##### Table of Contents



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
August 15, 2004
 Commission file number
1-08395
 Morgans Foods, Inc. 
  Ohio
    
    34-0562210(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer
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 [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [   ]        No [X] As of September 24, 2004, the issuer had 2,718,441 shares of common stock
outstanding. 1




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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 EXHIBITSSIGNATURESCertification CEOCertification CFOSarbanes- for CEOSarbanes- for CFO    Table of Contents  
 PART I  FINANCIAL INFORMATION 
 Item 1. Financial Statements. Morgans Foods, Inc. 
 CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) Quarter EndedAugust 15, 2004
    
    August 17, 2003Revenues
    
    $
    19,791,000
    
    
    $
    19,663,000Cost of sales:Food, paper and beverage
    
    
    6,303,000
    
    
    
    5,812,000Labor and benefits
    
    
    5,359,000
    
    
    
    5,623,000Restaurant operating expenses
    
    
    5,109,000
    
    
    
    5,001,000Depreciation and amortization
    
    
    777,000
    
    
    
    796,000General and administrative expenses
    
    
    1,122,000
    
    
    
    1,384,000Loss on restaurant assets
    
    
    22,000
    
    
    
    37,000Operating income
    
    
    1,099,000
    
    
    
    1,010,000Interest Expense:Bank debt and notes payable
    
    
    (1,010,000
    )
    
    
    (1,057,000
    )Capital leases
    
    
    (11,000
    )
    
    
    (12,000
    )Other income and expense, net
    
    
    22,000
    
    
    
    33,000Income (loss) before income taxes
    
    
    100,000
    
    
    
    (26,000
    )Provision for income taxes
    
    
    1,000
    
    
    
    Net income (loss)
    
    $
    99,000
    
    
    $
    (26,000
    )Basic and diluted net income (loss)
per common share
    
    $
    .04
    
    
    $
    (.01
    )Basic weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,718,441Diluted weighted average number of
shares outstanding
    
    
    2,722,928
    
    
    
    2,718,441
 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) Twenty-Four Weeks EndedAugust 15, 2004
    
    August 17, 2003Revenues
    
    $
    38,134,000
    
    
    $
    39,491,000Cost of sales:Food, paper and beverage
    
    
    11,875,000
    
    
    
    11,881,000Labor and benefits
    
    
    10,839,000
    
    
    
    10,981,000Restaurant operating expenses
    
    
    9,891,000
    
    
    
    10,001,000Depreciation and amortization
    
    
    1,560,000
    
    
    
    1,599,000General and administrative expenses
    
    
    2,395,000
    
    
    
    2,689,000Loss on restaurant assets
    
    
    292,000
    
    
    
    47,000Operating income
    
    
    1,282,000
    
    
    
    2,293,000Interest Expense:Bank debt and notes payable
    
    
    (2,046,000
    )
    
    
    (2,166,000
    )Capital leases
    
    
    (22,000
    )
    
    
    (23,000
    )Other income and expense, net
    
    
    39,000
    
    
    
    54,000Income (loss) before income taxes
    
    
    (747,000
    )
    
    
    158,000Provision for income taxes
    
    
    1,000
    
    
    
    4,000Net income (loss)
    
    $
    (748,000
    )
    
    $
    154,000Basic and diluted net income (loss)
per common share
    
    $
    (.28
    )
    
    $
    .06Basic weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,718,441Diluted weighted average number of
shares outstanding
    
    
    2,718,441
    
    
    
    2,725,096
 See notes to consolidated financial statements. 3




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Morgans Foods, Inc. 
 CONSOLIDATED BALANCE SHEETS (unaudited) August 15, 2004
    
    February 29, 2004ASSETSCurrent assets:Cash and equivalents
    
    $
    4,049,000
    
    
    $
    4,353,000Short term
investment  restricted
    
    
    
    
    
    
    300,000Receivables
    
    
    233,000
    
    
    
    242,000Inventories
    
    
    699,000
    
    
    
    573,000Prepaid expenses
    
    
    610,000
    
    
    
    324,0005,591,000
    
    
    
    5,792,000Property and equipment:Land
    
    
    10,886,000
    
    
    
    10,971,000Buildings and improvements
    
    
    19,297,000
    
    
    
    19,246,000Property under capital leases
    
    
    776,000
    
    
    
    776,000Leasehold improvements
    
    
    7,314,000
    
    
    
    7,353,000Equipment, furniture and fixtures
    
    
    19,105,000
    
    
    
    18,864,000Construction in progress
    
    
    61,000
    
    
    
    58,00057,439,000
    
    
    
    57,268,000Less accumulated depreciation and amortization
    
    
    24,837,000
    
    
    
    23,377,00032,602,000
    
    
    
    33,891,000Other assets
    
    
    1,104,000
    
    
    
    1,186,000Franchise agreements
    
    
    1,832,000
    
    
    
    1,876,000Deferred taxes
    
    
    600,000
    
    
    
    600,000Goodwill
    
    
    9,327,000
    
    
    
    9,327,000$
    51,056,000
    
    
    $
    52,672,000LIABILITIES AND SHAREHOLDERS DEFICIENCYCurrent liabilities:Current maturities of long-term debt
    
    $
    2,833,000
    
    
    $
    2,743,000Current maturities of capital lease obligations
    
    
    27,000
    
    
    
    58,000Accounts payable
    
    
    4,352,000
    
    
    
    3,642,000Accrued liabilities
    
    
    3,510,000
    
    
    
    3,348,00010,722,000
    
    
    
    9,791,000Long-term debt
    
    
    41,839,000
    
    
    
    43,370,000Long-term capital lease obligations
    
    
    377,000
    
    
    
    379,000Other long-term liabilities
    
    
    1,582,000
    
    
    
    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
    
    
    (32,039,000
    )
    
    
    (31,291,000
    )Total shareholders deficiency
    
    
    (3,464,000
    )
    
    
    (2,716,000
    )$
    51,056,000
    
    
    $
    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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (748,000
    )
    
    
    (748,000
    )Balance August 15, 2004
    
    
    2,969,405
    
    
    $
    30,000
    
    
    
    (250,964
    )
    
    $
    (284,000
    )
    
    $
    28,829,000
    
    
    $
    (32,039,000
    )
    
    $
    (3,464,000
    )
 See notes to consolidated financial statements 5




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Morgans Foods, Inc. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Twenty-Four Weeks EndedAugust 15, 2004
    
    August 17, 2003Cash flows from operating activities:Net income (loss)
    
    $
    (748,000
    )
    
    $
    154,000Adjustments to reconcile to net cash
provided by operating activities:Depreciation and amortization
    
    
    1,560,000
    
    
    
    1,599,000Amortization of deferred financing costs
    
    
    57,000
    
    
    
    63,000Amortization of supply agreement advances
    
    
    (365,000
    )
    
    
    (413,000
    )Funding from supply agreements
    
    
    63,000
    
    
    
    579,000Loss on restaurant assets
    
    
    292,000
    
    
    
    47,000Change in assets and liabilities:Decrease in receivables
    
    
    9,000
    
    
    
    81,000Increase in inventories
    
    
    (126,000
    )
    
    
    (20,000
    )Decrease (increase) in prepaid expenses
    
    
    (286,000
    )
    
    
    115,000Decrease in other assets
    
    
    25,000
    
    
    
    Increase in accounts payable
    
    
    710,000
    
    
    
    885,000Increase (decrease) in accrued liabilities
    
    
    196,000
    
    
    
    (107,000
    )Net cash provided by operating activities
    
    
    1,387,000
    
    
    
    2,983,000Cash flows from investing activities:Capital expenditures
    
    
    (492,000
    )
    
    
    (771,000
    )Purchase of franchise agreement
    
    
    (25,000
    )
    
    
    (35,000
    )Redemption(purchase)of certificate of deposit
    
    
    300,000
    
    
    
    (300,000
    )Net cash used in investing activities
    
    
    (217,000
    )
    
    
    (1,106,000
    )Cash flows from financing activities:Principal payments on long-term debt
    
    
    (1,470,000
    )
    
    
    (1,281,000
    )Principal payments on capital lease obligations
    
    
    (33,000
    )
    
    
    (53,000
    )Proceeds from issuance of long-term debt,
net of financing costs
    
    
    29,000
    
    
    
    Net cash used in financing activities
    
    
    (1,474,000
    )
    
    
    (1,334,000
    )Net change in cash and equivalents
    
    
    (304,000
    )
    
    
    543,000Cash and equivalents, beginning balance
    
    
    4,353,000
    
    
    
    4,901,000Cash and equivalents, ending balance
    
    $
    4,049,000
    
    
    $
    5,444,000
 See notes to consolidated financial statements. 6




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Morgans Foods, Inc. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS QUARTERS ENDED AUGUST 15, 2004 AND AUGUST 17, 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 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 ended August 15, 2004 and the 24 weeks ended August 17, 2003, 275,000
shares were excluded from the computation of diluted earnings per share due to
their antidilutive effect. For the quarter ended August 17, 2003 and for the
24 weeks ended August 15, 2004, 286,500 shares were excluded from the
computation of diluted earnings per share due to their antidilutive effect. Note 3. 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 24 weeks ended August 15, 2004
and August 17, 2003. Note 4. 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 its mortgage loans and
individual restaurant coverage ratios between 1.2 and 1.5 to 1 on certain of
its loans. As of February 29, 2004, the Company was not in compliance with the
consolidated ratio of 1.2 to 1 or the unit level ratios relating to $31,933,000
of its debt. The Company has obtained waivers of these violations from the
applicable lenders as of February 29, 2004 and August 15, 2004, in which the
lenders agree to 7




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forebear exercising their rights and remedies through the following twelve
months. One August 2004 waiver specifies that forbearance shall terminate if
the consolidated fixed charge coverage ratio drops below 0.8 to 1.0 during the
forbearance period. Based upon projected operating results, the Company
believes that it will comply with the terms of the waivers throughout the
forbearance period, and accordingly has classified its debt as long term as of
February 29, 2004 and August 15, 2004. All payments on the Companys debt have
been, and continue to be current. The fixed charge coverage ratios are
computed quarterly based upon financial results for the preceding twelve
months. Based upon financial results for the 24 weeks ended August 15, 2004
management anticipates that the Company may not achieve the required
consolidated fixed charge coverage ratio of 1.2 to 1 regarding all of its
mortgage loans and the individual restaurant coverage ratios between 1.2 to 1
and 1.5 to 1 of certain of its loans for the fiscal year ending February 27,
2005. If the Company does not comply with debt covenants in the future, and if
future waivers are not obtained, the lenders will have certain remedies
available to them which could include calling of the debt or acceleration of
payments. Noncompliance with the requirements of the Companys mortgage debt,
if not waived, could also trigger cross-default provisions of other debt
agreements. The Company has on-going procedures to project and monitor
expected future operating results and cash flows, including annual projections
through the winter season, when the Company typically consumes cash due to
seasonal declines in revenues. Primarily due to very weak revenues and cash
flows in the first quarter of fiscal 2005, the Company has implemented
additional monitoring procedures for cash flows and cash balances expected
through spring of 2005. If conditions warrant, management believes the Company
could initiate additional, more rigorous, actions to generate or preserve cash
in order to continue to service its debt and other obligations. However,
management believes that increases in comparable restaurant revenues, primarily
from more effective product promotions from the franchisors, will be necessary
to restore positive results of operations and stronger operating cash flows. Note 5. 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 August 15, 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 August 15, 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. Note 6. Subsequent Event. On September 17 and September 18, 2004, seven of the Companys restaurants
were affected by flood waters caused by the Hurricane Ivan storm system. As of
September 29, 2004 two of the seven7 restaurants remain closed as a result of
the substantial damage that they incurred. The Company estimates that its
exposure for lost profits and property damage as a result of the flooding will
be approximately $100,000 net of insurance proceeds. 8




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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
September 24, 2004, the Company operates 76 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
    
    Twenty-Four Weeks EndedAug. 15, 2004
    
    Aug. 17, 2003
    
    Aug. 15, 2004
    
    Aug. 17, 2003Cost of sales:Food, paper and beverage
    
    
    31.9
    %
    
    
    29.6
    %
    
    
    31.1
    %
    
    
    30.1
    %Labor and benefits
    
    
    27.1
    %
    
    
    28.6
    %
    
    
    28.4
    %
    
    
    27.8
    %Restaurant operating expenses
    
    
    25.8
    %
    
    
    25.4
    %
    
    
    25.9
    %
    
    
    25.3
    %Depreciation and amortization
    
    
    3.9
    %
    
    
    4.1
    %
    
    
    4.1
    %
    
    
    4.1
    %General and administrative expenses
    
    
    5.7
    %
    
    
    7.0
    %
    
    
    6.3
    %
    
    
    6.8
    %Operating income
    
    
    5.6
    %
    
    
    5.1
    %
    
    
    3.4
    %
    
    
    5.8
    %
 Revenues. Revenues for the quarter ended August 15, 2004 were $19,791,000
compared to $19,663,000 for the quarter ended August 17, 2003. This increase
of $128,000 was due mainly to a 1.3% increase in comparable restaurant revenues
which was partially offset by $111,000 in revenues lost due to the closing of
one restaurant. 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
promotions. Revenues for the twenty-four weeks ended August 15, 2004 were
$38,134,000 compared to $39,491,000 for the twenty-four weeks ended August 17,
2003. This decrease was primarily due to a 2.8% decrease in comparable
restaurant revenues and $247,000 in revenues lost due to the closing of one
restaurant. The decrease in comparable restaurant revenues was primarily the
result of ineffective product promotions by the KFC franchisor during the first
quarter. Costs
of Sales - Food, Paper and Beverages. Food, paper and beverage
costs for the second quarter increased as a percentage of revenue from 29.6% in
fiscal 2004 to 31.9% in fiscal 2005. This increase was primarily the result of
increased commodity costs (primarily chicken). Additionally, in the prior year
second quarter, the Company received a $156,000 settlement negotiated by
FRANMAC, the Taco Bell franchisee association, with certain system food
suppliers. Food, paper and beverage costs for the twenty-four weeks ended
August 15, 2004 increased to 31.1% of revenue compared to 30.1% in the year
earlier period for the reasons discussed above. Cost
of Sales - Labor and Benefits. Labor and benefits decreased as a
percentage of revenue for the quarter ended August 15, 2004 to 27.1% compared
to 28.6% for the year earlier quarter. The decrease was primarily due to lower
workers compensation and healthcare costs. Labor and benefits for the
twenty-four weeks ended August 15, 2004 increased as a percentage of revenue to
28.4% from 27.8% in the year earlier period due to increased labor of $157,000
as a result of hiring for open restaurant management positions and lower
average restaurant 9




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volumes in the first quarter of fiscal 2005 which was
partially offset by lower workers compensation and healthcare costs. Restaurant Operating Expenses. Restaurant operating expenses increased as
a percentage of revenue to 25.8% in the second quarter of fiscal 2005 compared
to 25.4% in the second quarter of fiscal 2004 primarily as a result of
increased repair and maintenance costs, small equipment purchases required as
part of recent promotions and increased credit card fees resulting from the
shift to a higher portion of credit card sales. Restaurant operating expenses
for the twenty-four weeks ended August 15, 2004 increased to 25.9% of revenue
compared to 25.3% in the prior year period for the reasons discussed above. Depreciation and Amortization. Depreciation and amortization was
substantially unchanged at $777,000 and $796,000 for the second quarters of
2005 and 2004, respectively. Depreciation and amortization was also
substantially unchanged at $1,560,000 and $1,599,000 for the twenty-four weeks
ended August 15, 2004 and August 17, 2003, respectively. General and Administrative Expenses. General and administrative expenses
decreased to $1,122,000 in the second quarter of fiscal 2005 from $1,384,000 in
the second quarter of fiscal 2004 due to decreases in legal and professional
expenses, training expense, bonus expense and healthcare costs. General and
administrative expenses decreased to $2,395,000 for the twenty-four weeks ended
August 15, 2004 from $2,689,000 for the twenty-four weeks ended August 17, 2003
for the reasons discussed above. Loss on Restaurant Assets. The loss on restaurant assets decreased from
$37,000 in the second quarter of fiscal 2004, to $22,000 in the second 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 $21,000 on one restaurant to reduce its
carrying value to its estimated fair value. The loss on restaurant assets for
the twenty-four weeks ended August 15, 2004 increased to $292,000 from $47,000
in the year earlier period. The 2005 amount includes impairment losses of
$287,000 on four restaurants 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 second quarter of fiscal 2005
increased to $1,099,000 or 5.6% of revenues compared to $1,010,000 or 5.1% of
revenues for the second quarter of fiscal 2004 primarily as a result of
increased comparable restaurant revenues, decreased healthcare, workers
compensation and general and administrative expenses which were partially
offset by increased food costs. Operating income for the twenty-four weeks
ended August 15, 2004 decreased to $1,282,000 or 3.4% of revenues compared to
$2,293,000 or 5.8% of revenues for the year earlier period. These decreases
were primarily the result of decreased comparable restaurant revenues in the
first quarter of fiscal 2005, increased food costs 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 $1,010,000
in the second quarter of fiscal 2005 from $1,057,000 in the second quarter of
fiscal 2004 due to lower debt balances during the fiscal 2005 quarter.
Interest expense on bank debt for the twenty-four weeks ended August 15, 2004
decreased to $2,046,000 from $2,166,000 for the year earlier period for the
reason discussed above. Interest expense on capitalized leases was
substantially unchanged from the prior year second quarter and prior year
twenty-four weeks. Other Income. Other income was substantially unchanged in the second
quarter and first twenty-four weeks of fiscal 2005 compared to the comparable
periods in fiscal 2004. 10




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Provision for Income Taxes. The provision for income taxes was
substantially unchanged in the second quarter and first twenty-four weeks of
fiscal 2005 compared to the comparable periods in fiscal 2004. The low
effective tax rates result from tax net operating loss carryforwards. Liquidity and Capital Resources. Cash flow activity for the first
twenty-four weeks of fiscal 2005 and fiscal 2004 is presented in the
Consolidated Statements of Cash Flows. Cash provided by operating activities
was $1,387,000 for the twenty-four weeks ended August 15, 2004 compared to
$2,983,000 for the twenty-four weeks ended August 17, 2003. The decline in
operating cash flow resulted principally from the net loss in the first quarter
of fiscal 2005, 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 $1,503,000 in the first
twenty-four weeks of fiscal 2005 compared to payments of $1,334,000 for the
same period in fiscal 2004. Capital expenditures in the twenty-four weeks
ended August 15, 2004 were $492,000, compared to $771,000 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 its mortgage loans and
individual restaurant coverage ratios between 1.2 and 1.5 to 1 on certain of
its loans. As of February 29, 2004, the Company was not in compliance with the
consolidated ratio of 1.2 to 1 or the unit level ratios relating to $31,933,000
of its debt. The Company has obtained waivers of these violations from the
applicable lenders as of February 29, 2004 and August 15, 2004, in which the
lenders agree to forebear exercising their rights and remedies through the
following twelve months. One August 2004 waiver specifies that forbearance
shall terminate if the consolidated fixed charge coverage ratio drops below 0.8
to 1.0 during the forbearance period. Based upon projected operating results,
the Company believes that it will comply with the terms of the waivers
throughout the forbearance period, and accordingly has classified its debt as
long term as of February 29, 2004 and August 15, 2004. All payments on the
Companys debt have been, and continue to be current. The fixed charge
coverage ratios are computed quarterly based upon financial results for the
preceding twelve months. Based upon financial results for the 24 weeks ended
August 15, 2004 management anticipates that the Company may not achieve the
required consolidated fixed charge coverage ratio of 1.2 regarding all of its
mortgage loans and the individual ratios between 1.2 to 1 and 1.5 to 1 of
certain of its loans for the fiscal year ending February 27, 2005. If the
Company does not comply with debt covenants in the future, and if future
waivers are not obtained, the lenders will have certain remedies available to
them which could include calling of the debt or acceleration of payments.
Noncompliance with the requirements of the Companys mortgage debt, if not
waived, could also trigger cross-default provisions of other debt agreements.
The Company has on-going procedures to project and monitor expected future
operating results and cash flows, including annual projections through the
winter season, when the Company typically consumes cash due to seasonal
declines in revenues. Primarily due to very weak revenues and cash flows in
the first quarter of fiscal 2005, the Company has implemented additional
monitoring procedures for cash flows and cash balances expected through spring
of 2005. If conditions warrant, management believes the Company could initiate
additional, more rigorous, actions to generate or preserve cash in order to
continue to service its debt and other obligations. However, management
believes that increases in comparable restaurant revenues, primarily from more
effective product promotions from the franchisors, will be necessary to restore
positive results of operations and stronger operating cash flows. The Company continues to be out of compliance with certain of the
continued listing standards of the American Stock Exchange and was required to
submit a revised business plan to the Exchange indicating how the Company would
achieve compliance with those standards. Specifically, the Company fell under
the guidelines in Section 1003(a)(i) with shareholders equity of less than
$2,000,000 and has sustained losses from continuing operations and/or net
losses in two of its three most recent fiscal years and Section 1003(a)(ii)
with shareholders 11




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equity of less than $4,000,000 and has sustained losses from
continuing operations and/or net losses in three out of its four most recent
fiscal years. The Company has not been in compliance with the aforementioned continued
listing standards since June of 1997 and has provided periodic reports and
analyses to the Exchange indicating its plans for achieving
compliance with the standards. During this time, the Company has been near
compliance several times but has not achieved compliance with the continued
listing standards. The Board of Directors of the Company, after consultation
with management and counsel, determined that it is in the best interest of the
Company to withdraw the Companys common shares from listing and registration
on the Exchange. As a result, on June 29, 2004 the Company submitted an
application to remove its common shares from listing on the Exchange. On
August 25, 2004 the Companys application was accepted and its common shares
have been removed from listing on the Exchange. The Company has obtained a
broker to make a market in its common shares and its shares are now listed in
the Pink Sheets and quotes can be obtained at www.pinksheets.com under the
symbol MRFD, however, it appears that the liquidity of the Companys common
shares may have been, and may continue to be, adversely affected. The Companys market risk exposure is primarily due to possible
fluctuations in interest rates as they relate to future borrowings. The
Company has evaluated the potential effect of a 1.0% increase in these rates on
future capital spending plans and believes that there would be no material
effect. 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 August 15, 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 August 15, 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 and its ability
to obtain waivers of any debt covenant violations as well as the listing status
of its common shares. 12




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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. 
 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 are 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. 13




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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
 14




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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: September 29, 2004
    
    By:
    
    /s/ Kenneth L. HignettKenneth L. HignettSenior Vice President,Chief Financial Officer & Secretary
 15