |   | **Total**              |   | **Amount of Commitment Expiration Per Period  As of June 30, 2003** |   |
|------------------------------------|--------|------------------------|--------|--------------------------------------------------------------------------|--------|
| **Other  Commercial  Commitments** |   | **Amounts  Committed** |   | **Less than 1  year**                                                    |   | **1-3 years** |   | **4-5 years** |   | **After 5 years** |   |
| Guarantees                         |   | $                      | 29,233 |                                                                     | $      | 9,555 |   | $ | 3,188 |   | $ | 2,530 |   | $ | 13,960 |   |
|                                    |        |                        |        |                                                                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

We haveexperienced net reductions in the number of restaurants systemwide quarterlysince 2000 and have experienced negative same store contractual sales quarterlysince mid-2001.  While we have beendeveloping and implementing strategies to reverse these trends, we expect thatthe number of restaurants will continue to decline in the near term until ourrenewed efforts to expand our franchising program reverses this trend.  Continuation of these trends would have anegative impact on our royalty revenue and brand contribution, which in turnwould impact our cash flow and liquidity.

 

OnJuly 31, 2003 we effected a reduction in force eliminating 39 positions onthe corporate staff, reducing the personnel employed at our corporateheadquarters or as field personnel to approximately 110.  These reductions, along with certain salaryadjustments, will begin to impact operating results in the third quarter of2003, but will be largely offset by separation expenses in that quarter.  The full effect of these position reductionswill be reflected in the fourth quarter of 2003.  We have developed and are implementing plans to significantlyreduce non-compensation general and administrative expenses and certainemployee benefits, and our goal is to, between the two actions, achieve areduction in total general and administrative expenses of at least$4 million on an annualized basis.

 

We plan todevelop additional Company-operated restaurants. One restaurant opened in theAustin area in June 2003.  We alsohave acquired building sites for four additional restaurants in the Austin areaand entered into a lease for a site in the Houston area. Sites for additionalrestaurants in Texas and other markets are under consideration.  We do not plan to pursue development ofthese properties until financing arrangements are in place to fund this growthin our Company-operated restaurants.

 

We are continuing to pursuerefinancing of certain seller financed debt which matures in 2005 and higherrate mortgage debt and generate additional working capital.  We are pursuing financing alternatives,including asset-backed financing secured by our intellectual property andrelated royalty rights and agreements, as well as real estate mortgages.  There can be no assurances that suchfinancing can be arranged in acceptable amounts and on acceptable terms.  Failure to obtain such refinancing or otherinterim partial financing or restaurant mortgages by the end of 2003 couldrequire us to further modify our operating costs or reduce capital expenditureplans or defer payments.

 

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

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations in this Form 10-Q should be read in conjunction with Management’sDiscussion and Analysis of Financial Condition and Results of Operations andother material included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2002.

 

**Forward-Looking Statements**

 

This reportmay contain “forward-looking statements” within the meaning of Section 27A ofthe Securities 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 deemedforward-looking statements.  Forward-looking statements are not meantto predict or guarantee actual results, performance, events, or circumstancesand may not be realized because they are based on our current projections,plans, objectives, beliefs, expectations, estimates, and assumptions and aresubject to a number of risk factors and uncertainties, many of which are beyondour control.  Actual results and thetiming of future events and circumstances may differ materially from thosedescribed or implied by the forward-looking statements as a result of theserisk factors and uncertainties. Forward-looking statements may

 

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include, without limitation,statements concerning earnings or other financial item projections, the plansand objectives of management, future economic performance, new restaurantdevelopment, future Schlotzsky’s Deli brand products, and assumptionsunderlying or relating to any other forward-looking statement.  Factors that could cause actual results todiffer materially from those described in the forward-looking statements may include, withoutlimitation, an inability of the Companyor our franchisees to obtain adequate financing, increased competitionwithin the restaurant industry, the continued viability of restaurants during aweak economy, the results of arbitration and litigation, an inability to sellrestaurants, a failure to successfully recruit multi-unit and single-unitfranchisees, and stock volatility andilliquidity.

 

Because of therisks and uncertainties related to these factors and the forward-lookingstatements, readersare cautioned not to place undue reliance on the forward-lookingstatements.  There can be noassurance that any events or results described in any forward-looking statementwill actually occur or be achieved.  We undertake no obligation to publicly revisethe forward-looking statements to reflect events or circumstances that ariseafter the date of this report or to reflect new information, futureevents or circumstances, changes in assumptions, or otherwise. Readers should carefully review the risk factors described above and inother documents filed by us with the Commission.  Readers are specifically directed to the discussion under “RiskFactors” in our most recent annual report on Form 10-K.

 

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

 

Changes inshort-term interest rates on loans from financial institutions could materiallyaffect the Company’s earnings because the interest rates charged on certainunderlying obligations are variable.

 

AtJune 30, 2003, a hypothetical 100 basis point increase in interest rateswould result in a decrease of approximately $74,000 in annual pre-taxearnings.  The estimated decrease isbased upon the increased interest expense of the Company’s variable rate debtand assumes no change in the volume or composition of debt at June 30,2003.

 

**ITEM 4.****                                                    ****CONTROLS AND PROCEDURES**

 

(a)                      Evaluation of Disclosure Controls andProcedures.** **The term “disclosure controls and procedures”is defined in Rule 13a-14(c) of the Securities Exchange Act of 1934, or theExchange Act.  This term refers to thecontrols and procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports it files underthe Exchange Act is recorded, processed, summarized and reported within therequired time periods.  Our ChiefExecutive Officer and our Chief Financial Officer have evaluated theeffectiveness of our disclosure controls and procedures as of a date within 90days before the filing of this quarterly report, and they have concluded thatas of that date, our disclosure controls and procedures were effective atensuring that required information will be disclosed on a timely basis in ourreports filed under the Exchange Act.

 

(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 or inother factors that could significantly affect our internal controls subsequentto the date of their evaluation by our Chief Executive Officer and Chief FinancialOfficer, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

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**PARTII**

**OTHER INFORMATION**

 

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

 

*New Florida Markets, Ltd. v. Schlotzsky’s,Inc., Schlotzsky’s Franchise Limited Partnership, Schlotzsky’s Franchisor, LLC,Schlotzsky’s Franchise Operations, LLC, Schlotzsky’s NAMF, Inc., andSchlotzsky’s NAMF Funding, LLC*, (Case No. 701140045603) was filed onor 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., anarea developer 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 claims includebreach of the implied covenant of good faith and fair dealing, constructivetermination, and violation of the Texas Deceptive Trade Practices Act.Claimants seek actual, compensatory, and punitive damages of an unspecifiedamount, attorneys’ fees, and costs.  Thecase is not yet set for hearing.

 

*Comerica Bank vs. James E. Wright, John D.Wright, Lorraine Wright, and Kimberly Wright v. Schlotzsky’s, Inc. andSchlotzsky’s Real Estate, Inc., In the Circuit Court for the County ofGenessee, State of Michigan* (Case No. 02-74931), wasfiled 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 restaurant in Grand Blanc,Michigan and filed Chapter 11 bankruptcy. In January 2003, Schlotzsky’sReal Estate, Inc. had filed suit against John and James Wright, for collectionof $283,872.68 due under a promissory note. In the instant case, Third Party Plaintiffs allege that they wereinduced into participating in the Turnkey program and that an employee of theCompany represented that the restaurant would attain a certain level ofsales.  Third Party Plaintiffs’ claimsinclude fraud in the inducement, fraudulent and negligent misrepresentation,and breach of the Michigan Franchise Investment Act.  They seek damages of an unspecified amount in excess of $25,000,attorneys’ fees, and costs.  The case isnot yet set for trial.

 

*Russell R. Kesterson and Steven P. Schmidt v.Schlotzsky’s, Inc., Ron Lynch and Jane Doe Lynch, John Does I—X, Jane DoesI—X, ABC Corporations I—X, XYZ Companies I—X*, (CaseNo. CV2002-021158) was filed on October 31, 2002, in the SuperiorCourt of Maricopa County, Arizona. Plaintiffs were franchisees of the Companyand owned and operated a Schlotzsky’s Deli restaurant in Phoenix, Arizona. TheComplaint includes claims of breach of contract, interference with businessexpectancy, interference with business relationship, unfair competition andnegligence. Plaintiffs allege that a “superstore” owned by Lynch and/or ouraffiliates encroached on their business and allege that we failed to collectroyalties from the “superstore,” creating unfair competition. Plaintiffsfurther state that they attempted to relocate their restaurant but that wefailed to approve a proposed alternative location and that we induced one oftheir employees to work for a competing restaurant. Plaintiffs are seeking anunspecified amount of damages, including treble damages, attorney’s fees, andcosts. On December 3, 2002, we filed a petition styled *Schlotzsky’s, Inc., v. Russell R. Kesterson andSteven P. Schmidt*, in the United States District Court for theWestern District of Texas, Austin Division (Civil Action No. AO2CA 768SS) tocompel Plaintiffs to arbitrate their claims in Austin, Texas. The federal courtentered an order on December 20, 2002, granting our petition to compelarbitration in the manner provided in the franchise agreement and enjoinedKesterson and Schmidt from pursuing any of their claims in the lawsuit pendingin Arizona. To date, we are unaware of any subsequent demand for arbitrationfiled by either Kesterson or Schmidt.

 

*Kimberly L.E. Garland v.Schlotzsky’s, Inc., Schenck & Associates, John C. Wooley, DarrellW. Kolinek, Kelly R. Arnold, Joyce Cates, Brian Wieters, David B. Gerstner, andJeffrey P. Noeldner* (Case No. 01-CV-2377) wasfiled on or about December 26, 2001 in the United States District Courtfor the District of Minnesota. Plaintiff, a principal of a former franchisee inApple Valley, Minnesota, brought suit against the Company and five of itscurrent and former employees (John Wooley, Darrell Kolinek, Kelly Arnold, JoyceCates, and Brian Wieters, collectively the “Schlotzsky’s Parties”), her AreaDeveloper (Jeffrey Noeldner), her accountant (David Gerstner), and hisaccounting firm (Schenck & Associates). Plaintiff claimed she wasfraudulently induced into developing a Schlotzsky’s Deli restaurant through theCompany’s Turnkey program, and that Defendants should have advised her thatfranchisees’ financial projections were unrealistic.  Her claims included fraudulent and negligent misrepresentationand omission and violations of the Minnesota Franchise Act, Minnesota UniformDeceptive Trade Practices Act, and the Texas Deceptive Trade Practices andConsumer Protection Act. Defendants filed motions to dismiss or stay the casepending arbitration as required in the Franchise Agreement. Prior to a hearingon the motions, the parties were ordered to appear for a settlement conferenceon May 19, 2003.  Without concedingthe facts that formed the basis of any claims, the parties entered into asettlement agreement.  Plaintiff agreedto terminate the franchise agreement, exit the system, and pay $5,500 inmediator’s fees.  In exchange, Schenck& Associates and Gerstner agreed to pay $90,000, the Schlotzsky’s Partiesand Noeldner paid $11,525, and their insurer contributed $218,975 in settlementto Plaintiff.  The parties agreed todismiss all of their respective claims, with prejudice.

 

*Robert Coshott v.Schlotzsky’s, Inc.* (Cause No. GN 1-02279), wasfiled on July 24, 2001, in the 200th Judicial District Court of TravisCounty, Texas. Plaintiff is the Master Licensee for Australia and New Zealand,and he opened a Schlotzsky’s Deli restaurant in Melbourne, Australia. Plaintiffbrings causes 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

 

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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 InternationalChamber of Commerce styled *Robert Gilbert Coshott v. Schlotzsky’s, Inc.*(Case. No. TBD).  The claims in theDemand are similar to those brought in the above-entitled action and includeadditional allegations that we required the purchase of goods and services fromcertain suppliers in violation of the Trade Practices Act of 1974 that that wefailed to disclose the existence of a predecessor Master License Agreement, inviolation of the Fair Trading Act of 1987 (New South) Wales, breach ofcontract, 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.  

 

*Dae Kim, DWK Enterprises, Inc., andAecon International, Inc. v. John Wooley, Schlotzsky’s, Inc.,Schlotzsky’s Franchising Limited Partnership, Schlotzsky’s N.A.M.F., Inc.,Schlotzsky’s National Advertising Association, Inc., and Schlotzsky’s,Brands, Inc., Schlotzsky’s Brand Products, L.P., Schlotzsky’s RealEstate, Inc., and Schlotzsky’s Restaurants, Inc.*(Cause No. 2001-CI-13672) was originally filed in the 73rd Judicial DistrictCourt of Bexar County, Texas on or about September 25, 2001 (after asimilar lawsuit was filed and later withdrawn in Harris County, Texas) againstSchlotzsky’s, Inc., John Wooley, Schlotzsky’s Franchising LimitedPartnership, and Schlotzsky’s NAMF, Inc. (collectively, “Defendants”). Plaintiffsare, or claim to be, franchisees in Houston and San Antonio Texas, andPlaintiff Kim was an area developer for those markets. Plaintiffs bring causesof action for breach of contract, breach of fiduciary duty, breach of the dutyof good faith and fair dealing, civil conspiracy, tortious interference withcontract, tortious interference with prospective business relationship,violation of the Texas Deceptive Trade Practices and Consumer Protection Act,restraint of trade, detrimental reliance-fraud in the inducement, anddefamation-business disparagement. They seek an unspecified amount of moneydamages plus exemplary damages, attorneys’ fees, pre-judgment interest, costs,and a jury trial. Defendants, except for Mr. Wooley, who was previouslydismissed from the case, answered and asserted counterclaims alleging breach ofcontract and that Plaintiffs’ claim under the Texas Deceptive Trade PracticesAct is groundless in fact or in law and brought in bad faith or for the purposeof harassment, and seeking money damages, costs of court, penalty fees, costsincurred in performing the accounting, attorneys’ fees, and pre- andpost-judgment interest. Defendants (except for Mr. Wooley) removed thecase to federal court. The case was remanded to state court on April 17,2003.  The case is not yet set for trial.

 

*U.S. RestaurantProperties Operating L.P. v. Schlotzsky’s, Inc.*(CauseNo. 03-01758) was filed on February 27, 2003, in the District Courtof Dallas County, B-44th Judicial District. Plaintiff is a real estate investment company that owns certainSchlotzsky’s Deli restaurants and leases them to franchisees. It alleges thatin 1997 and 1998 we entered into several agreements where we agreed toguarantee certain lease agreements. Plaintiff states that in 1998 the partiesentered into an agreement whereby Plaintiff agreed to release Schlotzsky’s fromits guaranty obligations pertaining to six properties in which the tenants haddefaulted, in exchange for Schlotzsky’s agreement to purchase seven other properties.The Company purchased one of the properties located in Texas. Plaintiffs areseeking an order requiring us to purchase the other six properties, two ofwhich 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 order reinstating the previously releasedguaranties. Plaintiff’s claims include breach of contract and a request forattorneys’ fees. A trial date has been set for February 16, 2004.

 

In addition tothe matters discussed above, we are defendants in various other legalproceedings arising from our business. The ultimate outcome of these pendingproceedings cannot be projected with certainty. However, based on our experienceto date, we believe such proceedings will not have a material effect on ourbusiness or financial condition.

 

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**ITEM 2.****                                                     CHANGESIN SECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM 3.****                                                     DEFAULTSUPON SENIOR SECURITIES**

 

None.

 

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

 

The AnnualMeeting of the Shareholders of the Company was held on June 23, 2003.  At the meeting, the following items werevoted on:

 

Election of adirector, whose term expired at the meeting, to a term expiring in 2006.

 
|           |   | **FOR**   |   | **WITHHELD** |   |
|----------------|--------|-----------|--------|--------------|--------|
| Floor Mouthaan |   | 5,320,234 |   | 1,550,814    |   |

 

Election ofdirectors to terms expiring in 2006:

 
|             |   | **FOR**   |   | **WITHHELD** |   |
|------------------|--------|-----------|--------|--------------|--------|
| Pike Powers      |   | 5,269,202 |   | 1,601,846    |   |
| Sarah Weddington |   | 5,280,499 |   | 1,590,549    |   |

 

Election of adirector for a term expiring in 2005:

 
|       |   | **FOR**   |   | **WITHHELD** |   |
|------------|--------|-----------|--------|--------------|--------|
| John Sharp |   | 5,288,690 |   | 1,582,358    |   |

 

Shareholderproposal to pursue a sale of the Company:

 
|   |   | **FOR**   |   | **AGAINST** |   | **ABSTAIN** |   |
|--------|--------|-----------|--------|-------------|--------|-------------|--------|
|   |   | 1,601,230 |   | 3,283,730   |   | 64,247      |   |

 

**ITEM5.****                                                     OTHERINFORMATION**

 

None.

 

27

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**ITEM 6.****     EXHIBITSAND 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) |
|   |   |      |   |   |
|   |   | 10.46     |   | Guaranty Agreement, dated  June 12, 2003 between the Company, as Guarantor, Commerce National Bank,  as Lender, and Schlotzsky’s NAMF Funding, LLC, as Borrower. (4) |
|   |   |      |   |   |
|   |   | 10.47     |   | Equipment Finance Agreement  dated July 24, 2003 between the Company and American Express Business  Finance Corporation. (4) |
|   |   |      |   |   |
|   |   | 10.48     |   | Modification, Extension and  Renewal dated August 8, 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. (4) |
|   |   |      |   |   |
|   |   | 31.1      |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002, signed by John C. Wooley,  Chief Executive Officer.  (4) |
|   |   |      |   |   |
|   |   | 31.2      |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002, signed by Richard H. Valade,  Chief Financial Officer.  (4) |
|   |   |      |   |   |
|   |   | 32.1      |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, signed by John C. Wooley,  Chief Executive Officer.  (4) |
|   |   |      |   |   |
|   |   | 32.2      |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, signed by Richard H. Valade,  Chief Financial Officer.  (4) |
|   |   |      |

----

|   |   | (1)                                                                                                                                                                                                                                                                |   | Incorporated by reference  from the Company’s Registration Statement on Form S-1 filed on  October 12, 1995, as amended.   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | (2)                                                                                                                                                                                                                                                                |   | Incorporated by referenced  from the Company’s Registration of certain Securities on Form 8-A filed on  December 18, 1998. |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | (3)                                                                                                                                                                                                                                                                |   | Incorporated by reference  from the Company’s Annual Report on Form 10-K filed on April 2, 2001.                           |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | (4)                                                                                                                                                                                                                                                                |   | Filed with this Quarterly  Report on Form 10-Q.                                                                                      |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
| b)     |   | Current Reports on Form  8-K:                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | The  Registrant filed a Current Report on Form 8-K dated April 3, 2003,  containing a press release dated March 28, 2003, announcing the  Company’s release of financial results for the quarter and fiscal year ended  December 31, 2002.     |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | The Registrant filed a  Current Report on Form 8-K dated May 15, 2003, containing a press  release dated May 15, 2003, announcing the Company’s release of  financial results for the quarter ended March 31, 2003.                            |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | The Registrant filed a  Current Report on Form 8-K dated June 24, 2003, containing a press  release dated June 23, 2003, announcing the results of shareholder  voting at the Company’s Annual Meeting of Shareholders held on June 23,  2003. |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | The Registrant filed a  Current Report on Form 8-K dated August 4, 2003, containing a press  release dated July 31, 2003, announcing a realignment and reduction in  force effected on July 31, 2003.                                               |
|   |   |                                                                                                                                                                                                                                                               |   |                                                                                                                                 |
|   |   | The Registrant filed a  Current Report on Form 8-K dated August 14, 2003, containing a press  release dated August 14, 2003, announcing the Company’s release of  financial results for the quarter ended June 30, 2003                        |

 

28

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**SIGNATURES**

 

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

 
|                                | SCHLOTZSKY’S,  INC. |
|-------------------------------------|--------------------------|
|                                |                     |   |
|                                |                     |   |
|                                | By:                      | /s/  John C. Wooley |   |
|                                |                     | John C.  Wooley |
|                                |                     | Chairman of  the Board,  President and Chief Executive Officer  (Principal Executive Officer) |
|                                |                     |   |
|                                |                     |   |
|                                | By:                      | /s/  Richard H. Valade |   |
|                                |                     | Richard H.  Valade |
|                                |                     | Executive  Vice President,  Treasurer and Chief Financial Officer  (Principal Financial Officer) |
|                                |                     |   |
|                                |                     |   |
|                                | By:                      | /s/  Matthew D. Osburn |   |
|                                |                     | Matthew D.  Osburn  Controller and Assistant Treasurer  (Principal Accounting Officer) |
|                                |                     |   |
|                                |                     |   |
| Austin, Texas  August 14, 2003 |                     |   |

 

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