** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-KSB**

 

**ý****  ANNUALREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

 

**For thefiscal year ended June 30, 2004**

 

**o****  TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

 

**Commissionfile number 0-29478**

 

**PRECISIONAUTO CARE, INC.**

(Name of small businessissuer in its charter)

 
| **Virginia**                                                     | ** ** | **54-1847851**                           |
|------------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification Number) |
|                                                             |       |                                     |
| **748  Miller Drive, S.E., Leesburg, Virginia 20175**            |
| (Address of principal  executive offices)                        |
| (Zip Code)                                                       |
|                                                             |       |                                     |
| **703-777-9095**                                                 |
| (Issuer’s telephone  number, including area code)           |
|                                                             |       |                                     |
| Securities registered  pursuant to Section 12(b) of the Act:     |
| **None**                                                         |
|                                                             |       |                                     |
| Securities registered  pursuant to Section 12(g) of the Act:     |
| **Common  Stock, par value $.01 per share**                      |

 

Check whether the issuer (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   ý  Yes   o  No

 

Check if no disclosure of delinquent filers in response to Item 405 ofRegulation S-B is contained in this form, and no disclosure will be contained,to the best of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB.  o

 

The issuer’s revenues for its most recent fiscal year were:$11,773,853.

 

The aggregate market value of Common Stock held by persons not“affiliated” with the issuer at August 12, 2004 was $11,708,816 based on theclosing price of $0.60 per share.  As ofAugust 12, 2004, 23,808,602 of Common Stock were issued and outstanding.

 

Transitional Small Business Disclosure Format:                                      o  Yes  ý  No

 

**DOCUMENTS INCORPORATED BYREFERENCE:**

 

Certain portions of Registrant’s definitive proxy statement, to befiled with the Securities and Exchange Commission pursuant to Regulation 14Anot later than 120 days after the close of the Corporation’s fiscal year, areincorporated by reference under Part III.

 

 

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**TABLE OF CONTENTS**

 
| PART I    | Item  1.  | Business                                                                                                          |   |
|-----------|-----------|-------------------------------------------------------------------------------------------------------------------|--------|
|      | Item  2.  | Properties                                                                                                        |   |
|      | Item  3.  | Legal  Proceedings                                                                                                |   |
|      | Item  4.  | Submission  of Matters to a Vote of Security Holders                                                              |   |
|      |      |                                                                                                              |   |
| PART  II  | Item  5.  | Market  for Common Equity and Related Stockholder Matters                                                         |   |
|      | Item  6.  | Management’s  Discussion and Analysis or Plan of Operation                                                   |   |
|      | Item  7.  | Financial  Statements                                                                                             |   |
|      | Item  8.  | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                             |   |
|      | Item  8A. | Controls  and Procedures                                                                                          |   |
|      |      |                                                                                                              |   |
| PART  III | Item  9.  | Directors,  Executive Officers, Promoters and Control Persons; Compliance With Section  16(a) of the Exchange Act |   |
|      | Item  10. | Executive  Compensation                                                                                           |   |
|      | Item  11. | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                  |   |
|      | Item  12. | Certain  Relationships and Related Transactions                                                                   |   |
|      | Item  13. | Exhibits  and Reports on Form 8-K                                                                                 |   |
|      | Item  14. | Principal  Accountant Fees and Services                                                                           |   |

 

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**FORWARD-LOOKING STATEMENTS**

 

This report includes forward-looking statements withinthe meaning of the Securities Act of 1933 (the “Securities Act”) and theSecurities Exchange Act of 1934. When used in this report, the words“anticipate,” “believe,” “estimate,” “expect,” “intend” and “plan” as theyrelate to Precision Auto Care, Inc. or its management are intended to identifysuch forward-looking statements. All statements regarding Precision Auto Care,Inc. or Precision Auto Care, Inc.’s expected future financial position,business strategy, cost savings and operating synergies, projected costs andplans, and objectives of management for future operations are forward-lookingstatements. Although Precision Auto Care, Inc. believes the expectationsreflected in such forward-looking statements are based on reasonableassumptions, no assurance can be given that such expectations will prove tohave been correct.  Important factorsthat could cause actual results to differ materially from the expectationsreflected in the forward-looking statements herein include, among others, thefactors set forth under the caption “Business—Risk Factors,” general economicand business and market conditions, changes in federal and state laws, andincreased competitive pressure in the automotive aftermarket services business.

 

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**PART I**

 

**Item 1****.   *Business***

 

**OVERVIEW**

 

Precision Auto Care, Inc. (“PACI” or the “Company”) isa franchisor of automotive service centers located in the United States and incertain foreign countries.  At June 30,2004, the Company had 31 total employees of which 30 are full timeemployees.  Through its franchisedcenters, services are provided to automobile owners and focus on thosehigh-frequency items required on a periodic basis to maintain the vehicleproperly.

 

The Company was incorporated as a Virginia corporationin April 1997, but its predecessors have been in the automotive maintenanceservices business since 1976.  The firstPrecision Tune was established in 1976 to provide quick, convenient andinexpensive engine tune-ups.  Franchisingof Precision Tune centers began the next year. As automotive technology changed, Precision Tune expanded its menu ofoffered automotive maintenance and repair services to include oil changes, fuelinjection service, air conditioning service, cooling system service, brakeservice and more diagnostic services.  InSeptember 1996, the Precision Tune brand name was changed to Precision TuneAuto Care to reflect the shift in emphasis.

 

The Company is the result of the November 1997combination of WE JAC Corporation (the owner of Precision Tune Auto Care) andnine other automotive maintenance services companies in connection with itsinitial public offering.  In March 1998,the Company acquired the holder of the master franchise agreement for PrecisionTune Auto Care in Mexico and Puerto Rico. The Company’s Mexican assets were sold in January 2002.  In March and April 2003, the Company disposedof its manufacturing operations.  SeeNotes to Financial Statements for financial information regarding the disposalof the Company’s Manufacturing and Distribution business segment.

 

The Company has one remaining business segment,Automotive Care Franchising.  TheAutomotive Care Franchising business segment, which is comprised of PrecisionTune Auto Care (“PTAC”) and Precision Lube Express, provides automotiveservices primarily through franchised operations located in the United Statesand in certain foreign countries.

 

•                  Through its franchisees, PTACprovides automotive maintenance and repair services, such as engineperformance, oil change and lubrication and brake services, which requirerelatively short service times.  At June30, 2004, these services were provided at 413 Precision Tune Auto Care centersowned and operated by franchisees.

 

•                  Precision Lube Express franchiseesand licensees provide convenient fast oil change and lube services.  At June 30, 2004, there was 1 Precision LubeExpress center owned and operated by a franchisee.  In the future, the Company will not beselling Precision Lube Express franchises.

 

**OPERATIONS**

 

*Precision Tune Auto Care*

 

Precision Tune Auto Careis a franchisor of automotive service centers that provide specialized qualitymaintenance and repair services that require relatively short servicetimes.  The automotive care servicesprovided by Precision Tune Auto Care centers include the diagnosis, maintenanceand repair of ignition systems, fuel systems, computerized engine controlsystems, cooling systems, starting/charging systems, emissions control systems,engine drive train systems, electrical systems, air conditioning systems, oiland other fluid systems, and brake systems.

 

*Prototype Center.*  The current prototype Precision Tune AutoCare center is a free-standing building with six to eight service bays, ofwhich two to four are drive-through and include pits to facilitate fast oilchange and lubrication services. Franchisees typically develop Precision Tune Auto Care centers either byentering into a build-to-suit lease, under which the landlord constructs thecenter and leases it to the franchisee, or by purchasing land and building thefacility.  The Company typically seekssites in commercial areas with a minimum population of 50,000 people within afive mile radius.   Exclusive of realestate, the estimated capital required to open a prototype Precision Tune AutoCare center ranges from $123,000 to $208,075.

 

*Retail Marketing.*  Precision Tune Auto Care’s marketingobjectives at the retail level are to increase franchisee sales, enhancefirst-time customers’ experiences, and bolster each franchisee’s customerretention efforts.  To further theseobjectives, Precision Tune Auto Care has developed and implemented a marketingplan containing programs and materials for use by Precision Tune Auto Carecenters.  The plan includes targetedmarketing programs designed to reach key market segments, in-storemerchandising materials designed to enhance retail sales and first timecustomer trials, and other local marketing materials (e.g., second cardiscounts, service reminder cards, and ATM receipt coupons) designed to generatecustomers and improve customer retention.

 

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*Training and Operational Support.*  A significant element of Precision Tune AutoCare’s commitment to service is its training program for franchisees.  New franchisees are required to successfullycomplete over 40 hours of initial training at its national training center inLeesburg, Virginia.  The Company alsooffers a full line of technical training, including courses on engineperformance, fuel systems and emissions, automotive electronics, fuelinjection, and brake certification. These courses, which include both classroom and hands-on training, aredesigned to allow franchisees and service center technicians to maintain andupdate their technical capability to service today’s more complex vehicles.

 

*Franchise Marketing.*  The Company (through a predecessor company)has marketed franchises for Precision Tune Auto Care centers since 1977.  Its franchise sales process includesadvertising in appropriate franchise and business publications, establishingrelationships and working with sales brokers, conducting franchise salesseminars, maintaining a home page on the Internet through which interestedparties may submit a franchise inquiry, and advertising on several franchisesales orientated web sites.  Prospectivefranchisees are asked to complete a Confidential Qualifications Report, whichserves as the initial screening to determine whether a prospect is qualified.  The Company seeks individuals with managementexperience who will make a full-time commitment to the operation of theirfranchise and who have a minimum of $70,000 and $200,000 in liquid assets andnet worth, respectively.

 

Precision Tune AutoCare’s area-development system has played a significant role in its franchisedevelopment efforts.  Under this system,Precision Tune Auto Care has entered into area-development agreements thatgrant area developers the right and obligation to develop franchises withinspecific geographic regions for stated periods of time.  Franchise agreements within the area arebetween the Company and the franchisee. The area developer typically receives up to one-half of the initialfranchise fee, one-half of the subsequent royalty revenues and one-half offranchise renewal and transfer fees. After the creation of a franchise, the area developer performs many ofPrecision Tune Auto Care’s franchise support obligations. As of June 30, 2004,19 area developers and their affiliates had an ownership interest inapproximately 29% of the total number of Precision Tune Auto Care centers.

 

*Open Area Development.*  Precision Tune Auto Care’s current strategyis also to pursue new area developers to develop open areas in which currentarea developers have not been granted rights. To attract new area developers, the company employs strategies similarto those used in marketing unit franchises. However, the net worth requirements for prospective area developers aregreater than those required for a unit franchisee.  These requirements range from $250,000 to$1,000,000 net worth, depending upon the size of the particular area.

 

**FRANCHISING ACTIVITIES**

 

*Precision Tune Auto Care*.  As of June 30, 2004, all of Precision TuneAuto Care domestic and international centers were owned and managed byfranchisees.  Precision Tune Auto Care’sfranchises have been sold during the preceding years under franchise agreementsthat vary in detail as the Precision Tune Auto Care’s franchise program hasevolved.  Royalty rates in existingfranchise agreements are 7.5%. Currently, Precision Tune Auto Care’s standard franchise agreementrequires payment to the Company of an initial franchise fee of $25,000 and acontinuing royalty of 7.5% of weekly gross receipts.  In addition, the franchisee is required to contributeto or expend up to 9% of weekly gross receipts on advertising, of which 1.5% iscurrently paid into the national marketing fund and up to 7.5% of which isspent locally.  The current standard formfranchise agreement has an initial term of ten years and provides for five-yearrenewal options.

 

The Company hasimplemented a program under which qualified franchisees are eligible to havetheir royalty rate reduced to as low as 6% if they satisfy certaincriteria.  Under the program, franchiseesare also provided with an incentive to purchase additional Precision Tune AutoCare franchises.  Any franchisee that hasowned and operated a center for at least one year in accordance with thisprogram will be charged an initial franchise fee of $15,000 for a secondfranchise and $10,000 for each additional franchise purchased, provided certainconditions are met.

 

Under its current form offranchise agreement, the Company has a continuing obligation to make technicaland administrative support available, centralized marketing support, andtraining and related support available to its franchisees.  In areas where there are area developers, theCompany has delegated most of these duties to area developers under its area developersystem.

 

Upon non-renewal and transfer,the Company has the first right to purchase the operating assets and obtain anassignment of leased facilities in certain cases.  In certain situations, the Company willrepurchase franchise rights.  Thedecision to repurchase is made solely at its discretion and is not acontractual obligation.  The Company alsoperiodically obtains possession of some franchisees’ franchise rights byexchanging for such rights notes payable or other consideration, or by exercisingrights outlined in the franchise agreements.

 

The Company also entersinto master franchise agreements to develop international markets.  At the present time, the Company has masterfranchise agreements in Taiwan, Indonesia, United Arab Emirates, the Bahamas,the Dominican Republic, Peru, Brazil, El Salvador, Ecuador, Guatemala,Honduras, Saudi Arabia, and Portugal. Generally, the master franchisee pays a license fee and is required todevelop Precision Tune Auto Care centers in accordance with an agreed uponschedule within the defined area. Franchise agreements within the area arebetween the master franchisee and the unit franchisee.  The master franchisee is required to performall

 

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of the obligations of the franchisor including training,administrative and operational support, and the Company generally receives 20%of the initial franchise fee and up to one-third of ongoing royalty fees.

 

**CO-BRANDING**

 

On March 20, 2000, the Company entered into anagreement with Petro USA, Inc., a subsidiary of Getty Petroleum Marketing,Inc., to provide Getty’s dealers with the opportunity to host a Precision TuneAuto Care franchise or Precision Lube Express franchise.  This co-branding program involves a plannedassociation of two distinct brands, which are typically associated withdifferent business concepts.  ** **At June 30, 2004,there were seven Getty stores that were hosting Precision Tune Auto Carecenters and one Getty store that was hosting a Precision Lube Express center.

 

The Company is seeking toenter into other similar alliance agreements or other related agreements, whereits franchised businesses will be the secondary tenant at the primary tenant’slocation.  The co-branding program mayhave separate agreements with the primary tenant’s organization or itsaffiliates to assist Precision Tune Auto Care in the offer of franchises to theprimary tenants and the provision of services. The Company expects that these co-branding opportunities will be with otherproviders of automotive services not similar to its own, like gasolinestations, detail, paint and body work stations, tire shops, glass shops, andmuffler shops.  Due to the nature ofthese co-branding relationships, the Company expects to modify its standardform of franchise agreement to reflect the differences or similarities betweenits businesses.  Some of these primarytenants may be in direct competition with the Company and may choose not tofranchise their particular location. Additionally, the Company makes the final decision as to entering into afranchise agreement with a primary tenant.

 

**COMPETITION**

 

The Company’s franchisees and licensees encountercompetition in all aspects of their business, including the sale by PrecisionTune Auto Care and Precision Lube Express centers of automotive maintenance andrepair services and fast oil and lubrication services.  The Company believes that automobiledealerships, including recently emerging national and regional new and usedauto dealerships, represent Precision Tune Auto Care’s principalcompetitors.  Other Precision Tune AutoCare competitors include tire companies and regional under-the-hood servicespecialists.  National competitors withinPrecision Tune Auto Care’s market include Sears Auto Center and the automotivemaintenance centers operated by Goodyear and Firestone, among others.  Its regional competitors include All Tune andLube (East Coast), Econo Lube N’ Tune (West Coast), Tunex International,Inc.  (Rocky Mountain region), Tune-UpMasters, and Speedee Oil Change and Tune-Up (Southern region).  The Company believes that the greatertechnical complexity of today’s vehicles provides a substantial barrier toentry for competitors in the “under-the-hood” segment of the automotive care servicesindustry.

 

The Company believes thatthe Precision Tune Auto Care centers all compete on the basis of customerawareness through advertising, service, convenience and location and, to alesser extent, on price.  The Companybelieves that the potential ability to offer all of the services provided byeach of the operations at one center or in centers in close proximity to oneanother will be a significant competitive advantage.

 

**GOVERNMENT REGULATION**

 

*Franchising Regulation*.  The Company is subject to federal,international and state laws and regulations, including the regulations of theFederal Trade Commission as well as similar authorities in individual states,in connection with the offer, sale and termination of franchises and theregulation of the franchisor/franchisee relationship.  From time to time, the Company experiencesperiods during which sales are restricted while it registers updates of itsdisclosure material with various states. Such delays may have an adverse effect on its ability to offer and sellfranchises.  In addition, the Company maybecome subject to litigation with, or other claims filed with state, federal orinternational authorities by, franchisees or area developers based on allegedunfair trade practices, implied covenants of good faith and fair dealing or expressviolations of agreements.  The failure bythe Company to comply with these laws could subject the Company to liability tofranchisees and to fines or other penalties imposed by governmental authoritiesand could have a material adverse effect on its financial condition and resultsof operations.

 

*Environmental Regulation*.  Precision Tune Auto Care and Precision LubeExpress centers store new oil and handle large quantities of used automotiveoils and fluids.  As a result of theseactivities, the Company, its franchisees and area developers are subject tovarious federal, state and local environmental laws and regulations dealingwith the transportation, storage, presence, use, disposal and handling ofhazardous materials and hazardous wastes, and underground fuel storagetanks.  If any such substances wereimproperly released or improperly stored on the property of any franchisee,including leased properties, or if the Company were found to be in violation ofapplicable environmental laws and regulations, the Company could be responsiblefor clean-up costs, property damage and fines or other penalties, any one ofwhich could have a material adverse effect on its financial condition andresults of operations.

 

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**TRADEMARKS**

 

The Company hasregistered a number of trademarks and service marks with the United StatesPatent and Trademark Office, including “Precision Tune Auto Care.”  Its failure to obtain and maintain trademarkand service mark registration could have a material adverse effect on itsoperations.  The Company has alsoregistered or made application to register trademarks in foreign countrieswhere master franchise licenses have been granted.

 

**SEASONALITY**

 

Seasonal changes mayimpact various sectors of the Company’s businesses and, accordingly, itsoperations may be adversely affected by seasonal trends in certainperiods.  In particular, severe weatherin winter months may make it difficult for consumers in affected parts of thecountry to travel to Precision Tune Auto Care and Precision Lube Express andobtain services.

 

**RISK FACTORS**

 

The Company’s businessand investment in its Common Stock are subject to certain risks, including thefollowing:

 

*Stock Listing. *The Company’s common stocktrades on the National Association of Securities Dealers, Inc.’s OTC BulletinBoard.  Like other stocks traded overthis quotation system, its common stock is thinly traded, highly volatile andnot followed by analysts.

 

*Penny Stock Regulations. *The Company’s common stockis subject to the rules promulgated under the Securities Exchange Act of 1934,as amended, relating to “penny stocks.” These rules require brokers selling securities subject to these rules topersons other than established customers and institutional accredited investorsto complete certain documentation, make suitability inquiries of investors andprovide investors with certain information concerning the risks of trading inthe security.  These rules may restrictthe ability of brokers to sell the Company’s common stock and thus may have anadverse effect on the liquidity and market price of its common stock.

 

*Resale Restrictions on CommonStock. *Because oflarge broker-dealer spreads, investors may be unable to sell the stockimmediately back to the broker-dealer at the same price the broker-dealer soldthe stock to the investor.  In somecases, the stock may fall quickly in value. The market among broker-dealers may not be active, making it moredifficult for investors to sell this stock. Investors in a penny stock often are unable to sell stock back to thedealer that sold them the stock.  Themark-ups or commissions charged by the broker-dealers may be greater than anyprofit a seller may make.

 

*PennyStock Market.* Shareholders should be aware that, according to Securities and ExchangeCommission Release No. 34-29093, the market for penny stocks has suffered inrecent years from patterns of fraud and abuse which could cause investors tolose their entire investment.  Suchpatterns include:

 

•                  control of the market for thesecurity by one or a few broker-dealers that are often related to the promoteror issuer;

•                  manipulation of prices throughprearranged matching of purchases and sales and false and misleading pressreleases;

•                  “boiler room” practices involvinghigh pressure sales tactics and unrealistic price projections by inexperiencedsales persons;

•                  excessive and undisclosed bid-askdifferentials and mark-ups by selling broker-dealers; and

•                  the wholesale dumping of the samesecurities by promoters and broker-dealers after prices have been manipulatedto a desired level, along with the inevitable collapse of those prices withconsequent investor losses.

 

The Company’s management is aware of the abuses that have occurredhistorically in the penny stock market. Although it does not expect to be in a position to dictate the behaviorof the market or of broker-dealers who participate in the market, it willstrive within the confines of practical limitations to prevent the describedpatterns from being established with respect to its securities.

 

*Competition*.  The automotive services industry is highlycompetitive.  The Company believes thatautomobile dealerships, including recently emerging national and regional newand used auto dealerships, represent the principal competitors for PrecisionTune Auto Care and Precision Lube Express service centers; however, theseservice centers also compete with national and regional fast oil change andlube companies, major oil manufacturers, local service stations and local,regional and national automobile maintenance and repair service providers.

 

The Company believes theprincipal competitive factors in the markets serviced by each of its businessunits are location, name recognition and reputation, and quality of service andprice.

 

The Company also competeswith some of those noted above and with other parties in the sale offranchises.  Competitive factors includestartup costs, royalty rates, franchisee support and the financial performanceof existing centers.  With respect to thesales of supplies and equipment for franchisees, competition is based onavailability, price, ability to provide prompt delivery and the quality ofsupport services.

 

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Certain competitors discussed above have greaterfinancial resources than the Company does. There can be no assurance that the Company or individual Precisioncenters will be able to compete effectively. *See “Business**3⁄4Competition.”*

 

*Reliance on Franchising.*  Franchise royalties are a significantcomponent of its revenue base. Therefore, the Company depends upon the ability of its franchisees topromote and capitalize upon the “Precision” brand and the reputation the Companybelieves the Company enjoys for quality and value.  There can be no assurance that the Company orour area developers will be able to recruit and retain franchisees with thebusiness abilities or financial resources necessary to open Precision Tune AutoCare centers on schedule or that the franchisees will conduct operationsprofitably.  In addition, to the extentthat franchisees finance their operations with secured indebtedness, theCompany’s rights to receive franchise royalties would be effectivelysubordinated to the rights of franchisees’ lenders.  *See “Business**3⁄4Operations.”*

 

*Automotive Technology Advances.*  The demand for the services offered by itsPrecision Tune Auto Care and Precision Lube Express centers could be adverselyaffected by continuing developments in automotive technology.  Automotive manufacturers are producing carsthat last longer and require service and maintenance at less frequentintervals.  For example, somemanufacturers now recommend that consumers change oil at 10,000 mile intervalsand replace spark plugs and other engine components at 100,000 miles, asignificant increase from the mileage intervals recommended for earlier modelsand those currently recommended by most manufacturers.  The demand for its services also could beadversely affected by longer and more comprehensive warranty programs offeredby automobile manufacturers and other third parties.  The Company believes that a majority of newautomobile owners have their cars serviced by a dealer during the period thecar is under warranty.  In addition, advancesin automotive technology may require the Company to incur additional costs toupdate its technical training program and upgrade the diagnostic capabilitiesof its centers.

 

*Labor Availability.*The provision of high quality maintenance services by Precision Tune Auto Carecenters requires an adequate supply of skilled labor.  In addition, the operating costs andoperating revenues of such centers may be adversely affected by high turnoverin skilled technicians.  Trained andexperienced automotive technicians are in high demand.  Accordingly, a center’s ability to increaseproductivity and revenues could be affected by its inability to maintain theemployment of skilled technicians necessary to provide the center’sservices.  There can be no assurance thatPrecision Tune Auto Care or its franchisees will be able to attract andmaintain an adequate skilled labor force necessary to operate these centersefficiently or that labor expenses will not increase as a result of a shortagein the supply of skilled technicians, thereby adversely impacting its financialperformance.

 

*Dependence on Management and KeyPersonnel.*  TheCompany’s success depends to a significant extent on the performance andcontinued services of senior management and certain key personnel.  The Company believes these individualspossess the necessary experience in financing, operating and managing a companyintent on improving its financial performance. The loss of the services of one or more of these key employees couldhave a material adverse impact on its financial condition and results ofoperations.

 

*Seasonal Nature of Portions ofthe Business.*  Seasonalchanges may impact various sectors of its businesses and, accordingly, itsoperations may be adversely affected by seasonal trends in certainperiods.  In particular, severe weatherin winter months may make it difficult for consumers in affected parts of thecountry to travel to Precision Tune Auto Care and Precision Lube Expresscenters and obtain services.

 

*Control by Management andPrincipal Shareholders.* As of August 12, 2004, its directors,executive officers and shareholders beneficially owning more than 5% of itsoutstanding common stock, in the aggregate, beneficially owned approximately18% of its outstanding common stock.  Accordingly,these persons have substantial influence over its affairs, including theability to influence the election of directors and appointment of management,the outcome of votes by its shareholders on major corporate transactions,including mergers and the sales of substantial assets and other mattersrequiring shareholder approval.

 

*Franchising Regulations.*  The Company is subject to federal,international and state laws and regulations, including the regulations of theFederal Trade Commission as well as similar authorities in individual states,in connection with the offer, sale and termination of franchises and theregulation of the franchisor/franchisee relationship.  *See “Business**3⁄4Government Regulation.”*  Its failure to comply with these laws couldsubject the Company to liability to franchisees and to fines or other penaltiesimposed by governmental authorities. From time to time, the Company experiences periods during which salesare restricted while the Company registers updates of its disclosure materialwith various states.  Such delays mayhave an adverse effect on its ability to offer and sell franchises.  In addition, the Company may become subjectto litigation with, or other claims filed with state, federal or internationalauthorities by, franchisees or area developers based on alleged unfair tradepractices, implied covenants of good faith and fair dealing or expressviolations of agreements.  Accordingly,its failure to comply with applicable franchise laws and regulations could havea material adverse effect on its financial condition and results of operations.

 

*Environmental Regulation.*  Precision Tune Auto Care and Precision LubeExpress centers store new oil and handle large quantities of used automotiveoils and fluids.  Precision Auto Washcenters (which were formerly franchise operations under the PACI umbrella) usedchemicals in the washing process.  Thesechemicals, along with oils, fluids and other chemicals washed off of thevehicle were collected with the waste water from the car wash process.  As a result of these activities, the Company,its franchisees and area developers are subject to various federal, state andlocal environmental laws and regulations dealing with the transportation, 

 

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storage, presence, use,disposal and handling of hazardous materials and hazardous wastes, discharge ofstorm water, and underground fuel storage tanks.  If any such substances were improperlyreleased or improperly stored on its property or the property of anyfranchisee, including leased properties, or the Company were found to be inviolation of applicable environmental laws and regulations, the Company couldbe responsible for clean-up costs, property damage and fines or other penalties,any one of which could have a material adverse effect on its financialcondition and results of operations.  *See “Business**3⁄4GovernmentRegulation.”*

 

**EXECUTIVE OFFICERS OF PRECISION AUTO CARE, INC.**

 

*Louis M. Brown, Jr.*,age 61 became Chairman of the Board in October 2003.  He also remains Chief Executive Officer.  He is Vice Chairman of Micros Systems, Inc.since April 2003 and was Chairman of the Board from January 1987 to April 2003.

 

*Robert R. Falconi,*age50, became President in October 2003. He also remains Chief Operating Officerand Chief Financial Officer.  From March2002 to October 2003, he was Executive Vice President and Chief OperatingOfficer/Chief Financial Officer.From September 2000 to February 2002,he was the Company’s Vice President – Finance, Administration and ChiefFinancial Officer.  From August 1998until September 2000, he was Chief Financial Officer of Apptis, Inc.

 

*Frederick F. Simmons*,age 42, became Senior Vice President, General Counsel and Secretary in March2001. From December 1995 to February 2001, he was Assistant General Counsel andAssistant Secretary of Advantica Restaurant Group, Inc.

 

*John T. Wiegand*,age 42, became Senior Vice President – Operational Programs and Training inMarch 2002.  From August 2000 to March2002, he was Senior Vice president of Franchise Operations and from June 1998to August 2000, he was Vice President of North American Operations. Mr. Wiegandjoined WE JAC Corporation, the Company’s predecessor, as Director of FieldOperations in August 1996.

 

*Kevin Bates*,age 42, became Vice President - Marketing and Advertising in October 1999. FromJanuary 1998 until October 1999, he was our Director of Field Operations.

 

*Joel Burrows*,age 47, became Vice President - Training/Research and Development in September1999. From December 1997 until September 1999, he was the PTAC Director ofTraining/Research and Development.

 

*Glyn D. Massingill*,age 58, became Vice President - Franchise Services in January 2000.  From September 1990 through December 1999,Mr. Massingill was Vice President and General Manager of Precision AutomotiveComponents Manufacturing and Distribution (PAC), a division of the Company.

 

*Douglas V. Krueger*,age 33, became Controller in January 2003. From September 2001 until January 2003, Mr. Krueger was the AssistantController of the Company.  FromSeptember 2000 until September 2001, Mr. Krueger was a financial analyst of theCompany.  From September 1998 until September2000, he was a financial analyst of Apptis, Inc.

 

**Item 2****.   *Properties***

 

The Company’s corporate headquarters are located inapproximately 18,000 square feet of leased office space in Leesburg, Virginiapursuant to a lease that expires in 2009.

 

In the opinion of management, the Company’s currentspace is adequate for its operating needs.

 

###### **Item 3**.  *Legal Proceedings*

###### ** **

From timeto time, the Company and its subsidiaries are subject to litigation in theordinary course of business, including contract, franchisee andemployment-related litigation. In the course of enforcing its rights underexisting and former franchisee agreements, the Company is subject to complaintsand letters threatening litigation concerning the interpretation andapplicability of these agreements, particularly in cases involving defaults andterminations of franchises.  As of thedate hereof, there are no such lawsuits pending against the Company.

 

RebeccaAbdallah v. Volkswagen of America, Inc., et al., District Court of Webb County,Texas, Case No. 2003-CVE-00798-D2

 

OnSeptember 8, 2003, Precision Franchising LLC (“PFL”) was served withPlaintiff’s First Amended Petition seeking damages in excess of $75,000 fromthe manufacturer of a vehicle purchased by her husband, the seller of thevehicle, a franchised Precision Tune Auto Care center which conducted a pre-purchaseinspection of the vehicle, and against PFL.  With respect to PFL,Plaintiff alleges that she suffered personal injuries as a result of PFL’sinadequate policies and procedures regarding the pre-purchase inspection;failure to adequately hire, train and supervise employees; failure toinvestigate the vehicle’s history of fuel leaks and ongoing recallinvestigations; failure to investigate the vehicle’s fuel system; and negligentmisrepresentations about the condition of the vehicle.  In

 

9

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June2004, the Company filed a motion to dismiss the lawsuit, and in July 2004, theplaintiff voluntarily dismissed the lawsuit against the Company withoutprejudice.

 

PreviouslyReported Cases:

 

Lumnivision,S.A. de C.V. v. Praxis Afinaciones, S.A. de C.V., Third Civil Court, First JudicialDistrict, Monterrey, Nuevo Laredo, Mexico.

 

Lumnivisionfiled suit against Praxis Afinaciones, an indirect wholly owned subsidiary ofPACI, seeking payment of 766,000 Mexican Pesos, plus interest at the rate of 5%per month, for services under a contract.  Praxis Afinaciones denies theallegations and is defending the allegations in the lawsuit.

 

UnitedBank, NA v. C. Eugene Deal, Miracle Partners, Inc., Star Auto Center, Inc., Common Pleas Court of Cuyahoga County,Ohio, Case No. 01-CV0019, Filed January 11, 2001

 

MiraclePartners, Inc., a wholly-owned subsidiary of the Company, is party to aconfessed judgment of approximately $1.3 million.  The subsidiary iscurrently inactive and has no assets.  As such, management believes thisjudgment will have no material impact on the Company’s consolidated results ofoperations.  Furthermore, the Company believes that it has a meritoriousclaim against Mr. Deal, former President of Miracle Partners, formisrepresentations made in connection with PACI’s acquisition of MiraclePartners, Inc. in 1997 for all amounts covered by the judgment.

 

ThreatenedLitigation:

 

PuyallupAuto Stop Associates, Inc. v. PTW, Inc.

 

By letterdated July 1, 2003, a former landlord has asserted a claim against PTW, Inc.for reimbursement of the costs of remediating environmental contamination tothe leased premises during the term of the lease, which costs allegedly exceed$250,000.  Investigation into the Company’s liability is ongoing.

 

TheCompany does not believe that any of the above claims or proceedings willresult in a material judgment against the Company.  There can be noassurance, however, that these suits will ultimately be decided in itsfavor.  Any one of these claims or proceedings may result in a materialjudgment against the Company, which could cause material adverse consequencesto its operations.

 

**Item 4****.   *Submission of Matters to a Vote of Security Holders***

 

None.

 

10

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**PART II**

 

**Item 5****.   *Market forCommon Equity and Related Stockholder Matters***

 

The Company’s common stock, par value $.01 per share(“Common Stock”) is publicly traded on the National Association of SecurityDealers Inc.’s OTC Bulletin Board and is quoted under the symbol “PACI.”

 

The following table sets forth the high and low salesprices on NASD OTC Bulletin Board for the Common Stock during the fiscal yearsended June 30, 2004, and June 30, 2003, respectively. To date, the Company hasnot paid any Common Stock dividends and does not anticipate paying any CommonStock dividends in the foreseeable future, however dividends are currentlybeing paid on the Company’s Series A redeemable preferred stock (see“Management’s Discussion and Analysis or Plan of Operation – Liquidity andCapital Resources”  and Note 7 to theConsolidated Financial Statements).

 

These over the counter market quotations reflectinter-dealer prices, without retail mark-up, markdown, or commission, and maynot necessarily represent actual transactions.

 

**Fiscal Year Ended June 30, 2004**

 
| **Quarter** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------|------------|----------|------------|---------|------------|
| First       |       | $        | 0.85       |    | $          | 0.55 |   |
| Second      |       | 1.25     |       | 0.68    |       |
| Third       |       | 0.91     |       | 0.60    |       |
| Fourth      |       | 0.95     |       | 0.60    |       |
|             |            |          |            |         |            |  |  |

 

**Fiscal Year Ended June 30, 2003**

 
| **Quarter** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------|------------|----------|------------|---------|------------|
| First       |       | $        | 0.31       |    | $          | 0.16 |   |
| Second      |       | 0.42     |       | 0.17    |       |
| Third       |       | 0.32     |       | 0.20    |       |
| Fourth      |       | 1.01     |       | 0.23    |       |
|             |            |          |            |         |            |  |  |

 

As of September 1, 2004, there were approximately 200record holders of Common Stock and approximately 1,200 beneficial owners of theCompany’s Common Stock.

 

**Equity Compensation Plan Information**

 
| **Plan  category**                                          | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted average exercise  price of outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                            | ** ** | **(b)**                                                                           | ** ** | **(c)**                                                            | ** ** |
| Equity  compensation plans approved by security holders     |       | 1,739,200                                                                                          |       | 0.74                                                                              |       | 674,497                                                            |       |
| Equity  compensation plans not approved by security holders |       | 0                                                                                                  |       | 0                                                                                 |       | 0                                                                  |       |
| Total                                                       |       | 1,739,200                                                                                          |       | 0.74                                                                              |       | 674,497                                                            |       |

 

11

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**Item 6****.*  Management’s Discussion and Analysis or Planof Operation***

 

**Introduction**

 

The following discussion should be read in conjunctionwith the Financial Statements of the Company and related notes thereto includedelsewhere herein.

 

**Overview**

 

Precision Auto Care is a global franchisor of autocare and quick-lube centers. Company revenues are derived from three primaryareas: franchise development, royalties, and distribution. Franchisedevelopment revenues include sales of franchises and master licenses. Royaltyrevenues are derived from royalty fees paid by individual franchisees to theCompany based on qualified retail sales by the franchisee. Distributionrevenues are derived from the sale of automotive related supplies to individualfranchisees.

 

Direct costs consist of fees paid to area developersfor the sale of new franchises and for supporting franchisees on an ongoingbasis, other costs associated with directly supporting the franchise system,and the cost of automotive related supplies. General and administrativeexpenses include all legal, accounting, general overhead, informationtechnology and corporate staff expenses. Other income and expense items includeinterest income and expense which are included within the non-operatingincome/expense category on the Statement of Operations.  Severances, abandoned acquisitions, earlybuyout of lease obligations, and sale of assets are included in the operatingexpenses on the Statement of Operations.

 

The Company has one remaining business segment,Automotive Care Franchising, due to the disposal of its manufacturingoperations in March and April 2003.  SeeNotes to Financial Statements for financial information regarding the disposalof the Company’s Manufacturing and Distribution business segment.  This disposal was accounted for as adiscontinued operation resulting in the reclassification of amounts associatedwith the manufacturing business in its historical financial statements.  The Automotive Care Franchising business segment,which is comprised of Precision Tune Auto Care (“PTAC”) and Precision LubeExpress, provides automotive services primarily through franchised operationslocated in the United States and in certain foreign countries.

 

The Company’s core auto care and franchising businesscontinues to benefit from an improved focus on unit economics, and in the fieldtraining programs. Additionally, the Company is seeking growth throughco-branding. This strategy is designed to permit the Company to partner withother retailers and service providers who are also seeking to improve cashflows through complementary brands.

 

**Critical Accounting Policies**

 

The following is a summary of the Company’s criticalaccounting policies.  For a fulldescription of these and other accounting policies, see Note 1 of the Notes tothe Consolidated Financial Statements. These critical accounting policies require estimates and assumptionsthat affect the amounts of assets, liabilities, revenues and expenses reportedin the consolidated financial statements. Due to their nature, estimates involve judgments based on availableinformation.  Actual results or amountscould differ from estimates and the difference could have a material impact onthe consolidated financial statements. Therefore, understanding these policies is important in understandingthe reported results of operations and the financial position of the Company.

 

*Revenue Recognition*

 

The Company’s royalty revenue is recognized as earnedin accordance with the specific terms of each agreement and to the extent noknown issues involving collection exist. In the case when revenues are not likely to be collected, the Companyprovides for estimated losses.  Thisestimate is based upon our historical experience as well as a detailed reviewof our receivable balances.

 

Revenue from the sale of a franchise is recognizedupon the opening of the franchised center.

 

The Company enters into domestic Area Developmentagreements and international Master License agreements (Agreements) which grantthe area developer and master licensor, respectively, the right to sell, on theCompany’s behalf, Precision Tune Auto Care franchises and Precision LubeExpress franchises within a specific geographic region.  Revenue from the sale of Area Development agreementsis recognized as all material services or conditions related to the sale aresatisfied.  Revenue from the sale ofmaster licenses is recognized upon signing the Agreement since the Company isnot required to support the international franchises as there is no contractualagreement between the Company and the international franchisees.

 

*Goodwill and Intangible Assets*

 

Statement of Financial Accounting Standards (SFAS) No.142, “Goodwill and Intangible Assets”, requires that goodwill no longer be amortized,but instead be tested for impairment at least annually.  Historically, management has performed itsimpairment analysis

 

12

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in the first quarter ofeach fiscal year.  Goodwill impairmenttesting for the period ending June 30, 2004, did not result in the impairmentof recorded goodwill of approximately $8.7 million.  Subsequent to year-end, the Company obtaineda current business enterprise valuation for purposes of supporting itsimpairment analysis for fiscal year 2005. Such analysis further affirmed management’s conclusion that goodwill wasnot impaired at June 30, 2004.

 

*Deferred Tax Valuation Allowance*

 

The Company recognizes deferred income tax liabilitiesand assets for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns.  Deferred tax liabilities and assets reflectthe effects of tax losses and the future income tax effects of temporary differencesbetween the consolidated financial statement carrying amounts of existingassets and liabilities and their respective tax bases and are measured usingenacted tax rates that apply to taxable income in the years in which thosetemporary differences are expected to be recovered or settled.  The Company recognizes deferred tax assets ifit is more likely than not that the asset will be realized in future years.

 

The Company regularly reviews the recoverability ofits tax deferred assets and establishes a valuation allowance as deemedappropriate.  As of June 30, 2004, theCompany had a valuation allowance of $6.4 million against deferred taxassets.  Given the Company’s currentoperating performance, management released approximately $629,000 of thevaluation allowance during 2004.  Thisadjustment was based upon management’s assessment of the recoverability ofdeferred taxes which included projections of future pretax earnings.

 

###### **Results of Operations**

 

**Comparison of the year ended June 30,2004 to the year ended June 30, 2003**

 

Summary (in thousands)

 
| ** **                                    | ** ** | **Twelve Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **2004**                         | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** |
| Automotive care  franchising revenue          |       | $                                | 11,116     |   | 94 |   | $ | 11,320 |   | 95 |   |
| Other                                         |       | 658                              |       | 6 |   | 617 |   | 5 |   |
| Total revenues                                |       | $                                | 11,774     |   | 100 | % | $ | 11,937 |   | 100 | % |
| Automotive care  franchising direct cost      |       | 6,616                            |       | 56 |   | 6,457 |   | 54 |   |
| Other                                         |       | 611                              |       | 5 |   | 613 |   | 5 |   |
| Total direct  cost                            |       | 7,227                            |       | 61 |   | 7,070 |   | 59 |   |
| General and  administrative                   |       | 3,290                            |       | 28 |   | 3,467 |   | 29 |   |
| Depreciation  expense                         |       | 318                              |       | 3 |   | 410 |   | 3 |   |
| Other operating  expense                      |       | —                           |       | 0 |   | 11 |   | 0 |   |
| Operating income                              |       | 939                              |       | 8 |   | 979 |   | 9 |   |
| Gain on debt  restructuring                   |       | 193                              |       | 2 |   | 10,406 |   | 87 |   |
| Other income  (expense)                       |       | 47                               |       | 0 |   | (664 | ) | (6 | ) |
| Gain from  discontinued operations            |       | 18                               |       | 0 |   | 254 |   | 2 |   |
| Earnings before  taxes                        |       | 1,197                            |       | 10 |   | 10,975 |   | 92 |   |
| Income taxes                                  |       | (473                             | )          | (4 | ) | — |   | 0 |   |
| Net income                                    |       | 1,670                            |       | 14 |   | 10,975 |   | 92 |   |
| Preferred stock  dividends                    |       | 80                               |       | — |   | 43 |   | — |   |
| Net income  applicable to common shareholders |       | $                                | 1,590      |   | 14 | % | $ | 10,932 |   | 92 | % |

 

*Revenue.* Total revenue for theyear ended June 30, 2004 was $11.8 million, a decrease of approximately$100,000, or 1%, compared with total revenue of $11.9 million for the yearended June 30, 2003.

 

Automotive care franchising revenue for the year ended June 30, 2004was $11.1 million, a decrease of approximately $204,000, or 2%, compared withautomotive care revenues of $11.3 million for the year ended June 30,2003.  This decrease was the result of adecrease in royalty revenues of $470,000. This decrease was offset by anincrease in franchise development revenues of $112,000, and an increase inprinting revenue related to franchise operations of $154,000.  The decrease in royalty revenues was drivenby the result of system wide store sales being lower than last year and due tothe fact that there were no revenues received from the discontinued operationin Mexico.  The increase in franchisedevelopment is due to the Company’s improved financial condition and increasedsales efforts.  Subsequent to fiscal yearend, in August 2004, the Company signed an area development agreement withNorth Pacific Precision, Inc. for the area rights for the Seattle market.  Under the agreement, North Pacific Precision,Inc. paid $500,000 for the area developer rights for the Seattle market, andthe Company will receive fifty percent of the income from the sale offranchises and from 

 

13

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royalties from franchisees in the area (see Note 13 of the ConsolidatedFinancial Statements).  The increase inprinting revenue is due to new programs offered to franchisees that enable themto purchase more products from the company’s printing subsidiary.

 

Other revenue for the year ended June 30, 2004 was $658,000, anincrease of approximately $41,000, or 7%, compared to $617,000 for the yearended June 30, 2003.   This increase wasdriven by an increase in revenues derived from training and rebate programs.

 

*Direct Cost.* Total direct costsfor the year ended June 30, 2004 totaled $7.2 million, an increase ofapproximately $157,000 or 2%, compared with $7.1 million for the year endedJune 30, 2003.

 

Automotive care franchising direct costs for the year ended June 30,2004 totaled $6.6 million, an increase of $159,000 or 2%, compared with $6.5million for the year ended June 30, 2003. This increase is directly attributable to the fact that printing revenuecomprised a greater percentage of the total revenue mix than it did in fiscalyear 2003.  The increased printingrevenues have a lower margin compared to the revenues associated with royalties,which decreased during the current year.

 

Other direct costs for the year ended June 30, 2004 totaled $611,000, adecrease of $2,000, compared with $613,000 for the year ended June 30, 2003.

 

*General and Administrative Expense.*General and administrative expense was $3.3 million for the year ended June 30,2004, a decrease of $177,000 or 5%, compared with $3.5 million for the yearended June 30, 2003.  This decrease wasprimarily the result of management’s cost reduction initiatives in general andadministrative costs.  Specifically, legaland personnel costs were reduced.  Thegeneral and administrative expenses also include a charge of $127,000 and$40,000, respectively, due to variable accounting for certain employee stockoptions in 2004 and 2003 (see Note 10 of the Consolidated FinancialStatements).

 

*Operating Income From Continuing Operations. *The Company recordedoperating income for the year ended June 30, 2004 of approximately $939,000, adecrease of $40,000, or 4%, compared with an operating income of $979,000 forthe year ended June 30, 2003.

 

*Gain on Debt Restructuring. *The Company recognized a gain from debt restructuring in the amount of$193,000 for the year ended June 30, 2004, as a result of restructuring theBoard LLC debt.  During January 2003, theCompany recognized a gain of $9.7 million from the Precision Funding debtrestructuring (see Note 7 in the Consolidated Financial Statements) anda reduction of approximately $659,000 in accrued expenses associated with itsMexican subsidiary based on management’s assessment of the Company’s futureobligations.

 

*Other Income (Expense).*The Company recorded Other Income of $47,000 for the year ended June 30, 2004,compared with Other Expense of $664,000 for the year ended June 30, 2003.  The Other Income in 2004 represents interestincome derived from notes receivable with franchisees.  The Other Expense from 2003 was primarilyinterest expense on the Precision Funding and Board LLC debt.

 

*Gain From Discontinued Operations. *The Company recorded a gainfrom discontinued operations for the year ended June 30, 2004 of $18,000compared with a gain from discontinued operations of $254,000 for the yearended June 30, 2003 relating to the disposal of its manufacturing anddistribution operations (see Note 4 of the Consolidated Financial Statements).

 

*Net Income Applicable to CommonShareholders and Earnings Per Share*. The Company recorded NetIncome Applicable to Common Shareholders of $1.6 million, or $0.08 per share,for the year ended June 30, 2004 compared to $10.9 million, or $0.72 per share,for the year ended June 30, 2003. The decrease in net income is primarilyattributable to the gain that was recognized on the debt restructuring in 2003.

 

Liquidity and Capital Resources

 

Sources and Uses of Cash

 

Cash atJune 30, 2004 was $1.6 million.  Duringthe period, cash provided by operations was $837,000.  The Company generated operating profit infiscal year 2004 and expects to do so in fiscal year 2005.

 

Cash used in investing activities forthe twelve months ended June 30, 2004 was $100,000 resulting primarily from thepurchase of property and equipment.

 

Cash used in financing activities for the twelve months ended June 30,2004 was $727,000. Cash used in financing activities during the periodconsisted of repayments of the subordinated debt and other notes payable.

 

Management believes that the Company’s current cashbalance, cash generated from operations, and available credit line will besufficient to meet the Company’s working capital needs, capital expenditures,and contractual obligations for fiscal year 2005.

 

14

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Debt Transactions

 

On October 30, 2002, the Company reached an agreement with PrecisionFunding, L.L.C. and a former board member to convert approximately $17.6million of outstanding debt and accrued interest due to them to equity.  In exchange for the extinguishment of theapproximately $17.6 million in outstanding debt and accrued interest due, theCompany issued Precision Funding, L.L.C. and the former board member thefollowing:

 

•                  2.5 millionshares of the Company’s common stock.

•                  500,000 shares of Series A redeemablepreferred stock of the Company with a stated value of $10.36 per share.  These shares are redeemable by theshareholder at any time after the 3rdanniversary of the Issue Date, October 30, 2002 on 30 days prior written noticefor an aggregate value of $5,180,000 plus any unpaid dividends.  The holders of these shares are also entitledto receive, when and as declared by the Board of Directors, cumulativepreferential cash dividends at the rate of 2% of the liquidation preference ofthe Series A preferred stock, $10.36 per share, per annum payable quarterly inarrears in cash on the last day, or the next succeeding business day, ofJanuary, April, July, and October in each year, beginning January 31,2003.  Accrued dividends wereapproximately $4,000 and $9,000 at June 30, 2004 and 2003, respectively.

•                  Warrants topurchase 11,472,039 shares of the Company’s common stock with an exercise priceof $0.44 per share.

 

Issuance of the warrants was subject to shareholder approval of aproposal to amend the Articles of Incorporation to increase the Company’sauthorized shares of common stock.  Suchapproval was granted at the annual shareholder meeting held on January 15,2003.  As a result, the Companyrecognized a gain of approximately $6.9 million from the exchange of debt witha carrying value of $12.6 million for common and preferred stock with a fairvalue of $5.7 million during the 2nd quarter of fiscal year2003.  The remaining $2.8 million gainfrom the exchange of warrants valued at $2.2 million for the remaining debtwith a carrying value of $5.0 million was recognized in January 2003 whenshareholder approval was granted to increase the Company’s authorized shares ofcommon stock.

 

In October 1998, a subordinated debenture in the amount of $2.0 millionwas executed with an LLC composed of certain members of the Company’s board ofdirectors (Board LLC).  On July 17, 2003,the Company reached an agreement to restructure the remaining $633,000 due tothe Board LLC.  The terms of theagreement called for the following:

 

•                  Payment of$200,000 within 3 days of receipt of approval by the Company’s Board ofDirectors.

•                  Issuance of a non-interest bearingnote payable in the amount of $50,000, payable in ten monthly installments of$5,000 each, commencing one month after the date of approval by the Company’sBoard of Directors.

•                  Issuance ofwarrants to purchase 400,000 shares of the Company’s common stock with an exerciseprice of $0.44 per share having a fair value of approximately $222,000.

 

TheCompany recognized a gain of approximately $160,000 from this debtrestructuring in the first quarter of fiscal year 2004.

 

InDecember 2003, the Company paid approximately $169,000 in full satisfaction ofthe $201,000 of debt owed to Radiant Systems, Inc.  The Company recognized a gain ofapproximately $32,000 from this transaction in the second quarter of fiscalyear 2004.

 

InJanuary 2004, 2,469,600 warrants were exercised pursuant to an agreement theCompany reached with Precision Funding, L.L.C. and a former board member inOctober 2002.  Upon the exercise of thesewarrants at the previously agreed to exercise price of $0.44 per share, theholder purchased 2,469,600 restricted shares of common stock in exchange forsurrendering 104,885 shares of Series A Preferred Stock to the Company,therefore, there were no cash proceeds received by the Company from thistransaction.

 

In February 2004, 4,530,169 warrants were exercised pursuant to anagreement the Company reached with Precision Funding, L.L.C. and a former boardmember in October 2002.  Upon theexercise of these warrants at the previously agreed to exercise price of $0.44per share, the holder purchased 4,530,169 restricted shares of common stock inexchange for surrendering 192,401 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

 

Seasonality and Quarterly Fluctuations

 

Seasonal changes may impact various sectors of theCompany’s business differently and, accordingly, the Company’s operations maybe affected by seasonal trends in certain periods. In particular, severeweather in winter months can adversely affect the Company because such weathermakes it difficult for consumers in affected parts of the country to travel toPrecision Auto Care and Precision Lube Express centers.

 

15

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**Item 7****.  *FinancialStatements***

 

16

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**Report ofIndependent Registered Public Accounting Firm**

 

To the Board of Directorsand

Stockholders of PrecisionAuto Care, Inc.

 

We have audited theaccompanying consolidated balance sheets of Precision Auto Care, Inc. (the Company)and subsidiaries as of June 30, 2004 and 2003, and the related consolidatedstatements of operations, stockholder’s equity and cash flows for the yearsthen ended.  These financial statements are the responsibility of theCompany’s management.  Our responsibility is to express an opinion onthese financial statements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that we plan and perform the audits toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation.  We believe that our audits provide a reasonablebasis for our opinion.

 

In our opinion, the financial statements referred toabove, present fairly, in all material respects, the consolidated financialposition of Precision Auto Care, Inc. and subsidiaries as of June 30, 2004 and2003, and the consolidated results of its operations and its cash flows for theyears then ended in conformity with accounting principles generally accepted inthe United States of America.

 
|                | GRANT  THORNTON LLP |
|---------------------|---------------------|
|                |
| Vienna,  Virginia   |
| September  10, 2004 |

 

17

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**PRECISION AUTO CARE, INC. ANDSUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                           | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| **ASSETS**                                                                                                                           | ** ** | ** **         | ** ** | ** **         | ** ** |
| Current assets:                                                                                                                      |       |               |       |               |       |
| Cash and cash  equivalents                                                                                                           |       | $                  | 1,573,368  |               | $          | 1,564,110 |   |
| Restricted cash                                                                                                                      |       | 50,200             |       | —             |       |
| Accounts  receivable, net of allowance of $72,815 and $184,607, respectively                                                         |       | 620,761            |       | 756,565            |       |
| Notes receivable                                                                                                                     |       | 294,243            |       | 160,352            |       |
| Deferred tax  asset                                                                                                                  |       | 473,000            |       | —             |       |
| Other assets                                                                                                                         |       | 283,244            |       | 240,727            |       |
| Assets of  discontinued operations                                                                                                   |       | —             |       | 16,759             |       |
| Total current  assets                                                                                                                |       | 3,294,816          |       | 2,738,513          |       |
|                                                                                                                                 |       |               |       |               |       |
| Property, plant  and equipment, at cost                                                                                              |       | 4,147,329          |       | 4,092,222          |       |
| Less:  Accumulated depreciation                                                                                                      |       | (3,982,924         | )          | (3,664,823         | )          |
|                                                                                                                                 |       | 164,405            |       | 427,399            |       |
|                                                                                                                                 |       |               |       |               |       |
| Goodwill                                                                                                                             |       | 8,711,744          |       | 8,711,744          |       |
| Notes  receivable, net of allowance of $254,832 and $178,796, respectively                                                           |       | 161,685            |       | 106,334            |       |
| Deposits and  other                                                                                                                  |       | 27,914             |       | 24,314             |       |
|                                                                                                                                 |       |               |       |               |       |
| Total assets                                                                                                                         |       | $                  | 12,360,564 |               | $          | 12,008,304 |   |
|                                                                                                                                 |       |               |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                        | ** ** | ** **         | ** ** | ** **         | ** ** |
| Current  liabilities:                                                                                                                |       |               |       |               |       |
| Accounts payable  and accrued liabilities                                                                                            |       | $                  | 1,942,650  |               | $          | 2,543,945 |   |
| Board LLC note                                                                                                                       |       | —             |       | 116,163            |       |
| Other notes  payable- current                                                                                                        |       | 75,240             |       | 174,267            |       |
| Line-of-credit                                                                                                                       |       | —             |       | —             |       |
| Deferred revenue                                                                                                                     |       | 396,150            |       | 307,500            |       |
| Liabilities from  discontinued operations                                                                                            |       | 12,780             |       | 73,443             |       |
| Total current  liabilities                                                                                                           |       | 2,426,820          |       | 3,215,318          |       |
|                                                                                                                                 |       |               |       |               |       |
| Board LLC note                                                                                                                       |       | —             |       | 516,365            |       |
| Other notes  payable- non-current                                                                                                    |       | 13,770             |       | 222,357            |       |
| Deferred revenue  and other                                                                                                          |       | —             |       | 210,000            |       |
| Total  liabilities                                                                                                                   |       | 2,440,590          |       | 4,164,040          |       |
|                                                                                                                                 |       |               |       |               |       |
| Commitments and  contingencies                                                                                                       |       | —             |       | —             |       |
|                                                                                                                                 |       |               |       |               |       |
| Series A  redeemable preferred stock, $.01par value; 1,000,000 shares authorized;  202,714 and 500,000 shares issued and outstanding |       | 2,100,117          |       | 5,180,000          |       |
|                                                                                                                                 |       |               |       |               |       |
| Stockholders’  equity:                                                                                                          |       |               |       |               |       |
| Common stock,  $.01 par value; 39,000,000 shares authorized; 23,808,602 and 16,558,833  shares issued and outstanding                |       | 238,086            |       | 165,588            |       |
| Additional  paid-in capital                                                                                                          |       | 55,873,804         |       | 52,380,481         |       |
| Accumulated  deficit                                                                                                                 |       | (48,292,033        | )          | (49,881,805        | )          |
| Total  stockholders’ equity                                                                                                     |       | 7,819,857          |       | 2,664,264          |       |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                  | 12,360,564 |               | $          | 12,008,304 |   |

 

Seeaccompanying notes.

 

18

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**PRECISION AUTO CARE, INC. ANDSUBSIDIARIES**

## **CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                       | ** ** | **For The Years Ended  June 30,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                       | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| Revenues:                                                        | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Franchise  royalties                                             |       | $                                 | 10,624,998 |   | $ | 10,941,143 |   |
| Franchise  development                                           |       | 490,826                           |       | 379,097 |   |
| Company owned  centers                                           |       | —                            |       | 73,763 |   |
| Other                                                            |       | 658,029                           |       | 542,881 |   |
|                                                             |       |                              |       |   |   |
| Total revenues                                                   |       | 11,773,853                        |       | 11,936,884 |   |
|                                                             |       |                              |       |   |   |
| Direct cost:                                                     |       |                              |       |   |   |
| Franchise  support and other                                     |       | 7,227,399                         |       | 7,070,492 |   |
|                                                             |       |                              |       |   |   |
| Contribution                                                     |       | 4,546,454                         |       | 4,866,392 |   |
|                                                             |       |                              |       |   |   |
| General and  administrative expense                              |       | 3,289,797                         |       | 3,466,837 |   |
| Depreciation  expense                                            |       | 318,101                           |       | 409,840 |   |
| Other operating  expense                                         |       | —                            |       | 11,300 |   |
|                                                             |       |                              |       |   |   |
| Operating income                                                 |       | 938,556                           |       | 978,415 |   |
|                                                             |       |                              |       |   |   |
| Gain on debt  restructuring                                      |       | 192,875                           |       | 10,405,993 |   |
| Interest expense                                                 |       | (19,611                           | )          | (754,073 | ) |
| Other income                                                     |       | 66,777                            |       | 98,214 |   |
|                                                             |       |                              |       |   |   |
| Total other  income                                              |       | 240,041                           |       | 9,750,134 |   |
|                                                             |       |                              |       |   |   |
| Income before  income tax expense                                |       | 1,178,597                         |       | 10,728,549 |   |
| Provision for  income taxes                                      |       | (473,000                          | )          | 7,500 |   |
| Income from  continuing operations                               |       | 1,651,597                         |       | 10,721,049 |   |
|                                                             |       |                              |       |   |   |
| Discontinued  operations:                                        |       |                              |       |   |   |
| Income (loss)  from discontinued operations                      |       | 18,302                            |       | (647,545 | ) |
| Gain on disposal                                                 |       | —                            |       | 901,508 |   |
|                                                             |       |                              |       |   |   |
| Net income                                                       |       | 1,669,899                         |       | 10,975,012 |   |
| Preferred stock  dividends                                       |       | 80,127                            |       | 43,167 |   |
| Net income  applicable to common shareholders                    |       | $                                 | 1,589,772  |   | $ | 10,931,845 |   |
|                                                             |       |                              |       |   |   |
| Income from  continued operations per common share- Basic        |       | $                                 | 0.08       |   | $ | 0.70 |   |
| Gain from  discontinued operations per common share- Basic       |       | —                            |       | 0.02 |   |
| Net income  applicable to common stock per common share- Basic   |       | $                                 | 0.08       |   | $ | 0.72 |   |
|                                                             |       |                              |       |   |   |
| Income from  continued operations per common share- Diluted      |       | $                                 | 0.07       |   | $ | 0.70 |   |
| Gain from  discontinued operations per common share- Diluted     |       | —                            |       | 0.02 |   |
| Net income  applicable to common stock per common share- Diluted |       | $                                 | 0.07       |   | $ | 0.72 |   |
|                                                             |       |                              |       |   |   |
| Weighted average  common shares outstanding—Basic           |       | 19,392,950                        |       | 15,152,379 |   |
| Weighted average  common shares outstanding—Diluted         |       | 22,549,311                        |       | 15,188,186 |   |

 

Seeaccompanying notes.

 

19

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**PRECISION AUTO CARE, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

 
| ** **                           | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total**  | ** **  |
|--------------------------------------|------------|--------------------|------------|-------------------|------------|---------------------------------|------------|--------------------------|------------|------------|-------------|
| Balance at June  30, 2002            |       | 13,318,030         |       | $                 | 133,180    |                            | $          | 49,327,613               |       | $          | (60,817,895 | ) | $ | (11,357,102 | ) |
| Issuance of  common stock            |       | 2,500,000          |       | 25,000            |       | 475,000                         |       | —                   |       | 500,000    |        |
| Common stock  issued as compensation |       | 741,303            |       | 7,413             |       | 248,087                         |       | —                   |       | 255,500    |        |
| Debt to equity  conversion           |       | —             |       | —            |       | 2,294,408                       |       | —                   |       | 2,294,408  |        |
| Stock option  compensation           |       | —             |       | —            |       | 39,868                          |       | —                   |       | 39,868     |        |
| Retirement of  treasury stock        |       | (500               | )          | (5                | )          | (4,495                          | )          | 4,245                    |       | (255       | )           |
| Net income                           |       | —             |       | —            |       | —                          |       | 10,931,845               |       | 10,931,845 |        |
| Balance at June  30, 2003            |       | 16,558,833         |       | $                 | 165,588    |                            | $          | 52,380,481               |       | $          | (49,881,805 | ) | $ | 2,664,264 |   |
| Issuance of  common stock            |       | 6,999,769          |       | 69,998            |       | 3,009,885                       |       | —                   |       | 3,079,883  |        |
| Common stock  issued as compensation |       | 250,000            |       | 2,500             |       | 130,000                         |       | —                   |       | 132,500    |        |
| Debt to equity  conversion           |       | —             |       | —            |       | 222,175                         |       | —                   |       | 222,175    |        |
| Stock option  compensation           |       | —             |       | —            |       | 131,263                         |       | —                   |       | 131,263    |        |
| Net income                           |       | —             |       | —            |       | —                          |       | 1,589,772                |       | 1,589,772  |        |
| Balance at June  30, 2004            |       | 23,808,602         |       | $                 | 238,086    |                            | $          | 55,873,804               |       | $          | (48,292,033 | ) | $ | 7,819,857 |   |

 

See accompanying notes.

 

20

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**PRECISION AUTO CARE, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

 
| ** **                                                                                        | ** ** | **For The Years Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                        | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| Operating  activities:                                                                            |       |                              |       |   |   |
| Net income  applicable to common shareholders                                                     |       | $                                 | 1,589,772  |   | $ | 10,931,845 |   |
| Net gain from  discontinued operations                                                            |       | (18,302                           | )          | (253,963 | ) |
| Adjustments to  reconcile net income to net cash provided by operating activities:                |       |                              |       |   |   |
| Depreciation and  amortization                                                                    |       | 318,101                           |       | 409,840 |   |
| Decrease in  valuation allowance                                                                  |       | (629,000                          | )          | — |   |
| Amortization of  debt discount                                                                    |       | —                            |       | 76,196 |   |
| Gain on debt  restructuring                                                                       |       | (192,875                          | )          | (10,405,993 | ) |
| Gain on sale of  assets                                                                           |       | (25,000                           | )          | — |   |
| Stock issued for  compensation                                                                    |       | 132,500                           |       | 255,500 |   |
| Stock option  compensation                                                                        |       | 131,263                           |       | 39,868 |   |
| Cancellation of  treasury stock                                                                   |       | —                            |       | 4,245 |   |
| Changes in  assets and liabilities from continuing operations:                                    |       |                              |       |   |   |
| Restricted cash                                                                                   |       | (50,200                           | )          | — |   |
| Accounts and  notes receivable                                                                    |       | 16,562                            |       | 32,593 |   |
| Prepaid  expenses, deposits and other                                                             |       | 19,323                            |       | (291,475 | ) |
| Accounts payable  and accrued liabilities                                                         |       | (464,379                          | )          | (1,221,636 | ) |
| Deferred revenue  and other                                                                       |       | (121,350                          | )          | (319,196 | ) |
| Deferred taxes                                                                                    |       | 156,000                           |       | — |   |
| Changes in  assets and liabilities of discontinued operations                                     |       | (25,602                           | )          | 857,753 |   |
|                                                                                              |       |                              |       |   |   |
| Net cash  provided by operating activities                                                        |       | 836,813                           |       | 115,577 |   |
| Investing  activities:                                                                            |       |                              |       |   |   |
| Purchases of  property and equipment                                                              |       | (100,107                          | )          | (14,741 | ) |
| Proceeds from  sale of Mexican subsidiary and related technical services Agreement                |       | —                            |       | 175,000 |   |
| Proceeds from  sale of assets of manufacturing operations                                         |       | —                            |       | 966,000 |   |
|                                                                                              |       |                              |       |   |   |
| Net cash (used  in) provided by investing activities                                              |       | (100,107                          | )          | 1,126,259 |   |
| Financing  activities:                                                                            |       |                              |       |   |   |
| Retirement of  treasury stock                                                                     |       | —                            |       | (500 | ) |
| Payment of  preferred stock dividends                                                             |       | (85,560                           | )          | (34,029 | ) |
| Repayment of  subordinated debt and other notes payable                                           |       | (641,888                          | )          | (672,840 | ) |
|                                                                                              |       |                              |       |   |   |
| Net cash used in  financing activities                                                            |       | (727,448                          | )          | (707,369 | ) |
|                                                                                              |       |                              |       |   |   |
| Net change in  cash and cash equivalents                                                          |       | 9,258                             |       | 534,467 |   |
| Cash and cash  equivalents at beginning of year                                                   |       | 1,564,110                         |       | 1,029,643 |   |
|                                                                                              |       |                              |       |   |   |
| Cash and cash  equivalents at end of period                                                       |       | $                                 | 1,573,368  |   | $ | 1,564,110 |   |
|                                                                                              |       |                              |       |   |   |
| Supplemental  schedule of non cash investing and finance activities:                              |       |                              |       |   |   |
| Carrying value  of debt cancelled in exchange for issuance of common and preferred stock          |       | $                                 | —     |   | $ | 17,720,508 |   |
| Fair value of  preferred stock exchanged for issuance of common stock                             |       | $                                 | 3,079,883  |   | $ | — |   |
| Fair value of  common, preferred stock, and warrants issued in exchange for cancellation of  debt |       | $                                 | 272,175    |   | $ | 7,974,408 |   |
| Property and  equipment acquired under capital lease                                              |       | $                                 | —     |   | $ | 79,459 |   |

 

See accompanying notes.

 

21

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Precision Auto Care, Inc.and SubsidiariesNotes to Consolidated Financial Statements

 

Note 1 - Business Description and Financial Statement Presentation

 

Precision Auto Care, Inc. (the “Company”) is afranchisor of automotive maintenance service centers which provide specializedautomotive care services, and fast oil change and lube services.  These franchisee owned centers operateprimarily under the Precision Tune Auto Care and Precision Lube Express brandnames. The Company disposed of its manufacturing and distribution business inMarch and April 2003 (see Note 4).

 

Note 2 – Summary of Significant Accounting Policies

 

*Principles of Consolidation*

 

The accompanying consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaries.

 

*Revenue Recognition*

 

The Company’s royalty revenue is recognized as earnedin accordance with the specific terms of each agreement and to the extent noissues involving collection exist.  Inthe case when revenues are not likely to be collected, the Company provides foran estimate of bad debt expense.  Thisestimate is based upon our historical experience as well as a detailed reviewof our receivable balances.

 

Revenue from the sale of a franchise is recognizedupon the opening of the franchised center.

 

The Company enters into domestic Area Developmentagreements and international Master License agreements (Agreements) which grantthe area developer and master licensor, respectively, the right to sell, on theCompany’s behalf, Precision Tune Auto Care franchises and Precision LubeExpress franchises within a specific geographic region.  Revenue from the sale of Area Development agreementsis recognized as all material services or conditions related to the sales aresatisfied, which is typically upon signing as there are very minimal servicesprovided.  Revenue from the sale ofmaster licenses is recognized upon signing the Agreement since the Company isnot required to support the international franchises as there is no contractualagreement between the Company and the international franchisees.

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents are comprised of highlyliquid debt instruments with original maturities of three months or less.  Cash balances may exceed insured amounts.

 

*Property, Plant and Equipment*

 

Property, plant and equipment are stated at cost anddepreciated on a straight-line basis for book purposes and accelerated methodsfor tax purposes over the estimated useful lives of the related assets. Theestimated useful lives are as follows:

 
| ** **                           | ** ** | **Years** | ** ** |
|--------------------------------------|------------|-----------|------------|
| Building and  leasehold improvements |       | 11-30     |       |
| Furniture and  fixtures              |       | 5-7       |       |
| Equipment                            |       | 3-10      |       |
| Other items                          |       | 3-7       |       |

 

*Income Taxes*

 

The Company recognizes deferred income tax liabilitiesand assets for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns.  Deferred tax liabilities and assets reflectthe effects of tax losses and the future income tax effects of temporarydifferences between the consolidated financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and are measuredusing enacted tax rates that apply to taxable income in the years in which thosetemporary differences are expected to be recovered or settled.  A valuation allowance is established whenmanagement is not able to conclude more likely than not that the assets will berealized in future years.

 

22

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*Impairment of Long-Lived Assets*

 

The Company evaluates the carrying amount oflong-lived assets to be held and used, including goodwill and other intangibleassets, when events and circumstances warrant such a review. The carryingamount of a long lived asset is considered impaired when the estimatedundiscounted cash flow from each asset is less than its carrying amount. Inthat event, the Company would record a loss equal to the amount by which thecarrying amount exceeds the fair market value of the long-lived asset.  Assets to be disposed of are measured at thelower of carrying amount or fair value less cost to sell.

 

*Concentration of Credit Risk*

 

Financial instruments that potentially subject theCompany to significant concentrations of credit risk consist primarily of cash,trade accounts receivable and notes receivable. The Company’s cash is held atFDIC insured financial institutions. The trade receivable balances aredispersed among a wide customer and franchisee base. The Company routinelyassesses the financial strength of its franchises.  The Company maintains reserves for creditlosses, and such losses have been within management’s expectations.

 

*Advertising Costs*

 

The Company expenses all advertising costs asincurred. The Company incurred $85,000 and $136,000 in advertising costs forthe years ended June 30, 2004 and 2003, respectively.

 

*Use of Estimates in the Preparation of FinancialStatements*

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates.

 

*Goodwill and Intangible Assets*

 

Statement of Financial Accounting Standards (SFAS) No.142, “Goodwill and Intangible Assets”, requires that goodwill no longer beamortized, but instead be tested for impairment at least annually.  Historically, management has performed itsimpairment analysis in the first quarter of each fiscal year.  Goodwill impairment testing for the period endingJune 30, 2004, did not result in the impairment of recorded goodwill ofapproximately $8.7 million.  Subsequentto year-end, the Company obtained a current business enterprise valuation forpurposes of supporting its impairment analysis for fiscal year 2005.  Such analysis further affirmed management’sconclusion that goodwill was not impaired at June 30, 2004.

 

*SegmentReporting*

 

The Company adopted the provisions of SFAS No. 131, “Disclosures aboutSegments of an Enterprise and Related Information”, in the quarter endedSeptember 30, 2001.  As a result, theCompany evaluated its operations along two business lines: Automotive CareFranchising and Manufacturing and Distribution. In March and April 2003, theManufacturing and Distribution segment was disposed of as a result ofmanagement’s decision to discontinue this business line (see Note 4).

 

*StockOptions*

 

The Company applies Accounting Principles Board (APB)Opinion No. 25, “Accounting for Stock Issued to Employees”, and relatedinterpretations in accounting for stock based compensation and presents proforma net income and earnings per share data as if the accounting prescribed byStatement of Financial Accounting Standards No. 123, “Accounting for StockBased Compensation” had been applied. The Company also applies the provisions of FIN 44, “Accounting forCertain Transactions Involving Stock Compensation”, as required whenmodifications and other provisions cause the application of variable accountingwhich calls for the periodic measurement of compensation expense based on thedifference in the exercise price and the underlying value of the related stock.

 

Historically, no stock-based compensation was reflected in net income,as all options granted had an exercise price equal to the market value of theunderlying common stock on the date of grant. However, the Company issued 65,000 options in the during fiscal year2004 which had an exercise price below the fair market value of the underlyingcommon stock on the date of grant.  As aresult, approximately $15,000 of compensation expense will be recognized overthe vesting period of these options.  TheCompany granted stock to an officer with a fair value of $212,500 during fiscalyear 2003, and recognized compensation expense of $132,500 and $80,000 as ofJune 30, 2004 and 2003, respectively. The Company also repurchased certain options from employees and issuednew options exercisable at an exercise price of $0.44 in fiscal year 2003,resulting in the newly issued options being treated as a repricing under FIN44, which triggered variable accounting. As a result, the Company recorded compensation expense of approximately$127,000 and $40,000 associated with these options as of June 30, 2004 and2003, respectively.

 

23

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Had compensation expense for all options been determined based on thefair value at the grant dates during the years ending June 30, 2004 and 2003consistent with the fair value method of SFAS No. 123, the pro forma net incomeand income per share would have been as follows:

 
| ** **                                                                                                | ** ** | **Year ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                | ** ** | **2004**                | ** ** | **2003** | ** ** |
|                                                                                                      |       |                    |       |   |   |
| Net income  applicable to common shareholders                                                             |       | $                       | 1,589,772  |   | $ | 10,931,845 |   |
| Add: Total  stock-based compensation expense reported in net income                                       |       | 263,763                 |       | 295,368 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards* |       | 243,500                 |       | 383,500 |   |
| Pro forma net  income                                                                                     |       | $                       | 1,610,035  |   | $ | 10,843,713 |   |
| Earnings per  share:                                                                                      |       |                    |       |   |   |
| Basic- as  reported and pro forma                                                                         |       | $                       | 0.08       |   | $ | 0.72 |   |
| Diluted- as  reported and pro forma                                                                       |       | $                       | 0.07       |   | $ | 0.72 |   |
| Weighted average  shares:                                                                                 |       |                    |       |   |   |
| Weighted average  common shares outstanding—Basic                                                    |       | 19,392,950              |       | 15,152,379 |   |
| Weighted average  common shares outstanding—Diluted                                                  |       | 22,549,311              |       | 15,188,186 |   |

 

----

*  *All awards*refers to awards granted, modified, or settled infiscal periods beginning after December 15, 1994 – awards for which the fairvalue was required to be measured under Statement 123.

 

*Earnings Per Share*

 

The Company reports earnings per share (“EPS”) in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earningsper Share” which specifies the methods of computation, presentation, anddisclosure. SFAS No. 128 requires the presentation of basic EPS and dilutedEPS. Basic EPS is calculated by dividing net income available to commonshareholders by the weighted average number of shares outstanding during theperiod. Diluted EPS is calculated by dividing net income available to commonshareholders by the weighted average number of shares outstanding during theperiod plus the dilutive effect of common stock equivalents.  The weighted average number of sharesoutstanding related to stock options and warrants at June 30, 2004 and 2003 was6,811,470 and 13,346,239, respectively. Only stock options and warrants with exercise prices lower than theaverage market price of the common shares were included in the diluted EPScalculation for fiscal year 2004 and 2003. For the years ended June 30, 2004 and 2003, 182,950 and 1,734,200 sharesattributable to outstanding stock options, and 0 and 11,472,039 sharesattributable to outstanding warrants were not included in the computation ofdiluted income per share as they were anti-dilutive.

 

Thefollowing table sets forth the computation of basic and diluted net loss pershare.

 
| ** **                                                  | ** ** | **For The Years Ended June 30,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| Numerator:                                                  |       |                             |       |   |   |
| Income from  continuing operations                          |       | $                                | 1,651,597  |   | $ | 10,721,049 |   |
| Gain from  discontinued operations                          |       | 18,302                           |       | 253,963 |   |
| Preferred stock  dividends                                  |       | (80,127                          | )          | (43,167 | ) |
| Net income  applicable to common Shareholders               |       | $                                | 1,589,772  |   | $ | 10,931,845 |   |
| Denominator:                                                |       |                             |       |   |   |
| Denominator for  basic EPS weighted- Average-shares         |       | 19,392,950                       |       | 15,152,379 |   |
| Common stock  equivalents                                   |       | 3,156,361                        |       | 35,807 |   |
| Denominator for diluted  EPS weighted- Average-shares       |       | 22,549,311                       |       | 15,188,186 |   |
| Basic income  from continued operations per share           |       | $                                | 0.08       |   | $ | 0.70 |   |
| Basic income  from discontinued operations per share        |       | 0.00                             |       | 0.02 |   |
| Basic income  applicable to Common shareholders per share   |       | 0.08                             |       | 0.72 |   |
| Diluted income  from continued operations per share         |       | 0.07                             |       | 0.70 |   |
| Diluted income  from discontinued operations per share      |       | 0.00                             |       | 0.02 |   |
| Diluted income  applicable to Common shareholders per share |       | $                                | 0.07       |   | $ | 0.72 |   |

 

24

----

 

*Reclassifications*

 

Certain amounts on the prior period financialstatements have been reclassed to be in conformity with the current periodfinancial statements.  Due to thedisposal of its manufacturing and distribution operations in April 2003, theCompany has one remaining business segment, Automotive Care Franchising.  Accordingly, the printing revenue and directcosts associated with the Company’s franchising activities have been reclassifiedto its Automotive Care Franchising segment for fiscal years 2004 and 2003.

 

Note 3 - New Accounting Pronouncements

 

In January 2003, the Financial Accounting StandardsBoard (“FASB”) issued Interpretation No. 46, “Consolidation of VariableInterest Entities” (FIN 46), which was amended by FIN 46R issued in December2003. This interpretation of Accounting Research Bulletin No. 51, “ConsolidatedFinancial Statements,” addresses consolidation by business enterprises ofvariable interest entities (VIEs) that either: (1) do not have sufficientequity investment at risk to permit the entity to finance its activitieswithout additional subordinated financial support, or (2) for which the equityinvestors lack an essential characteristic of a controlling financial interest.This Interpretation applies immediately to VIEs created after January 31, 2003.It also applies in the first fiscal year or interim period ending after March15, 2004, to VIEs created before February 1, 2003 in which an enterprise holdsa variable interest. FIN 46 requires disclosure of VIEs in financial statementsissued after January 31, 2003, if it is reasonably possible that as of thetransition date: (1) the company will be the primary beneficiary of an existingVIE that will require consolidation or, (2) the company will hold a significantvariable interest in, or have significant involvement with, an existingVIE.  The adoption of FIN 46R did nothave a material effect on the Company’s financial statements.

 

In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and HedgingActivities.” SFAS No. 149 amends and clarifies accounting and reportingfor derivative instruments and hedging activities under SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities.” SFASNo. 149 is effective for derivative instruments and hedging activitiesentered into or modified after June 30, 2003, except for certain forwardpurchase and sale securities. For these forward purchase and sale securities,SFAS No. 149 is effective for both new and existing securities afterJune 30, 2003. The adoption of this standard did not have a materialimpact on the Company’s financial statements.

 

In May 2003, the FASB issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity.” SFAS No. 150 establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability. Theprovisions of SFAS No. 150 are effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective atthe beginning of the first interim period beginning after June 15,2003.  The adoption of this standard didnot have a material impact on the Company’s financial statements.  The Company’s redeemable preferred stock willcontinue to be presented in the mezzanine section of the balance sheet since itfalls outside the scope of this standard.

 

Note 4 – Discontinued Operations

 

The Company disposed of its manufacturing anddistribution operating segment as a result of the sale of substantially all ofthe assets of Worldwide Drying Systems (Worldwide) and Hydro Spray Car WashEquipment Co. (Hydro Spray) in March 2003 and April 2003, respectively.  The sale of Worldwide for $300,000 in cashincluded inventory and manufacturing equipment with a carrying value of$93,000.  The resulting gain of $144,000,which included $63,000 in selling expenses associated with this sale, wasrecognized in March 2003.  Substantiallyall of the assets of Hydro Spray were sold in April 2003 for $900,000 to agroup led by Ernest Malas, a former director and consultant of the Company’smanufacturing division.  The Companyreceived $450,000 in cash and a note for $450,000, payable to the Company in 75monthly payments of $6,000. On June 17, 2003, the purchaser of Hydro Spraypurchased the note from the Company for $204,000.  The Company recorded a gain of $758,000 fromthe sale of Hydro Spray in the fourth quarter of fiscal year 2003.

 

As a result of the sale of Hydro Spray and Worldwide, the Companyretained the following assets and liabilities. These assets and liabilities are included in the assets and liabilitiesfrom discontinued operations at June 30, 2004 and 2003:

 

25

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| ** **                                    | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|--------------------|------------|
| Assets of  discontinued operations:           |       |               |       |               |       |
| Accounts  receivable, net                     |       | $                  | —     |               | $          | 16,759 |   |
| Total assets of  discontinued operations      |       | $                  | —     |               | $          | 16,759 |   |
|                                          |       |               |       |               |       |
| Liabilities of  discontinued operations:      |       |               |       |               |       |
| Accounts payable  and accrued liabilities     |       | $                  | 12,780     |               | $          | 45,230 |   |
| Note payable                                  |       | —             |       | 24,998             |       |
| Other                                         |       | —             |       | 3,215              |       |
| Total  liabilities of discontinued operations |       | $                  | 12,780     |               | $          | 73,443 |   |

 

The following amounts related to the Company’s manufacturing anddistribution operations have been segregated from continuing operations andreflected as discontinued operations for the years ended June 30, 2004 and 2003:

 
| ** **                                  | ** ** | **For The Years Ended  June 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------|------------|
| ** **                                  | ** ** | **2004**                          | ** ** | **2003** | ** ** |
|                                        |       |                              |       |   |   |
| Revenues                                    |       | $                                 | —     |   | $ | 3,894,506 |   |
|                                        |       |                              |       |   |   |
| Expenses:                                   |       |                              |       |   |   |
| Direct costs                                |       | —                            |       | 3,208,197 |   |
| General and  administrative expense         |       | 7,017                             |       | 1,243,179 |   |
| Depreciation  expense                       |       | —                            |       | 67,448 |   |
| Other (income)  expense                     |       | (25,319                           | )          | 23,227 |   |
| Income (loss)  from discontinued operations |       | 18,302                            |       | (647,545 | ) |
| Gain on sale of  discontinued operations    |       | —                            |       | 901,508 |   |
| Net gain from  discontinued operations      |       | $                                 | 18,302     |   | $ | 253,963 |   |

 

Note 5 - Property,Plant and Equipment

 

The components of property, plant and equipment are asfollows:

 
| ** **                           | ** ** | **June 30,** | ** ** |
|--------------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2004**     | ** ** | **2003** | ** ** |
| Building and  leasehold improvements |       | $            | 46,809     |   | $ | 46,809 |   |
| Furniture and  fixtures              |       | 1,052,854    |       | 1,047,558 |   |
| Equipment                            |       | 2,498,685    |       | 2,463,324 |   |
| Equipment under  capital lease       |       | 79,459       |       | 79,459 |   |
| Other items                          |       | 469,522      |       | 455,072 |   |
|                                 |       | 4,147,329    |       | 4,092,222 |   |
| Accumulated  depreciation            |       | (3,982,924   | )          | (3,664,823 | ) |
| Property, plant  and equipment, net  |       | $            | 164,405    |   | $ | 427,399 |   |

 

Note 6 - Income Taxes

 

Theprovision for income taxes consisted of the following items:

 
| ** **                                                       | ** ** | **Years Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                       | ** ** | **2004**                 | ** ** | **2003** | ** ** |
| Current tax  expense —federal, foreign and state            |       | $                        | —     |   | $ | 7,500 |   |
| Deferred tax  (benefit) expense —federal, foreign and state |       | 156,000                  |       | 4,037,000 |   |
| Change in  valuation allowance                                   |       | (629,000                 | )          | (4,037,000 | ) |
| Total income tax  (benefit) expense                              |       | $                        | (473,000   | ) | $ | 7,500 |   |

 

The effective tax rate differed from the statutoryrate as follows:

 

26

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| ** **                        | ** ** | **Years Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------|------------|
| ** **                        | ** ** | **2004**                 | ** ** | **2003** | ** ** |
| Statutory  federal rate           |       | 34                       | %          | 34 | % |
| State taxes                       |       | 5                        |       | 5 |   |
| Nondeductible  expenses           |       | 5                        |       | — |   |
| Adjustment of  net operating loss |       | (31                      | )          | — |   |
| Change in  valuation allowance    |       | (51                      | )          | (39 | ) |
| Effective tax  rate               |       | (38                      | )%         | 0 | % |

 

Deferred tax assets and liabilities reflect the effectsof tax losses and the future income tax effects of temporary differencesbetween the consolidated financial statement carrying amounts of existingassets and liabilities and their respective tax bases and are measured usingenacted tax rates that apply to taxable income in the years in which thosetemporary differences are expected to be recovered or settled.  During fiscal year 2004, the Company made anadjustment of $974,000 to the deferred tax assets primarily to adjust theaccrued commissions and the net operating loss carryforwards. This adjustmenthad no effect on the income statement as the valuation allowance was adjustedby the same amount.

 

Significant components of the Company’s deferred taxliabilities and assets are as follows:

 
| ** **                                   | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2004**     | ** ** | **2003** | ** ** |
| Deferred tax  assets:                        |       |         |       |   |   |
| Net operating  loss                          |       | $            | 6,824,000  |   | $ | 6,971,000 |   |
| Other                                        |       | 74,000       |       | 83,000 |   |
|                                         |       | 6,898,000    |       | 7,054,000 |   |
| Valuation  allowance for deferred tax assets |       | (6,425,000   | )          | (7,054,000 | ) |
| Net deferred  taxes                          |       | $            | 473,000    |   | $ | — |   |

 

As of June 30, 2004, the Company had net operatingloss carryforwards for federal tax purposes of approximately $18 million, whichexpire from 2014 through 2017.  TheCompany regularly reviews the recoverability of its tax deferred assets andestablishes a valuation allowance as deemed appropriate.  As of June 30, 2004, the Company had avaluation allowance of $6.4 million against deferred tax assets.  Given the Company’s current operatingperformance, management released approximately $629,000 of the valuationallowance during 2004.  This adjustmentwas based upon management’s assessment of the recoverability of deferred taxeswhich included projections of future pretax earnings.

 

Note 7 - Debt

 

*Line of Credit*

 

On March 9, 2004, the Company executed a line ofcredit for $250,000 with Chevy Chase Bank bearing an initial interest rate of4% and maturing on March 1, 2005.  Theinterest rate on this line of credit is indexed to the Prime Rate as publishedin *The Wall Street Journal* and the Companyhas pledged all of its wholly-owned subsidiaries as collateral.  As of June 30, 2004, the Company has notborrowed against this line of credit. Under this agreement, the Company must meet financial covenants relatingto profitability, debt service coverage and a maximum leverage ratio.  The Company was in compliance with all suchcovenants as of June 30, 2004.

 

*Debt Restructuring*

 

On October 30, 2002, the Company reached an agreement with PrecisionFunding, L.L.C. and a former board member to convert approximately $17.6million of outstanding debt and accrued interest due to them to equity.  In exchange for the extinguishment of theapproximately $17.6 million in outstanding debt and accrued interest due, theCompany issued Precision Funding, L.L.C. and the former board member thefollowing:

 

•                  2.5 millionshares of the Company’s common stock.

•                  500,000 shares of Series A redeemablepreferred stock of the Company with a stated value of $10.36 per share.  These shares are redeemable by theshareholder at any time after the 3rdanniversary of the Issue Date, October 30, 2002 on 30 days prior written noticefor an aggregate value of $5,180,000 plus any unpaid dividends.  The holders of these shares are also entitledto receive, when and as declared by the Board of Directors, cumulativepreferential cash dividends at the rate of 2% of the liquidation preference ofthe Series A redeemable preferred stock, $10.36 per share, per annum payablequarterly in arrears in cash on the last day, or the next succeeding businessday, of January, April, July, and October in each year, beginning January 31,2003.  Accrued dividends wereapproximately $4,000 and $9,000 at June 30, 2004 and 2003, respectively.

•                  Warrants topurchase 11,472,039 shares of the Company’s common stock with an exercise priceof $0.44 per share.

 

27

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Issuance of the warrants was subject to shareholder approval of aproposal to amend the Articles of Incorporation to increase the Company’sauthorized shares of common stock.  Suchapproval was granted at the annual shareholder meeting held on January 15,2003.  As a result, the Companyrecognized a gain of approximately $6.9 million from the exchange of debt witha carrying value of $12.6 million for common and preferred stock with a fairvalue of $5.7 million during the 2nd quarter of fiscal year2003.  The remaining $2.8 million gainfrom the exchange of warrants valued at $2.2 million for the remaining debtwith a carrying value of $5.0 million was recognized in January 2003 whenshareholder approval was granted to increase the Company’s authorized shares ofcommon stock.

 

In October 1998, a subordinated debenture in the amount of $2.0 millionwas executed with an LLC composed of certain members of the Company’s board ofdirectors (Board LLC).  On July 17, 2003,the Company reached an agreement to restructure the remaining $633,000 due tothe Board LLC.  The terms of theagreement called for the following:

 

•                  Payment of$200,000 within 3 days of receipt of approval by the Company’s Board ofDirectors.

•                  Issuance of a non-interest bearingnote payable in the amount of $50,000, payable in ten monthly installments of$5,000 each, commencing one month after the date of approval by the Company’sBoard of Directors.

•                  Issuance ofwarrants to purchase 400,000 shares of the Company’s common stock with anexercise price of $0.44 per share having a fair value of approximately$222,000.

 

The Company recognized a gain of approximately $160,000 from this debtrestructuring in the first quarter of fiscal year 2004.

 

In December 2003, the Company paid approximately $169,000 in fullsatisfaction of the $201,000 of debt owed to Radiant Systems, Inc.  The Company recognized a gain ofapproximately $32,000 from this transaction in the second quarter of fiscalyear 2004.

 

In January 2004, 2,469,600 warrants were exercised pursuant to anagreement the Company reached with Precision Franchising, L.L.C. and a formerboard member in October 2002.  Upon theexercise of these warrants at the previously agreed to exercise price of $0.44per share, the holder purchased 2,469,600 restricted shares of common stock inexchange for surrendering 104,885 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

 

In February 2004, 4,530,169 warrants were exercised pursuant to anagreement the Company reached with Precision Franchising, L.L.C. and a formerboard member in October 2002.  Upon theexercise of these warrants at the previously agreed to exercise price of $0.44per share, the holder purchased 4,530,169 restricted shares of common stock inexchange for surrendering 192,401 shares of Series A Preferred Stock to theCompany, therefore, there were no cash proceeds received by the Company fromthis transaction.

 

During the years ended June 30, 2004 and 2003, the Company incurredinterest expense of approximately $20,000 and $754,000, respectively.

 

Long-term debt consists of the following:

 
| ** **                                                     | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------|------------|--------------|------------|
| ** **                                                     | ** ** | **2004**     | ** ** | **2003** | ** ** |
| Various notes  and obligations payable in monthly installments |       | $            | 62,117     |   | $ | 345,056 |   |
| Lease  obligations                                             |       | 26,893       |       | 51,568 |   |
| Board LLC note                                                 |       | —       |       | 632,528 |   |
|                                                           |       | 89,010       |       | 1,029,152 |   |
| Less: current  maturities                                      |       | (75,240      | )          | (290,430 | ) |
| Long-term  portion                                             |       | $            | 13,770     |   | $ | 738,722 |   |

 

The future debt obligations with maturities in excessof one year as of June 30, 2004 are as follows:

 
| ** ** | ** ** | **Future  Debt Maturities** | ** ** |
|------------|------------|-----------------------------|------------|
| 2005       |       | 75,240                      |       |
| 2006       |       | 5,779                       |       |
| 2007       |       | 6,758                       |       |
| 2008       |       | 1,233                       |       |
|       |       | $                           | 89,010     |   |
|            |            |                             |            |  |

 

28

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Note 8 - Lease Commitments

 

At June 30, 2004, the Company has lease commitmentsfor office space, a training center, and a number of service center locationsas well as office equipment under operating and capital leases. These leasesexpire between 2005 and 2009, with renewal options in certain of the leases.Most of the service center location leases are subleased to franchisees. Rentexpense for office space and warehouse facilities of approximately $290,000 and$385,000 is included in operating expenses for the year ended June 30, 2004 and2003 respectively. Rent expense for service center locations of approximately$6,000 and $70,000 is recorded net of sublease income of $0 and $40,000 for theyears ended June 30, 2004 and 2003, respectively.

 

The future minimum lease payments and related subleasepayments for operating leases with terms in excess of one year as of June 30,2004, are as follows:

 
| ** ** | ** ** | **Future Minimum  Lease Payments** | ** ** | **Sublease  Income** | ** ** | **Net** | ** ** |
|------------|------------|------------------------------------|------------|----------------------|------------|---------|------------|
| 2005       |       | $                                  | 574,000    |                 | $          | 223,000 |       | $ | 351,000 |   |
| 2006       |       | 576,000                            |       | 232,000              |       | 344,000 |       |
| 2007       |       | 564,000                            |       | 239,000              |       | 325,000 |       |
| 2008       |       | 570,000                            |       | 235,000              |       | 335,000 |       |
| 2009       |       | 245,000                            |       | 47,000               |       | 198,000 |       |
| Thereafter |       | —                             |       | —               |       | —  |       |
|       |       | $                                  | 2,529,000  |                 | $          | 976,000 |       | $ | 1,553,000 |   |

 

The future minimum lease payments for capital leases with terms inexcess of one year as of June 30, 2004, are as follows:

 
| ** **                           | ** ** | **Future Minimum  Lease Payments** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| 2005                                 |       | $                                  | 15,991     |   |
| 2006                                 |       | 7,543                              |       |
| 2007                                 |       | 7,543                              |       |
| 2008                                 |       | 1,258                              |       |
| Total lease  payments                |       | $                                  | 32,335     |   |
| Less amounts  representing interest  |       | 5,442                              |       |
| Present value of  net lease payments |       | $                                  | 26,893     |   |

 

Note 9 - Related Party Transactions

 

The Company manages the operation of PTAC MarketingFund, Inc. (“PMF”), the national advertising fund for Precision Tune Auto CareCenters, pursuant to a Management Agreement approved by the Board of Directorsof PMF, which is comprised of franchisee and Company personnel. The Companycharged PMF $741,000 and $669,000 for administrative and other expensesincurred on behalf of PMF, for the years ended June 30, 2004 and 2003,respectively.  Based on the timing ofreceipts and disbursements, it is common for amounts to be due to and from theCompany and PMF. At June 30, 2004 and 2003, the net amounts due from PMF were$61,417 and $0 respectively. These amounts are included in accounts receivable.

 

In January 1999, a subordinated debenture in the amount of$5.0 million was executed directly with Mr. Kellar, a former member of theCompany’s board of directors.  $1.4million of the original principal amount had been repaid.  Originally due May 25, 1999, the term of thissubordinated debenture was extended to September 30, 2003. The holder haswaived all debt covenants through September 30, 2003.  This debenture and related accrued interest wasconverted to equity as a result of the agreement reached on October 30, 2002(see Note 7).

 

Anothersubordinated debenture in the amount of $2.0 million was executed in October1998 with an LLC composed of certain current and former members of theCompany’s board of directors (Board LLC). On July 17, 2003, the Company reached an agreement with the Board LLC torestructure this debt obligation (see Note 7).

 

Bassam N. Ibrahim, a director of the Company, is a partner inBurns, Doane, Swecker & Mathis LLP, an Alexandria, Virginia law firm that performslegal services for the Company related to intellectual property protection.Fees paid in the amount of approximately $23,000 to the firm by the Company inthe fiscal year ended June 30, 2004 did not exceed five percent of the firm’sgross revenues.

 

The Company disposed of its manufacturing anddistribution operating segment as a result of the sale of substantially all ofthe assets of Worldwide Drying Systems (Worldwide) and Hydro Spray Car WashEquipment Co. (Hydro Spray) in March 2003 and April 2003, respectively.  Substantially all of the assets of Worldwidewere sold in March 2003 for $300,000 to a group led by a relative of an officerof the Company.  The sale of Worldwidefor $300,000 in cash included inventory and manufacturing equipment with acarrying value of $93,000.  The resultinggain of $144,000, which included $63,000 in selling expenses associated withthis sale, was recognized in March 2003. Substantially all of the assets of Hydro Spray were sold in April 2003for $900,000 to a group led by Ernest Malas, a former director and consultantof the Company’s manufacturing division. The Company received $450,000 in cash

 

29

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and a note for $450,000,payable to the Company in 75 monthly payments of $6,000. On June 17, 2003, thepurchaser of Hydro Spray bought the note back from the Company for$204,000.  The Company recorded a gain of$758,000 from the sale of Hydro Spray in the fourth quarter of fiscal year2003.

 

Note 10 - Stockholders’ Equity

 

During the year ended June 30, 2003, approximately 741,000 shares ofcommon stock were issued to officers of the Company as bonus compensationtotaling $175,500.  In addition, 250,000shares of common stock were issued to an officer of the Company in September2003.  Compensation expense of $132,500and $80,000 was recorded for the earned portion of these shares for the fiscalyears ended June 30, 2004 and June 30, 2003, respectively.

 

*Common Stock Option Plan*

 

In 1999, the Company’s Board of Directors and the Company’sstockholders approved the 1999 Employee Stock Option Plan (the “Option Plan”)and reserved 600,000 shares for issuance under the Plan. On March 21, 2001 theCompany’s stockholders approved an amendment to increase the authorized shares underthis plan to 1,600,000.  On January 15,2003 the Company’s stockholders approved an amendment to increase theauthorized shares under this plan to 2,600,000. Options available for future grants under this plan were 560,000 at June30, 2004.

 

Options reserved for issuance under predecessor plans consist of400,000 related to the 1997 Employee Stock Option Plan, 175,000 related to the1996 Employee Stock Option Plan, and 75,000 related to the 1998 Director’sStock Option Plan.  Options available forfuture grant at June 30, 2004, under these plans were 2,500, 0, and 75,000respectively.  The Compensation Committeeof the Company’s Board of Directors determines the recipients of the award tobe granted, exercise price, vesting period, and number of shares underlying theoptions.

 

The Company repurchased 704,000 shares of common stock options(exercise prices of these options range from $0.75 to $1.00 per share) for$0.001 per share in the first quarter of fiscal year 2003.  The Company in turn granted the sameparticipants options for the purchase of 704,000 shares.  These options are exercisable at an exerciseprice of $0.44 per share at the same vesting schedule as the participant’srepurchased options.  The repurchase ofsuch shares was deemed a repricing under FIN 44 and as such, the Companyapplies variable accounting during the remaining life of these options and indoing so, measures compensation expense periodically based upon the change inthe fair market value of the underlying common stock.  As a result, the Company recordedcompensation expense of approximately $127,000 and $40,000 associated withthese options as of June 30, 2004 and 2003, respectively.

 

A summary of the Company’s stock option activity for the years endedJune 30, are as follows:

 
| ** **         | ** ** | **Shares  Under Option** | ** ** | **Weighted-Average Exercise Price** | ** ** |
|--------------------|------------|--------------------------|------------|-------------------------------------|------------|
| June 30, 2002      |       | 1,717,325                |       | 0.99                                |       |
| Options granted    |       | 465,000                  |       | 0.44                                |       |
| Options  exercised |       | —                   |       | —                              |       |
| Options  forfeited |       | (308,125                 | )          | 0.46                                |       |
| June 30, 2003      |       | 1,874,200                |       | 0.75                                |       |
| Options granted    |       | 65,000                   |       | 0.44                                |       |
| Options  exercised |       | —                   |       | —                              |       |
| Options  forfeited |       | —                   |       | —                              |       |
| June 30, 2004      |       | 1,939,200                |       | 0.74                                |       |

 

At June30, 2004 and 2003, options for 1,438,000 and 938,000 shares, respectively, wereexercisable.  The weighted average grantdate fair value per option for options granted in 2004 and 2003 was $0.66 and$0.25, respectively.  The exercise priceof options outstanding at June 30, 2004 ranged from $0.22 to $10.00 per share.

 

The Company applies Accounting Principles Board (APB)Opinion No. 25, “Accounting for Stock Issued to Employees”, and relatedinterpretations in accounting for stock based compensation and presents proforma net income and earnings per share data as if the accounting prescribed byStatement of Financial Accounting Standards No. 123, “Accounting for StockBased Compensation” had been applied (see Note 2).

 

The following table summarizes theassumptions used by the Company in estimating compensation expense as of thedate the options were granted using a binomial model.

 

30

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| ** **                                            | ** ** | **2004** | ** ** | **2003**     | ** ** |
|-------------------------------------------------------|------------|----------|------------|--------------|------------|
| Risk free  interest rate                              |       | 2.19     | %          | 2.61 to 2.98 | %          |
| Volatility  factors                                   |       | 283.52   | %          | 230.74       | %          |
| Weighted-average  expected life of the option (years) |       | 3        |       | 4            |       |
| Dividend yield                                        |       | 0.00     | %          | 0.00         | %          |

 

Because option valuation models require the input ofhighly subjective assumptions, such as expected volatility, and because changesin these subjective input assumptions can materially affect the fair valueestimate, the existing model may not necessarily provide a reliable singlemeasure of the fair value of its stock options.

 

*OutsideDirector’s Stock Plan*

 

In 2000, the Company’s Board of Directors and theCompany’s stockholders approved the 2000 Outside Directors’ Stock Plan andreserved 50,000 shares for issuance under the Plan.  Shares available for future grants at June30, 2004, under this plan were 37,000.

 

Note 11 - Employees’ Savings Plan

 

The Company maintains a 401(k) plan under which theCompany may contribute up to 25% of an employee’s first 6% of compensationdeferred under the plan. Employees become eligible after attaining the age of21 and completing six months of employment with the Company. The employees mayelect to contribute up to 15% of their annual compensation subject tolimitations set forth in the Internal Revenue Code. Employees’ contributionsvest immediately. The employee matching contribution is discretionary and vests20% after one year and in increments of 20% each additional year.  The employee matching contributions for eachof the years ended June 30, 2004 and 2003 were $28,500 and $32,500,respectively.

 

Note 12 – Contingencies

 

The Company is currently subject to litigation that could have amaterial adverse impact on its liquidity as follows:

 

Lumnivision,S.A. de C.V. v. Praxis Afinaciones, S.A. de C.V., Third Civil Court, First JudicialDistrict, Monterrey, Nuevo Laredo, Mexico.

 

Lumnivisionfiled suit against Praxis Afinaciones, an indirect wholly owned subsidiary ofPACI, seeking payment of 766,000 Mexican Pesos, plus interest at the rate of 5%per month, for services under a contract.  Praxis Afinaciones denies theallegations and is defending the allegations in the lawsuit.

 

UnitedBank, NA v. C. Eugene Deal, Miracle Partners, Inc., Star Auto Center, Inc., Common Pleas Court of Cuyahoga County,Ohio, Case No. 01-CV0019, Filed January 11, 2001

 

MiraclePartners, Inc., a wholly-owned subsidiary of the Company, is party to aconfessed judgment of approximately $1.3 million.  The subsidiary iscurrently inactive and has no assets.  As such, management believes thisjudgment will have no material impact on the Company’s consolidated results ofoperations.  Furthermore, the Company believes that it has a meritoriousclaim against Mr. Deal for misrepresentations made in connection with PACI’s acquisitionof Miracle Partners, Inc. in 1997 for all amounts covered by the judgment.

 

ThreatenedLitigation:

 

PuyallupAuto Stop Associates, Inc. v. PTW, Inc.

 

By letterdated July 1, 2003, a former landlord has asserted a claim against PTW, Inc.for reimbursement of the costs of remediating environmental contamination tothe leased premises during the term of the lease, which costs allegedly exceed$250,000.  Investigation into the Company’s liability is ongoing.

 

TheCompany does not believe that any of the above claims or proceedings willresult in a material judgment against the Company.  There can be noassurance, however, that these suits will ultimately be decided in itsfavor.  Any one of these claims or proceedings may result in a material judgmentagainst the Company, which could cause material adverse consequences to itsoperations.

 

Note 13 – Subsequent Events

 

On August 9, 2004, the Company signed an area development agreementwith North Pacific Precision, Inc. (“NPPI”) for the area rights for the Seattlemarket.  Under the agreement, NPPI paid$500,000 for the area developer rights for the Seattle market, and the

 

31

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Company will receive fifty percent of the income from the sale offranchises and from royalties from franchisees in the area.  The entire amount paid by NPPI will berecognized as revenue in the first quarter of 2005 as the Company has nosignificant obligations remaining under this agreement.

 

On September 2, 2004, the Company signed a master franchise agreementwith senior executives of Hung Yue Holdings (Hong Kong) Co., Ltd. giving thatfirm’s affiliate, Precision Tune Auto Care (China) Company Limited, a licenseto open and operate at least 330 Precision Tune Auto Care (PTAC) car care centersin China over the next seven years.  Uponexecution of the agreement, the Company has received advanced payments totaling$150,000.

 

**Item 8****.   *Changes InAnd Disagreements With Accountants On Accounting And Financial Disclosures***

 

None.

 

**Item 8A****.   *Controls andProcedures***

 

Under the supervision and with the participation ofour management, including the Chief Executive Officer and Chief FinancialOfficer, we have evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c) asof the end of the period covered by this report. Based on that evaluation, theChief Executive Officer and Chief Financial Officer have concluded that thesedisclosure controls and procedures are effective. There were no changes in ourinternal control over financial reporting during the year ended June 30, 2004that have materially affected, or are reasonably likely to materially affect,our internal controls over financial reporting.

 

32

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**PART III**

 

**Item 9****.   *Directors,Executive Officers, Promoters and Control Persons; Compliance with Section16(a) of the Exchange Act.***

 

Therequired information on directors will be contained in the Company’s ProxyStatement, and reference is expressly made to the Proxy Statement for thespecific information incorporated in the Form 10-KSB.  The required information on executiveofficers is set forth in Part I of this Form 10-KSB under an unnumbered itemcaptioned “Executive Officers of Precision Auto Care, Inc.”

 

Thecode of ethics that applies to the Company’s Chief Executive Officer, ChiefFinancial Officer, Corporate Controller and all other employees is attached asan exhibit in Item 13 of this report.  Ifthe Company makes any substantive amendments to the code of ethics or grant anywaiver, including any implicit waiver, from a provision of the code to ourChief Executive Officer, Chief Financial Officer or Corporate Controller, theCompany will disclose the nature of such amendment or waiver in a report onForm 8-K.

 

**Item 10****.   *ExecutiveCompensation***

 

The required information will be set forth under“Executive Compensation” and “Report of the Organization and CompensationCommittee on Executive Compensation” in the Company’s Proxy Statement, andreference is expressly made to the Proxy Statement for the specific informationincorporated in the Form 10-KSB.

 

**Item 11****.   *SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters***

 

The required information will be set forth under“Security Ownership of Certain Beneficial Owners and Management” in theCompany’s Proxy Statement, and reference is expressly made to the ProxyStatement for the specific information incorporated in the Form 10-KSB. Exceptas otherwise stated in the Proxy Statement, the address of each of the personsowning more than 5% of the Company’s Common Stock is 748 Miller Drive, S. E.,Leesburg, VA 20175.

 

**Item 12****.   *CertainRelationships and Related Transactions***

 

The required information will be set forth under“Certain Relationships and Related Transactions” in the Company’s ProxyStatement, and reference is expressly made to the Proxy Statement for thespecific information incorporated in the Form 10-KSB.

 

**Item 13****.  *Exhibits andReports On Form 8-K***

 

(a)          Thefollowing documents are filed as part of this report:

 

1.          FinancialStatements

 

The following financial statements appear in Part II,Item 7 of this report:

 

Report of IndependentAuditors

Audited FinancialStatements

Consolidated Balance Sheets

Consolidated Statements of Operations

Consolidated Statements of Stockholders’ Equity

Consolidated Statements of Cash Flows

Notes to Consolidated Financial Statements

 

(b)  Reports on Form 8-K

 

(i)                                     None.

 

(c) Exhibits

 

2.1                            Planof Reorganization and Agreement for Combination of Business dated as of August27, 1997, by and among the Company, WE JAC Corporation, Miracle Industries,Inc., Lube Ventures, Inc., Rocky Mountain Ventures, Inc., Rocky MountainVentures II, Inc., Miracle Partners, Inc., Prema Properties, LLC, Ralston CarWash, LLC and KBG LLC, included as an Exhibit to the Company’s RegistrationStatement on Form S-1 (No. 333-34439) filed August 27, 1997, is incorporatedherein by reference.

 

3.1                            Articlesof Incorporation of the Company included as an exhibit to the Company’sRegistration Statement on Form S-1 (No. 333-34439) filed August 27, 1997, areincorporated herein by reference.

 

3.2*                     By-laws ofthe Company as amended August 18, 2004.

 

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3.3                            Articlesof Amendment to the Articles of Incorporation of Precision Auto Care, Inc.dated October 28, 2002 to create a new series of preferred stock designated asSeries A Cumulative Redeemable Preferred Stock, included as an exhibit to theCompany’s Quarterly Report on Form 10-QSB, filed November 14, 2002, isincorporated herein by reference.

 

3.4                            Articlesof Amendment to the Articles of Incorporation of Precision Auto Care, Inc.dated January 15, 2003 to increase the number of authorized shares, amend therequired number of Board of Directors, and amend the terms of the Board ofDirectors, included as an exhibit to the Company’s Quarterly Report on Form10-QSB, filed February 14, 2003, is incorporated herein by reference.

 

4.1                            Warrantto Purchase Shares of Common Stock of Precision Auto Care, Inc. dated October30, 2002 (Warrant No. 2002-01) between the Company and Desarollo Integrado, S.A. de C. V., included as an exhibit to the Company’s Quarterly Report on Form10-QSB, filed November 14, 2002, is incorporated herein by reference.

 

4.2                            Warrantto Purchase Shares of Common Stock of Precision Auto Care, Inc. dated October30, 2002 (Warrant No. 2002-02) between the Company and Arthur C. Kellar,included as an exhibit to the Company’s Quarterly Report on Form 10-QSB, filedNovember 14, 2002, is incorporated herein by reference.

 

10.1                      PrecisionAuto Care, Inc. 1998 Employee Stock Purchase Plan, included as an exhibit tothe Company’s Registration Statement on Form S-8 (No. 333-49097), filed April1, 1998, is incorporated herein by reference.

 

10.2                      PrecisionAuto Care Inc. 2000 Outside Directors’ Stock Plan, included as an exhibit tothe Company’s Registration Statement on Form S-8 (No. 333-39226), filed June14, 2000, is incorporated herein by reference.

 

10.3                      PrecisionAuto Care, Inc. 1998 Outside Directors’ Stock Option Plan, included as anexhibit to the Company’s Registration Statement on Form S-8 (No. 333-85877),filed August 25, 1999, is incorporated herein by reference.

 

10.4                      Precision AutoCare, Inc. 1999 Employee Stock Option and Restricted Stock Plan, included as anexhibit to the Company’s Registration Statement on Form S-8 (No. 333-85879),filed August 25, 1999, is incorporated herein by reference.

 

10.5                      PrecisionTune Stock Option Plan, included as an exhibit to the Company’s RegistrationStatement on Form S-8 (No. 333-47165), filed March 2, 1998, is incorporatedherein by reference.

 

10.6                      PrecisionAuto Care Employee Stock Option Plan, included as an exhibit to the Company’sRegistration Statement on Form S-8 (No. 333-47169), filed March 2, 1998, isincorporated herein by reference.

 

10.7                      PrecisionAuto Care, Inc. Director Stock Option Plan, included as an exhibit to theCompany’s Registration Statement on Form S-8 (No. 333-47171), filed March 2,1998, is incorporated herein by reference.

 

10.8                      SubordinatedDebenture Agreement with Board LLC, dated October 15, 1998, included as anexhibit to the Company’s Amended Quarterly Report on Form 10-Q/A, filedNovember 20, 1998, is incorporated herein by reference.

 

10.9                      Agreementdated August 3, 2000 between the Company and Louis M. Brown, Jr., included asan Exhibit to the Company’s Annual Report on Form 10-K, filed October 13, 2000,is incorporated herein by reference.

 

10.10                Lease dated December3, 2001 between Leesburg Airpark III, LLC and Precision Tune Auto Care, Inc.,included as an Exhibit to the Company’s Annual Report on Form 10-K, filedOctober 15, 2002, is incorporated herein by reference.

 

10.11                Agreement datedJuly 17, 2003 between the Company and Board L.L.C. terminating the SubordinatedDebenture dated October 15, 1998 between the Company and Board L.L.C.

 

10.12                Promissory Notedated March 9, 2004 between Precision Auto Care, Inc. and Chevy Chase Bank,F.S.B.

 

14*                             Codeof Ethics

 

21*                        SignificantSubsidiaries of the Company.

 

23.1*               Consent of GrantThornton LLP, Independent Auditors.

 

31.1*               Written statementof Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

 

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31.2*               Written statementof Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

 

32.1*               Written statementof Chief Executive Officer and Chief Financial Officer pursuant to Section 906of the Sarbanes-Oxley Act of 2002.

 

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*                    Filed herewith

 

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**Item 14****.  Principal Accountant Fees and Services**

 

The requiredinformation will be set forth under “Principal Accountant Fees and Services” inthe Company’s Proxy Statement, and reference is expressly made to the ProxyStatement for the specific information incorporated in the Form 10-KSB.

 

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**SIGNATURES**

 

**Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized, on September 28, 2004.**

 
|       | PRECISION AUTO CARE, INC.                             |
|------------|-------------------------------------------------------|
|       |
|       | By                                                    | : | /s/ Louis M. Brown, Jr. |   |
|       | **Louis M. Brown, Jr.**                               |
| ** ** | **Chief Executive Officer and Chairman of the Board** |
| ** ** | **(Duly Authorized Officer)**                         |
|            |                                                       |  |  |  |  |

 

**Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.**

 
| **Signature**           | ** ** | **Title**  | ** **                                        | **Date** |
|-------------------------|------------|------------|---------------------------------------------------|----------|
|                    |       |       |                                              |     |
| /s/ Louis M. Brown      | ** ** | ** ** | Chief Executive Officer and Chairman of the Board |     | September 28, 2004 |
| **Louis M. Brown, Jr.** |       |       |                                              |     |   |
|                    |       |       |                                              |     |   |
| /s/ Robert R. Falconi   | ** ** | ** ** | President and Chief Operating Officer             |     | September 28, 2004 |
| **Robert R. Falconi**   |       |       | (Principal Financial Accounting Officer)          |     |   |
|                    |       |       |                                              |     |   |
| /s/ Woodley A. Allen    |       |       | Director                                          |     | September 28, 2004 |
| **Woodley A. Allen**    |       |       |                                              |     |   |
|                    |       |       |                                              |     |   |
| /s/ Bassam N. Ibrahim   | ** ** | ** ** | Director                                          |     | September 28, 2004 |
| **Bassam N. Ibrahim**   |       |       |                                              |     |   |
|                    |       |       |                                              |     |   |
| /s/ John D. Sanders     |       |       | Director                                          |     | September 28, 2004 |
| **John D. Sanders**     |       |       |                                              |     |   |
|                    |       |       |                                              |     |   |
| /s/ Peter C. Keefe      |       |       | Director                                          |     | September 28, 2004 |
| **Peter C. Keefe**      |       |       |                                              |     |   |

 

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