**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**FORM 10-Q**

 

| **ý**                                                                                                                                                                                                                                                     |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                           |
| **For the quarterly period ended June 30, 2003**                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                           |
| **OR**                                                                                                                                                                                                                                                         |
|                                                                                                                                                                                                                                                           |
| **o**                                                                                                                                                                                                                                                          |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                           |
| **For the transition period from                    to                  ** |
|                                                                                                                                                                                                                                                           |
| **Commission file number 1-13089**                                                                                                                                                                                                                             |

 

| **U.S. Restaurant Properties, Inc.**                    |
|---------------------------------------------------------|
| (Exact  name of registrant as specified in its charter) |

 

| **Maryland**                                                     |   | **75-2687420**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation  or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |
| **12240 Inwood Rd.,  Suite 300, Dallas, Texas 75244**            |
| (Address of principal executive offices)  (Zip Code)             |
|                                                             |
| **(972) 387-1487**                                               |
| (Registrant’s telephone number, including  area code)       |

 
| **Title of  each class**                               |   | **Name of each exchange on which registered** |
|--------------------------------------------------------|--------|-----------------------------------------------|
| Common  Stock, par value $0.001 per share              |   | New York  Stock Exchange                      |
| $1.93 Series  A Cumulative Convertible Preferred Stock |   | New York Stock  Exchange                      |

 

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

 

| Yes  ý | No  o |
|-----------------------|-----------------|

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule12b-2).  Yes  ý  Noo

 

As of August 5, 2003, U.S.Restaurant Properties, Inc. had 19,890,689 shares of common stock $0.001 parvalue outstanding.

 

 

----

 

U.S. RESTAURANT PROPERTIES, INC.

 
| PART I.  |    | FINANCIAL INFORMATION                                                                                                               |
|----------|---------|-------------------------------------------------------------------------------------------------------------------------------------|
|     |    |                                                                                                                                |
|     | Item 1. | Financial Statements                                                                                                                |
|     |    |                                                                                                                                |
|     |    | Unaudited Condensed Consolidated Balance  Sheets as of June 30, 2003 and December 31, 2002                                          |
|     |    |                                                                                                                                |
|     |    | Unaudited Condensed Consolidated Statements  of Operations for the three and six months ended June 30, 2003 and 2002                |
|     |    |                                                                                                                                |
|     |    | Unaudited Condensed Consolidated Statements  of Comprehensive Operations for the three and six months ended June 30, 2003  and 2002 |
|     |    |                                                                                                                                |
|     |    | Unaudited Condensed Consolidated Statement  of Stockholders’ Equity for the six months ended June 30, 2003                     |
|     |    |                                                                                                                                |
|     |    | Unaudited Condensed Consolidated Statements  of Cash Flows for the six months ended June 30, 2003 and 2002                          |
|     |    |                                                                                                                                |
|     |    | Notes to Unaudited Condensed Consolidated  Financial Statements                                                                     |
|     |    |                                                                                                                                |
|     | Item 2. | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                         |
|     |    |                                                                                                                                |
|     | Item 3. | Quantitative and Qualitative Disclosures  About Market Risk                                                                         |
|     |    |                                                                                                                                |
|     | Item 4. | Controls and Procedures                                                                                                             |
|     |    |                                                                                                                                |
| PART II. |    | OTHER INFORMATION                                                                                                                   |
|     |    |                                                                                                                                |
|     | Item 7. | Exhibits and Reports on Form 8-K                                                                                                    |

 

2

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**PARTI.****FINANCIALINFORMATION**

 

**Item1****.    FinancialStatements**

 

**U.S.Restaurant Properties, Inc.**

**UnauditedCondensed Consolidated Balance Sheets**

**(Inthousands, except per share data)**

 
|                                                                                                                                                                               |   | **June 30,  2003** |    | **December 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|---------|------------------------|--------|
|                                                                                                                                                                               |   |               |    |                   |   |
| **Assets**                                                                                                                                                                         |   |               |    |                   |   |
|                                                                                                                                                                               |   |               |    |                   |   |
| Property, net                                                                                                                                                                      |   |               |    |                   |   |
| Land                                                                                                                                                                               |   | $                  | 201,434 |                   | $      | 202,404 |   |
| Building and leasehold  improvements                                                                                                                                               |   | 369,862            |    | 376,506                |   |
| Machinery and equipment                                                                                                                                                            |   | 12,829             |    | 11,868                 |   |
|                                                                                                                                                                               |   | 584,125            |    | 590,778                |   |
| Less:  accumulated depreciation                                                                                                                                               |   | (105,208           | )       | (99,964                | )      |
|                                                                                                                                                                               |   | 478,917            |    | 490,814                |   |
|                                                                                                                                                                               |   |               |    |                   |   |
| Construction in progress                                                                                                                                                           |   | 393                |    | 256                    |   |
| Cash and cash equivalents                                                                                                                                                          |   | 31,161             |    | 4,392                  |   |
| Restricted cash and marketable  securities                                                                                                                                         |   | 2,890              |    | 2,211                  |   |
| Rent and other receivables, net  (includes $1,370 and $2,531 allowance for doubtful accounts at June 30, 2003  and December 31, 2002, respectively)                                |   | 5,308              |    | 7,299                  |   |
| Straight line rent, net  (includes $440 and $484 allowance for doubtful accounts at June 30, 2003 and  December 31, 2002, respectively)                                            |   | 11,237             |    | 11,247                 |   |
| Prepaid expenses and other  assets                                                                                                                                                 |   | 4,432              |    | 3,354                  |   |
| Inventories                                                                                                                                                                        |   | 2,567              |    | 1,289                  |   |
| Investments                                                                                                                                                                        |   | 2,948              |    | 3,025                  |   |
| Notes receivable, net (includes  $0 and $13 due from related parties, and $2,964 and $3,636 allowance for  doubtful accounts at June 30, 2003 and December 31, 2002, respectively) |   | 8,342              |    | 9,805                  |   |
| Mortgage loans receivable, net  (includes $266 and $583 allowance for doubtful accounts at June 30, 2003 and  December 31, 2002, respectively)                                     |   | 14,251             |    | 34,932                 |   |
| Net investment in direct  financing leases                                                                                                                                         |   | 335                |    | 518                    |   |
| Deferred financing costs and  intangibles, net                                                                                                                                     |   | 8,380              |    | 9,935                  |   |
| **Total assets**                                                                                                                                                                   |   | $                  | 571,161 |                   | $      | 579,077 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

3

----

 

**U.S.Restaurant Properties, Inc.**

**Unaudited Condensed Consolidated BalanceSheets (continued)**

**(Inthousands, except per share data)**

 
|                                                                                                                                                                                                     |   | **June 30,  2003** |    | **December 31,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|---------|------------------------|--------|
|                                                                                                                                                                                                     |   |               |    |                   |   |
| **Liabilities and stockholders’ equity**                                                                                                                                                            |   |               |    |                   |   |
|                                                                                                                                                                                                     |   |               |    |                   |   |
| Accounts payable and accrued  liabilities                                                                                                                                                                |   | $                  | 19,638  |                   | $      | 18,142 |   |
| Accrued dividends and  distributions                                                                                                                                                                     |   | 2,190              |    | 2,181                  |   |
| Unearned contingent rent                                                                                                                                                                                 |   | 594                |    | 826                    |   |
| Deferred gain on sale of  property                                                                                                                                                                       |   | 237                |    | 926                    |   |
| Line of credit                                                                                                                                                                                           |   | 13,750             |    | 25,000                 |   |
| Interest rate derivatives at  fair value                                                                                                                                                                 |   | 3,970              |    | 4,536                  |   |
| Notes payable                                                                                                                                                                                            |   | 320,727            |    | 327,428                |   |
| Mortgage note payable                                                                                                                                                                                    |   | 928                |    | 946                    |   |
| **Total liabilities**                                                                                                                                                                                    |   | 362,034            |    | 379,985                |   |
|                                                                                                                                                                                                     |   |               |    |                   |   |
| **Commitments and contingencies**                                                                                                                                                                        |   |               |    |                   |   |
|                                                                                                                                                                                                     |   |               |    |                   |   |
| **Minority interest in operating partnerships**                                                                                                                                                          |   | 52,845             |    | 52,845                 |   |
|                                                                                                                                                                                                     |   |               |    |                   |   |
| **Stockholders’ equity**                                                                                                                                                                            |   |               |    |                   |   |
|                                                                                                                                                                                                     |   |               |    |                   |   |
| Preferred stock, $0.001 par  value per share:                                                                                                                                                            |   |               |    |                   |   |
| Series A Cumulative Convertible  Preferred Stock -  50,000 shares  authorized, 3,680 shares issued and outstanding at June 30, 2003 and December  31, 2002 (aggregate liquidation value of $92,000) |   | 4                  |    | 4                      |   |
| Series B Convertible Preferred  Stock - 20 shares authorized, 16 shares issued and outstanding at June 30,  2003 (aggregate liquidation value of $16,000)                                                |   | —             |    | —                 |   |
| Common stock, $0.001 par value  per share:                                                                                                                                                               |   |               |    |                   |   |
| 100,000 shares authorized,  19,891 and 19,832 shares issued and outstanding at June 30, 2003 and December  31, 2002, respectively                                                                        |   | 20                 |    | 20                     |   |
| Additional paid-in capital                                                                                                                                                                               |   | 343,304            |    | 327,756                |   |
| Excess stock, $0.001 par value  per share 15,000 shares authorized, no shares issued                                                                                                                     |   | —             |    | —                 |   |
| Accumulated other comprehensive  loss                                                                                                                                                                    |   | (3,970             | )       | (4,411                 | )      |
| Loans to stockholders for  common stock                                                                                                                                                                  |   | (299               | )       | (299                   | )      |
| Distributions in excess of net  income                                                                                                                                                                   |   | (182,777           | )       | (176,823               | )      |
| **Total stockholders’ equity**                                                                                                                                                                      |   | 156,282            |    | 146,247                |   |
| **Total liabilities and stockholders’ equity**                                                                                                                                                      |   | $                  | 571,161 |                   | $      | 579,077 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

4

----

 

**U.S.Restaurant Properties, Inc.**

**UnauditedCondensed Consolidated Statements of Operations**

**(Inthousands, except per share data)**

 
|                                                                                                                           |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|--------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                                                           |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Revenues:                                                                                                                      |   |                             |   |                           |   |   |   |   |   |
| Real estate rental                                                                                                             |   | $                                | 15,135 |                           | $      | 15,710 |   | $ | 30,632 |   | $ | 31,051 |   |
| Tenant expense reimbursements                                                                                                  |   | 843                              |   | 843                            |   | 1,735 |   | 1,718 |   |
| Lease termination                                                                                                              |   | 581                              |   | —                         |   | 2,058 |   | 217 |   |
| Interest on real estate loans                                                                                                  |   | 884                              |   | 692                            |   | 1,774 |   | 1,311 |   |
| Retail operations                                                                                                              |   | 15,476                           |   | 10,001                         |   | 28,743 |   | 17,217 |   |
|                                                                                                                           |   |                             |   |                           |   |   |   |   |   |
| Total revenues                                                                                                                 |   | 32,919                           |   | 27,246                         |   | 64,942 |   | 51,514 |   |
| Expenses:                                                                                                                      |   |                             |   |                           |   |   |   |   |   |
| Ground rent                                                                                                                    |   | 992                              |   | 968                            |   | 1,995 |   | 1,944 |   |
| Property taxes                                                                                                                 |   | 178                              |   | 193                            |   | 382 |   | 406 |   |
| Other property                                                                                                                 |   | 104                              |   | 95                             |   | 213 |   | 205 |   |
| Legal                                                                                                                          |   | 295                              |   | 631                            |   | 563 |   | 995 |   |
| Depreciation and amortization                                                                                                  |   | 5,303                            |   | 5,546                          |   | 10,898 |   | 10,435 |   |
| Impairment of long-lived assets                                                                                                |   | 752                              |   | 347                            |   | 1,609 |   | 523 |   |
| Provision for doubtful accounts                                                                                                |   | (133                             | )      | (91                            | )      | (170 | ) | (5 | ) |
| Real estate general and  administrative                                                                                        |   | 1,625                            |   | 1,368                          |   | 2,939 |   | 2,887 |   |
| Retail general and  administrative                                                                                             |   | 1,835                            |   | 1,517                          |   | 3,838 |   | 2,626 |   |
| Retail cost of sales                                                                                                           |   | 13,006                           |   | 8,464                          |   | 24,773 |   | 14,394 |   |
| Interest                                                                                                                       |   | 5,461                            |   | 5,576                          |   | 11,090 |   | 11,097 |   |
| Total expenses                                                                                                                 |   | 29,418                           |   | 24,614                         |   | 58,130 |   | 45,507 |   |
|                                                                                                                           |   |                             |   |                           |   |   |   |   |   |
| Income from continuing  operations                                                                                             |   | 3,501                            |   | 2,632                          |   | 6,812 |   | 6,007 |   |
| Non-operating income                                                                                                           |   | 13                               |   | 158                            |   | 21 |   | 634 |   |
| Minority interest                                                                                                              |   | (1,168                           | )      | (1,216                         | )      | (2,337 | ) | (2,349 | ) |
| Net income from continuing  operations before discontinued operations and cumulative effect of change in  accounting principle |   | 2,346                            |   | 1,574                          |   | 4,496 |   | 4,292 |   |
| Income (loss) from discontinued  operations                                                                                    |   | 5,171                            |   | (306                           | )      | 6,477 |   | 926 |   |
| Cumulative effect of change in  accounting principle                                                                           |   | —                           |   | —                         |   | (270 | ) | — |   |
| Net income                                                                                                                     |   | 7,517                            |   | 1,268                          |   | 10,703 |   | 5,218 |   |
| Dividends on preferred stock                                                                                                   |   | (1,814                           | )      | (1,775                         | )      | (3,590 | ) | (3,551 | ) |
| Net income (loss) allocable to  common stockholders                                                                            |   | $                                | 5,703  |                           | $      | (507 | ) | $ | 7,113 |   | $ | 1,667 |   |
|                                                                                                                           |   |                             |   |                           |   |   |   |   |   |
| Basic and diluted net income  (loss) per share:                                                                                |   |                             |   |                           |   |   |   |   |   |
| Income (loss) from continuing  operations allocable to common stockholders                                                     |   | $                                | 0.03   |                           | $      | (0.01 | ) | $ | 0.04 |   | $ | 0.04 |   |
| Income (loss) from discontinued  operations                                                                                    |   | 0.26                             |   | (0.02                          | )      | 0.33 |   | 0.04 |   |
| Cumulative effect of change in  accounting principle                                                                           |   | —                           |   | —                         |   | (0.01 | ) | — |   |
| Net income (loss) per share                                                                                                    |   | $                                | 0.29   |                           | $      | (0.03 | ) | $ | 0.36 |   | $ | 0.08 |   |
|                                                                                                                           |   |                             |   |                           |   |   |   |   |   |
| Weighted average shares  outstanding                                                                                           |   |                             |   |                           |   |   |   |   |   |
| Basic                                                                                                                          |   | 19,867                           |   | 19,561                         |   | 19,852 |   | 19,540 |   |
| Diluted                                                                                                                        |   | 19,891                           |   | 19,794                         |   | 19,873 |   | 19,766 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

5

----

 

**U.S.Restaurant Properties, Inc.**

**Unaudited Condensed Consolidated Statementsof Other Comprehensive Operations**

**(Inthousands)**

 
|                                                                                |   | **Three months ended June 30,** |       | **Six months ended June 30,** |       |
|-------------------------------------------------------------------------------------|--------|---------------------------------|------------|-------------------------------|------------|
|                                                                                |   | **2003**                        |       | **2002**                      |       | **2003** |   | **2002** |   |
|                                                                                |   |                            | ** ** |                          | ** ** |   | ** ** |   | ** ** |
| Net income                                                                          |   | $                               | 7,517      |                          | $          | 1,268 |   | $ | 10,703 |   | $ | 5,218 |   |
| Other comprehensive income  (loss) - reclassification adjustment - hedge settlement |   | 689                             |       | 958                           |       | 1,585 |   | 1,942 |   |
| Fair value adjustment for  derivatives                                              |   | (470                            | )          | (1,983                        | )          | (1,144 | ) | (1,820 | ) |
| Change in unrealized loss on  investments                                           |   | —                          |       | 67                            |       | — |   | 16 |   |
| Comprehensive income                                                                |   | $                               | 7,736      |                          | $          | 310 |   | $ | 11,144 |   | $ | 5,356 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

6

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**U.S.Restaurant Properties, Inc.**

**Unaudited Condensed Consolidated Statement ofStockholders’ Equity**

**Forthe Six Months Ended June 30, 2003**

**(Inthousands)**

** **
|                                                                                           |   |                          |   |       |   |          |       | **Additional  Paid-in  Capital** |          | **Accumulated  Other  Comprehensive  Gain (Loss)** |   | **Loans  To  Shareholders** |   | **Distributions  In Excess of  Net Income** |   | **Total  Stockholders’  Equity** |   |
|------------------------------------------------------------------------------------------------|--------|-------------------------------|--------|------------|--------|---------------|------------|----------------------------------|---------------|----------------------------------------------------|--------|-----------------------------|--------|---------------------------------------------|--------|---------------------------------------|--------|
|                                                                                           |   |                          |   |       |
|                                                                                           |   |                          |   |       |
| **Series A  Preferred Stock**                                                                  |   | **Series B  Preferred Stock** |   |       |
|                                                                                           |   | **Common Stock**              |
| **Shares**                                                                                     |   | **Par Value**                 |   | **Shares** |   | **Par Value** | **Shares** |                             | **Par Value** |
|                                                                                           |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   |                                  |   |   |   |   |   |   |   |
| Balance at January 1, 2003                                                                     |   | 3,680                         |   | $          | 4      |          | —     |                             | $             | —                                             |   | 19,832                      |   | $                                           | 20     |                                  | $      | 327,756 |   | $ | (4,411 | ) | $ | (299 | ) | $ | (176,823 | ) | $ | 146,247 |   |
| Net income                                                                                     |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   |                                  |   |   |   | 10,703 |   | 10,703 |   |
| Proceeds from issuance of preferred stock -  Series B, net of placement and professional  fees |   |                          |   |       |   | 16            |       | —                           |          |                                               |   |                        |   | 14,637                                      |   |                                  |   |   |   |   |   | 14,637 |   |
| Estimated fair value of warrants issued in  preferred  stock - Series B                        |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   | 253                                         |   |                                  |   |   |   |   |   | 253 |   |
| Proceeds from exercised                                                                        |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   |                                  |   |   |   |   |   |   |   |
| Stock options                                                                                  |   |                          |   |       |   |          |       |                             |          | 59                                                 |   |                        |   | 649                                         |   |                                  |   |   |   |   |   | 649 |   |
| Stock-based compensation to employees                                                          |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   | 9                                           |   |                                  |   |   |   |   |   | 9 |   |
| Other comprehensive gain (loss) -                                                              |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   |                                  |   |   |   |   |   |   |   |
| Reclassification adjustment - hedge settlement                                                 |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   | 1,585                                 |   |   |   |   |   | 1,585 |   |
| Fair value adjustment for derivatives                                                          |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   | (1,144                                | )      |   |   |   |   | (1,144 | ) |
| Distributions declared on common stock                                                         |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   |                                  |   |   |   | (13,106 | ) | (13,106 | ) |
| Distributions on preferred stock                                                               |   |                          |   |       |   |          |       |                             |          |                                               |   |                        |   |                                        |   |                                  |   |   |   | (3,551 | ) | (3,551 | ) |
| Balance at June 30, 2003                                                                       |   | 3,680                         |   | $          | 4      |          | 16         |                             | $             | —                                             |   | 19,891                      |   | $                                           | 20     |                                  | $      | 343,304 |   | $ | (3,970 | ) | $ | (299 | ) | $ | (182,777 | ) | $ | 156,282 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

7

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**U.S.Restaurant Properties, Inc.**

**Unaudited Condensed Consolidated Statements of Cash Flows**

**(Inthousands)**

 
|                                                                              |   | **Six Months Ended  June 30,** |       |
|-----------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                              |   | **2003**                       |       | **2002** |   |
|                                                                              |   |                           | ** ** |   | ** ** |
| **Cash flows from operating activities:**                                         |   |                           |       |   |   |
|                                                                              |   |                           |       |   |   |
| Net income                                                                        |   | $                              | 10,703     |   | $ | 5,218 |   |
| Adjustments to reconcile net  income to net cash flows from operating activities: |   |                           |       |   |   |
| Depreciation and amortization                                                     |   | 11,130                         |       | 11,224 |   |
| Cumulative effect of change in  accounting principle                              |   | 270                            |       | — |   |
| Amortization of deferred  financing costs and discounts                           |   | 1,092                          |       | 846 |   |
| Impairment of long-lived assets                                                   |   | 2,347                          |       | 1,718 |   |
| Provision for doubtful accounts                                                   |   | (170                           | )          | 17 |   |
| Stock-based compensation                                                          |   | 9                              |       | 86 |   |
| Accretion of interest income                                                      |   | —                         |       | (313 | ) |
| Fair value adjustment for  interest rate derivatives                              |   | (124                           | )          | (256 | ) |
| Minority interests                                                                |   | 2,337                          |       | 2,349 |   |
| Gain on sales of property                                                         |   | (6,704                         | )          | (1,274 | ) |
| Gain on sale of investments                                                       |   | —                         |       | (113 | ) |
| Decrease in rent and other  receivables, net                                      |   | 1,943                          |       | 555 |   |
| Increase in straight line rent,  net                                              |   | (730                           | )          | (1,243 | ) |
| Decrease (increase) in prepaid  expenses                                          |   | (1,074                         | )          | 312 |   |
| Increase in inventories                                                           |   | (1,471                         | )          | (1,062 | ) |
| Reduction in net investment in  direct financing leases                           |   | 102                            |       | 322 |   |
| Increase (decrease) in accounts  payable and accrued liabilities                  |   | 1,633                          |       | (3,177 | ) |
| Decrease in unearned contingent  rent                                             |   | (232                           | )          | (307 | ) |
| Cash flows from operating  activities                                             |   | 21,061                         |       | 14,902 |   |
|                                                                              |   |                           |       |   |   |
| **Cash flows from investing activities:**                                         |   |                           |       |   |   |
|                                                                              |   |                           |       |   |   |
| Proceeds from sales of property  and equipment                                    |   | 21,062                         |       | 9,989 |   |
| Purchase of property                                                              |   | (1,183                         | )          | (393 | ) |
| Purchase of machinery and  equipment                                              |   | (2,740                         | )          | (82 | ) |
| Purchase of investments                                                           |   | —                         |       | (3,014 | ) |
| Proceeds from sale of  investments                                                |   | —                         |       | 4,838 |   |
| Distributions received from  investments                                          |   | 76                             |       | 546 |   |
| Decrease (increase) in  restricted cash                                           |   | (679                           | )          | 2,483 |   |
| Mortgage notes receivable  acquired                                               |   | —                         |       | (84 | ) |
| Mortgage loans receivable  principal payments                                     |   | 8,998                          |       | 1,665 |   |
| Notes receivable issued                                                           |   | —                         |       | (6,625 | ) |
| Increase (decrease) in lease  acquisition premiums                                |   | 38                             |       | (26 | ) |
| Notes receivable principal  payments                                              |   | 1,114                          |       | 255 |   |
| Cash flows from investing  activities                                             |   | 26,686                         |       | 9,552 |   |
|                                                                                   |        |                                |            |  |  |  |  |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

8

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|                                                         |   | **Six Months Ended  June 30,** |   |
|--------------------------------------------------------------|--------|--------------------------------|--------|
|                                                         |   | **2003**                       |   | **2002** |   |
|                                                         |   |                           |   |   |   |
| **Cash flows from financing activities:**                    |   |                           |   |   |   |
|                                                         |   |                           |   |   |   |
| Proceeds from line of credit                                 |   | $                              | 15,700 |   | $ | — |   |
| Payments on line of credit                                   |   | (26,950                        | )      | — |   |
| Proceeds from issuance of  Series B preferred stock          |   | 14,947                         |   | — |   |
| Proceeds from issuance of  Series B preferred stock warrants |   | 253                            |   | — |   |
| Distributions to minority  interest shareholders             |   | (2,337                         | )      | (2,409 | ) |
| Cash distributions to  stockholders                          |   | (13,106                        | )      | (12,904 | ) |
| Payment of preferred stock  dividends                        |   | (3,551                         | )      | (3,551 | ) |
| Proceeds from sale of stock and  exercised stock options     |   | 649                            |   | 1,351 |   |
| Payments on notes/mortgage  payable                          |   | (6,583                         | )      | (4,919 | ) |
| Financing costs                                              |   | —                         |   | (526 | ) |
| Cash flows from financing  activities                        |   | (20,978                        | )      | (22,958 | ) |
|                                                         |   |                           |   |   |   |
| Increase in cash and cash  equivalents                       |   | 26,769                         |   | 1,496 |   |
| Cash and cash equivalents at  beginning of period            |   | 4,392                          |   | 10,346 |   |
| Cash and cash equivalents at  end of period                  |   | $                              | 31,161 |   | $ | 11,842 |   |
|                                                         |   |                           |   |   |   |
| **Supplemental disclosure:**                                 |   |                           |   |   |   |
| Interest paid during the period                              |   | $                              | 8,448  |   | $ | 14,725 |   |
| Income taxes paid during the  period                         |   | $                              | 319    |   | $ | 308 |   |
|                                                         |   |                           |   |   |   |
| **Non-cash investing and financing  activities:**            |   |                           |   |   |   |
| Mortgage loans receivable used  for property acquisitions    |   | $                              | 12,000 |   | $ | — |   |
| Security deposit and note  receivable written off            |   | 1,037                          |   | — |   |
| Decrease in common and  preferred stock dividends accrued    |   | —                         |   | 3,921 |   |
| Notes received on sale of  property                          |   | —                         |   | 741 |   |
| Account receivable conversion  to note receivable            |   | 135                            |   | — |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

9

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**U.S. RestaurantProperties, Inc.**

**Notes to UnauditedCondensed Consolidated Financial Statements**

 

**1.             InterimUnaudited Financial Information**

 

U.S. Restaurant Properties,Inc. (“USRP” and, collectively with its subsidiaries, the “Company”) is a fullyintegrated, self-administered and self-managed Real Estate Investment Trust (a“REIT”), as defined under the Internal Revenue Code of 1986, as amended. TheCompany owns, acquires and manages branded chain restaurants and selectedservice retail properties.  The businessand operations of the Company are conducted primarily through the USRP’swholly-owned and controlled subsidiary, U.S. Restaurant Properties OperatingL.P., USRP’s operating partnership (“OP”). As of June 30, 2003, the Company owned 801 properties in 48 states.

 

In June 2003, the Companyformed a new taxable REIT subsidiary (a “TRS”), USRP Holding Corp.(“Holding”).  Holding was formed as awholly-owned subsidiary of OP.  Thechange in the Company’s structure was made to ensure continued compliance bythe Company with Internal Revenue Service rules regarding qualification as aREIT with regard to related party transactions between the Company’ssubsidiaries.  As a result of the changein organizational structure, rental income from the Company’s Shoney’s andCaptain D’s restaurants, as well as the gasoline stations and restaurantsoperated by the Company affiliates, will become subject to Federal and Stateincome taxes.

 

Holding has three wholly-ownedsubsidiaries, Fuel Supply, Inc. (“FSI”), USRP (Hawaii), LLC, and USRP(S&C), LLC.  FSI, which wasorganized in April 2001, is the Company’s existing TRS and operates variousretail businesses located on certain Company properties in order to transitionthe operations from one tenant to another. USRP (Hawaii), LLC was formed in June 2003 and owns the Company-operatedHawaii service stations.  USRP(S&C), LLC was formed in June 2003 and owns and operates 45 of theCompany’s Shoney’s and Captain D’s restaurants.  Holding owns the Company operated non-Hawaii service stations.

 

Basis ofPresentation and Estimates

 

The accompanying interimunaudited condensed consolidated financial statements should be read inconjunction with the consolidated financial statements and notes theretoincluded in the Company’s Annual Report on Form 10-K, as amended, for the yearended December 31, 2002, filed with the Securities and Exchange Commission(“SEC”).  Operating results for thethree and six months ended June 30, 2003 are not necessarily indicative of theresults to be expected for the year ending December 31, 2003.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen omitted in this report on Form 10-Q pursuant to the Rules and Regulationsof the SEC.  In the opinion ofmanagement, the disclosures contained in this report are adequate to make theinformation presented not misleading.

 

Accounting measurements atinterim dates inherently involve greater reliance on estimates than at year endand the results of operations for the interim periods shown in the report arenot necessarily indicative of results to be expected for the fiscal year.  In the opinion of management, theaccompanying unaudited condensed consolidated financial statements include alladjustments (of a normal recurring nature) necessary to present fairly theconsolidated financial position of the Company as of June 30, 2003, theconsolidated results of its operations and comprehensive income for the threeand six months ended June 30, 2003 and 2002, and the consolidated statements ofcash flows and stockholders’ equity for the six months ended June 30, 2003.

 

The preparation of consolidatedfinancial statements, in conformity with accounting principles generallyaccepted in the United States of America, requires management to make estimatesand assumptions that affect reported amounts of certain assets, liabilities,contingent assets and liabilities, revenues and expenses as of and for the reportingperiods.  Actual results may differ fromsuch estimates.  Any differences fromthose estimates are recorded in the period in which they are identified.

 

Amounts in previous periodshave been reclassified to conform to current period presentation.

 

10

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SIGNIFICANT ACCOUNTING POLICIES

 

This section should be read inconjunction with the more detailed information regarding the Company’ssignificant accounting policies contained in the Company’s Annual Report onForm 10-K, as amended, for the year ended December 31, 2002.

 

New AccountingStandards

 

Statement of FinancialAccounting Standard (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.”  SFAS No.148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” andprovides new transition methods if an entity adopts the fair value based methodof valuing stock-based compensation as well as requiring additional disclosuresin interim and annual financial statements. At this time, the Company intends to continue to utilize the intrinsicvalue model of accounting for stock option grants, which results incompensation costs equal to the excess, if any, of the fair value of theCompany’s stock at the measurement date above the stock options strikeprice.  Pro-forma disclosures are asfollows (in thousands, except per share data):

 

Pro-forma Stock-BasedCompensation Cost

 
|                                                             |   | **Three months ended June 30,** |   | **Six months ended June 30,** |   |
|------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                             |   | **2003**                        |   | **2002**                      |   | **2003** |   | **2002** |   |
| Net income (loss) allocable to  common stockholders, as reported |   | $                               | 5,703  |                          | $      | (507 | ) | $ | 7,113 |   | $ | 1,667 |   |
| Stock-based compensation  recognized                             |   | 9                               |   | 24                            |   | 9 |   | 86 |   |
|                                                             |   | 5,712                           |   | (483                          | )      | 7,122 |   | 1,753 |   |
| Pro-forma stock-based  compensation                              |   | (19                             | )      | (46                           | )      | (25 | ) | (86 | ) |
| Pro-forma net income (loss)  allocable to common stockholders    |   | $                               | 5,693  |                          | $      | (529 | ) | $ | 7,097 |   | $ | 1,667 |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Basic and diluted income (loss)  per share:                      |   |                            |   |                          |   |   |   |   |   |
| As reported - basic and diluted                                  |   | $                               | 0.29   |                          | $      | (0.03 | ) | $ | 0.36 |   | $ | 0.08 |   |
| Pro-forma - basic                                                |   | $                               | 0.29   |                          | $      | (0.03 | ) | $ | 0.36 |   | $ | 0.08 |   |
| Pro-forma - diluted                                              |   | $                               | 0.29   |                          | $      | (0.03 | ) | $ | 0.36 |   | $ | 0.08 |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Stock options:                                                   |   |                            |   |                          |   |   |   |   |   |
| Pro-forma estimated  compensation value per options granted      |   | $                               | 2.10   |                          | $      | 2.50 |   | $ | 2.12 |   | $ | 2.01 |   |

 

SFAS No. 149, “Amendment of Statement133 on Derivative Instruments and Hedging Activities.”  In April 2003, the Financial AccountingStandards Board (the “FASB”) issued SFAS No. 149, which amends and clarifiesaccounting for derivative instruments, including certain derivative instrumentsembedded in other contracts, and for hedging activities under SFAS No.133.  This Statement is effective forcontracts entered into or modified after June 30, 2003, and for hedgingrelationships designated after June 30, 2003. Management is currently evaluating the provisions of SFAS No. 149 todetermine the impact, if any, on the Company’s consolidated financialstatements but does not believe that there will be any material impact on itsconsolidated financial statements.

 

SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of Both Liabilities andEquity.” SFAS No. 150 addresses how an issuer classifies and measures financialinstruments with characteristics of both liabilities and equity. The Statementis effective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003.  Forfinancial instruments created before the issuance date of this Statement andstill existing at the beginning of the interim period of adoption, transitionshall be achieved by reporting the cumulative effect of a change in accountingprinciple by initially measuring the financial instruments at fair value orother measurement attribute required by this Statement.  The Company is evaluating its financialinstruments that may be included in the scope of this Statement and thepotential impact of its adoption on the consolidated financial statements. Atthis time, management believes

 

11

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the current classification ofits preferred equity instruments and its Minority Interest in the Company’sUnaudited Condensed Consolidated Balance Sheets are appropriate.  The Company will continue to monitor itsfinancial instruments for appropriate treatment under SFAS 150.

 

Income PerShare

 

Basic income per share iscomputed based upon the weighted average number of shares of common stockoutstanding.  Diluted income per sharetypically reflects the dilutive effect of stock options, OP units, OP units andshares on which the price is guaranteed (“guaranteed stock”), convertiblepreferred stock and convertible stock warrants. A reconciliation of the basicand diluted weighted average shares is as follows (in thousands, except pershare data):

 
|                                                                                                                            |   | **Three months ended  June 30,** |   | **Six months ended  June 30,** |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                                                            |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** | ** ** |
| Net income from continuing  operations before discontinued operations and cumulative effect of change in  accounting  principle |   | $                                | 2,346  |                           | $      | 1,574 |   | $ | 4,496 |   | $ | 4,292 |   |
| Dividends on preferred stock                                                                                                    |   | (1,814                           | )      | (1,775                         | )      | (3,590 | ) | (3,551 | ) |
| Net income (loss) from  continuing operations allocable to common stockholders                                                  |   | 532                              |   | (201                           | )      | 906 |   | 741 |   |
| Income (loss) from discontinued  operations                                                                                     |   | 5,171                            |   | (306                           | )      | 6,477 |   | 926 |   |
| Cumulative effect of change in  accounting principle                                                                            |   | —                           |   | —                         |   | (270 | ) | — |   |
| Net income (loss) allocable to  common stockholders                                                                             |   | $                                | 5,703  |                           | $      | (507 | ) | $ | 7,113 |   | $ | 1,667 |   |
|                                                                                                                            |   |                             |   |                           |   |   |   |   |   |
| Basic and diluted net income  (loss) per share:                                                                                 |   |                             |   |                           |   |   |   |   |   |
| Income (loss) from continuing  operations allocable to common stockholders                                                      |   | $                                | 0.03   |                           | $      | (0.01 | ) | $ | 0.04 |   | $ | 0.04 |   |
| Income (loss) from discontinued  operations                                                                                     |   | 0.26                             |   | (0.02                          | )      | 0.33 |   | 0.04 |   |
| Cumulative effect of change in  accounting principle                                                                            |   | —                           |   | —                         |   | (0.01 | ) | — |   |
| Net income (loss) per share                                                                                                     |   | $                                | 0.29   |                           | $      | (0.03 | ) | $ | 0.36 |   | $ | 0.08 |   |
|                                                                                                                            |   |                             |   |                           |   |   |   |   |   |
| Weighted average shares  outstanding:                                                                                           |   |                             |   |                           |   |   |   |   |   |
| Basic                                                                                                                           |   | 19,867                           |   | 19,561                         |   | 19,852 |   | 19,540 |   |
| Dilutive effect of OP units                                                                                                     |   | —                           |   | 132                            |   | — |   | 132 |   |
| Dilutive effect of stock  options                                                                                               |   | 24                               |   | 46                             |   | 21 |   | 39 |   |
| Dilutive effect of guaranteed  stock                                                                                            |   | —                           |   | 55                             |   | — |   | 55 |   |
| Diluted                                                                                                                         |   | 19,891                           |   | 19,794                         |   | 19,873 |   | 19,766 |   |
|                                                                                                                            |   |                             |   |                           |   |   |   |   |   |
| Antidilutive securities:                                                                                                        |   |                             |   |                           |   |   |   |   |   |
| Stock options                                                                                                                   |   | 41                               |   | 46                             |   | 41 |   | 46 |   |
| Convertible preferred stock                                                                                                     |   | 4,453                            |   | 3,453                          |   | 4,453 |   | 3,453 |   |
| Convertible stock warrants                                                                                                      |   | 253                              |   | —                         |   | 253 |   | — |   |

 

Investments

 

Investments in equitysecurities with readily determinable fair values and debt securities areclassified as either available-for-sale or trading, based on the Company’sintent with respect to those securities. Such investments are classified as trading securities if thosesecurities are held principally for the purpose of selling them in the nearterm.  All other such investments areclassified as available-for-sale.  Theseinvestments are recorded at fair value on the balance sheet.  Changes in fair value during the period arerecorded in earnings for trading securities and in other comprehensiveoperations for available-for-sale securities. Investments in equity securities that do not have readily determinablefair values are recorded using the cost method since the Company does not havethe ability to exercise significant influence over the investees.  The Company disposed of all of its tradingand available-for-sale securities in 2002.

 

12

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Derivatives

 

Derivative financialinstruments are recognized as either assets or liabilities on the balance sheetat fair value.  If the derivative isdesignated as a fair-value hedge, the changes in the fair value of thederivative and the hedged item are recognized currently in earnings.  If the derivative is designated as a cashflow hedge, the effective portion of the changes in fair value of thederivative is recorded in other comprehensive income and is reclassified toearnings when the hedged item affects earnings.  For a derivative that does not qualify or is not designated as ahedge, changes in fair value are recognized currently in earnings.

 

RevenueRecognition

 

The Company’s revenuesprimarily include rental income on real estate properties and operating revenuefrom retail operations.

 

Rental revenues are derivedfrom the leasing of the Company’s properties to operators (primarilyrestaurants) on a “triple net” basis. Triple net leases typically require the tenants to be responsible forproperty operating costs, including property taxes, insurance, maintenance and,in most cases, the ground rents where applicable.  Accordingly, the accompanying consolidated financial statementsdo not reflect property taxes and insurance costs or reimbursements when thetenant has legally assumed responsibility for these liabilities.  As the Company remains legally responsiblefor ground rents under its ground leases and receives payment from its tenantsfor these costs, amounts reimbursed from tenants for ground rents are recordedas rent revenue.  The treatment ofground rents has changed from the 2002 interim period due to the adoption ofEITF No. 01-14, “Income Statement Characterization of Reimbursements Receivedfor ‘Out-of-Pocket’ Expenses Incurred” after June 30, 2002.  In accordance with this consensus, the 2002prior period presented has been reclassified. Rent revenues and ground rent expense under operating leases arerecognized on a straight-line basis, unless significant collection problemsoccur with the lessee, at which time rents are recognized on a cash basis.  Contingent rent is recognized as revenueafter the related lease sales targets are achieved.  The Company has recorded contingent rent revenues of $1,528,000and $889,000 for the three and six months ended June 30, 2003, respectively, ascompared to $2,015,000 and $1,119,000 for the three and six months ended June30, 2002, respectively.

 

Retail revenues are derivedfrom gasoline sales, car washes, convenience store merchandise and food salesat properties operated by the Company. Revenue is recognized upon the sale of gasoline, merchandise or thedelivery of services.

 

**2.             Property**

 

**Discontinued Operations**

 

SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” requires that the results ofoperations of assets sold or held for sale, and any gains or losses recognizedon assets sold and held for sale, be classified separately in the Company’sUnaudited Condensed Consolidated Statements of Operations. In accordance withSFAS No. 144, the results of operations of the assets sold or held for salehave been presented as “Income (loss) from discontinued operations,” in theaccompanying Unaudited Condensed Consolidated Statements of Operations for thethree and six months ended June 30, 2003 and 2002.

 

During the three and six monthsended June 30, 2003, the Company completed the sale or disposal of 30 and 37properties, respectively, for net cash proceeds of $18,116,000 and $21,062,000,respectively, net of closing costs of $859,000 and $978,000, respectively.

 

The following table indicatesthe revenues, depreciation and amortization, impairment of long-lived assets,other expenses, gain (loss) on sales of property, and income (loss) fromdiscontinued operations for the three and six months ended June 30, 2003 and2002 for the 37 properties sold during the six months ended June 30, 2003 and46 properties sold during the twelve months ended December 31, 2002 (inthousands):

 

13

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|                                        |   | **Three months ended June 30,** |   | **Six months ended June 30,** |   |
|---------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                        |   | **2003**                        |   | **2002**                      |   | **2003** |   | **2002** |   |
|                                        |   |                            |   |                          |   |   |   |   |   |
| Revenues                                    |   | $                               | 249    |                          | $      | 1,117 |   | $ | 1,039 |   | $ | 2,229 |   |
| Depreciation and amortization               |   | (47                             | )      | (395                          | )      | (232 | ) | (789 | ) |
| Impairment of long-lived assets             |   | —                          |   | (562                          | )      | (738 | ) | (1,195 | ) |
| Other expenses                              |   | (116                            | )      | (260                          | )      | (296 | ) | (593 | ) |
|                                        |   | 86                              |   | (100                          | )      | (227 | ) | (348 | ) |
| Gain (loss) on sales of  property           |   | 5,085                           |   | (206                          | )      | 6,704 |   | 1,274 |   |
| Income (loss) from discontinued  operations |   | $                               | 5,171  |                          | $      | (306 | ) | $ | 6,477 |   | $ | 926 |   |

 

**Other Impairments**

 

During the three and six monthsended June 30, 2003, as a result of the Company’s regular analysis of itsinvestments to determine if circumstances indicate that the carrying amount ofan asset may not be recoverable, impairment charges of $752,000 and $1,609,000were recorded in continuing operations from the revaluing of five and 19assets, respectively, to their estimated fair value.

 

**3.****                                      Lineof Credit and Notes Payable**

 

The Company’s debt issummarized as follows (in thousands):

 
|                                                                |   | **Maturity  Date** |   | **Interest  Rate** |   | **June 30,  2003** |    | **December 31,  2002** |   |
|---------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|--------------------|---------|------------------------|--------|
|                                                                |   |               |   |               |   |               |    |                   |   |
| Line of credit                                                      |   | May 2004           |   | LIBOR + 3.0        | %      | $                  | 13,750  |                   | $      | 25,000 |   |
|                                                                |   |               |   |               |   |               |    |                   |   |
| Notes Payable                                                       |   |               |   |               |   |               |    |                   |   |
| Senior unsecured notes,  interest-only payments semiannually        |   | May 2005           |   | 7.15               | %      | $                  | 111,000 |                   | $      | 111,000 |   |
| Variable rate certificates,  principal and interest payable monthly |   | August 2006        |   | LIBOR + 0.48       | %      | 161,655            |    | 168,220                |   |
| Senior unsecured notes,  interest-only payments semiannually        |   | August 2003        |   | 8.22               | %      | 47,500             |    | 47,500                 |   |
| Debt premium, net                                                   |   |               |   |               |   | 572                |    | 708                    |   |
| Total notes payable                                                 |   |               |   |               |   | $                  | 320,727 |                   | $      | 327,428 |   |
|                                                                |   |               |   |               |   |               |    |                   |   |
| Mortgage note payable                                               |   | June 2007          |   | 8.00               | %      | $                  | 928     |                   | $      | 946 |   |

 

In May 2002, the Company enteredinto a Credit Agreement with Bank of America (the “Credit Agreement”), throughits subsidiary USRP Funding 2002-A, L.P., for a secured revolving creditfacility of $35,000,000, which is subject to a Derivative Exposure Reserve anda Borrowing Base, as defined. Borrowings under this facility are being used primarily to acquirecertain Shoney’s and Captain D’s properties in purchase/leaseback transactions.This facility is secured by the 138 properties owned by USRP Funding 2002-A,L.P. with a net book value of $68,344,000 as of June 30, 2003.  The Credit Agreement, as originallystructured, had a term of up to two years and allows for Base Rate Loans,Eurodollar Loans or a combination of the two. Base Rate Loans bear interest at 3.0% plus the higher of the FederalFunds Rate plus 0.5% or the Prime Rate. Eurodollar Loans bear interest at 3.0% plus LIBOR.  The Credit Agreement also provides that upto $10,000,000 of the facility may be used for letters of credit.  There is a 3% fee per annum on outstandingletters of credit as well as a 3% Derivative Exposure Usage Fee under thisfacility.  As of June 30, 2003, theCompany had letters of credit outstanding and drawn under this facility in theamount of $2,511,000.  In May 2003, theCompany executed a letter agreement for a one-month extension of the originalmaturity date of the Credit Agreement to allow time to complete a fourthamendment.  In June 2003, the Companyexecuted the fourth amendment which decreased the maximum borrowing capacity to$30,000,000 effective June 30, 2003, which capacity will be further reduced,effective September 30, 2003 to $20,000,000, and which extended the maturitydate to May 31, 2004.  In addition,under the fourth amendment, the Company was granted waivers from compliance withthe second and third quarters of 2003 for two of the financial covenantsrelated to distribution limitations and leverage ratio.  All other significant terms of the CreditAgreement were unchanged.  As of June30, 2003, funds available under the Credit Agreement were approximately$11,424,000. As of August 5, 2003, funds available under the Credit Agreementwere approximately $1,264,000.

 

14

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In December 2002, a limited andtemporary waiver and amendment was executed under the Credit Agreement whichallowed the Company to borrow funds under this facility to partially financethe purchase of mortgage notes issued by Captain D’s with a face value of$12,000,000 on December 18, 2002. The Captain D’s mortgage notes bear interestat 12.5% per annum. The amount of this investment, without the waiver, wouldhave violated the limitations on investments under this facility. On June 13,2003, prior to the initial waiver period’s expiration, the Company tendered thenotes as partial consideration for the acquisition of 15 Captain D’sproperties.

 

In August 2001, the Companycompleted a $180,000,000 offering of Triple Net Lease Mortgage Certificates(the “Certificates”) through its subsidiary USRP Funding 2001-A, L.P.  The Certificates have an assumed amortizationover 15 years and are secured by 275 properties with a net book value of$191,161,000.  Under the PropertyManagement Agreement associated with these properties, certain covenants andratios must be maintained.  The Companyreceived a waiver dated December 31, 2002 on certain covenants in the Amendedand Restated Property Management Agreement. The waiver allowed Unsecured Indebtedness, as defined, to exclude the$12,000,000 of Captain D’s mortgage notes purchased in December 2002.  Prior to the June 30, 2003 expiration of thewaiver, the mortgage notes were tendered as partial consideration for theacquisition of 15 Captain D’s properties.

 

On November 13, 1998, theCompany issued $47,500,000 in senior notes in a private placement which wereoriginally scheduled to mature on August 1, 2003. On July 1, 2003, the Companyprepaid $23,750,000 of the notes.  Inconnection with this prepayment, the Company paid $813,000 in accrued interestand incurred a make-whole interest payment of $137,000.  The Company paid the remaining balance onJuly 29, 2003.

 

After receiving the waiverdiscussed above for the Credit Agreement, the Company is in compliance with allcovenants associated with its debt and credit facilities as of June 30, 2003.

 

**4.****                                      DerivativeInstruments**

 

The Company’s derivativeinstruments as of June 30, 2003 are summarized as follows (in thousands):

 
|                 |   |                   |   |         |   |                 |   | **Fixed Swap** |   |            |   |          |   | **Liability  as of** |   |
|----------------------|--------|------------------------|--------|--------------|--------|----------------------|--------|----------------|--------|-----------------|--------|---------------|--------|----------------------|--------|
| **Type**             |   | **Settlement  Period** |   | **Maturity** |   | **Notional  Amount** |   | **Rate  Paid** |   | **Floor  Paid** |   | **Cap  Rate** |   | **June 30,  2003**   |   | **December  31,  2002** |   |
| Interest rate swap   |   | Quarterly              |   | May 2003     |   | $                    | 15,000 |           | 7.0500 | %               |   |          |   |                 | $      | — |   | $ | 325 |   |
| Interest rate collar |   | Monthly                |   | August 2005  |   | 67,463               |   |           |   | 4.42            | %      | 6.00          | %      | 3,572                |   | 3,678 |   |
| Interest rate swap   |   | Monthly                |   | June 2004    |   | 25,000               |   | 2.4200         | %      |            |   |          |   | 326                  |   | 315 |   |
| Interest rate swap   |   | Monthly                |   | August 2003  |   | 50,000               |   | 1.9975         | %      |            |   |          |   | 72                   |   | 218 |   |
|                 |   |                   |   |         |   |                 |   |           |   |            |   |          |   | $                    | 3,970  |   | $ | 4,536 |   |
|                      |        |                        |        |              |        |                      |        |                |        |                 |        |               |        |                      |        |  |  |  |  |  |

 

Derivative financialinstruments are utilized by the Company to manage its exposure to market risksfrom changes in interest rates.  TheCompany’s derivative financial instruments include interest rate swaps andinterest rate collars, in which the Company receives variable payments based onan appropriate LIBOR index.

 

The Company terminated a fixed tofloating interest rate swap with Bank of America in September 2002.  Proceeds from the termination of $1,105,000were collected in October 2002.  Thegain resulting from the termination of approximately $860,000 was recorded as abasis adjustment to notes payable in the Company’s Unaudited CondensedConsolidated Balance Sheets and is being amortized over the original term ofthe derivative, through May 2005.  As ofJune 30, 2003, the remaining unamortized basis adjustment was $610,000.

** **

**5.             RelatedParty Transactions**

 

In March 2000, the Companyadvanced $400,000 to Robert J. Stetson, the Company’s Chief Executive Officer,for the purchase of common stock of the Company.  The promissory note provides for an interest rate of 7.0% perannum and quarterly payments of interest only through December 2005, with afinal payment of principal and interest due in March 2006.  This note is classified as “Loans tostockholders for common stock” in the Company’s Unaudited CondensedConsolidated Balance Sheets.  During thethird quarter of 2002, this promissory note was paid down by $125,000.  At June 30, 2003, there was a balance of$275,000 due on this note.

 

15

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Pursuant to an agreementbetween Harry O. Davis, the Company’s Chief Operating Officer, and the Board ofDirectors, in January 2002, the Company advanced Mr. Davis $24,000 for thepurpose of acquiring shares of the Company’s Common Stock.  The promissory note provides for an interestrate of 6.0% per annum and quarterly payments of interest only beginning inApril 2002 through December 2006, with a final payment of principal and allunpaid interest in January 2007.  Thisnote is classified as a “Loan to stockholders for common stock” in theCompany’s Unaudited Condensed Consolidated Balance Sheets.

 

On January 24, 2002, Lone StarU.S. Acquisitions LLC (an affiliate of the Lone Star Holders described in Note6 below), the OP, LSF 4 Acquisition, LLC and Shoney’s Inc. entered into anAgreement and Plan of Merger pursuant to which LSF 4 Acquisition, LLC wouldmerge into Shoney’s, with Shoney’s being the surviving entity.  Pursuant to the terms of the merger, whichwas consummated on April 10, 2002, all of the outstanding shares of commonstock of Shoney’s were cancelled and converted into the right to receive $0.36in cash and each outstanding membership interest in LSF 4 Acquisition, LLC(owned 90.1% by Lone Star U.S. Acquisitions and 9.9% by the OP) would beconverted into and exchanged for 100 shares of common stock of Shoney’s, as thesurviving entity in the merger.  Underthe terms of the limited liability company agreement, Lone Star Acquisitionscontributed 90.1% of the initial capital and the OP contributed 9.9% of theinitial capital to LSF 4 Acquisition, LLC. Pursuant to the terms of financing arrangements entered into inconjunction with the merger, the OP now owns 7.5% of the equity of the soleshareholder of Shoney’s.  In addition,the OP has no obligation to fund any capital requirements of the entity, otherthan its initial capital contribution. However, in December 2002, the OP did contribute an additional $892,000in order to preserve its 7.5% equity stake. In the event there is another capital call by Shoney’s and the Companychooses not to participate, no penalties would be incurred by the Company, butthe Company’s percentage ownership in Shoney’s would be diluted.  Since the merger, the Company has completedthe purchase of 66 properties from Shoney’s. The Company’s investments in Shoney’s as of June 30, 2003 consisted ofan investment in common stock of $2,384,000, mortgage loans receivable of$4,680,000 and a net book value of real estate purchased and leased back toShoney’s of approximately $48,761,000.

 

**6.             Stockholders’Equity and Minority Interests**

 

**Lone Star Holders**

 

Two stockholders of the Company(LSF3 Investments I, LLC, a Delaware limited liability company, and LSF3Investments II, LLC, a Delaware limited liability company (the “Lone StarHolders”)) owned approximately 19% of the outstanding Common Stock as of June30, 2003.

 

The Company had 19,890,689 and19,831,689 shares of common stock outstanding as of June 30, 2003 and December31, 2002, respectively.

 

**Series B Preferred**

 

On June 19, 2003, the Companyraised proceeds, net of placement fees, of $15,200,000, exclusive of certaintransaction costs, from the sale of 16,000 shares of Series B ConvertiblePreferred Stock (the “Series B Preferred”) in a private placement with certaininstitutional investors.

 

The Series B Preferred carriesan 8% dividend and is convertible into common shares at a fixed conversionprice of $16.00 per share, which represents a premium to the Company’s thencurrent market price for its common stock at the date of issuance.  The Series B Preferred has a perpetual termbut is redeemable after three years at stated value plus accrued and unpaiddividends, or in common stock based on a weighted average conversioncalculation.  The Company also grantedwarrants to the investors to purchase 206,452 shares of common stock at anexercise price of $16.50 per share.  Thewarrants have a seven-year term. The offering also included registrationrights, which require the Company to file a “shelf” registration statement toregister the resale of the underlying common stock on or prior to August 18,2003.

 

The offering also included atwelve-month option for the institutional investors to invest an additional$4,000,000 in stated value Series B Preferred under the same terms as theinitial investment, with certain conversion price adjustments for the thencurrent market price for the Company’s common stock.

 

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Management evaluated the SeriesB Preferred for appropriate classification in the balance sheet.  Management concluded that the Series BPreferred is neither mandatorily redeemable, as defined in SFAS No. 150, nordoes it embody an unconditional obligation to transfer equity shares of theCompany.  The Series B Preferred doescontain conditional obligations to redeem in cash or shares, but the conditionsor events are not certain to occur at June 30, 2003.  Accordingly, the Series B Preferred does not fall under the scopeof SFAS No. 150 at this time.

 

Since the Series B Preferred isoutside the scope of SFAS No. 150, management evaluated the requirements ofEITF D-98, “Classification and Measurement of Preferred Securities,” todetermine if the securities should be classified as permanent equity.  As none of the redemption requirements of thesecurities are outside the control of the Company, management concluded thatthe Series B Preferred should be classified as equity as of June 30, 2003.

 

**Distributions to Common and PreferredStockholders**

 

During the six months endedJune 30, 2003, the Company declared distributions of $13,106,000 to its commonstockholders (or $0.66 per share of Common Stock), and $3,551,000 to its SeriesA preferred stockholders (or $0.965 per share of Series A PreferredStock).  The Company also declared apro-rated distribution from the date of issuance to June 30, 2003, of $39,000to its Series B preferred shareholders. During the six months ended June 30, 2002, the Company changed itsdeclaration date for its common stock dividends from the last working day ofthe previous period to the first of every period.  During the six months ended June 30, 2002, the Company declareddistributions of $10,758,000 to its common stockholders (or $0.55 per share ofCommon Stock) and $1,775,000 to its Series A preferred stockholders (or $0.4825per share of Series A Preferred Stock).

 

**Minority Interests**

 

During 1999, the Company issued$55,000,000 of 8.5% preferred interest in USRP/HCI Partnership 1, L.P. (“HJV”)to a third party for net proceeds of $52,793,000.  Under the terms of this transaction, the preferred interest holderreceives annual distributions equal to $4,675,000, payable monthly from thecash flows of HJV.  Income is allocatedto the preferred interest holder equal to their distribution.  The Company may be required from time totime to exchange Propeties that do not meet specified criteria as defined inthe partnership agreement.  During 2001,the HJV preferred interest holder contributed $52,000 to the OP.  This interest held by the third party isreflected as Minority Interest in the Company’s Unaudited CondensedConsolidated Balance Sheets.

 

**7.             SegmentInformation**

 

Effective April 2001, with theformation of FSI, a wholly-owned subsidiary of the Company, and thecommencement of retail operations, the Company began operating two segments,real estate and retail.  Operatingsegments are defined as components of an enterprise for which separatefinancial information is available that is evaluated by the chief operatingdecision maker(s) in deciding how to allocate resources and in assessingperformance.

 

*Real Estate.*  Real estate activities are comprised ofacquisition, property management and development operations and relatedbusiness objectives.  The Companyderives its real estate revenues from rental income received on its 801 brandedchain restaurants and service station properties located throughout 48 states.

 

*Retail*. Revenuesfrom this segment are generated from the sales of gasoline and conveniencestore merchandise, and food sales at restaurants operated by the Company.  At June 30, 2003, FSI operated eight servicestations in Texas, eight in Hawaii, one in California and one in Illinois,along with two restaurants, one in Texas and one in Kansas.  In January 2002, FSI commenced utilizing afuel terminal in Hawaii to store fuel distributed to its Hawaii servicestations.  At June 30, 2003, in additionto the service stations currently operated, FSI sold fuel to seven servicestations in Hawaii, three in Texas and two in Illinois.

 

*Intersegment Charges. *Intersegmentcharges are eliminated in consolidation and primarily include the costs of rentand interest.  The Retail segment paysrent to the Real Estate segment for lease of certain the properties that itoperates.  Interest is also paid by theRetail segment to the Real Estate segment. Interest is charged at an annual rate of 9.5% on intercompany balancesas well as on a note established on January 1, 2002 for the sale of the Hawaiifuel terminal to FSI.  Intercompanybalances represent primarily the cash advances made by the Real Estate segmentto the Retail segment to fund its operations.

 

The following presents theCompany’s reportable amounts by segment as of and for the six months ended June30, 2003 and 2002 (in thousands):

 

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| **2003**                                                                                                    |   | **Real Estate** |    | **Retail** |   | **Intercompany** |   | **Consolidated** |    |
|-------------------------------------------------------------------------------------------------------------|--------|-----------------|---------|------------|--------|------------------|--------|------------------|---------|
| Real estate rental                                                                                          |   | $               | 31,254  |       | $      | —           |   | $                | (622    | ) | $ | 30,632 |   |
| Retail operations                                                                                           |   | —          |    | 28,743     |   | —           |   | 28,743           |    |
| Interest on real estate loans  and tenant expense reimbursements                                            |   | 4,227           |    | —     |   | (718             | )      | 3,509            |    |
| Lease termination fees                                                                                      |   | 2,058           |    | —     |   | —           |   | 2,058            |    |
| Total revenues                                                                                              |   | 37,539          |    | 28,743     |   | (1,340           | )      | 64,942           |    |
| Interest expense                                                                                            |   | (11,090         | )       | (718       | )      | 718              |   | (11,090          | )       |
| Depreciation and amortization  (1)                                                                          |   | (10,701         | )       | (197       | )      | —           |   | (10,898          | )       |
| Retail cost of sales                                                                                        |   | —          |    | (24,773    | )      | —           |   | (24,773          | )       |
| Other expenses, net                                                                                         |   | (9,847          | )       | (4,460     | )      | 622              |   | (13,685          | )       |
| Income (loss) from continuing  operations before discontinued operations and change in accounting principle |   | 5,901           |    | (1,405     | )      | —           |   | 4,496            |    |
| Income from discontinued  operations                                                                        |   | 6,477           |    | —     |   | —           |   | 6,477            |    |
| Change in accounting principle                                                                              |   | (270            | )       | —     |   | —           |   | (270             | )       |
| Net income (loss)                                                                                           |   | $               | 12,108  |       | $      | (1,405           | )      | $                | —  |   | $ | 10,703 |   |
|                                                                                                        |   |            |    |       |   |             |   |             |    |   |   |   |   |
| Identifiable assets                                                                                         |   | $               | 542,009 |       | $      | 13,160           |   | $                | (15,298 | ) | $ | 540,000 |   |
| Cash allocable to segments                                                                                  |   | 29,784          |    | 1,377      |   | —           |   | 31,161           |    |
| Total assets                                                                                                |   | $               | 571,793 |       | $      | 14,537           |   | $                | (15,298 | ) | $ | 571,161 |   |

 
| **2002**                                                                 |   | **Real Estate** |    | **Retail** |   | **Intercompany** |   | **Consolidated** |   |
|--------------------------------------------------------------------------|--------|-----------------|---------|------------|--------|------------------|--------|------------------|--------|
| Real estate rental                                                       |   | $               | 31,658  |       | $      | —           |   | $                | (607   | ) | $ | 31,051 |   |
| Retail operations                                                        |   | —          |    | 17,217     |   | —           |   | 17,217           |   |
| Interest on real estate loans  and tenant expense reimbursements         |   | 3,411           |    | —     |   | (382             | )      | 3,029            |   |
| Lease termination fees                                                   |   | 217             |    | —     |   | —           |   | 217              |   |
| Total revenues                                                           |   | 35,286          |    | 17,217     |   | (989             | )      | 51,514           |   |
| Interest expense                                                         |   | (11,097         | )       | (382       | )      | 382              |   | (11,097          | )      |
| Depreciation and amortization  (1)                                       |   | (10,418         | )       | (17        | )      | —           |   | (10,435          | )      |
| Retail cost of sales                                                     |   | —          |    | (14,394    | )      | —           |   | (14,394          | )      |
| Other expenses, net                                                      |   | (8,670          | )       | (3,233     | )      | 607              |   | (11,296          | )      |
| Income (loss) from continuing  operations before discontinued operations |   | 5,101           |    | (809       | )      | —           |   | 4,292            |   |
| Income from discontinued  operations                                     |   | 926             |    | —     |   | —           |   | 926              |   |
| Net income (loss)                                                        |   | $               | 6,027   |       | $      | (809             | )      | $                | — |   | $ | 5,218 |   |
|                                                                     |   |            |    |       |   |             |   |             |   |   |   |   |   |
| Identifiable assets                                                      |   | $               | 555,766 |       | $      | 966              |   | $                | (7,136 | ) | $ | 549,596 |   |
| Cash allocable to segments                                               |   | 7,937           |    | 1,377      |   | —           |   | 9,314            |   |
| Total assets                                                             |   | $               | 563,703 |       | $      | 2,343            |   | $                | (7,136 | ) | $ | 558,910 |   |

 

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(1)            Retaildepreciation and amortization expense for the three months ended June 30, 2003and 2002 is $120,000 and $7,000, respectively.

 

**8.             Changein Accounting Principle**

 

On January 1, 2003, the Companyadopted SFAS No. 143, “Accounting for Asset Retirement Obligations.”  This Statement addresses financialaccounting and reporting for obligations associated with the retirement oftangible long-lived assets and the associated asset retirement costs.  As a result of adopting SFAS No. 143, theCompany capitalized net asset retirement costs of $325,000, recorded assetretirement obligations of $595,000 and recorded a cumulative effect of changein accounting principle of $270,000 on January 1, 2003.  The retirement obligations recorded relateto the estimated future costs for the removal of tanks, fuel lines and otherrequired modifications to the Company’s gas stations.  The Company recognized $21,000 in accretion expense for theproperties with asset retirement obligations related to the six months endedJune 30, 2003.

 

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**9.             SignificantTenant Negotiations and Legal Proceedings**

 

**Fina**

In February 2002, the leaseholdlender of 51 Fina stations in the Dallas/Ft. Worth area assumed the defaultingtenant’s interest in the lease and took over operations from the bankrupttenant.  Since the lease assumption, allpost-assumption rent was collected by the Company.  As of December 31, 2002, there was $2,564,000 owed to the Companyunder the leases, representing pre-assumption property taxes, for which theCompany had reserved $792,000. Effective in February 2003, the Company enteredinto a lease termination agreement and received a lease termination fee of$3,400,000, a portion of which was applied to outstanding receivable balances,with the remaining $1,715,000 recorded as revenue.  The Company also, through its subsidiary FSI, purchased equipmentfor approximately $2,200,000, gas and convenience store inventory from thetenant at an agreed-upon cost of $2,941,000, and took over the operation of 25of these Fina stations.  The remaining26 properties were temporarily closed. As of June 30, 2003, 25 stations (14 formerly operated by the Companyand eleven others) had been re-leased, 10 other stations (three formerlyoperated by the Company and seven others) had been sold and four leaseholdproperties were returned to the property owners.  Of the remaining 12, nine are fee-owned and three are leaseholds.  Of the nine fee properties, FSI is operatingthree and six are vacant.  FSI is alsooperating the remaining three leaseholds. During the six months ended June 30,2003, impairment charges of $973,000 were recorded from revaluing 14 Finastations to their estimated fair value.

 

**Alon USA, L.P.**

During the first quarter of2003, the Company filed a lawsuit against Alon USA, L.P. (“Alon”), the owner ofthe Fina brand.  The Company terminatedthe tenant’s leasehold interest during February 2003 for 51 Fina service stations,and immediately closed 26 of them.  Aloncounter-claimed against the Company, alleging that these gas stations must becontinuously operated selling Fina branded gasoline pursuant to a BrandingAssurance Agreement it allegedly entered into with the Company.  The Company's suit maintains that theBranding Assurance Agreement only required open and operating stations toremain under the Fina brand during the Company's ownership period, and that theCompany had a right to sell the properties for other than Fina branded gasolinestations.  The Company disputes Alon'sposition and has not reopened several of the stations, has sold four stationsfor other than a Fina branded gasoline station and contemplates selling otherstations for possible uses other than as Fina branded gasoline stations.  If Alon’s position is upheld, the Company’sability to sell or lease these gas stations could be impaired and the Companycould be liable for damages.  It is notpossible to predict the outcome of the litigation or to estimate thepossibility of damages at this time.

 

**Lyon’s of California**

At June 30, 2003, the Companyhad $2,919,000 of mortgage notes receivable due from Lyon’s of California, Inc.(“Lyons”).  These notes are secured bycertain Lyons restaurant properties and are partially guaranteed by ICH Corporation(“ICH”), the former owner of Lyons.  AtJune 30, 2003, the Company had $102,000 of notes receivable due from ICH.  Sybra, Inc. (“Sybra”), a former wholly-ownedsubsidiary of ICH, is the lessee of 58 of the Company’s Arby’s restaurants,making it the Company’s largest tenant.

 

Due to the 2001 Lyons and ICHbankruptcy filings, the Company recorded an allowance for doubtful accounts of$2,500,000 and $275,000 on the balances due from Lyons and ICH, respectively,during the year ended December 31, 2001. Interest income associated with thesenotes has not been recognized since September 2001.  All of these notes are valued based on the estimated fair valueof the collateral, as collateral disposal is the only means through which theCompany will collect proceeds.  Sincethe inceptions of the notes, through June 30, 2003, the Company has received$6,906,000 in proceeds from the liquidation of this collateral, including$3,612,000 in April 2003, which is primarily associated with the ICHguarantee.  As a result of these events,the fair value of the collateral supporting these notes has become morecertain.  The allowance on the Lyonsnotes was reduced from $2,500,000 to $583,000 during the year ended December31, 2002.  The Company further reducedthe allowance on the Lyons notes by $317,000 during the three months endedMarch 31, 2003.  During the three monthsended June 30, 2003, the allowance was reduced by $216,000 as the result of anevaluation of collections and the remaining amount due. The allowanceassociated with the ICH note as of June 30, 2003 was $102,000, the amount ofthe unsecured note receivable.

 

**Embers**

During 2002, a significanttenant/mortgagee, Embers, experienced financial difficulty and the Companyexecuted a workout agreement whereby the tenant would sell all of its realestate (including those fee properties owned by the Company that were leased tothe tenant) and remit all net proceeds to the Company until 100% of all notes,accrued interest, real estate taxes, rent receivables, late fees and othercosts have been recovered.  Interestincome associated with these notes has not been recognized since December2002.  During 2002, the Company receivedapproximately $1.5 million of cash from these sale transactions to partiallyrepay its mortgage notes.  During 2003,the Company

 

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received $1.9 million in cashfrom the sale of three of its fee-owned properties, and recognized a gain onsale of $839,000.  Each quarter, theCompany individually evaluates all of its mortgage notes and real estateassociated with this tenant to determine if any asset has been impaired.  As a result of this evaluation, a $200,000impairment was recorded on two fee-owned properties during the first quarter of2003.  At June 30, 2003, the Company hadmortgage notes receivable of $2,565,000, net book value of real estate andequipment of $1,378,000 and rent receivables and other assets of $854,000related to Embers.

 

Prior to 2001, the Company losta case at the trial court level. After the judgment of specific performance wasentered against the Company for a total of $550,000, plus interest andattorneys’ fees, USRP posted a $783,000 bond and appealed the damage award ofthe trial court, arguing that the court provided erroneous instructions as tothe measure of damages and improperly excluded the Company’s expertwitness.  USRP accrued $425,000 for thiscase, based on the amount of the judgement, less the underlying value of thenotes receivable which the Company would be required to purchase if the verdictwas ultimately upheld.  USRP prevailedon appeal and the judgment was reversed and remanded for a new trial.  The same judge who presided over the initialtrial also presided over the retrial. A verdict was again issued against theCompany.  The case is currently onappeal with the Supreme Court of Texas, which has requested a response from theplaintiff.   The Petition is currentlypending.  At this time, management andmanagement’s counsel cannot determine the likely outcome; however, the Companybelieves it will prevail at the Supreme Court level.  Management intends to vigorously defend this action. 

 

**Item2****.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

Management’s discussion andanalysis of financial condition and results of operations are based upon theCompany’s consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation of theseconsolidated financial statements requires management of the Company to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities.  On a regular basis,the Company evaluates these estimates, including asset impairment and provisionfor doubtful accounts.  These estimatesare based on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances.  Actual results may differ from these estimates.

 

**Results of Operations**

** **

Real estate rental revenues arederived primarily from leasing the Company’s properties (primarily brandedchain restaurants) to operators on a “triple net” basis.  Triple net leases typically require thetenants to be responsible for property operating costs, including propertytaxes, insurance, maintenance, and in most cases, the ground rents whereapplicable.  Approximately 45% of theCompany’s leases provide for a base rent plus a percentage of the sales inexcess of a threshold amount.  As aresult, portions of the Company’s revenues are a function of the number ofproperties in operation and their level of sales.  Sales at individual properties are influenced by local marketconditions, the efforts of specific operators, marketing, new product programs,support of the franchisor and the general state of the economy.

 

***Comparison of the three months endedJune 30, 2003 to the three months ended June 30, 2002***

 

**Revenues**

Revenues from real estateproperties consist of rental revenues, tenant expense reimbursements, leaseterminations and interest on real estate loans.  Revenue from retail operations is derived primarily from serviceproperties operated by the Company, including service stations and car washes,as well as from convenience store sales.   For the three months ended June 30, 2003, revenues increased $5,673,000,or 20.83%, to $32,919,000 compared to the corresponding prior year period.  The increase is primarily attributable tothe following:

 

•                  an increase of$5,475,000, or 54.7%, to $15,476,000, in retail operations compared to thecorresponding prior year period due to increased volumes for store sales and agreater number of service stations the Company operated during the quarter,including the remaining unsold Fina stores, which the Company began operatingafter a lease termination in February 2003. The nature of the Company’s retail operations has been that there are arelatively high number of ownership changes, as well as numerous acquisitionsand dispositions, making it difficult to utilize a same store measure thatpresents meaningful information.  As aresult, one measure of store performance utilized by the Company relates to thenumber of months that the stores are open for business in each period.  For the three months ended June 30, 2003,there were 116 open store months based on an average of 39 stores open duringthat period, compared to 107 open store months based on an average of 36 storesopen during the same prior year period;

•                  $581,000 inlease termination fees due primarily to leases with two tenants; and

•                  an increase of$192,000, or 27.7%, in interest on real estate loans, due primarily to theCaptain D’s mortgage notes purchased in December 2002.  These notes, totaling approximately$12,000,000, were  tendered  on June 13, 2003, as partial considerationon the acquisition of Captain D’s real estate.

 

These increases were partially offset by a decrease of $575,000, or3.7%, in rental revenues due primarily to:

•     a decrease of $346,000, or 2.2%, in base rents dueto an increase in the number of vacant non-billable properties by 23 to 78, ascompared to 55 at June 30, 2002; and

•      a decrease of $229,000 in percentage rentsof which $412,000 is attributable to lower sales at Burger King units, offsetpartially by a $183,000 increase in percentage rents due to a prior year tenantsales audit.

 

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**Expenses**

Expenses increased $4,804,000,or 19.5%, to $29,418,000 for the three months ended June 30, 2003 compared tothe corresponding prior year period. The increase was primarily attributable to the following:

 

•      an increase of $4,542,000, or 53.7%, to$13,006,000 in retail cost of sales due to increased volumes and to theinclusion of operations of the remaining unsold Fina stores, which the Companybegan operating after a lease termination in February 2003. The increasedvolumes resulted from an increase to 39 stores operated from 36 in the sameprior year period and from an increase to 116 months open from 107 in the sameprior year period;

•      an increase of $575,000 in general andadministrative expenses primarily due to higher state tax expense and highercompensation costs, due in part to expenses associated with the Fina resultswhich were not present in the prior year; and

•      an increase of $405,000, or 116.7%, to$752,000 in impairments of long-lived assets due to the revaluing of fiveassets to their estimated fair value; partially offset by

 

•      a decrease of $336,000, or 53.3%, to$295,000 in legal expenses due to fewer legal proceedings for tenant work-outsand management’s efforts to monitor and reduce tenant-related legal costs;

•      a decrease of $243,000, or 4.4%, to$5,303,000 in depreciation and amortization due primarily to higherdepreciation related to a catch-up in depreciation expense in the 2002 secondquarter when certain properties were reclassified out of the Assets Held forSale category in accordance with SFAS No. 144;
    - a net decrease of $115,000, or 2.1%, to     $5,461,000 in interest expense due to:

•                  $192,000increase to $615,000 in amortization of deferred financing costs related to therevolving credit facility into which the Company entered on May 31, 2002;

•                  $169,000 increaseto $85,000 for the fair value adjustment for interest rate derivatives;

•                  $269,000decrease for derivative settlement payments;

•                  $207,000decrease in interest expense due to a lower overall notes payable balanceoutstanding, as well as lower interest rates in 2003 compared to 2002; and

•      a net decrease of $24,000, or 2.1%, to$1,141,000 in various accounts mostly attributable to:

•      $42,000 decrease related to lowerprovision for doubtful accounts for certain tenants (see "Status ofFinancially Troubled Tenants" below for additional information); partiallyoffset by 

•      $24,000 increase due to higher ground rentexpense.

 

Gains on sale of property forthe three months ended June 30, 2003 was $5,085,000 and was due to the sale ordisposal of 30 properties, compared to a loss on sale of $206,000 for the threemonths ended June 30, 2002, which related to the sale or disposal of tenproperties. These sales are reflected in the Company’s Unaudited CondensedConsolidated Statements of Operations as “Income (loss) from discontinuedoperations” in accordance with the requirements of SFAS No. 144.

 

Income (loss) from discontinuedoperations was $5,171,000 for the three months ended June 30, 2003. Inaccordance with SFAS No. 144, discontinued operations represent the operationsof properties disposed of, as well as any gain or loss recognized on theirdisposition. The operating results relate to the sale or disposal of 37properties during the six months ended June 30, 2003 and 46 properties duringthe twelve months ended December 31, 2002 and is reflected in the Company'sUnaudited Condensed Consolidated Statements of Operations as "Income(loss) from discontinued operations."

 

*Comparison of the six months ended June 30, 2003 tothe six months ended June 30, 2002*

 

**Revenues**

Revenues from real estateproperties, consist of rental revenues, tenant expense reimbursements, leasetermination fees and interest on real estate loans.  Revenue from retail operations is derived primarily from serviceproperties operated by the Company, including service stations and car washes,as well as from convenience store sales. For the six months ended June 30, 2003, revenues increased $13,428,000,or 26.1%, to $64,942,000 compared to the corresponding prior year period.  The increase is primarily attributable tothe following:

 

•      an increase of $11,526,000, or 67%, to$28,743,000 in retail operations compared to the corresponding prior yearperiod due to increased volumes for store sales and a greater number of servicestations the Company operated, including the results of operations of theremaining unsold Fina stores, which the Company began operating after a leasetermination in February 2003. The nature of the Company’s retail 

 

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operations hasbeen that there are a relatively high number of ownership changes, as well asnumerous acquisitions and dispositions, making it difficult to utilize a samestore measure that presents meaningful information.  As a result, one measure of store performance utilized by theCompany relates to the number of months that the stores are open for businessin each period.  For the six monthsended June 30, 2003, there were 228 open store months based on an average of 38stores open during that period, compared to 186 open store months based on anaverage of 31 stores open during the same prior year period;

•      an increase of $1,841,000 in leasetermination fees due primarily to the termination of the lease of the Finastations in the Dallas/Ft. Worth area in February 2002;

•      an increase of $463,000, or 35.3%, ininterest on real estate loans, due primarily to the Captain D’s mortgage notesof $12,000,000 purchased in December 2002, which the Company tendered on June13, 2003, as partial consideration on the second quarter acquisition of 15Captain D’s properties; and

•      an increase of $17,000 in operatingexpense reimbursements, primarily due to a 23-property increase in the numberof vacant non-billable properties as of June 30, 2003 to 78, as compared to 55at June 30, 2002.

 

Theseincreases were partially offset by a decrease of $575,000, or 3.7%, in rentalrevenues primarily attributable to:

•      a decrease of $346,000, or 2.2%, in baserents due to an increase in the number of non-billable properties by 23 to 78,as compared to 55 at June 30, 2002; and

•      a $229,000 decrease in percentage rents(rents determined as a percentage of tenant sales), of which a $412,000decrease is attributable to lower sales at Burger King units; partially offsetby 

•      a $183,000 increase resulting from a prioryear tenant sales audit.

** **

**Expenses**

Expenses increased $12,623,000,or 27.7%, to $58,130,000 for the six months ended June 30, 2003 compared to thecorresponding prior year period.  Theincrease was primarily attributable to the following:

•      an increase of $10,739,000, or 72.1%, to$24,773,000 in retail cost of sales due to increased volumes for and to theinclusion of operations of the remaining unsold Fina stores, which the Companybegan operating after a lease termination in February 2003. The increasedvolumes resulted from an increase to 38 stores operated from 31 in the sameprior year period and from an increase to 228 months open from 186 in the sameprior year period;

•      an increase of $1,212,000, or 46.2%, inRetail general and administrative expenses due primarily to higher salaries,property taxes and insurance as a reuslt of the increased number of storesopen.

•      an increase of $1,086,000, or 207.7%, to$1,609,000 in impairments of long-lived assets due to the revaluing of 19assets, of which 11 were Fina stations, to their estimated fair value; and

•      an increase of $463,000, or 4.4%, to$10,898,000 in depreciation and amortization related to a catch-up indepreciation expense in the 2002 second quarter when certain properties werereclassified out of the Assets Held for Sale category in accordance with SFASNo. 144.

 

Theseincreases were partially offset by a decrease of $432,000, or 43.4%, to$563,000 in legal expenses due to fewer legal proceedings involved with tenantwork-outs and the concerted effort of the Company to reduce tenant-relatedcosts.

 

Retail operations areadministered by Fuel Supply, Inc. ("FSI"), a wholly-owned subsidiaryof USRP Holding Corp. ("Holding"). Holding is a taxable REIT subsidiary of U.S. Restaurant Properties,Inc.  FSI has incurred net operatinglosses (“NOLs”) since inception.  TheCompany recognized a deferred tax benefit in 2002 of approximately $102,000associated with these NOLs, which management believes may be used to offset anyUSRP (S&C), LLC and USRP (Hawaii), LLC taxable income.

 

Gain on sale of property forthe six months ended June 30, 2003 and 2002 was $6,704,000 and $1,274,000,respectively, and was due to the sale or disposal of 37 and 17 properties,respectively.  These gains are reflectedin

 

22

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the Company’s UnauditedCondensed Consolidated Statements of Operations as “Income (loss) fromdiscontinued operations” in accordance with the requirements of SFAS No. 144.

 

Income from discontinuedoperations was $6,477,000 for the six months ended June 30, 2003.  In accordance with the requirements of SFASNo. 144, discontinued operations represent the operations of propertiesdisposed of as well as any gain or loss recognized on their disposition.  The operating results relate to the sale ordisposal of 37 properties during the six months ended June 30, 2003, and arereflected in the Company’s Unaudited Condensed Consolidated Statements of Operationsas  “Income (loss) from discontinuedoperations.”

 

Minority interests in earningswere $2,337,000 and $2,349,000 for the six months ended June 30, 2003 and 2002,respectively, and related primarily to the Company’s minority interest in HJV,which was formed in October 1999.

 

Non-operating income was$21,000 and $634,000 for the six months ended June 30, 2003 and 2002,respectively.  The decrease is primarilydue to lower interest income resulting from the Company’s liquidation of itstrading securities during 2002 and to gains on sale of securities in 2002.

 

On January 1, 2003, the Companyadopted SFAS No. 143, “Accounting for Asset Retirement Obligations.”  This Statement addresses financialaccounting and reporting for obligations associated with the retirement of tangiblelong-lived assets and the associated asset retirement costs.  As a result of adopting SFAS No. 143, theCompany recorded a $270,000 charge in the Company’s Unaudited CondensedConsolidated Statements of Operations as “Cumulative effect of change inaccounting principle” on January 1, 2003. The retirement obligations recorded relate to the estimated future costsfor the removal of tanks, fuel lines and other required modifications to theCompany’s gas stations.

 

23

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**Liquidity and Capital Resources**

 

CASH FLOWS

 
| **(in thousands)**                             |   | **For the six  months ended  June 30, 2003** |   |
|------------------------------------------------|--------|----------------------------------------------|--------|
|                                           |   |                                         |   |
| Cash flows from operating activities           |   | $                                            | 21,061 |   |
| Cash flows from investing activities           |   | 26,686                                       |   |
| Cash flows from financing activities           |   | (20,978                                      | )      |
|                                           |   |                                         |   |
| Increase in cash and cash equivalents          |   | $                                            | 26,769 |   |
| Cash and cash equivalents, beginning of period |   | 4,392                                        |   |
|                                           |   |                                         |   |
| Cash and cash equivalents, end of period       |   | $                                            | 31,161 |   |

 

OPERATING ACTIVITIES

The Company’s principal sourcesof cash to meet its working capital and dividend requirements are rentalrevenues generated by the Company’s properties and operating revenues from theCompany’s retail segment.

 

Cash flows from operatingactivities of $21,061,000 is attributable to the real estate and retailoperations.

 

INVESTING ACTIVITIES

Cash generated in excess ofoperating requirements and dividend payments is generally used to acquireadditional properties or to reduce amounts outstanding under the Company’scredit agreement. 

 

The Company’s cash flows frominvesting activities of $26,686,000 is primarily attributable to:

 

•                  $21,062,000 ofnet proceeds from property sales;

•                  $8,998,000resulting from a decrease in mortgage loans receivable; and

•                  $1,114,000resulting from a decrease in notes receivable as a result of payments received.

 

The cash flows from investingactivities is partially offset by:

 

•                  $3,923,000 foracquisition of rental properties, machinery and equipment; and

•                  $679,000increase in restricted cash and marketable securities, of which $590,000 isattributable to restricted cash resulting from $390,000 collateralizing two letters of credit and  $200,000 attributable to escrow deposits.The remaining $89,000 increase is due to additional marketable securities.

 

FINANCING ACTIVITIES

Cash generated in excess ofoperating requirements and dividend payments is generally used to reduceamounts outstanding under the Company’s credit agreements or to acquireadditional properties.

 

The Company’s cash flows fromfinancing activities of $20,978,000 is attributable to:

 

•                  $15,700,000 ofproceeds from borrowings under the Company’sline of credit; and

•                  $15,200,000, netof placement fees of approximately $800,000, of proceeds from the Series Bconvertible preferred stock offering and the Series B warrants.

 

24

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The Company’s cash flows fromfinancing activities was partially offset by:

 

•                  $13,106,000 inCommon Stock dividends;

•                  $6,583,000resulting from a decrease in notes payable, primarily due to payments on theCompany’s variable rate certificates for which principal and interest arepayable monthly;

•                  $3,551,000 inPreferred Stock dividends;

•                  $26,950,000 ofpayments under the Company’s line of credit; and

•                  $2,337,000 indistributions to minority interest stockholders.

 

LIQUIDITY REQUIREMENTS

As of June 30, 2003, theCompany expects to spend approximately $339,000 during the remainder of 2003 torenovate and remodel currently owned properties. The Company expects to meetits short-term liquidity requirements consisting of normal recurring operatingexpenses, debt service requirements, property improvements and distributions tostockholders primarily through cash flow provided from real estate and retailoperations.  To the extent that theCompany’s cash flow from real estate and retail operating activities is notsufficient to finance such short-term liquidity requirements, the Company mayutilize its credit facility.  As of June30, 2003, the Company’s funds availability under the credit facility was$11,424,000.  As of August 5, 2003, theCompany’s funds availability under the credit facility was $1,264,000. TheCompany’s long-term liquidity requirements as of June 30, 2003 consistsprimarily of debt maturing after June 30, 2003, which totaled approximately$272,655,000. The Company expects to meet these long-term liquidityrequirements primarily through long-term secured and unsecured borrowings andother debt and equity financing alternatives as well as cash proceeds receivedfrom the sale of properties.

 

On July 1, 2003, the Companypaid $23,750,000 of the $47,500,000 senior unsecured note balance.  On July 29, 2003, the remaining balance ofthe senior unsecured note was paid in full.

 

*Status of Financially Troubled Tenants*

 

**Gant Acquisition, LLC**

During June 2001, the Companywas notified that one of its tenants had filed for protection under Chapter 11of the Bankruptcy Code of the United States (the “Bankruptcy Code”).  Gant Acquisition LLC (“Gant”), which leased27****servicestations in North Carolina under a Master Lease with the Company, filed forChapter 11 bankruptcy on May 21, 2001. Annual rent from all 27 properties is approximately $1,288,000.  At June 30, 2003, there was approximately$240,000 of receivables due from this tenant on all 27 properties and the Companyhad reserved $31,000 for these amounts.****The Bankruptcy Court has severed theMaster Lease between Gant and the Company, permitting Gant to reject 12 of theproperties subject to the Master Lease while continuing to pay rent on theremaining 15 properties.  The Companyappealed this ruling in May 2002.  TheBankruptcy Court’s ruling was upheld by the District Court in March 2003.  The Company is now appealing this ruling tothe Fourth Circuit Court of Appeals. Depending on the outcome of this appeal, which is anticipated to beruled upon in the latter part of 2003, the remaining 12 properties will eitherbe sold, with all proceeds payable to the Company, or Gant will be responsiblefor all back rent due. Gant continues to pay rent on 15 of the 27 properties.

 

**Lyon’s of California, Inc.**

During 2002, the Company wasnotified that ICH, the guarantor on the Lyons notes, had filed for protectionunder Chapter 11 of the bankruptcy code, along with its former wholly-ownedsubsidiary, Sybra.  At the time of filing,Sybra was the Company’s largest tenant and is currently leasing 58 of theCompany’s Arby’s restaurants. Subsequent to the filing, all post-bankruptcy rent continued to be paidby Sybra.

 

In December 2002, pursuant to aPlan of Reorganization approved by the United States Bankruptcy Court, Sybrawas acquired by a wholly-owned subsidiary of Triarc Companies, Inc.(“Triarc”).  This subsidiary assumed allof the Company’s Sybra leases and is now the Company’s largest tenant.  The Bankruptcy Court, in accepting thesubsidiary’s purchase of Sybra, required that the proceeds from the purchase beplaced in escrow with the Court for the benefit of the unsecuredcreditors.  Through June 30, 2003, theCompany has received $6,906,000 in proceeds, including $3,612,000 in April2003, which is primarily associated with the ICH guarantee.

 

25

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Due to the relationship amongICH, Lyons and Sybra, the proceeds received by the Company related to the Planof Reorganization of ICH and Sybra are considered in the collateral valueanalysis of the Lyons mortgage notes. Although the amount of recoverability on the Lyons notes is an estimateand is subject to change, the Company expects to recover substantially more ofthe original principal balance than originally estimated because the fair valueof the collateral has become more certain over time.  Taking this into consideration, during March 2003 the Companyreduced the allowance on the Lyons notes by $317,000.  During the three months ended June 30, 2003, the allowance wasreduced by $216,000 as the result of an evaluation of collections and theremaining amount due. The allowance associated with the ICH note as of June 30,2003 was $102,000, the amount of the unsecured note receivable.

 

**Fina**

In February 2002, the leaseholdlender of 51 Fina stations in the Dallas/Ft. Worth area assumed the defaultingtenant’s interest in the lease and took over operations from the bankrupttenant.  Since the lease assumption, allpost-assumption rent has been collected by the Company.  As of December 31, 2002, there was$2,564,000 owed to the Company under the leases, representing pre-assumptionproperty taxes, for which the Company had reserved $792,000. Effective inFebruary 2003, the Company entered into a lease termination agreement andreceived a lease termination fee of $3,400,000, a portion of which was appliedto outstanding receivable balances, with the remaining $1,715,000 recorded asrevenue.  The Company also, through itssubsidiary FSI, purchased equipment for approximately $2,200,000, gas andconvenience store inventory from the tenant at an agreed-upon cost of$2,941,000, and took over the operation of 25 of these Fina stations.  The remaining 26 properties were temporarilyclosed.  As of June 30, 2003, 25stations (14 formerly operated by the Company and eleven others) had beenre-leased, 10 other stations (three formerly operated by the Company and sevenothers) had been sold and four leasehold properties were returned to the propertyowners. Of the remaining 12, nine are fee-owned and three are leaseholds.  Of the nine fee properties, FSI is operatingthree and six are vacant.  FSI is alsooperating the remaining three leaseholds. During the six months ended June 30,2003, impairment charges of $973,000 were recorded from revaluing 14 Finastations to their estimated fair value.

 

**Alon USA, L.P.**

During the first quarter of2003, the Company filed a lawsuit against Alon USA, L.P. (“Alon”), the owner ofthe Fina brand.  The Company terminatedthe tenant’s leasehold interest during February 2003 for 51 Fina servicestations, and immediately closed 26 of them. Alon counter-claimed against the Company, alleging that these gasstations must be continuously operated selling Fina branded gasoline pursuantto a Branding Assurance Agreement it allegedly entered into with theCompany.  The Company's suit maintainsthat the Branding Assurance Agreement only required open and operating stationsto remain under the Fina brand during the Company's ownership period, and thatthe Company had a right to sell the properties for other than Fina brandedgasoline stations.  The Company disputesAlon's position and has not reopened several of the stations, has sold fourstations for other than a Fina branded gasoline station and contemplatesselling other stations for possible uses other than as Fina branded gasolinestations.  If Alon’s position is upheld,the Company’s ability to sell or lease these gas stations could be impaired andthe Company could be liable for damages. It is not possible to predict the outcome of the litigation or toestimate the possibility of damages at this time.

 

**Ameriking**

In December 2002, the Companywas notified that one of its tenants, Ameriking, which leases 12 Burger Kingproperties, had filed for protection under Chapter 11 of the BankruptcyCode.  As of June 30, 2003, Amerikingowed the Company approximately $147,000 for which a reserve of $32,000 has beenestablished.  The 12 properties have anet book value of approximately $5,800,000 and the annual rent on theseproperties is approximately $1,000,000. Ameriking has rejected four of the 12 leases.  In April 2003, one of eight properties still subject to the leasewas sold, and Ameriking continues to pay post-petition rent on the remainingseven properties.  The outcome of theAmeriking bankruptcy and the effects on the Company are uncertain at this time.

 

**Embers**

During 2002, a significanttenant/mortgagee, Embers, experienced financial difficulty and the Company,after numerous discussions and negotiations, initiated foreclosure proceedingsin March 2002.  In September 2002, theCompany executed a workout agreement with the tenant and its lender, MedallionCapital.  In exchange for the Companyagreeing to stay its eviction and foreclosure proceedings, the Company wouldreceive 100 percent of the net proceeds of each sale of property until theCompany received a sum equal to the entirety of its mortgage balances with allaccrued interest, an agreed upon sale price of the fee properties representingapproximately 119% of the Company’s original cost in the properties, and allthe Company’s legal fees and costs of collection, as well as all rent andmortgage payment obligations going forward. Embers agreed that these payments would be made in full within 24 monthsof the agreement.  At the time ofpayment in full, the Company would agree to release any remaining

 

26

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mortgages and deed over anyremaining properties to Embers.  Interestincome associated with the mortgage notes has not been recognized sinceDecember 2002.  During 2003, the Companyreceived $1.9 million in cash from the sale of three of its fee-ownedproperties, and recognized a gain on sale of $839,000.  Each quarter, the Company individuallyevaluates all of its mortgage notes and real estate associated with this tenantto determine if any asset has been impaired. As a result of this evaluation, a $200,000 impairment was recorded ontwo fee-owned properties during the first quarter of 2003.  At June 30, 2003, the Company had mortgagenotes receivable of $2,565,000, net book value of real estate and equipment of$1,378,000 and rent receivables and other assets of $854,000 related to Embers.

 

Prior to 2001, the Company losta case at the trial court level. After the judgment of specific performance wasentered against the Company for a total of $550,000, plus interest andattorneys’ fees, USRP posted a $783,000 bond and appealed the damage award ofthe trial court, arguing that the court provided erroneous instructions as tothe measure of damages and improperly excluded the Company’s expertwitness.  USRP accrued $425,000 for thiscase, based on the amount of the judgement, less the underlying value of thenotes receivable which the Company would be required to purchase if the verdictwas ultimately upheld.  USRP prevailedon appeal and the judgment was reversed and remanded for a new trial.  The same judge who presided over the initialtrial also presided over the retrial. A verdict was again issued against theCompany.  The case is currently onappeal with the Supreme Court of Texas, which has requested a response from theplaintiff.   The Petition is currentlypending.  At this time, management andmanagement’s counsel cannot determine the likely outcome; however, the Companybelieves it will prevail at the Supreme Court level.  Management intends to vigorously defend this action.

* *

*Company Debt and Derivatives*

 

The Company’s debt issummarized as follows (in thousands):

 
|                                                                |   | **Maturity  Date** |   | **Interest  Rate** |   | **June 30,  2003** |    | **December 31,  2002** |   |
|---------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|--------------------|---------|------------------------|--------|
|                                                                |   |               |   |               |   |               |    |                   |   |
| Line of credit                                                      |   | May 2004           |   | LIBOR + 3.0        | %      | $                  | 13,750  |                   | $      | 25,000 |   |
| Notes Payable                                                       |   |               |   |               |   |               |    |                   |   |
| Senior unsecured notes,  interest- only Payments semiannually       |   | May 2005           |   | 7.15               | %      | $                  | 111,000 |                   | $      | 111,000 |   |
| Variable rate certificates,  principle and Interest payable monthly |   | August 2006        |   | LIBOR + 0.48       | %      | 161,655            |    | 168,220                |   |
| Senior unsecured notes,  interest-only Payments semiannually        |   | August 2003        |   | 8.22               | %      | 47,500             |    | 47,500                 |   |
| Debt premium, net                                                   |   |               |   |               |   | 572                |    | 708                    |   |
| Total notes payable                                                 |   |               |   |               |   | $                  | 320,727 |                   | $      | 327,428 |   |
|                                                                |   |               |   |               |   |               |    |                   |   |
| Mortgage note payable                                               |   | June 2007          |   | 8.00               | %      | $                  | 928     |                   | $      | 946 |   |

 

In May 2002, the Companyentered into a Credit Agreement with Bank of America (the “Credit Agreement”),through its subsidiary USRP Funding 2002-A, L.P., for a secured revolvingcredit facility of $35,000,000, which is subject to a Derivative ExposureReserve and a Borrowing Base, as defined. Borrowings under this facility are being used primarily to acquire certainShoney’s and Captain D’s properties in sale/leaseback transactions. Thisfacility is secured by the 138 properties owned by USRP Funding 2002-A, L.P.with a net book value of $68,344,000 as of June 30, 2003.  The Credit Agreement, as amended, has a termof up to two years and allows for Base Rate Loans, Eurodollar Loans or acombination of the two.  Base Rate Loansbear interest at 3.0% plus the higher of the Federal Funds Rate plus 0.5% orthe Prime Rate.  Eurodollar Loans bearinterest at 3.0% plus LIBOR.  The CreditAgreement also provides that up to $10,000,000 of the facility may be used forletters of credit.  There is a 3% feeper annum on outstanding letters of credit as well as a 3% Derivative ExposureUsage Fee under this facility.  As ofJune 30, 2003, the Company had letters of credit outstanding and drawn underthis facility in the amount of $2,511,000. In May 2003, the Company executed a letter agreement for a one-monthextension of the original maturity date of the Credit Agreement to allow timeto complete a fourth amendment.  In June2003, the Company executed the fourth amendment which decreased the maximumborrowing capacity to $30,000,000, effective June 30, 2003, which capacity willbe further reduced, effective September 30, 2003, to $20,000,000 and whichextended the maturity date to May 31, 2004. In addition, under the fourth amendment, the Company was granted waiversfor compliance with the second and third quarters of 2003 for two of the financialcovenants related to distribution limitations and leverage ratio.  All other significant terms of the CreditAgreement were unchanged.  As of June30, 2003, funds available under the Credit Agreement were approximately$11,424,000.  As of August 5, 2003,funds available under the Credit Agreement were approximately $1,264,000.

 

In December 2002, a limited andtemporary waiver and amendment was executed under the Credit Agreement whichallowed the Company to borrow funds under this facility to partially financethe purchase of mortgage notes issued by Captain D’s with a face value of$12,000,000 on December 18, 2002. The Captain D’s mortgage notes bear interestat 12.5% per annum. The amount of this investment, without the waiver, wouldhave violated the limitations on investments under this facility. On June 13,2003, prior to the initial waiver period’s expiration, the Company tendered thenotes as partial consideration on the June 13, 2003 acquisition of 15 CaptainD’s properties.

 

In August 2001, the Companycompleted a $180,000,000 offering of Triple Net Lease Mortgage Certificates(the “Certificates”) through its subsidiary USRP Funding 2001-A, L.P.  The Certificates have an assumedamortization over 15 years and are secured by 275 properties with a net bookvalue of $191,161,000.  Under theProperty Management Agreement associated with these properties, certaincovenants and ratios must be maintained. The Company received a waiver dated December 31, 2002 on certaincovenants in the Amended and Restated Property Management Agreement.  The waiver allowed Unsecured Indebtedness,as defined, to exclude the $12,000,000 of

 

27

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Captain D’s mortgage notespurchased in December 2002.  Prior tothe June 30, 2003 expiration of the waiver, the mortgage notes were tendered onJune 13, 2003, as partial consideration on the June 13, 2003 acquisition of 15Captain D’s properties.

 

On November 13, 1998, theCompany issued $47,500,000 in senior notes in a private placement which wereoriginally scheduled to mature on August 1, 2003. In July 2003, the Companyprepaid $23,750,000 of the notes.  Inconnection with this prepayment, the Company paid $813,000 in accrued interestand incurred a make-whole payment of $137,000. The Company paid the remaining balance in full on July 29, 2003.

 

After receiving the waiversdiscussed above, the Company is in compliance with all covenants associatedwith its debt and credit facilities as of June 30, 2003.

 

The Company’s derivativeinstruments are summarized as follows (in thousands):

 
|                 |   |                   |   |         |   |                 |   | **Fixed Swap** |   |            |   |          |   | **Liability as of** |   |
|----------------------|--------|------------------------|--------|--------------|--------|----------------------|--------|----------------|--------|-----------------|--------|---------------|--------|---------------------|--------|
| **Type**             |   | **Settlement  Period** |   | **Maturity** |   | **Notional  Amount** |   | **Rate  Paid** |   | **Floor  Rate** |   | **Cap  Rate** |   | **June 30,  2003**  |   | **December 31,  2002** |   |
| Interest rate swap   |   | Quarterly              |   | May 2003     |   | $                    | 15,000 |           | 7.05   | %               |   |          |   |                | $      | — |   | $ | 325 |   |
| Interest rate collar |   | Monthly                |   | August 2005  |   | 67,463               |   |           |   | 4.42            | %      | 6.00          | %      | 3,572               |   | 3,678 |   |
| Interest rate swap   |   | Monthly                |   | June 2004    |   | 25,000               |   | 2.42           | %      |            |   |          |   | 326                 |   | 315 |   |
| Interest rate swap   |   | Monthly                |   | August 2003  |   | 50,000               |   | 1.9975         | %      |            |   |          |   | 72                  |   | 218 |   |
|                 |   |                   |   |         |   |                 |   |           |   |            |   |          |   | $                   | 3,970  |   | $ | 4,536 |   |
|                      |        |                        |        |              |        |                      |        |                |        |                 |        |               |        |                     |        |  |  |  |  |  |

 

Management believes that cashflow from operations, along with the Company’s ability to raise additionalequity, anticipated sales of properties, funds available under the CreditAgreement and the Company’s anticipated ability to obtain financing willprovide the Company with sufficient liquidity to meet its foreseeable capitalneeds.  However, there can be noassurance that such additional financing will be available at the time the Companyneeds it or the terms of anticipated financing will be as favorable to theCompany as under the existing facilities.

 

**Funds From Operations (FFO)**

 

The Company believes that itcomputes FFO in accordance with the standards established by the NationalAssociation of Real Estate Investment Trusts (“NAREIT”) in their NationalPolicy Bulletins dated November 8, 1999 and April 5, 2002, which may differfrom the methodology for calculating FFO utilized by other equity REITs, and,accordingly, may not be comparable to such other REITs.  The Company’s FFO is computed as net income(loss) available to common stockholders (computed in accordance with accountingprinciples generally accepted in the United States of America), plus realestate related depreciation and amortization, gains (or losses) from sales ofproperty, impairment of long-lived assets, extraordinary items and income/lossallocable to minority interest holders. The Company believes that FFO, when viewed in conjunction with netincome and cash flows, provides investors with a useful supplemental measure ofthe operating performance of a real estate company because it provides a directmeasure of the actual operating results of the Company’s properties.  FFO is not defined by generally acceptedaccounting principles and should not be considered an alternative to net incomeor cash flow as an indication of operating performance or liquidity.  FFO as disclosed by other REITs may not becomparable to the Company’s calculation. The Company believes FFO is helpful to investors as a measure of theperformance of an equity REIT because, along with the Company’s statements offinancial condition, results of operations and cash flows, it providesinvestors with an understanding of the ability of the Company to incur andservice debt and make capital expenditures. In evaluating FFO and the trends it depicts, investors should considerthe major factors affecting FFO.  Growthin FFO will result from increases in revenue or decreases in related operatingexpenses.  Conversely, FFO will declineif revenues decline or related operating expenses increase.  FFO does not represent amounts available formanagement’s discretionary use because of needed capital replacement orexpansion, debt service obligation, or other commitments anduncertainties.  FFO should not beconsidered as an alternative to net income (determined in accordance withaccounting principles generally accepted in the United States of America), asan indication of the Company’s financial performance, to cash flows fromoperating activities (determined in accordance with accounting principlesgenerally accepted in the United State of America) or as a measure of theCompany’s liquidity, nor is it indicative of funds available to fund theCompany’s cash needs, including its ability to make distributions.

 

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The following table sets forth,for the three and six months ended June 30, 2003 and 2002, the reconciliationof funds from operations to net income.

** **
|                                                |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|-----------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
| **(in thousands)**                                  |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                                |   |                             |   |                           |   |   |   |   |   |
| Funds from operations – diluted                |   | $                                | 6,690  |                           | $      | 6,573 |   | $ | 14,097 |   | $ | 13,298 |   |
| Adjustments to minority  interest                   |   | —                           |   | (45                            | )      | — |   | (76 | ) |
| Income allocable to minority  interest              |   | —                           |   | (48                            | )      | — |   | (12 | ) |
|                                                |   |                             |   |                           |   |   |   |   |   |
| Funds from operations – basic                  |   | 6,690                            |   | 6,480                          |   | 14,097 |   | 13,210 |   |
|                                                |   |                             |   |                           |   |   |   |   |   |
| Depreciation and amortization                       |   | (5,320                           | )      | (5,917                         | )      | (11,071 | ) | (11,175 | ) |
| Gain (loss) on sale of property                     |   | 5,085                            |   | (206                           | )      | 6,704 |   | 1,274 |   |
| Impairment of long-lived assets                     |   | (752                             | )      | (909                           | )      | (2,347 | ) | (1,718 | ) |
| Income allocable to minority  interests             |   | —                           |   | 45                             |   | — |   | 76 |   |
| Change in accounting principle                      |   | —                           |   | —                         |   | (270 | ) | — |   |
| Net income (loss) allocable to  common stockholders |   | 5,703                            |   | (507                           | )      | 7,113 |   | 1,667 |   |
| Preferred stock dividends                           |   | 1,814                            |   | 1,775                          |   | 3,590 |   | 3,551 |   |
|                                                |   |                             |   |                           |   |   |   |   |   |
| Net income                                          |   | $                                | 7,517  |                           | $      | 1,268 |   | $ | 10,703 |   | $ | 5,218 |   |

 

**Inflation**

 

Some of the Company’s leasesare subject to adjustments for increases in the Consumer Price Index, whichreduces the risk to the Company of the adverse effects of inflation.  Additionally, to the extent inflationincreases sales volume, percentage rents may tend to offset the effects ofinflation.  Because triple net leasesalso require the property operator to pay for some or all operating expenses,property taxes, property repair and maintenance costs and insurance, some orall of the inflationary impact of these expenses will be borne by the propertyoperator and not by the Company.

 

**Seasonality**

 

Fast food restaurant operationshistorically have been seasonal in nature, reflecting higher unit sales duringthe second and third quarters due to warmer weather and increased leisuretravel.  This seasonality can beexpected to cause fluctuations in the Company’s quarterly revenue to the extentit earns percentage rent.

 

**Risks Associated with Forward-Looking Statements included in this Form10-Q**

 

Certain statements contained inthis Form 10-Q, including without limitation statements regarding theobjectives of management for future operations and statements containing thewords “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,”“expect” and similar expressions, are forward-looking statements within themeaning of the federal securities laws. Such forward-looking statements are subject to known and unknown risks,uncertainties and assumptions which may cause the Company’s actual results,performance or achievements to differ materially from those anticipated orimplied by the forward-looking statements. The Company disclaims any obligation to update any such statements orpublicly announce any updates or revisions to any of the forward-lookingstatements contained herein to reflect any change in the Company’s expectationwith regard thereto or any change in events, conditions, circumstances orassumptions underlying such statements. Reference is hereby made to the disclosures contained in the Company’sfilings with the Securities and Exchange Commission, including, but not limitedto, the disclosures under the headings “Risk Associated with Forward-LookingStatements included in this Form 10-K” and “Factors Affecting the Company’sBusiness and Prospects” in “Item 1. Business” of the Company’s Annual Report onForm 10-K, as amended, filed with the Securities and Exchange Commission.

 

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**Item3****.    Quantitativeand Qualitative Disclosures About Market Risk**

** **

The Company is exposed tocertain market risks that arise in the ordinary course of business. The Companymay enter into derivative financial instrument transactions to manage or reducemarket risk, but does not enter into derivative financial instrumenttransactions for trading purposes, nor does the Company have any foreignoperations and thus is not exposed to foreign currency fluctuations. Adiscussion of the Company’s primary market risk exposure is presented below. 

 

**MarketRisk on Investments**

The fair value of the Company’sinvestments would be negatively affected by a decrease in interest rates as themajority of the investments are interest-bearing, and therefore subject to themarket risk of loss from a decline in interest rates which could impact futureearnings and cash flows.  However, theCompany’s investment portfolio of $2,948,000 is relatively small, and changesin value relating to market risks would not significantly impact the Company’soperations.  The Company also hasinvestments in fixed rate notes and mortgage loans receivable.  Changes in interest rates do not have adirect impact on interest income related to these notes and loans.

 

**MarketRisk on Variable Rate Debt**

The Company’s interest raterisk is sensitive to interest rate changes on its variable rate debt.  The Company had total outstanding debt of$334,477,000 at June 30, 2003, of which approximately $175,405,000 was variablerate debt.  Of this amount, $7,942,400,or 4.5% was unhedged. All other things being equal, the interest expense on theCompany’s unhedged variable rate debt will decrease as interest rates declineand will increase as rates rise.  Thisexposure to interest rate risk is generally managed using derivative financialinstruments such as interest rate swaps in conjunction with a portion of theCompany’s variable rate debt to mitigate the interest rate risk on anassociated financial instrument or to lock in an interest rate on its variablerate debt under its Credit Agreement with Bank of America and its Triple NetLease Mortgage Certificates.  As itrelates to unhedged variable rate debt, if market interest rates average 1.0% morethan in 2002, the impact related to additional annual interest expense woulddecrease net income and cash flows by $225,000 for 2003.  This amount was determined by calculatingthe effect of a hypothetical interest rate on our unhedged variable rate debt.  This sensitivity analysis assumes that thereare no changes in the Company’s financial structure.  Management believes the fair value of its variable rate debtequals its carrying value as of June 30, 2003.

 

**MarketRisk on Fixed Rate Debt**

The Company’s long-term fixedinterest rate debt is also subject to market risk.  Fixed rate debt outstanding at June 30, 2003 was $159,572,000with a weighted average interest rate of 7.5%. All other things being equal,the interest expense on the Company’s debt with a fixed interest rate willincrease as rates decline and will decrease as rates rise.  $47,500,000, or 29.9% of the Company’s totalfixed rate debt was paid in full before its August 1, 2003 due date, thusreducing the fixed rate market risk on that portion of the Company’s debtportfolio. None of the liquidated debt was replaced with additional fixed ratedebt; however, a portion of the payoff was made with borrowings under theCompany’s variable rate line of credit. Of the remaining $111,572,000 of fixedrate debt, all is unhedged.  As itrelates to the unhedged fixed rate debt, if annual market interest ratesaverage 1.0% more than in 2002, the impact related to additional annualinterest expense would decrease net income and cash flows by $1,150,000 for2003.  This amount was determined bycalculating the effect of hypothetical interest rate changes on our remainingunhedged fixed rate debt.  Thissensitivity analysis assumes that there are no changes in the Company’sfinancial structure.  Management believesthe fair value of its fixed rate debt equals its carrying value as of June 30,2003.

 

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**Item4****.    Controls andProcedures**

 

TheChief Executive Officer and Chief Financial Officer of the Company (its principalexecutive officer and principal financial officer) have concluded, based ontheir evaluation as of June 30, 2003 that, except as described below, theCompany’s disclosure controls and procedures are effective to ensure thatinformation required to be disclosed by the Company in the reports filed orsubmitted by it under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and include controls and procedures designed toensure that information required to be disclosed by the Company in such reportsis accumulated and communicated to the Company’s management, including theChief Executive Officer and Chief Financial Officer, as appropriate to allowtimely decisions regarding required disclosure.  In its March 2003 Letter to the Audit Committee, the Company’sauditors noted that the Company does not have an adequate process in place toprovide for a timely and accurate closing of its accounts, which preventscritical analysis of accounts prior to financial statement preparation.  To address this comment, the Companyreviewed its closing process and began making adjustments that would facilitatea more timely close of the accounts for the quarter presented herein. Inaddition, the Company will continue to refine its closing and analysisprocedures as they relate to future quarterly and annual reporting periods.

 

Exceptas outlined above, there were no significant changes in the Company’s internalcontrol or in other factors that could significantly affect these controlssubsequent to the date of such evaluation, including any corrective actions inregard to significant deficiencies and material weaknesses.

 

**PART II**.                OTHER INFORMATION

 

**Item 7**.    Exhibits and Reports on Form 8-K

 
| a)     |   | Exhibits                                                                                                                                                                                                                |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                    |
|   |   | Exhibit 4.01 - U.S. Restaurant Properties, Inc. Articles  Supplementary Classifying and Designating a Series of Preferred Stock as  Series B Redeemable Convertible Preferred Stock                                     |
|   |   | Exhibit 4.02 - Securities Purchase Agreement relating to the Series B  Preferred Stock                                                                                                                                  |
|   |   | Exhibit 4.03 - Registration Rights Agreement relating to the Series B  Preferred Stock                                                                                                                                  |
|   |   | Exhibit 4.04 - Stock Purchase  Warrant - Omicron Master Trust                                                                                                                                                           |
|   |   | Exhibit 4.05 - Stock Purchase  Warrant - The Riverview Group, LLC                                                                                                                                                       |
|   |   | Exhibit 10.1 - Fourth Amendment to Credit Agreement                                                                                                                                                                     |
|   |   | Exhibit 21. 1 - Principal subsidiaries of the  Company                                                                                                                                                                  |
|   |   | Exhibit 31.1 – Section 302 Certification by Robert J. Stetson  Pursuant to Sarbanes-Oxley Act of 2002                                                                                                              |
|   |   | Exhibit 31.2 – Section 302 Certification by  Stacy M. Riffe Pursuant to Sarbanes-Oxley Act of 2002                                                                                                                 |
|   |   | Exhibit 32.1 – Section 906 Certification by Robert J. Stetson  Pursuant to Sarbanes-Oxley Act of 2002                                                                                                              |
|   |   | Exhibit 32.2 – Section 906 Certification by Stacy M. Riffe Pursuant  to Sarbanes-Oxley Act of 2002                                                                                                                 |
|   |   |                                                                                                                                                                                                                    |
| b)     |   | Reports on  Form 8-K                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                    |
|   |   | A report on  Form 8-K dated May 7, 2003 was filed with the Securities and Exchange  Commission on May 8, 2003 reporting the issuance of a press release on May 7,  2003 announcing first quarter earnings.              |
|   |   |                                                                                                                                                                                                                    |
|   |   | A report on  Form 8-K dated August 6, 2003 was filed with the Securities and Exchange  Commission on August 6, 2003 reporting on the issuance of a press release on  August 5, 2003 announcing second quarter earnings. |

 

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**SIGNATURE**

 

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                         |   | U.S.  Restaurant Properties, Inc. |
|------------------------------|--------|-----------------------------------|
|                         |   |                              |
|                         |   |                              |
| Dated:  August 14, 2003 | By:    |                              | /s/ Stacy M.  Riffe |   |
|                         |   |                              | Stacy M.  Riffe |
|                         |   |                              | Chief  Financial Officer |
|                         |   |                              |
|                              |        |                                   |  |  |  |

 

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**Indexto Exhibits**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                       |
|---------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.01                |   | U.S.  Restaurant Properties, Inc. Articles Supplementary Classifying and  Designating a Series of Preferred Stock as Series B Redeemable Convertible  Preferred Stock |
| 4.02                |   | Securities Purchase Agreement relating to Series B Preferred Stock                                                                                                    |
| 4.03                |   | Registration Rights Agreement relating to Series B Preferred Stock                                                                                                    |
| 4.04                |   | Stock Purchase Warrant – Omicron Master Trust                                                                                                                    |
| 4.05                |   | Stock Purchase Warrant – The Riverview Group, LLC                                                                                                                |
| 10.1                |   | Fourth Amendment to Credit Agreement                                                                                                                                  |
| 21.1                |   | Principal subsidiaries of the Company                                                                                                                                 |
| 31.1                |   | Section 302 Certification by Robert J. Stetson Pursuant to the  Sarbanes-Oxley Act of 2002                                                                            |
| 31.2                |   | Section 302 Certification by Stacy M. Riffe Pursuant to the  Sarbanes-Oxley Act of 2002                                                                               |
| 32.1                |   | Section 906 Certification by Robert J. Stetson Pursuant to the  Sarbanes-Oxley Act of 2002                                                                            |
| 32.2                |   | Section 906 Certification by Stacy M. Riffe Pursuant to the  Sarbanes-Oxley Act of 2002                                                                               |

 

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