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SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended                                November 7, 2004 Commission file number                               1-08395 Morgans Foods, Inc. 
  Ohio
    
    34-0562210(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)24200 Chagrin Boulevard, Suite 126, Beachwood, Ohio
    
    44122(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code:                                (216) 360-7500    Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes            x                      No            o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes           o                      No            x As of December 22, 2004, the issuer had 2,718,441 shares of common stock
outstanding.




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TABLE OF CONTENTS  PART I  FINANCIAL INFORMATIONItem 1. Financial StatementsCONSOLIDATED STATEMENTS OF OPERATIONSCONSOLIDATED BALANCE SHEETSCONSOLIDATED STATEMENT OF SHAREHOLDERS DEFICIENCYCONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONSOLIDATED FINANCIAL STATEMENTSItem 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures About Market RiskItem 4. Controls and ProceduresINDEX TO EXHIBITSSIGNATURESEX-31.1 Section 302 CEO CertificationEX-31.2 Section 302 CFO CertificationEX-32.1 CEO 906 CertificationEX-32.2 CFO 906 Certification    Table of Contents  
 PART I            FINANCIAL INFORMATION 
 Item 1. Financial
Statements. Morgans Foods, Inc. 
 CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) Quarter EndedNovember 7, 2004
    
    November 9, 2003Revenues
    
    $
    19,190,000
    
    
    $
    19,382,000Cost of sales:Food, paper and beverage
    
    
    6,182,000
    
    
    
    5,963,000Labor and benefits
    
    
    5,290,000
    
    
    
    5,219,000Restaurant operating expenses
    
    
    4,927,000
    
    
    
    5,065,000Depreciation and amortization
    
    
    944,000
    
    
    
    809,000General and administrative expenses
    
    
    1,110,000
    
    
    
    1,170,000Loss on restaurant assets
    
    
    434,000
    
    
    
    27,000Operating income
    
    
    303,000
    
    
    
    1,129,000Interest Expense:Bank debt and notes payable
    
    
    (991,000
    )
    
    
    (1,047,000
    )Capital leases
    
    
    (11,000
    )
    
    
    (11,000
    )Other income and expense, net
    
    
    23,000
    
    
    
    19,000Income (loss) before income taxes
    
    
    (676,000
    )
    
    
    90,000Provision for income taxes
    
    
    601,000
    
    
    
    Net income (loss)
    
    $
    (1,277,000
    )
    
    $
    90,000Basic and diluted net income (loss)
per common share
    
    $
    (.47
    )
    
    $
    .03Basic weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,718,441Diluted weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,723,984
 See notes to consolidated financial statements. 2




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PART I   FINANCIAL INFORMATION Item 1. Financial Statements. Morgans Foods, Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) Thirty-Six Weeks EndedNovember 7, 2004
    
    November 9, 2003Revenues
    
    $
    57,324,000
    
    
    $
    58,873,000Cost of sales:Food, paper and beverage
    
    
    18,057,000
    
    
    
    17,844,000Labor and benefits
    
    
    16,129,000
    
    
    
    16,200,000Restaurant operating expenses
    
    
    14,818,000
    
    
    
    15,066,000Depreciation and amortization
    
    
    2,504,000
    
    
    
    2,408,000General and administrative expenses
    
    
    3,505,000
    
    
    
    3,859,000Loss on restaurant assets
    
    
    726,000
    
    
    
    74,000Operating income
    
    
    1,585,000
    
    
    
    3,422,000Interest Expense:Bank debt and notes payable
    
    
    (3,037,000
    )
    
    
    (3,213,000
    )Capital leases
    
    
    (33,000
    )
    
    
    (34,000
    )Other income and expense, net
    
    
    62,000
    
    
    
    73,000Income (loss) before income taxes
    
    
    (1,423,000
    )
    
    
    248,000Provision for income taxes
    
    
    602,000
    
    
    
    4,000Net income (loss)
    
    $
    (2,025,000
    )
    
    $
    244,000Basic and diluted net income (loss)
per common share
    
    $
    (.74
    )
    
    $
    .09Basic weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,718,441Diluted weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,724,758
 See notes to consolidated financial statements. 3




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Morgans Foods, Inc. 
 CONSOLIDATED BALANCE SHEETS (unaudited) November 7, 2004
    
    February 29, 2004ASSETSCurrent assets:Cash and equivalents
    
    $
    2,644,000
    
    
    $
    4,353,000Short term investment  restricted
    
    
    
    
    
    
    300,000Receivables
    
    
    171,000
    
    
    
    242,000Inventories
    
    
    669,000
    
    
    
    573,000Prepaid expenses
    
    
    985,000
    
    
    
    324,0004,469,000
    
    
    
    5,792,000Property and equipment:Land
    
    
    10,662,000
    
    
    
    10,971,000Buildings and improvements
    
    
    19,280,000
    
    
    
    19,246,000Property under capital leases
    
    
    776,000
    
    
    
    776,000Leasehold improvements
    
    
    7,229,000
    
    
    
    7,353,000Equipment, furniture and fixtures
    
    
    19,180,000
    
    
    
    18,864,000Construction in progress
    
    
    49,000
    
    
    
    58,00057,176,000
    
    
    
    57,268,000Less accumulated depreciation and amortization
    
    
    25,570,000
    
    
    
    23,377,00031,606,000
    
    
    
    33,891,000Other assets
    
    
    1,061,000
    
    
    
    1,186,000Franchise agreements
    
    
    1,740,000
    
    
    
    1,876,000Deferred taxes
    
    
    
    
    
    
    600,000Goodwill
    
    
    9,227,000
    
    
    
    9,327,000$
    48,103,000
    
    
    $
    52,672,000LIABILITIES AND SHAREHOLDERS DEFICIENCYCurrent liabilities:Long-term debt, current
    
    $
    43,945,000
    
    
    $
    2,743,000Current maturities of capital lease obligations
    
    
    14,000
    
    
    
    58,000Accounts payable
    
    
    3,991,000
    
    
    
    3,642,000Accrued liabilities
    
    
    3,112,000
    
    
    
    3,348,00051,062,000
    
    
    
    9,791,000Long-term debt
    
    
    
    
    
    
    43,370,000Long-term capital lease obligations
    
    
    374,000
    
    
    
    379,000Other long-term liabilities
    
    
    1,408,000
    
    
    
    1,848,000SHAREHOLDERS DEFICIENCYPreferred shares, 1,000,000 shares authorized,
no shares outstandingCommon StockAuthorized
shares  25,000,000Issued shares  2,969,405
    
    
    30,000
    
    
    
    30,000Treasury stock  250,964
    
    
    (284,000
    )
    
    
    (284,000
    )Capital in excess of stated value
    
    
    28,829,000
    
    
    
    28,829,000Accumulated deficit
    
    
    (33,316,000
    )
    
    
    (31,291,000
    )Total shareholders deficiency
    
    
    (4,741,000
    )
    
    
    (2,716,000
    )$
    48,103,000
    
    
    $
    52,672,000
 See notes to consolidated financial statements. 4




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Morgans Foods, Inc. 
 CONSOLIDATED STATEMENT OF SHAREHOLDERS DEFICIENCY (unaudited) Common Shares
    
    Treasury Shares
    
    Capital inexcess of
    
    Accumulated
    
    TotalShareholdersShares
    
    Amount
    
    Shares
    
    Amount
    
    stated value
    
    Deficit
    
    DeficiencyBalance March 2, 2003
    
    
    2,969,405
    
    
    $
    30,000
    
    
    
    (250,964
    )
    
    $
    (284,000
    )
    
    $
    28,829,000
    
    
    $
    (29,997,000
    )
    
    $
    (1,422,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,294,000
    )
    
    
    (1,294,000
    )Balance February 29, 2004
    
    
    2,969,405
    
    
    
    30,000
    
    
    
    (250,964
    )
    
    
    (284,000
    )
    
    
    28,829,000
    
    
    
    (31,291,000
    )
    
    
    (2,716,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,025,000
    )
    
    
    (2,025,000
    )Balance November 7, 2004
    
    
    2,969,405
    
    
    $
    30,000
    
    
    
    (250,964
    )
    
    $
    (284,000
    )
    
    $
    28,829,000
    
    
    $
    (33,316,000
    )
    
    $
    (4,741,000
    )
 See notes to consolidated financial statements 5




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Morgans Foods, Inc. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Thirty-Six Weeks EndedNovember 7, 2004
    
    November 9, 2003Cash flows from operating activities:Net income (loss)
    
    $
    (2,025,000
    )
    
    $
    244,000Adjustments to reconcile to net cash
provided by operating activities:Depreciation and amortization
    
    
    2,420,000
    
    
    
    2,408,000Amortization of deferred financing costs
    
    
    84,000
    
    
    
    94,000Amortization of supply agreement advances
    
    
    (535,000
    )
    
    
    (599,000
    )Funding from supply agreements
    
    
    130,000
    
    
    
    647,000Loss on restaurant assets
    
    
    726,000
    
    
    
    74,000Provision for deferred taxes
    
    
    600,000
    
    
    
    Change in assets and liabilities:Decrease in receivables
    
    
    71,000
    
    
    
    124,000Increase in inventories
    
    
    (96,000
    )
    
    
    (40,000
    )Decrease (increase) in prepaid expenses
    
    
    (661,000
    )
    
    
    37,000Decrease in other assets
    
    
    110,000
    
    
    
    Increase in accounts payable
    
    
    349,000
    
    
    
    120,000Decrease in accrued liabilities
    
    
    (275,000
    )
    
    
    (347,000
    )Net cash provided by operating activities
    
    
    898,000
    
    
    
    2,762,000Cash flows from investing activities:Capital expenditures
    
    
    (665,000
    )
    
    
    (976,000
    )Redemption (purchase) of certificate of deposit
    
    
    300,000
    
    
    
    (300,000
    )Purchase of franchise agreement
    
    
    (25,000
    )
    
    
    (35,000
    )Net cash used in investing activities
    
    
    (390,000
    )
    
    
    (1,311,000
    )Cash flows from financing activities:Principal payments on long-term debt
    
    
    (2,197,000
    )
    
    
    (1,935,000
    )Principal payments on capital lease obligations
    
    
    (49,000
    )
    
    
    (79,000
    )Proceeds from issuance of long-term debt,
net of financing costs
    
    
    29,000
    
    
    
    Net cash used in financing activities
    
    
    (2,217,000
    )
    
    
    (2,014,000
    )Net change in cash and equivalents
    
    
    (1,709,000
    )
    
    
    (563,000
    )Cash and equivalents, beginning balance
    
    
    4,353,000
    
    
    
    4,901,000Cash and equivalents, ending balance
    
    $
    2,644,000
    
    
    $
    4,338,000Supplemental Disclosure of Cash Flow Information:Cash paid during the period for interest
    
    $
    3,303,000
    
    
    $
    3,482,000
 See notes to consolidated financial statements. 6




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Morgans Foods, Inc. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS QUARTERS ENDED NOVEMBER 7, 2004 AND NOVEMBER 9, 2003
(unaudited)
 Note 1. Summary of Significant Accounting Policies. The interim consolidated financial statements of Morgans Foods, Inc.
(the Company) have been prepared without audit. In the opinion of Company
Management, all adjustments have been included. Unless otherwise disclosed,
all adjustments consist only of normal recurring adjustments necessary for a
fair statement of results of operations for the interim periods. These
unaudited financial statements have been prepared using the same accounting
principles that were used in preparation of the Companys annual report on Form
10-K for the year ended February 29, 2004. Cash and Investments.The Company held a $300,000 certificate of deposit as a
restricted short-term investment to secure a letter of credit that expired June
18, 2004 at which time the certificate of deposit was redeemed and converted to
cash. Note 2. Income (Loss) Per Common Share. Basic net income (loss) per common share is computed by dividing net
income (loss) by the weighted average number of common shares outstanding
during the period. Diluted net income (loss) per common share is based on the
combined weighted average number of shares outstanding, which includes the
assumed exercise, or conversion of options. In computing diluted net income
(loss) per common share, the Company has utilized the treasury stock method.
For the quarter and thirty-six weeks ended November 9, 2003 275,000 shares were
excluded from the computation of diluted earnings (loss) per share due to their
antidilutive effect. For the quarter and thirty-six weeks ended November 7,
2004, 286,500 shares were excluded from the computation of diluted earnings
(loss) per share due to their antidilutive effect. Note 3. Loss on Restaurant Assets. The Company recognized losses on restaurant assets of $27,000 and $74,000,
respectively, in the quarter and thirty-six weeks ended November 9, 2003.
These fiscal 2004 losses primarily resulted from charges for the costs
necessary to dispose of one previously closed restaurant. The Company
recognized losses on restaurant assets of $434,000 and $726,000, respectively,
in the quarter and thirty-six weeks ended November 7, 2004. These fiscal 2005
amounts primarily relate to impairment losses on nine restaurants to reduce
their carrying value to estimated fair value. The impairment losses recorded
in all periods presented were recognized as a result of management determining
that the future operating cash flows of these restaurants would not fully
recover the carrying value of the property and equipment. Note 4. Intangible Assets. On November 24, 2004 the Company completed previously planned closures of
three unprofitable restaurants (two in the St. Louis market and one in the
Pittsburgh market) which will improve cash flow. As a result of these closings
the Company reduced goodwill and franchise fees by $100,000 and $69,000,
respectively, in the quarter ended November 7, 2004. 7




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Note 5. Stock Options. The Companys outstanding stock options are accounted for using the
intrinsic value method, under which compensation cost is measured as the
excess, if any, of the quoted market price of the stock at the grant date over
the amount an employee must pay to acquire the stock. Had compensation cost
for the options granted been determined based on their fair values at the grant
dates in accordance with the fair value method of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation,
the proforma impact on the Companys net income (loss) and earnings (loss) per
share would be immaterial for the quarters and thirty-six weeks ended November
7, 2004 and November 9, 2003. Note 6. Long-Term Debt. The Companys debt arrangements require the maintenance of a consolidated
fixed charge coverage ratio of 1.2 to 1 regarding all of the Companys mortgage
loans and the maintenance of individual restaurant fixed charge coverage ratios
of between 1.2 and 1.5 to 1 on certain of the Companys mortgage loans. The
consolidated and individual coverage ratios are computed quarterly, based upon
financial results for the preceding twelve months. At the end of fiscal 2004
and each of the fiscal 2005 quarters, including November 7, 2004,, the Company
was not in compliance with the consolidated ratio or with individual restaurant
ratios relating to a substantial portion of its debt. The Company obtained
waivers of these violations from the applicable lenders at the end of fiscal
2004 and the first and second quarters of fiscal 2005, in each case with the
lenders agreeing to forebear exercising their rights and remedies through the
following twelve months. Based upon projected operating results, the Company
believed at the time it received the foregoing waivers that it would comply
with the terms thereof throughout the respective forbearance periods and,
accordingly, the Company classified the debt for which it received waivers as
long-term as of the end of fiscal 2004 and the first and second quarters of
fiscal 2005. For the quarter ended November 7, 2004, waivers of the fixed
charge coverage ratio violations were not obtained from the lenders. Due to
noncompliance with the fixed charge coverage ratios and as required by EITF
86-30, the Company has classified all of its debt as current as of November 7,
2004. As of November 7, 2004 and through December 22, 2004, all payments on
the Companys debt have been made timely and the lenders have not pursued any
remedies which may be available to them based on the violation. As described
below, the Company has initiated an operational and financial restructuring
process, which management believes, but cannot assure, will allow the Company
to satisfy the lenders without requiring repayment of the debt prior to its
scheduled maturities. On November 30, 2004 the Company announced an organizational restructuring
and meetings with its lenders which it believes will lead to a financial
restructuring. Both actions, which are described below, are intended to
substantially improve cash flow for the Company. Weak revenues and cash flows
in the first quarter of fiscal 2005 caused by a failed new product introduction
by the Companys KFC franchisor were compounded by the flooding of two of the
Companys more profitable restaurants in the third quarter of fiscal 2005.
Both of the flooded restaurants reopened in the fourth quarter of fiscal 2005.
As a result of the above mentioned items the Companys current cash balances
have dropped below the levels that it considers adequate to fund cash
obligations during the traditionally low revenue winter months. The
organizational and financial restructurings are expected to provide both the
short term cash flow improvements necessary to navigate the difficult winter
season and the permanent cash flow improvements to allow the Company to
function appropriately. 8




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Organizational and Operational Restructuring The organizational restructuring contains several elements. First,
substantial cost reduction measures have been put in place for both restaurant
and administrative operations. Three senior officers of the Company have reduced their salaries and other benefits to near zero while the
remainder of the Companys executive team and some of its management team have
taken pay cuts. These salary and benefit reductions are expected to improve
the Companys cash flow substantially during the winter months. Second, on
November 24, 2004 the Company completed previously planned closures of three
unprofitable restaurants (two in the St. Louis market and one in the Pittsburgh
market) which will improve cash flow. Last, several members of management have
been reassigned and several positions have been eliminated. The Companys
former Vice President of Operations Services is now Director of Operations
responsible for the operation of all 99 of its restaurants and the Companys
former Director of Operations has been reassigned to the extremely challenging
Missouri market and will be responsible for streamlining supervision and
improving the operation of those restaurants. Also, several restaurant
supervision and support positions have been eliminated. Financial Restructuring The Company has conducted meetings with its primary lenders with the
intent of securing short term, temporary reductions in its debt service
payments to conserve cash during the winter months and while the Company
executes sale/leaseback financing on one to ten of its restaurants. The
sale/leaseback transactions, if successful, will generate proceeds to prepay a
portion of the Companys debt and will create long term cash flow improvement.
As of November 7, 2004 and through December 22, 2004 all payments on the
Companys debt have been made timely. However, the Company intends to reduce
its debt service payments to interest only for one or more of its lenders
beginning with the January payment and will continue with this reduced payment
schedule until the restructuring is completed or the Companys cash flow
situation improves. Management believes that the lenders will consent to the
financial restructuring based on the substantial improvements to the strength
of the Companys operations provided by both the financial and the
organizational restructuring. Nonetheless, given the level of the Companys
indebtedness and other demands on its cash resources, there can be no assurance
that the Companys lenders will consent to the restructuring, that the
restructuring will be accomplished, or that other actions might not be taken by
creditors that would impede the Companys ability to satisfy its obligations. As a result of the Companys covenant violations, the lenders have certain
remedies available to them which could include calling of the debt or
acceleration of payments or foreclosure on the Companys assets which secure
the debt. Unless approved by the lenders, the Companys intended temporary
reduction of the required debt payments could also result in the aforementioned
remedies being available to the Companys lenders. The lenders have not
initiated any of these remedies and management believes, but cannot assure,
that these actions will not be taken prior to the Company implementing the
financial restructuring described above. The Company believes that the
substantially improved cash flows to be generated by the organizational and
financial restructurings will put the Company in a much better position to
weather the sluggish revenue performance of its KFC restaurants. Note 7. Commitments. In fiscal year 2000 the Company signed an agreement and prepaid franchise
fees of $170,000 which granted it the rights to develop 20 KFC, Taco Bell or
KFC 2n1 restaurants in specific geographic areas. Under the agreement five
restaurants are required to be developed each year over a four year period. As
of November 7, 2004 the Company has developed only five restaurants under this
agreement. The status of the development agreements has been discussed with
the franchisors and the Company has not been declared in default of the KFC
agreement. If the Company should default on the KFC agreement, it could lose
the rights to develop certain KFC restaurants and could forfeit the remaining
balance of prepaid franchise fees, which was $60,000 at November 7, 2004. The
Company was declared in default under the terms of its Taco Bell development
agreement which had a related deposit of $30,000. The Taco Bell franchisor allowed the Company to use $25,000 of the deposit
toward other franchise/license agreement extension fees and returned the
remaining $5,000 to the Company. 9




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Note 8. Income Taxes. During the quarter ended November 7, 2004, the Company determined that a
$600,000 valuation allowance should be recorded against deferred tax assets.
The Company determined that realization of the deferred tax assets was no
longer more likely than not due to continuing significant losses and a
projection of a taxable loss for fiscal 2006. 10




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Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations. Description of Business. Morgans Foods, Inc. operates through
wholly-owned subsidiaries KFC restaurants under franchises from KFC Corporation
and Taco Bell restaurants under franchises from Taco Bell Corporation. As of
December 22, 2004, the Company operates 73 KFC restaurants, 7 Taco Bell
restaurants, 14 KFC/Taco Bell 2n1s under franchises from KFC Corporation and
franchises or licenses from Taco Bell Corporation, 3 Taco Bell/Pizza Hut
Express 2n1s operated under franchisees from Taco Bell Corporation and
licenses from Pizza Hut Corporation, 1 KFC/Pizza Hut Express 2n1 operated
under a franchise from KFC Corporation and a license from Pizza Hut Corporation
and 1 KFC/A&W 2n1 operated under a franchise from KFC Corporation and a
license from A&W Restaurants, Inc. The Companys fiscal year is a 52  53 week
year ending on the Sunday nearest the last day of February. Summary of Expenses and Operating Income as a Percentage of Revenues Quarter Ended
    
    Thirty-Six Weeks EndedNov. 7, 2004
    
    Nov. 9, 2003
    
    Nov. 7, 2004
    
    Nov. 9, 2003Cost of sales:Food, paper and beverage
    
    
    32.2
    %
    
    
    30.8
    %
    
    
    31.5
    %
    
    
    30.3
    %Labor and benefits
    
    
    27.6
    %
    
    
    26.9
    %
    
    
    28.1
    %
    
    
    27.5
    %Restaurant operating expenses
    
    
    25.7
    %
    
    
    26.1
    %
    
    
    25.9
    %
    
    
    25.6
    %Depreciation and amortization
    
    
    4.9
    %
    
    
    4.2
    %
    
    
    4.4
    %
    
    
    4.1
    %General and administrative expenses
    
    
    5.8
    %
    
    
    6.0
    %
    
    
    6.1
    %
    
    
    6.6
    %Operating income
    
    
    1.6
    %
    
    
    5.8
    %
    
    
    2.8
    %
    
    
    5.8
    %
 Revenues. Revenues for the quarter ended November 7, 2004 were
$19,190,000 compared to $19,382,000 for the quarter ended November 9, 2003.
This decrease of $192,000 was due mainly to $279,000 in revenues being lost as
a result of 2 restaurants being closed for repairs to damages resulting from
the Hurricane Ivan storm system and $128,000 in revenues lost due to the
permanent closing of one restaurant. This decrease was partially offset by a
1.1% increase in comparable restaurant revenues. The increase in comparable
restaurant revenues was primarily the result of somewhat more effective product
promotions by the franchisors during the current year quarter as compared to
the ineffective prior year promotions. Revenues for the thirty-six weeks ended
November 7, 2004 were $57,324,000 compared to $58,873,000 for the thirty-six
weeks ended November 9, 2003. This decrease was primarily due to a 1.5%
decrease in comparable restaurant revenues, $374,000 in revenues lost due to
the closing of one restaurant and the revenues lost due to the Hurricane Ivan
storm system discussed above. The decrease in comparable restaurant revenues
was primarily the result of ineffective product promotions by the KFC
franchisor during the first quarter of fiscal 2005. Costs of Sales  Food, Paper and Beverages. Food, paper and beverage
costs for the third quarter increased as a percentage of revenue from 30.8% in
fiscal 2004 to 32.2% in fiscal 2005. This increase was primarily the result of
increased commodity costs (primarily chicken). Food, paper and beverage costs
for the thirty-six weeks ended November 7, 2004 increased to 31.5% of revenue
compared to 30.3% in the year earlier period for the reasons discussed above.
In addition, during the prior year thirty-six weeks, the Company received a
$156,000 settlement negotiated by FRANMAC, the Taco Bell franchisee
association, with certain system food suppliers. If this nonrecurring item was
removed from consideration, the food costs as a percentage of revenues for the
thirty-six weeks ended November 9, 2003 would have been 30.6% Cost of Sales  Labor and Benefits. Labor and benefits increased as a
percentage of revenue for the quarter ended November 7, 2004 to 27.6% compared
to 26.9% for the year earlier quarter. The increase was primarily due to
increased healthcare costs. Labor and benefits for the thirty-six weeks ended
November 7, 2004 increased as a percentage of revenue to 28.1% from 27.5% in
the year earlier period due to increased labor as a result of hiring for open
restaurant management positions and lower average restaurant volumes which was
partially offset by lower workers compensation and healthcare costs. 11




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Restaurant Operating Expenses. Restaurant operating expenses decreased as
a percentage of revenue to 25.7% in the third quarter of fiscal 2005 compared
to 26.1% in the third quarter of fiscal 2004 primarily as a result of decreased
repair and maintenance costs and decreased bonus expenses which were partially
offset by increased credit card fees resulting from the shift to a higher
portion of credit card sales. Restaurant operating expenses for the thirty-six
weeks ended November 7, 2004 increased to 25.8% of revenue compared to 25.6% in
the prior year period as a result of the increased credit card fees discussed
above and small equipment purchases required as part of first quarter fiscal
2005 promotions. Depreciation and Amortization. Depreciation and amortization increased to
$944,000 in the third quarter of fiscal 2005 from $809,000 in the third quarter
of fiscal 2004 and to $2,504,000 for the thirty-six weeks ended November 7,
2004 from $2,408,000 for the thirty-six weeks ended November 9, 2003. These
increases were a result of the acceleration in both goodwill and franchise fee
amortization resulting from the closing of three unprofitable restaurants on
November 24, 2004. General and Administrative Expenses. General and administrative expenses
decreased to $1,110,000 in the third quarter of fiscal 2005 from $1,170,000 in
the third quarter of fiscal 2004 due to decreases in training expense and bonus
expense. General and administrative expenses decreased to $3,505,000 for the
thirty-six weeks ended November 7, 2004 from $3,859,000 for the thirty-six
weeks ended November 9, 2003 for the reasons discussed above. Loss on Restaurant Assets. The loss on restaurant assets increased from
$27,000 in the third quarter of fiscal 2004, to $434,000 in the third quarter
of fiscal 2005. The 2004 amount primarily includes charges for the costs
necessary to dispose of one previously closed restaurant. The fiscal 2005
amount includes an impairment loss of $432,000 on nine restaurants to reduce
their carrying value to estimated fair value. The loss on restaurant assets
for the thirty-six weeks ended November 7, 2004 increased to $726,000 from
$74,000 in the year earlier period. The 2005 amount includes impairment losses
of $719,000 on the nine restaurants mentioned above to reduce their carrying
values to their estimated fair values. The impairment losses recorded in all
periods presented were recognized as a result of management determining that
the future operating cash flows of these restaurants would not fully recover
the carrying value of the property and equipment. Operating Income. Operating income in the third quarter of fiscal 2005
decreased to $303,000 or 1.6% of revenues compared to $1,129,000 or 5.8% of
revenues for the third quarter of fiscal 2004 primarily as a result of
decreased revenues, increased food, payroll and general and administrative
costs, as well as asset impairment charges. The Company estimates that
operating income for the quarter ended November 7, 2004 was decreased by
$125,000, net of insurance proceeds, as a result of the property damage and
lost profits from the Hurricane Ivan storm system. Operating income for the
thirty-six weeks ended November 7, 2004 decreased to $1,585,000 or 2.8% of
revenues compared to $3,422,000 or 5.8% of revenues for the year earlier
period. This decrease was primarily the result of decreased comparable
restaurant revenues in the first quarter of fiscal 2005, increased food costs,
lost profits from the Hurricane Ivan storm system and asset impairment charges
which were partially offset by decreased healthcare, workers compensation and
general and administrative expenses. Interest Expense. Interest expense on bank debt decreased to $991,000 in
the third quarter of fiscal 2005 from $1,047,000 in the third quarter of fiscal
2004 due to lower debt balances during the fiscal 2005 quarter. Interest
expense on bank debt for the thirty-six weeks ended November 7, 2004 decreased
to $3,037,000 from $3,213,000 for the year earlier period for the reason
discussed above. Interest expense on capitalized leases was substantially
unchanged from the prior year third quarter and prior year thirty-six weeks. 12




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Other Income. Other income was substantially unchanged in the third
quarter and first thirty-six weeks of fiscal 2005 compared to the comparable
periods in fiscal 2004. Provision for Income Taxes. The provision for income taxes increased by
$601,000 and $598,000 in the third quarter and first thirty-six weeks of fiscal
2005, respectively, compared to the comparable periods in fiscal 2004. The
increase in both periods presented is due to the Companys determination that a
$600,000 valuation allowance should be recorded against deferred tax assets.
The Company determined that realization of the deferred tax assets was no
longer more likely than not due to continuing significant losses and a
projection of a taxable loss for fiscal 2006. Liquidity and Capital Resources. Cash flow activity for the first
thirty-six weeks of fiscal 2005 and fiscal 2004 is presented in the
Consolidated Statements of Cash Flows. Cash provided by operating activities
was $899,000 for the thirty-six weeks ended November 7, 2004 compared to
$2,762,000 for the thirty-six weeks ended November 9, 2003. The decline in
operating cash flow resulted principally from the net loss for the thirty-six
weeks ended November 7, 2004, reduced funding from supply agreements and
changes in operating assets and liabilities related to the timing of payments.
The Company paid scheduled long-term bank and capitalized lease debt of
$2,246,000 in the first thirty-six weeks of fiscal 2005 compared to payments of
$2,014,000 for the same period in fiscal 2004. Capital expenditures in the
thirty-six weeks ended November 7, 2004 were $665,000, compared to $976,000 for
the same period in fiscal 2004, reflecting the Companys planned reduction in
capital spending. The Companys debt arrangements require the maintenance of a consolidated
fixed charge coverage ratio of 1.2 to 1 regarding all of the Companys mortgage
loans and the maintenance of individual restaurant fixed charge coverage ratios
of between 1.2 and 1.5 to 1 on certain of the Companys mortgage loans. The
consolidated and individual coverage ratios are computed quarterly, based upon
financial results for the preceding twelve months. At the end of fiscal 2004
and each of the fiscal 2005 quarters, including November 7, 2004, the Company
was not in compliance with the consolidated ratio or with individual restaurant
ratios relating to a substantial portion of its debt. The Company obtained
waivers of these violations from the applicable lenders at the end of fiscal
2004 and the first and second quarters of fiscal 2005, in each case with the
lenders agreeing to forebear exercising their rights and remedies through the
following twelve months. Based upon projected operating results, the Company
believed at the time it received the foregoing waivers that it would comply
with the terms thereof throughout the respective forbearance periods and,
accordingly, the Company classified the debt for which it received waivers as
long-term as of the end of fiscal 2004 and the first and second quarters of
fiscal 2005. For the quarter ended November 7, 2004, waivers of the fixed
charge coverage ratio violations were not obtained from the lenders.
Additionally, based upon financial results for the 36 weeks ended November 7,
2004, and results projected for the fiscal year ending February 27, 2005,
management anticipates that the Company will not achieve the required
consolidated ratio or individual restaurant ratios on certain of its loans
relating to a substantial portion of its debt, for the fiscal year ending
February 27, 2005. Due to noncompliance with the fixed charge coverage ratios
and as required by EITF 86-30, the Company has classified all of its debt as
current as of November 7, 2004. As of November 7, 2004 and through December
22, 2004, all payments on the Companys debt have been made timely and the
lenders have not pursued any remedies which may be available to them based on
the violation. As described below, the Company has initiated an operational
and financial restructuring process, which management believes, but cannot
assure, will allow the Company to satisfy the lenders without requiring
repayment of the debt prior to its scheduled maturities. 13




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On November 30, 2004 the Company announced an organizational restructuring
and meetings with its lenders which it believes will lead to a financial
restructuring. Both actions, which are described below, are intended to
substantially improve cash flow for the Company. Weak revenues and cash flows
in the first quarter of fiscal 2005 caused by a failed new product introduction
by the Companys KFC franchisor were compounded by the flooding of two of the
Companys more profitable restaurants in the third quarter of fiscal 2005.
Both of the flooded restaurants reopened in the fourth quarter of fiscal 2005.
As a result of the above mentioned items the Companys current cash balances
have dropped below the levels that it considers adequate to fund cash
obligations during the traditionally low revenue winter months. The
organizational and financial restructurings are expected to provide both the
short term cash flow improvements necessary to navigate the difficult winter
season and the permanent cash flow improvements to allow the Company to
function appropriately. Organizational and Operational Restructuring The organizational restructuring contains several elements. First,
substantial cost reduction measures have been put in place for both restaurant
and administrative operations. Three senior officers of the Company have
reduced their salaries and other benefits to near zero while the remainder of
the Companys executive team and some of its management team have taken pay
cuts. These salary and benefit reductions are expected to improve the
Companys cash flow substantially during the winter months. Second, on
November 24, 2004 the Company completed previously planned closures of three
unprofitable restaurants (two in the St. Louis market and one in the Pittsburgh
market) which will improve cash flow. Last, several members of management have
been reassigned and several positions have been eliminated. The Companys
former Vice President of Operations Services is now Director of Operations
responsible for the operation of all 99 of its restaurants and the Companys
former Director of Operations has been reassigned to the extremely challenging
Missouri market and will be responsible for streamlining supervision and
improving the operation of those restaurants. Also, several restaurant
supervision and support positions have been eliminated. Financial Restructuring The Company has conducted meetings with its primary lenders with the
intent of securing short term, temporary reductions in its debt service
payments to conserve cash during the winter months and while the Company
executes sale/leaseback financing on one to ten of its restaurants. The
sale/leaseback transactions, if successful, will generate proceeds to prepay a
portion of the Companys debt and will create long term cash flow improvement.
As of November 7, 2004 and through December 22, 2004 all payments on the
Companys debt have been made timely. However, the Company intends to reduce
its debt service payments to interest only for one or more of its lenders
beginning with the January payment and will continue with this reduced payment
schedule until the restructuring is completed or the Companys cash flow
situation improves. Management believes that the lenders will consent to the
financial restructuring based on the substantial improvements to the strength
of the Companys operations provided by both the financial and the
organizational restructuring. Nonetheless, given the level of the Companys
indebtedness and other demands on its cash resources, there can be no assurance
that the Companys lenders will consent to the restructuring, that the
restructuring will be accomplished, or that other actions might not be taken by
creditors that would impede the Companys ability to satisfy its obligations. As a result of the Companys covenant violations, the lenders will have
certain remedies available to them which could include calling of the debt or
acceleration of payments or foreclosure on the Companys assets which secure
the debt. Unless approved by the lenders, the Companys intended temporary
reduction of the required debt payments could also result in the aforementioned
remedies being available to the Companys lenders. The
lenders have not initiated any of these remedies and management believes, but
cannot assure, that these actions will not be taken prior to the Company
implementing the financial restructuring described above. The Company believes
that the substantially improved cash flows to be generated by the
organizational and financial restructurings will put the Company in a much
better position to weather the sluggish revenue performance of its KFC
restaurants. 14




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Market Risk Exposure The Companys existing borrowings are at fixed interest rates, and
accordingly the Company does not have market risk exposure for fluctuations in
interest rates. As described above, the Company has initiated a financial
restructuring process which could result in refinancing of debt through sale
leaseback transactions at higher or lower fixed interest rates, or at variable
rates. Until the financial restructuring process is completed, it is not
possible to quantify the market risk exposure, if any, that could result from
future borrowings. As the Companys current plans call for sale leaseback
transactions involving one to ten restaurants, increases in sale leaseback
rates are not expected to materially affect the Companys market risk exposure.
The Company does not enter into derivative financial investments for trading
or speculation purposes. As a result, the Company believes that its market
risk exposure is not material to the Companys financial position, liquidity or
results of operations. Commitments. In fiscal year 2000 the Company signed an agreement and
prepaid franchise fees of $170,000 which granted it the rights to develop 20
KFC, Taco Bell or KFC 2n1 restaurants in specific geographic areas. Under
the agreement five restaurants are required to be developed each year over a
four year period. As of November 7, 2004 the Company has developed only five
restaurants under this agreement. The status of the development agreements has
been discussed with the franchisors and the Company has not been declared in
default of the KFC agreement. If the Company should default on the KFC
agreement, it could lose the rights to develop certain KFC restaurants and
could forfeit the remaining balance of prepaid franchise fees, which was
$60,000 at November 7, 2004. The Company was declared in default under the
terms of its Taco Bell development agreement which had a related deposit of
$30,000. The Taco Bell franchisor allowed the Company to use $25,000 of the
deposit toward other franchise/license agreement extension fees and returned
the remaining $5,000 to the Company. Seasonality. The operations of the Company are affected by seasonal
fluctuations. Historically, the Companys revenues and income have been
highest during the summer months with the fourth fiscal quarter representing
the slowest period. This seasonality is primarily attributable to weather
conditions in the Companys marketplace, which consists of portions of Ohio,
Pennsylvania, Missouri, Illinois, West Virginia and New York. Safe Harbor Statements. This document contains forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended.
The statements include those identified by such words as may, will,
expect anticipate, believe, plan and other similar terminology. The
forward-looking statements reflect the Companys current expectations and are
based upon data available at the time of the statements. Actual results
involve risks and uncertainties, including both those specific to the Company
and general economic and industry factors. Factors specific to the Company
include, but are not limited to, its debt covenant compliance, actions that
lenders may take with respect to any debt covenant violations, its ability to
pay all of its current and long term obligations and the ultimate success or
failure of the Companys restructuring plans. Economic and industry risks and uncertainties include, but are not
limited, to, franchisor promotions, business and economic conditions,
legislation and governmental regulation, competition, success of operating
initiatives and advertising and promotional efforts, volatility of commodity
costs and increases in minimum wage
and other operating costs, availability and cost of land and construction,
consumer preferences, spending patterns and demographic trends. 15




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Item 3. Quantitative and Qualitative Disclosures About Market Risk. Information required by this item is included under Liquidity and Capital
Resources. 
 Item 4. Controls and Procedures. Management is responsible for the preparation, integrity and objectivity
of the consolidated financial statements and other information presented in
this report. The financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
reflect certain estimates and adjustments by management. In preparing
financial statements in conformity with accounting principles generally
accepted in the United States of America, we must make a variety of decisions
that affect the reported amounts and the related disclosures. Such decisions
include the selection of accounting principles that reflect the economic
substance of the underlying transactions and the assumptions on which to base
accounting estimates. In reaching such decisions, we apply judgment based on
our understanding and analysis of the relevant circumstances, including our
historical experience, actuarial studies and other assumptions. We re-evaluate
our estimates and assumptions on an ongoing basis. While actual results could,
in fact, differ from those estimated at the time of preparation of the
financial statements, we are committed to preparing financial statements
incorporating accounting principles, assumptions and estimates that promote the
representational faithfulness, verifiability, neutrality and transparency of
the accounting information included in the financial statements. We maintain a system of internal accounting controls and procedures, which
we believe provide reasonable assurance that transactions are properly recorded
and that assets are protected from loss or unauthorized use. We maintain a system of disclosure controls and procedures to ensure
timely collection and evaluation of information subject to disclosure, to
ensure the selection of appropriate accounting policies, and to ensure
compliance with our accounting policies and procedures. Our disclosure control
systems and procedures include the certification of financial information
provided from each of our key management personnel. The integrity of our disclosure control systems is based on written
policies and procedures, the careful selection and training of qualified
financial personnel and direct management review. Our disclosure control
committee meets periodically to review our systems and procedures and to review
our financial statements and related disclosures. Our independent auditors have direct and private access to the Audit
Committee. The effectiveness of the design and operation of our disclosure controls
and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act
of 1934) was evaluated as of the date of the financial statements. This
evaluation was carried out under the supervision of and with the participation
of management, including the Chief Executive Officer and the Chief Financial
Officer. Based upon that evaluation, the Chief Executive Officer and the Chief
Financial Officer concluded that the design and operation of these disclosure
controls and procedures are effective. There were no significant changes in
internal controls or in other factors that could significantly affect these
controls subsequent to the date of the most recent evaluation. 16




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MORGANS FOODS, INC.
INDEX TO EXHIBITS ExhibitNumber
    
    Exhibit Description31.1
    
    Certification of the Chairman and Chief Executive Officer
pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Senior Vice President, Chief Financial
Officer & Secretary pursuant to Rule 13a-14(a) of the Securities
Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chairman of the Board and Chief Executive
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of the Senior Vice President, Chief Financial
Officer and Secretary pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
 17




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Morgans Foods, Inc.
(Registrant)Dated: December 22, 2004
    
    By:
    
    /s/ Kenneth L. HignettKenneth L. HignettSenior Vice President,Chief Financial Officer & Secretary
 18