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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-K Annual Report Pursuant to Section 13 or 15 (d)
of the Securities Exchange Act of 1934 For the fiscal year ended February 27, 2005 Commission file number 1-08395 MORGANS FOODS, INC. 
  Ohio
    
    34-0562210(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)
 24200 Chagrin Boulevard, Suite 126, Beachwood, OH 44122 
  Registrants telephone number, including area code:(216) 360-7500 Securities registered pursuant to Section 12 (b) of the Act: Name of each exchange onTitle of each class
    
    which registeredCommon Shares, Without Par Value
    
    American Stock ExchangeSecurities registered pursuant to Section 12 (g) of the Act:
    
    None
 Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months and
(2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation
S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes o No þ As of August 15, 2004, the aggregate market value of the common stock held by nonaffiliates of
the Registrant was $1,386,448. As of May 11, 2005, the Registrant had 2,718,495 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Part III incorporates by reference certain information from the definitive Proxy Statement to
security holders for the 2005 annual meeting, to be filed with the Securities and Exchange
Commission on or before June 24, 2005.




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TABLE OF CONTENTS  PART IItem 1. BusinessItem 2. PropertiesItem 3. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security HoldersPART IIItem 5. Market for the Companys Common Equity and Related Stockholder MattersItem 6. Selected Financial DataItem 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsPART IIIItem 9. Changes in and Disagreements With Accountants on Accounting and Financial DisclosureItem 10. Directors and Executive Officers of the RegistrantItem 11. Executive CompensationItem 12. Security Ownership of Certain Beneficial Owners and ManagementItem 13. Certain Relationships and Related TransactionsItem 14. Controls and ProceduresPART IVItem 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-KItem 15 (a) 1Item 15 (a) 2INDEX TO EXHIBITSSIGNATURESEX-21 Subsidiaries of the RegistrantEX-23 Consent of Independent Registered Public AccountsEX-31.1 302 Certification - CEOEX-31.2 302 Certification - CFOEX-32.1 906 Certification - CEOEX-32.2 906 Certification - CFO    Table of Contents  MORGANS FOODS, INC. 
 PART I 
 Item 1. Business. General. Morgans Foods, Inc. (the Company) operates through wholly-owned
subsidiaries KFC restaurants under franchises from KFC Corporation, Taco Bell restaurants under
franchises from Taco Bell Corporation, Pizza Hut Express restaurants under licenses from Pizza Hut
Corporation and an A&W restaurant under a license from A&W Restaurants, Inc. As of May 27, 2005,
the Company operates 73 KFC restaurants, 7 Taco Bell restaurants, 14 KFC/Taco Bell 2n1s under
franchises from KFC Corporation and franchises or licenses from Taco Bell Corporation, 3 Taco
Bell/Pizza Hut Express 2n1s under franchises from Taco Bell Corporation and licenses from Pizza
Hut Corporation, 1 KFC/Pizza Hut Express 2n1 under a franchise from KFC Corporation and a license
from Pizza Hut Corporation and 1 KFC/A&W 2n1 operated under a franchise from KFC Corporation and
a license from A&W Restaurants, Inc. The Companys fiscal year is a 52  53 week year ending on
the Sunday nearest the last day of February. Restaurant Operations. The Companys KFC restaurants prepare and sell the distinctive
KFC branded chicken products along with related food items. All containers and packages bear KFC
trademarks. The Companys Taco Bell restaurants prepare and sell a full menu of quick service
Mexican food items using the appropriate Taco Bell containers and packages. The KFC/Taco Bell
2n1 restaurants operated under franchise agreements from KFC Corporation and license agreements
from Taco Bell Corporation prepare and sell a limited menu of Taco Bell items as well as the full
KFC menu while those operated under franchise agreements from both KFC Corporation and Taco Bell
Corporation offer a full menu of both KFC and Taco Bell items. The Taco Bell/Pizza Hut Express
2n1 restaurants prepare and sell a full menu of Taco Bell items and a limited menu of Pizza Hut
items. The KFC/Pizza Hut Express 2n1 restaurant prepares and sells a full menu of KFC items and
a limited menu of Pizza Hut items. The KFC/A&W 2n1 sells a limited menu of A&W items and a full
menu of KFC items. Of the 99 KFC, Taco Bell and 2n1 restaurants operated by the Company as of May 27, 2005, 16
are located in Ohio, 59 in Pennsylvania, 13 in Missouri, 2 in Illinois, 7 in West Virginia and 2 in
New York. The Company was one of the first KFC Corporation franchisees and has operated in excess
of 20 KFC franchises for more than 25 years. Operations relating to these units are seasonal to a
certain extent, with higher sales generally occurring in the summer months. Franchise Agreements. All of the Companys KFC and Taco Bell restaurants are operated
under franchise agreements with KFC Corporation and Taco Bell Corporation, respectively. The
Companys KFC/Taco Bell 2n1 restaurants are operated under franchises from KFC Corporation and
either franchises or licenses from Taco Bell Corporation. The Taco Bell/Pizza Hut Express 2n1s
are operated under franchises from Taco Bell Corporation and licenses from Pizza Hut Corporation.
The KFC/Pizza Hut Express 2n1 restaurant is operated under a franchise from KFC Corporation and a
license from Pizza Hut Corporation. The KFC/A&W 2n1 is operated under a franchise from KFC
Corporation and a license from A&W Restaurants, Inc. The Company considers retention of these agreements to be important to the success of its
restaurant business and believes that its relationships with KFC Corporation, Taco Bell
Corporation, Pizza Hut Corporation and A&W Restaurants, Inc. are satisfactory. For KFC products,
the Company is required to 2




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MORGANS FOODS, INC. PART I (contd) pay royalties of 4% of gross revenues and to expend an additional 5.5% of gross revenues on
national and local advertising pursuant to its franchise agreements. For Taco Bell products in
KFC/Taco Bell 2n1 restaurants operated under license agreements from Taco Bell Corporation and
franchise agreements from KFC Corporation the Company is required to pay royalties of 10% of Taco
Bell gross revenues and to make advertising fund contributions of 1/2% of Taco Bell gross revenues.
For Taco Bell product sales in restaurants operated under Taco Bell franchises the Company is
required to pay royalties of 5.5% of gross revenues and to expend an additional 4.5% of gross
revenues on national and local advertising. For Pizza Hut products in 2n1 restaurants the
Company is required to pay royalties of 5.5% of Pizza Hut gross revenues and to expend an
additional 4.5% of Pizza Hut gross revenues on national and local advertising. For A&W products in
2n1 restaurants the Company is required to pay royalties of 7% of A&W gross revenues and to
expend an additional 4% of A&W gross revenues on national and local advertising. In May 1997, the Company renewed substantially all of its existing franchise agreements for
twenty years. New 20 year franchise agreements were obtained for all 54 restaurants acquired in
July 1999. Subject to satisfying KFC and Taco Bell requirements for restaurant image and other
matters, franchise agreements are renewable at the Companys option for successive ten year
periods. The franchise and license agreements provide that each KFC, Taco Bell, Pizza Hut Express
and A&W unit is to be inspected by KFC Corporation, Taco Bell Corporation, Pizza Hut Corporation
and A&W Restaurants, Inc., respectively, approximately three or four times per year. These
inspections cover product preparation and quality, customer service, restaurant appearance and
operation. Competition. The quick service restaurant business is highly competitive and is
often affected by changes in consumer tastes; national, regional, or local economic conditions,
demographic trends, traffic patterns; the type, number and locations of competing restaurants and
disposable purchasing power. Each of the Companys KFC, Taco Bell and 2n1 restaurants competes
directly or indirectly with a large number of national and regional restaurant operations, as well
as with locally owned restaurants, drive-ins, diners and numerous other establishments which offer
low- and medium-priced chicken, Mexican food, pizza, hamburgers and hot dogs to the public. The Companys KFC, Taco Bell and 2n1 restaurants rely on innovative marketing techniques
and promotions to compete with other restaurants in the areas in which they are located. The
Companys competitive position is also enhanced by the national advertising programs sponsored by
KFC Corporation, Taco Bell Corporation, Pizza Hut Corporation, A&W Restaurants, Inc. and their
franchisees. Emphasis is placed by the Company on its control systems and the training of
personnel to maintain high food quality and good service. The Company believes that its KFC, Taco
Bell and 2n1 restaurants are competitive with other quick service restaurants on the basis of
the important competitive factors in the restaurant business which include, primarily, restaurant
location, product price, quality and differentiation, and also restaurant and employee appearance. Government Regulation. The Company is subject to various federal, state and local
laws affecting its business. Each of the Companys restaurants must comply with licensing and
regulation by a number of governmental authorities, which include health, sanitation, safety and
fire agencies in the state or municipality 3




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MORGANS FOODS, INC. PART I (contd) in which the restaurant is located. To date, the Company has not been significantly affected by
any difficulty, delay or failure to obtain required licenses or approvals. The Company is also subject to federal and state laws governing such matters as employment and
pay practices, overtime and working conditions. The bulk of the Companys employees are paid on an
hourly basis at rates not less than the federal and state minimum wages. The Company is also subject to federal and state child labor laws which, among other things,
prohibit the use of certain hazardous equipment by employees 18 years of age or younger. To
date, the Company has not been materially adversely affected by such laws. Suppliers. The Company has been able to obtain sufficient supplies to carry on its
business and believes it will be able to do so in the future. Growth. The Company added no new restaurants in fiscal 2005 or fiscal 2004. During
fiscal 2003, the Company purchased a KFC restaurant in Niles, OH which was previously leased and
added the A&W concept to the restaurant. Employees. As of May 11, 2005, the Company employed approximately 1,960 persons,
including 48 administrative and 200 managerial employees. The balance are hourly employees, most
of whom are part-time. None of the restaurant employees are represented by a labor union. The
Company considers its employee relations to be satisfactory. 
 Item 2. Properties. The Company leases approximately 6,000 square feet of space for its headquarters in Cleveland,
OH. The lease expires August 31, 2005 and the rent under the current term is $7,500 per month. The
Company also leases space for a regional office in Youngstown, OH, which is used to assist in the
operation of the KFC, Taco Bell and 2n1 restaurants. Of the 99 KFC, Taco Bell and 2n1 restaurants, the Company owns the land and building for 56
locations, owns the building and leases the land for 23 locations and leases the land and building
for 20 locations. 56 of the owned properties are subject to mortgages. Additionally, the Company
leases the land and building for one closed location and owns the land and building for two closed
locations which are subject to mortgages. Remaining lease terms (including renewal options) range
from 1 to 23 years and average approximately 12 years. These leases generally require the Company
to pay taxes and utilities, to maintain casualty and liability insurance, and to keep the property
in good repair. The Company pays annual rent for each leased KFC, Taco Bell or 2n1 restaurant in
amounts ranging from $19,000 to $95,000. In addition, 16 of these leases require payment of
additional rentals based on a percentage of gross sales in excess of certain base amounts. Sales
for 8 KFC, Taco Bell and 2n1 restaurants exceeded the respective base amounts in fiscal 2005. 4




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MORGANS FOODS, INC. PART I (contd) The Company believes that its restaurants are generally efficient, well equipped and
maintained and in good condition. 
 Item 3. Legal Proceedings. None. 
 Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to security holders for a vote during the last quarter of the
Companys fiscal year ended February 27, 2005. Executive Officers of the Company The Executive Officers and other Officers of the Company are as follows: Name
    
    Age
    
    Position with Registrant
    
    Officer SinceExecutive Officers:Leonard R. Stein-Sapir
    
    
    66
    
    
    Chairman of the Board
and Chief Executive
Officer
    
    April 1989James J. Liguori
    
    
    56
    
    
    President and Chief
Operating Officer
    
    June 1979Kenneth L. Hignett
    
    
    58
    
    
    Senior Vice President-
Chief Financial Officer
& Secretary
    
    May 1989Other Officers:Barton J. Craig
    
    
    56
    
    
    Senior Vice President -
General Counsel
    
    January 1994Vincent J. Oddi
    
    
    62
    
    
    Vice President-
Restaurant Development
    
    September 1979Ramesh J. Gursahaney
    
    
    56
    
    
    Vice President-
Operations Services
    
    January 1991
 Executive Officers of the Company serve for a term of one year and until their successors
are elected and qualified, unless otherwise specified by the Board of Directors. Any officer is
subject to removal with or without cause, at any time, by a vote of a majority of the Board of
Directors. 5




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MORGANS FOODS, INC. 
 PART II 
 Item 5. Market for the Companys Common Equity and Related Stockholder Matters. The Companys Common Shares are traded over the counter under the symbol MRFD. The following
table sets forth, for the periods indicated, the high and low sales prices of the Common Shares as
reported. Price RangeHigh
    
    
    LowYear ended February 27, 2005:1st Quarter
    
    $
    2.20
    
    
    $
    1.902nd Quarter
    
    
    1.90
    
    
    
    .953rd Quarter
    
    
    1.01
    
    
    
    .604th Quarter
    
    
    1.05
    
    
    
    .75Year ended February 29, 2004:1st Quarter
    
    $
    2.74
    
    
    $
    1.532nd Quarter
    
    
    2.46
    
    
    
    1.783rd Quarter
    
    
    1.92
    
    
    
    1.454th Quarter
    
    
    2.40
    
    
    
    1.30
 As of May 11, 2005, the Company had approximately 946 shareholders of record. The Company has
paid no dividends since fiscal 1975. 6




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MORGANS FOODS, INC. PART II (contd) 
 Item 6. Selected Financial Data. The following selected financial information for each of the five fiscal years in the period
ended February 27, 2005, is derived from, and qualified in its entirety by, the consolidated
financial statements of the Company. The following selected financial information should be read
in conjunction with Managements Discussion and Analysis of Financial Condition and Results of
Operations and the consolidated financial statements and the notes thereto included elsewhere in
this report. Dollars in thousands except per share amounts. Years EndedFebruary 27,
    
    
    February 29,
    
    
    March 2,
    
    
    March 3,
    
    
    February 25,2005
    
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001Revenues
    
    $
    80,960
    
    
    $
    81,738
    
    
    $
    82,326
    
    
    $
    84,930
    
    
    $
    78,140Cost of sales:Food, paper and beverage
    
    
    25,222
    
    
    
    24,712
    
    
    
    25,645
    
    
    
    25,987
    
    
    
    24,378Labor and benefits
    
    
    22,803
    
    
    
    22,816
    
    
    
    22,329
    
    
    
    22,155
    
    
    
    20,702Restaurant operating expenses
    
    
    21,015
    
    
    
    21,320
    
    
    
    21,018
    
    
    
    21,805
    
    
    
    19,795Depreciation and amortization
    
    
    3,419
    
    
    
    3,518
    
    
    
    3,499
    
    
    
    3,866
    
    
    
    3,817General and administrative
expenses
    
    
    4,870
    
    
    
    5,574
    
    
    
    5,749
    
    
    
    5,209
    
    
    
    5,516Loss on restaurant assets
    
    
    574
    
    
    
    567
    
    
    
    551
    
    
    
    215
    
    
    
    597Operating income
    
    
    3,057
    
    
    
    3,231
    
    
    
    3,535
    
    
    
    5,693
    
    
    
    3,335Income (loss) from
continuing operations
    
    
    (1,858
    )
    
    
    (1,294
    )
    
    
    (1,192
    )
    
    
    602
    
    
    
    (1,693
    )Gain (loss) from discontinued
operations (2)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    150Net income (loss)
    
    $
    (1,858
    )
    
    $
    (1,294
    )
    
    $
    (1,192
    )
    
    $
    602
    
    
    $
    (1,543
    )Basic and diluted income (loss)
per common share (1):Income (loss) from
continuing operations
    
    $
    (.68
    )
    
    $
    (.48
    )
    
    $
    (.44
    )
    
    $
    .21
    
    
    $
    (.58
    )Gain (loss) from
discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    .05Net income (loss)
    
    $
    (.68
    )
    
    $
    (.48
    )
    
    $
    (.44
    )
    
    $
    .21
    
    
    $
    (.53
    )Working capital (deficiency)
    
    $
    (46,048
    )
    
    $
    (3,999
    )
    
    $
    (3,111
    )
    
    $
    (1,312
    )
    
    $
    (2,454
    )Total assets
    
    
    48,790
    
    
    
    52,672
    
    
    
    56,025
    
    
    
    60,253
    
    
    
    61,554Long-term debt
    
    
    
    
    
    
    43,370
    
    
    
    46,113
    
    
    
    48,563
    
    
    
    51,046Long-term capital lease
obligations
    
    
    368
    
    
    
    379
    
    
    
    436
    
    
    
    544
    
    
    
    651Shareholders deficiency
    
    
    (4,574
    )
    
    
    (2,716
    )
    
    
    (1,422
    )
    
    
    (197
    )
    
    
    (578
    )
   (1)

Computed based upon the basic weighted average number of common shares outstanding
during each year, which were 2,718,441 in 2005 and 2004, 2,720,182 in 2003, 2,851,160 in 2002 and
2,931,227 in 2001 and the diluted weighted average number of common and common equivalent shares
outstanding during each year which were 2,718,441 in 2005 and 2004, 2,720,182 in 2003, 2,853,789
in 2002 and 2,931,227 in 2001.(2)
    The results of operations and gain/loss on disposals of the former East Side
Marios restaurant segment. 7




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MORGANS FOODS, INC. PART II (contd) 
 Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. Results of Operations. During fiscal 2003 through 2005 the Company operated KFC
franchised restaurants, Taco Bell franchised restaurants and various 2n1 restaurants which
include the KFC, Taco Bell, Pizza Hut and A&W concepts in the states of Illinois, Missouri, Ohio,
Pennsylvania, West Virginia and New York. The average number of restaurants in operation during
fiscal 2005 was 101 and 103 during fiscal years 2004 and 2003. During fiscal 2003, the Company
added a concept to one restaurant. Summary of Expenses and Operating Income as a Percentage of Revenues 2005
    
    
    2004
    
    
    2003Cost of sales:Food, paper and beverage
    
    
    31.2
    %
    
    
    30.2
    %
    
    
    31.2
    %Labor and benefits
    
    
    28.2
    %
    
    
    27.9
    %
    
    
    27.1
    %Restaurant operating expenses
    
    
    26.0
    %
    
    
    26.1
    %
    
    
    25.5
    %Depreciation and amortization
    
    
    4.2
    %
    
    
    4.3
    %
    
    
    4.3
    %General and administrative expenses
    
    
    6.0
    %
    
    
    6.8
    %
    
    
    7.0
    %Operating income
    
    
    3.8
    %
    
    
    4.0
    %
    
    
    4.3
    %
 Revenues. Revenue was $80,960,000 in fiscal 2005, a decrease of $778,000 or
1.0% compared to a decrease of $588,000 or 0.7% in fiscal 2004. The $777,000 decrease in
restaurant revenues during fiscal 2005 was due mainly to $997,000 in revenues being lost due to
the permanent closing of three restaurants and $558,000 in revenues being lost as a result of two
restaurants being closed for damages resulting from the Hurricane Ivan storm system and one
restaurant being closed for damages resulting from a fire. Revenue was also adversely affected
early in fiscal 2005 by a failed new product introduction by the Companys KFC franchisor. The
decreases were offset by a 1.0% increase in comparable restaurant revenues resulting from more
effective promotions from the franchisors, particularly in the fourth quarter of fiscal 2005.
Revenue was $81,738,000 in fiscal 2004, a decrease of $588,000 from fiscal 2003. The $588,000
decrease in restaurant revenues during fiscal year 2004 was primarily the result of ineffective
product promotions by the KFC franchisor during the year as well as severe winter weather
conditions in the Companys market areas. Revenue was $82,326,000 in fiscal 2003, a decrease of
$2,604,000 or 3.1% compared to fiscal 2002. The $2,604,000 decrease in restaurant revenues during
fiscal year 2003 was primarily the result of a 1.2% decrease in comparable restaurant revenues
which was due to franchisor product promotions which were ineffective in the face of increased
competition in the chicken segment of the quick service industry and $1,641,000 in revenues
generated from the extra week that occurred in fiscal 2002. Furthermore, fiscal year 2003
revenues were reduced as a result of a prolonged winter with near record snowfall in the Companys
market areas. Revenues for the 16 weeks ended February 27, 2005 were $23,636,000 an increase of $771,000
primarily the result of a 7.0% increase in comparable restaurant revenues. This increase was due
to successful product promotions including the KFC variety bucket of popcorn chicken, chicken
strips and fried chicken and the honey barbecue wing promotion. These revenue increases were
partially offset by the decreases in revenues caused by the restaurants either permanently or
temporarily closed as discussed above. Revenues for the 16 weeks ended February 29, 2004 were
$22,865,000, a decrease of $337,000 compared to the fourth quarter of fiscal 2003 due to a 1.5% decrease in
comparable restaurant revenues for the reasons discussed above. 8




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MORGANS FOODS, INC. PART II (contd) Cost of Sales  Food, Paper and Beverage. Food, paper and beverage costs were
$25,222,000 or 31.2% of revenues in fiscal year 2005 compared to $24,712,000 or 30.2% in fiscal
2004. This increase was primarily the result of increased commodity costs (primarily chicken).
Food, paper and beverage costs were $24,712,000 or 30.2% in fiscal 2004 compared to $25,645,000 or
31.2% of revenues in fiscal 2003. Food, paper and beverage costs as a percentage of revenue
decreased by 1.0% as a result of the development and implementation of tools that assist management
of food costs and 0.2% resulting from the receipt, during the second quarter of fiscal 2004, of a
$156,000 settlement negotiated by FRANMAC, the Taco Bell franchisee association, with certain
system food suppliers. For the fourth quarter of fiscal 2005, food, paper and beverage costs increased as a
percentage of revenues to 30.3% from 30.0% in the fourth quarter fiscal 2004. The increase of 0.3%
of revenues was primarily due to the reason discussed above as part of the fiscal 2005 comparison
but was partially offset by the efficiencies generated from the increased revenues in the fourth
quarter of fiscal 2005. Cost of Sales  Labor and Benefits. Labor and benefits increased to 28.2% of revenues
or $22,803,000 in fiscal 2005 from 27.9% of revenues or $22,816,000 in fiscal 2004 due to increased
labor as a result of hiring for open restaurant management positions which was partially offset by
decreased workers compensation costs. Labor and benefits increased to 27.9% of revenues or
$22,816,000 in fiscal 2004 from 27.1% of revenues or $22,329,000 in fiscal 2003. The increase was
primarily due to increased health care costs of $566,000 and increased workers compensation costs
of $254,000 which were partially offset by improved operating efficiencies. Labor and benefit costs for the fourth quarter of fiscal 2005 decreased to 28.2% of revenues
or $6,674,000 compared to 28.9% of revenues or $6,616,000 in fiscal 2004. This percentage decrease
was primarily the result of higher average restaurant volumes. Restaurant Operating Expenses. Restaurant operating expenses were relatively
unchanged as a percentage of revenue at $21,015,000 or 26.0% and $21,320,000 or 26.1% in fiscal
2005 and 2004, respectively. Restaurant operating expenses increased to 26.1% of revenues or
$21,320,000 in fiscal 2004 from 25.5% of revenues or $21,018,000 in fiscal 2003 primarily as a
result of increased general insurance costs, the increased cost of the toys included with kids
meals and the increased volume of kids meals sold as a result of promotional efforts. Restaurant operating expenses for the fourth quarter of fiscal 2005 decreased to 26.2% of
revenues or $6,201,000 from 27.3% of revenues or $6,254,000 in the year earlier quarter. This
decrease was primarily the result of higher average restaurant volumes. Depreciation and Amortization. Depreciation and amortization decreased to $3,419,000
in fiscal 2005 from $3,518,000 in fiscal 2004 as a result of certain assets becoming fully
depreciated during the year. Depreciation and amortization was relatively unchanged at $3,518,000
and $3,499,000 in fiscal 2004 and 2003, respectively. 9




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MORGANS FOODS, INC. PART II (contd) General and Administrative Expenses. General and administrative expenses decreased to
$4,870,000 or 6.0% of revenues in fiscal 2005 from $5,574,000 or 6.8% of revenues in fiscal 2004 as
a result of decreased wages and benefits of $448,000. Early in the fourth quarter, three senior
officers of the Company reduced their salaries and other benefits to near zero while the remainder
of the Companys executive team and some of its management took pay cuts. These salary and benefit
reductions reduced expenses during the fourth quarter of fiscal 2005 approximately $300,000. In
addition, training expenses were reduced by approximately $77,000, fees for debt covenant violation
waivers decreased $80,000 due to fewer waivers being obtained in 2005 and certain occupancy costs
were reduced. General and administrative expenses decreased to $5,574,000 or 6.8% of revenues in
fiscal 2004 from $5,749,000 or 7.0% percent of revenues in fiscal 2003 as a result of decreased
legal and professional, office supply and telephone expenses which was partially offset by
increased healthcare and workers compensation costs. These decreases were a result of negotiated
price decreases as well as reduced usage. For the fourth quarter of fiscal 2005, general and administrative expenses decreased to
$1,361,000 or 5.8% of revenues from $1,715,000 or 7.5% of revenues in the fourth quarter of fiscal
2004 primarily for the reasons discussed above. Loss on Restaurant Assets. The Company experienced a loss on restaurant assets of
$574,000 in fiscal 2005 compared to $567,000 in fiscal 2004. The 2005 amounts include impairment
losses of $823,000 on nine restaurants to reduce their carrying values to their estimated fair
values. These impairment losses were offset by gains recognized totaling $167,000 recognized for
property damage insurance proceeds received in excess of the net book value of the related
property, and $178,000 for business interruption insurance proceeds received. These insurance
proceeds relate to two restaurants damaged from the Hurricane Ivan storm system and one
fire-damaged restaurant. Insurance proceeds which will result in a gain are recognized in the
financial statements only when such gains are realized, which is generally upon receipt of the
proceeds. The Company anticipates recognizing gains in fiscal 2006 in excess of $250,000 from
additional insurance proceeds that have been, or are expected to be, received after February 27,
2005. In fiscal 2004, the Company recorded losses of $313,000 as a result of the disposal of
assets during the image enhancement of two restaurants, an increase of $81,000 in the reserve for
one previously closed restaurant and the $135,000 loss associated with the unanticipated closing of
another restaurant as a result of the landlord terminating the lease in order to use the property
for another project. In fiscal 2004, the Company also recorded impairment losses of $254,000 on
two operating restaurants to reduce their carrying values to their estimated fair values. In
fiscal 2003, the Company recorded losses of $218,000 as a result of the disposal of assets during
the image enhancement and expansion of several restaurants and the increase in the reserve for
disposal of previously closed restaurants. In fiscal 2003, the Company also recorded impairment
losses of $333,000 on three operating restaurants to reduce their carrying values to their
estimated fair values. In the fourth quarter of fiscal 2005 the Company recorded a gain on restaurant assets of
$152,000 which primarily resulted from the portion of the insurance proceeds received in the fourth
quarter of fiscal 2005 relating to the three damaged restaurants discussed above. This compared to
a loss of $493,000 in the prior year fourth quarter which included the $254,000 asset impairment
write-down mentioned above. The 10




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MORGANS FOODS, INC. PART II (contd) fiscal 2004 impairment write-down resulted from deterioration of the operating results and trade
areas of the locations during the fourth quarter. Operating Income. Operating income in fiscal 2005 decreased to $3,057,000 from
$3,231,000 in fiscal 2004 primarily as a result of lower revenues and increased commodity and labor
costs which were partially offset by reduced general and administrative expenses and a reduced loss
on restaurant assets primarily a result of insurance proceeds received. Operating income in fiscal
2004 decreased to $3,231,000 from $3,535,000 in fiscal 2003 primarily as a result of lower average
restaurant volumes and increased benefit costs which were partially offset by improved operating
efficiencies and the receipt of the settlement with certain Taco Bell system food suppliers
mentioned earlier. Interest Expense. Interest expense on bank debt and notes payable decreased to
$4,341,000 in fiscal 2005 from $4,578,000 in fiscal 2004. Interest expense on bank debt and notes
payable decreased to $4,578,000 in fiscal 2004 from $4,802,000 in fiscal 2003. The decreases in
interest expense for fiscal 2005 and 2004 were the result of principal payments which reduced the
outstanding debt balances. Interest expense from capitalized lease debt decreased $4,000 to
$45,000 in fiscal 2005 from $49,000 in fiscal 2004. Interest expense from capitalized lease debt
decreased $13,000 to $49,000 in fiscal 2004 from $62,000 in fiscal 2003. These decreases in both
years were due to lower principal balances. Other Income. Other income was substantially unchanged at $78,000 in fiscal 2005 and
$106,000 in fiscal 2004. Other income decreased to $106,000 in fiscal 2004 from $147,000 in fiscal
2003 as a result of lower interest income due to decreases in both the interest rate earned and the
amount of average cash investments. Provision for Income Taxes. The provision for income taxes increased by $603,000 in
fiscal 2005 as compared to fiscal 2004. The increase is due to the Companys determination that a
$600,000 valuation allowance should be recorded against deferred tax assets because realization of
the deferred tax asset was no longer more likely than not due to continuing significant losses.
This change has no effect on the Companys cash position. The provision for income taxes was
substantially unchanged at $4,000 and $10,000 in fiscal years 2004 and 2003, respectively. Trends in Results of Operations. The Company is encouraged by the operating results
experienced in the fourth quarter of fiscal 2005. As noted earlier, revenues increased by $771,000
in the fourth quarter of fiscal 2005 as compared to the fourth quarter of fiscal 2004 primarily as
a result of a 7.0% increase in comparable restaurant revenues due to successful product promotions.
Even more encouraging were the impacts on fourth quarter operating income and net income that
resulted from the higher revenues and from lower costs due to the organizational and operational
restructuring described below. Historically, the fourth quarter has been the weakest, typically
resulting in little or no operating income and substantial net losses. However, in the fourth
quarter of fiscal 2005, the Company recorded operating income of $1,472,000 and net income of
$167,000, compared to the fourth quarter of fiscal 2004 which had an operating loss of $191,000 and
a net loss of $1,538,000. Although there can be no assurance that these improvements will 11




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MORGANS FOODS, INC. PART II (contd) be sustained, the favorable results have continued in fiscal 2006 as the Company has experienced
increases in revenues, and anticipates reporting improved operating results, for the first quarter
of fiscal 2006. Liquidity and Capital Resources. Cash flow activity for fiscal 2005 and fiscal 2004
is presented in the Consolidated Statements of Cash Flows. Cash provided by operating activities
was $2,914,000 for the year ended February 27, 2005 compared to $3,667,000 for the year ended
February 29, 2004. The decline in operating cash flow resulted principally from the net loss for
the year ended February 27, 2005, reduced funding from supply agreements and changes in operating
assets and liabilities related to the timing of payments. The Company paid long-term bank and
capitalized lease debt of $2,901,000 in fiscal 2005 compared to payments of $2,710,000 in fiscal
2004. Capital expenditures in fiscal 2005 were $2,141,000, compared to $1,170,000 in fiscal 2004.
This increase is primarily a result of expenditures required to repair the two flood-damaged
restaurants and one fire-damaged restaurant discussed previously as well as the replacement of
substantially all of the KFC restaurants menu boards as required by the KFC franchisor. The Companys debt arrangements require the maintenance of a consolidated fixed charge
coverage ratio of 1.2 to 1 regarding all of the Companys mortgage loans and the maintenance of
individual restaurant fixed charge coverage ratios of between 1.2 and 1.5 to 1 on certain of the
Companys mortgage loans. The consolidated and individual coverage ratios are computed quarterly,
based upon financial results for the preceding twelve months. At the end of fiscal 2004 and
fiscal 2005 and each of the fiscal 2005 quarters, the Company was not in compliance with the
consolidated ratio or with individual restaurant ratios relating to a substantial portion of its
debt. The Company obtained waivers of these violations from the applicable lenders at the end of
fiscal 2004 and the first and second quarters of fiscal 2005, in each case with the lenders
agreeing to forebear exercising their rights and remedies through the following twelve months.
Based upon projected operating results, the Company believed at the time it received the foregoing
waivers that it would comply with the terms thereof throughout the respective forbearance periods
and, accordingly, the Company classified the debt for which it received waivers as long-term as of
the end of fiscal 2004 and the first and second quarters of fiscal 2005. As of the end of the
third quarter of fiscal 2005 and year ended February 27, 2005, waivers of the fixed charge
coverage ratio violations were not obtained from the lenders. Due to noncompliance with the fixed
charge coverage ratios and as required by Emerging Issues Task Force No. 86-30, the Company has
classified all of its debt as current as of February 27, 2005. As described below, the Company
has initiated an operational and financial restructuring process which management believes, but
cannot assure, will allow the Company to satisfy the lenders without a forced repayment of the
debt prior to its scheduled maturities. On November 30, 2004 the Company announced an organizational restructuring and discussions
with its lenders which the Company believes will lead to a financial restructuring. Both actions,
which are described below, are intended to substantially improve cash flow for the Company. Weak
revenues and cash flows in the first quarter of fiscal 2005 caused by a failed new product
introduction by the Companys KFC franchisor were compounded by the flooding of two of the
Companys more profitable restaurants in the third quarter of fiscal 2005. Both of the flooded
restaurants reopened in the fourth quarter of fiscal 2005. As a result of the above mentioned
items, the Companys cash balances in the fourth quarter of fiscal 2005 were 12




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MORGANS FOODS, INC. PART II (contd) projected to drop below the levels considered adequate to fund cash obligations during the
traditionally low revenue winter months. The organizational and financial restructurings were
initiated to provide both the short term cash flow improvements necessary to navigate the difficult
winter season and the permanent cash flow improvements to allow the Company to function
appropriately. Organizational and Operational Restructuring.The organizational restructuring contains
several elements. First, substantial cost reduction measures were put in place for both restaurant
and administrative operations. Early in the fourth quarter of fiscal 2005, three senior officers
of the Company reduced their salaries and other benefits to near zero while the remainder of the
Companys executive team and some of its management took pay cuts. These salary and benefit
reductions reduced expenses during the fourth quarter of fiscal 2005 approximately $300,000. The
Company is assessing the timing and extent of restoring some or all of these reductions. Second,
on November 24, 2004 the Company completed previously planned closures of three unprofitable
restaurants (two in the St. Louis market and one in the Pittsburgh market) which improved cash flow
in the fourth quarter of fiscal 2005. Last, several members of management were reassigned and
several positions were eliminated. The Companys Vice President of Operations Services is now
directly responsible for the operation of all restaurants and the Companys former Director of
Operations was reassigned to the extremely challenging Missouri market to streamline supervision
and improve operations of those restaurants. Also, several restaurant supervision and support
positions were eliminated. As a result of these organizational restructuring activities and
successful product promotions by the franchisors in the fourth quarter, the Company recorded
positive operating income and operating cash flows in the fourth quarter of fiscal 2005. This
represents a significant improvement, as the Company has historically recognized losses during the
fourth quarter. As indicated above, some of these operational improvements are intended to be
temporary measures (e.g., salary and benefit reductions). The Company cannot assure that the other
organizational changes described above and future product promotions by the franchisors will yield
sustained improvement of future operating results. Accordingly, the Company continues to pursue
the financial restructuring described below. Financial Restructuring. Beginning in the second half of fiscal 2005, the Company has
engaged in discussions with its three primary lenders with the intent of securing short term,
temporary reductions in its debt service payments to conserve cash and to allow the Company to
execute sale/leaseback financing on a number of its owned restaurant properties. On February 7,
2005, the Company reduced its debt service payments to interest only on loans with one lender
representing 50.2% of the principal balance of all of the Companys loans. The Company expects to
continue this reduced payment schedule until the financial restructuring is completed. Scheduled
principal payments that have not been paid total approximately $110,000 per month. The Company
has received a letter of understanding from this lender, acknowledging the financial restructuring
and confirming its intent to negotiate a formal agreement of forbearance. As of May 31, 2005,
negotiation of a forbearance agreement has been initiated but not completed. Accordingly, the
reduced payment schedule remains an event of default although the Company has no reason to believe
that the lender intends to take actions permitted by such default. On April 12, 2005 the Company
signed an Agreement of Sale relating to a sale/ leaseback of ten of its restaurants; however,
certain due diligence items remain before this transaction is finalized including 13




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MORGANS FOODS, INC. PART II (contd) inspections, appraisals, title work and finalization of the related leases. In addition, the
prepayment penalty on the mortgage debt for these restaurants must be waived for the transaction to
be financially viable for the Company. The sale leaseback transactions, if successful, will
generate proceeds to prepay a portion of the Companys debt and will result in cash flow
improvement by replacing debt service with rent payments of a lesser amount. Management expects
that it will be able to complete the financial restructuring successfully and is encouraged by the
improved financial results generated by the previously disclosed organizational restructuring.
Nonetheless, given the level of the Companys indebtedness and other demands on its cash resources,
there can be no assurance that the Companys lenders will consent to the restructuring, that the
restructuring will be accomplished, or that other actions might not be taken by creditors that
would impede the Companys ability to satisfy its obligations. The Companys reduced debt payment schedule and covenant violations discussed above could
result in the exercise of certain remedies available to the lenders which may include calling of
the debt, acceleration of payments or foreclosure on the Companys assets which secure the debt.
Note 5 to the consolidated financial statements provides further details of these matters including
the potential impact on the Companys ability to continue as a going concern and to realize its
assets and to discharge its liabilities in the normal course of business, that could result, if the
lenders exercise these remedies. The lenders have not initiated any of these remedies and
management believes, but cannot assure, that these actions will not be taken prior to the Company
completing the financial restructuring described above. Market Risk Exposure. The Companys existing borrowings are at fixed interest rates,
and accordingly the Company does not have market risk exposure for fluctuations in interest rates.
As described above, the Company has initiated a financial restructuring process which could result
in refinancing of debt through sale leaseback transactions at higher or lower fixed interest rates,
or at variable rates. Until the financial restructuring process is completed, it is not possible
to quantify the market risk exposure, if any, that could result from future borrowings. The
Companys current plans call for sale leaseback transactions involving one to ten restaurants.
Consequently, increases in sale leaseback rates are not expected to materially affect the Companys
market risk exposure. The Company does not enter into derivative financial investments for trading
or speculation purposes. As a result, the Company believes that its market risk exposure is not
material to the Companys financial position, liquidity or results of operations. The Companys contractual obligations and commitments as of February 27, 2005 were as follows: (In thousands) Contractual Obligations
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    Thereafter
    
    
    TotalLong-term debt, including
current
    
    $
    3,110
    
    
    $
    3,109
    
    
    $
    2,927
    
    
    $
    3,033
    
    
    $
    3,299
    
    
    $
    28,204
    
    
    $
    43,682Interest expense on
long-term debt
    
    
    3,972
    
    
    
    3,665
    
    
    
    3,351
    
    
    
    3,115
    
    
    
    2,812
    
    
    
    10,742
    
    
    
    27,657Capital leases
    
    
    13
    
    
    
    14
    
    
    
    16
    
    
    
    17
    
    
    
    18
    
    
    
    303
    
    
    
    381Operating leases
    
    
    1,988
    
    
    
    1,721
    
    
    
    1,444
    
    
    
    1,393
    
    
    
    1,044
    
    
    
    3,633
    
    
    
    11,219
 14




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MORGANS FOODS, INC. PART II (contd) Other Contractual Obligations and Commitments. At February 29, 2004 the Company had a letter of credit for $300,000 outstanding in favor of a
vendor. The letter of credit which expired June 18, 2004 was secured by a $300,000 certificate of
deposit. For KFC products, the Company is required to pay royalties of 4% of gross revenues and to
expend an additional 5.5% of gross revenues on national and local advertising pursuant to its
franchise agreements. For Taco Bell products in KFC/Taco 2n1 restaurants operated under license
agreements from Taco Bell Corporation and franchise agreements from KFC Corporation, the Company is
required to pay royalties of 10% of Taco Bell gross revenues and to make advertising fund
contributions of 1/2% of Taco Bell gross revenues. For Taco Bell product sales in restaurants
operated under Taco Bell franchises the Company is required to pay royalties of 5.5% of gross
revenues and to expend an additional 4.5% of gross revenues on national and local advertising. For
Pizza Hut products in Taco Bell/Pizza Hut Express 2n1 restaurants the Company is required to pay
royalties of 5.5% of Pizza Hut gross revenues and to expend an additional 4.5% of Pizza Hut gross
revenues on national and local advertising. For A&W products in 2n1 restaurants the Company is
required to pay royalties of 7% of A&W gross revenues and to expend an additional 4% of A&W gross
revenues on national and local advertising. Total royalties and advertising, which are included in
the Consolidated Statements of Operations as part of restaurant operating expenses, were
$8,033,000, $8,083,000 and $8,141,000 in fiscal 2005, 2004 and 2003, respectively. In fiscal year 2000 the Company signed an agreement and prepaid franchise fees of $170,000
which granted it the rights to develop 20 KFC, Taco Bell or KFC 2n1 restaurants in specific
geographic areas. Under the agreement five restaurants are required to be developed each year over
a four year period. As of February 27, 2005 the Company has developed only five restaurants under
this agreement. The status of the development agreements has been discussed with the franchisors
and the Company has not been declared in default of the KFC agreement. If the Company should
default on the KFC agreement, it could lose the rights to develop certain KFC restaurants and could
forfeit the remaining balance of prepaid franchise fees, which was $60,000 at February 27, 2005.
The Company was declared in default under the terms of its Taco Bell development agreement which
had a related deposit of $30,000. The Taco Bell franchisor allowed the Company to use $25,000 of
the deposits towards other franchise/license agreement extension fees and returned the remaining
amount to the Company. The Company believes that noncompliance with the development agreement will
not have a material impact on its financial position, results of operations or cash flows. The franchise agreements with KFC and Taco Bell Corporation require the Company to upgrade and
remodel its restaurants to comply with the franchisors current standards within agreed upon
timeframes. The Company does not expect to commit funds to image enhancements or expansions during
fiscal 2006. In order to meet the terms and conditions of the franchise agreements, the Company
has the following obligations: 15




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MORGANS FOODS, INC. PART II (contd) NumberFiscal Year
    
    of Units
    
    
    Obligation (1)2007 image enhancements
    
    
    9
    
    
    $
    1,710,0002008 image enhancements
    
    
    10
    
    
    
    1,880,0002008 relocations
    
    
    1
    (2)
    
    
    1,200,0002009 image enhancements
    
    
    13
    
    
    
    3,250,0002010 image enhancements
    
    
    11
    
    
    
    1,975,0002010 relocations
    
    
    2
    (2)
    
    
    2,000,000Thereafter to 2014Image Enhancements
    
    
    19
    
    
    
    3,550,000Relocations
    
    
    5
    (2)
    
    
    5,200,000Total
    
    
    70
    
    
    $
    20,765,000
     (2)
    Generally at the time relocation of an existing restaurant is required, the related assets
have been depreciated or amortized to a low net book value. If an economically suitable new
location cannot be obtained, the Company may choose to close the restaurant and abandon the
remaining assets. There can be no assurance that the Company will be able to accomplish the development
required in the franchise and development agreements on terms acceptable to the Company. If the
Company is unable to meet the requirements of a franchise agreement, the franchisor may choose to
extend the time allowed for compliance or may terminate the franchise agreement. Seasonality. The operations of the Company are affected by seasonal fluctuations.
Historically, the Companys revenues and income have been highest during the summer months with the
fourth fiscal quarter representing the slowest period. This seasonality is primarily attributable
to weather conditions in the Companys marketplace which consists of portions of Ohio,
Pennsylvania, Missouri, Illinois, West Virginia and New York. Critical Accounting Policies. The Companys reported results are impacted by the
application of certain accounting policies that require it to make subjective or complex judgments
or to apply complex accounting requirements. These judgments include estimations about the effect
of matters that are inherently uncertain and may significantly impact its quarterly or annual
results of operations, financial condition or cash flows. Changes in the estimates and judgments
could significantly affect results of operations, financial condition and cash flows in future
years. The Company believes that its critical accounting policies are as follows:  
    Estimating future cash flows and fair value of assets associated with assessing
potential impairment of long-lived and intangible assets and projected compliance with debt
covenants.  
    Assessing the Companys ability to complete its financial restructuring and to continue
as a going concern, including potential impacts on the carrying values and classifications
of the Companys assets and liabilities. See Note 5 to the consolidated financial
statements for discussion of the financial restructuring.  
    Determining the appropriate valuation allowances for deferred tax assets and reserves
for potential tax 16




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MORGANS FOODS, INC. PART II (contd) exposures. See Note 8 to the consolidated financial statements for a discussion of income
taxes.  
    Applying complex lease accounting requirements to the Companys capital and operating
leases of property and equipment. The Company leases the building or land, or both, for
nearly one-half of its restaurants. See Note 6 to the consolidated financial statements
for a discussion of lease accounting. New
Accounting Standards. In December 2004, the FASB issued SFAS No. 123(R),
Share-Based Payment. This standard will require compensation costs related to share-based
payment transactions to be recognized in the financial statements. With limited exceptions, the
amount of compensation cost will be measured based on the grant-date fair value of the equity or
liability instruments issued. In addition, liability awards will be measured based on the grant
date fair value of the equity or liability instruments issued and will be remeasured each reporting
period. Compensation costs will be recognized over the period that an employee provides service in
exchange for the award. This standard replaces SFAS No. 123 and supersedes Accounting Principles
Board (APB) Opinion No. 25 Accounting for Stock Issued to Employees, and applies to all awards
granted, modified, repurchased or cancelled after February 26, 2006. The Company is currently
evaluating the provisions of this standard to determine the impact on its consolidated financial
statements. To the extent that the Company grants options or other share-based payments after
February 26, 2006, SFAS No. 123(R) is expected to reduce operating results of the Company. Safe Harbor Statements. This document contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. The statements include those identified by such words
as may, will, expect anticipate, believe, plan and other similar terminology. The
forward-looking statements reflect the Companys current expectations and are based upon data
available at the time of the statements. Actual results involve risks and uncertainties, including
both those specific to the Company and general economic and industry factors. Factors specific to
the Company include, but are not limited to, its debt covenant compliance, actions that lenders may
take with respect to any debt covenant violations, and its ability to obtain waivers of any debt
covenant violations, its ability to pay all of its current and long-term obligations and the
ultimate success or failure of the Companys restructuring plans. Economic and industry risks and uncertainties include, but are not limited, to, franchisor
promotions, business and economic conditions, legislation and governmental regulation, competition,
success of operating initiatives and advertising and promotional efforts, volatility of commodity
costs and increases in minimum wage and other operating costs, availability and cost of land and
construction, consumer preferences, spending patterns and demographic trends. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Information required by this item is included under Liquidity and Capital Resources. Item 8. Financial Statements and Supplementary Data. The Consolidated Financial Statements of the Company are set forth in Item 14 of this Report. 17




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MORGANS FOODS, INC. 
 PART III 
 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None. 
 Item 10. Directors and Executive Officers of the Registrant. Information on Directors of the Company is incorporated herein by reference to the definitive
Proxy Statement to security holders for the 2005 annual meeting to be filed with the Securities and
Exchange Commission on or before June 24, 2005. Information regarding the Executive Officers of the Company is reported in a separate section
captioned Executive Officers of the Company included in Part I hereof. 
 Item 11. Executive Compensation. Information on executive compensation is incorporated herein by reference to the definitive
Proxy Statement to security holders for the 2005 annual meeting to be filed with the Securities and
Exchange Commission on or before June 24, 2005. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management. Information on security ownership of certain beneficial owners, officers and directors is
incorporated herein by reference to the definitive Proxy Statement to security holders for the 2005
annual meeting to be filed with the Securities and Exchange Commission on or before June 24, 2005. 
 Item 13. Certain Relationships and Related Transactions. Information on certain relationships and related transactions is incorporated herein by
reference to the definitive Proxy Statement to security holders for the 2005 annual meeting to be
filed with the Securities and Exchange Commission on or before June 24, 2005. 
 Item 14. Controls and Procedures. Management is responsible for the preparation, integrity and objectivity of the consolidated
financial statements and other information presented in this report. The financial statements have
been prepared in accordance with accounting principles generally accepted in the United States of
America and reflect certain estimates and adjustments by management. In preparing financial
statements in conformity with accounting principles generally accepted in the United States of
America, we must make a variety of decisions that affect the reported amounts and the related
disclosures. Such decisions include the selection of accounting principles that reflect the
economic substance of the underlying transactions and the assumptions on which to base accounting
estimates. In reaching such decisions, we apply judgment based on our understanding and 18




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MORGANS FOODS, INC. PART III (contd) analysis of the relevant circumstances, including our historical experience, actuarial studies and
other assumptions. We re-evaluate our estimates and assumptions on an ongoing basis. While actual
results could, in fact, differ from those estimated at the time of preparation of the financial
statements, we are committed to preparing financial statements incorporating accounting principles,
assumptions and estimates that promote the representational faithfulness, verifiability, neutrality
and transparency of the accounting information included in the financial statements. We maintain a system of internal accounting controls and procedures, which management believes
provide reasonable assurance that transactions are properly recorded and that assets are protected
from loss or unauthorized use. We maintain a system of disclosure controls and procedures to ensure timely collection and
evaluation of information subject to disclosure, to ensure the selection of appropriate accounting
policies, and to ensure compliance with our accounting policies and procedures. Our disclosure
control systems and procedures include the certification of financial information provided from
each of our key management personnel. The integrity of our disclosure control systems are based on written policies and procedures,
the careful selection and training of qualified financial personnel and direct management review.
Our disclosure control committee meets periodically to review our systems and procedures and to
review our financial statements and related disclosures. Our independent auditors have direct and private access to the Audit Committee. The effectiveness of the design and operation of our disclosure controls and procedures (as
defined in Rule 13a-14(c) under the Securities Exchange Act of 1934) was evaluated as of the date
of the financial statements. This evaluation was carried out under the supervision of and with the
participation of management, including the Chief Executive Officer and the Chief Financial Officer.
Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded
that the design and operation of these disclosure controls and procedures are effective. There
were no significant changes in internal controls or in other factors that could significantly
affect these controls subsequent to the date of the most recent evaluation. 19




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MORGANS FOODS, INC. 
 PART IV 
 Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.  (a)
    1 and 2. Financial Statements and Financial Statement Schedules.The Financial Statements and Financial Statement Schedules listed on the accompanying
Index to Financial Statements and Financial Statement Schedules are filed as part of
this Annual Report on Form 10-K.(a)
    3. Exhibits.The Exhibits listed on the accompanying Index to Exhibits are filed as part of this
Annual Report on Form 10-K. 20




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MORGANS FOODS, INC.
INDEX TO FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULES
ITEM 15 (a) 1 and 2 
 PageItem 15 (a) 1
    
    ReferenceReport of Independent Registered Public Accounting Firm
    
    
    22Consolidated Balance Sheets
at February 27, 2005 and February 29, 2004
    
    
    23Consolidated Statements of Operations
for the years ended February 27, 2005, February 29, 2004
and March 2, 2003
    
    
    24Consolidated Statements of Shareholders Equity (Deficiency)
for the years ended February 27, 2005, February 29, 2004
and March 2, 2003
    
    
    25Consolidated Statements of Cash Flows
for the years ended February 27, 2005, February 29, 2004
and March 2, 2003
    
    
    26Notes to Consolidated Financial Statements
    
    
    27
 
 Item 15 (a) 2 All schedules normally required by Form 10-K are not required under the related
instructions or are inapplicable, and therefore are not presented. 21




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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders
Morgans Foods, Inc.
Cleveland, Ohio We have audited the accompanying consolidated balance sheets of Morgans Foods, Inc. and
subsidiaries (the Company) as of February 27, 2005 and February 29, 2004 and the related
consolidated statements of operations, shareholders equity (deficiency), and cash flows for
each of the three years in the period ended February 27, 2005. These financial statements are
the responsibility of the Companys management. Our responsibility is to express an opinion
on the financial statements based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free of material
misstatement. The Company is not required to have, nor were we engaged to perform, an audit
of its internal control over financial reporting. Our audit included consideration of
internal control over financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances but not for the purpose of expressing an opinion on the
effectiveness of the Companys internal control over financial reporting. Accordingly we
express no such opinion. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our
opinion. In our opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of Morgans Foods, Inc. and subsidiaries at February 27, 2005
and February 29, 2004 and the results of their operations and their cash flows for each of the
three years in the period ended February 27, 2005 in conformity with accounting principles
generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will
continue as a going concern. As discussed in Note 5 to the financial statements, the Company
sustained recurring losses from operations and shareholders capital deficiency and is not in
compliance with its debt agreements. These matters raise substantial doubt about the
Companys ability to continue as a going concern. Managements plans in regard to these
matters are also detailed in Note 5. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty. /s/ Deloitte & Touche LLP
Cleveland, Ohio
May 31, 2005 22




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##### Table of Contents



MORGANS FOODS, INC.
Consolidated Balance Sheets
February 27, 2005 and February 29, 2004 2005
    
    
    2004ASSETSCurrent assets:Cash and equivalents
    
    $
    3,654,000
    
    
    $
    4,353,000Short term investment  restricted
    
    
    
    
    
    
    300,000Receivables
    
    
    392,000
    
    
    
    242,000Inventories
    
    
    588,000
    
    
    
    573,000Prepaid expenses
    
    
    589,000
    
    
    
    324,0005,223,000
    
    
    
    5,792,000Property and equipment (Notes 5 and 6):Land
    
    
    10,662,000
    
    
    
    10,971,000Buildings and improvements
    
    
    19,423,000
    
    
    
    19,246,000Property under capital leases
    
    
    435,000
    
    
    
    776,000Leasehold improvements
    
    
    7,210,000
    
    
    
    7,353,000Equipment, furniture and fixtures
    
    
    19,428,000
    
    
    
    18,864,000Construction in progress
    
    
    189,000
    
    
    
    58,00057,347,000
    
    
    
    57,268,000Less accumulated depreciation and amortization
    
    
    25,740,000
    
    
    
    23,377,00031,607,000
    
    
    
    33,891,000Other assets
    
    
    1,040,000
    
    
    
    1,186,000Franchise agreements
    
    
    1,693,000
    
    
    
    1,876,000Deferred taxes (Note 8)
    
    
    
    
    
    
    600,000Goodwill
    
    
    9,227,000
    
    
    
    9,327,000$
    48,790,000
    
    
    $
    52,672,000LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIENCY)Current liabilities:Long-term debt, current (Note 5)
    
    $
    43,682,000
    
    
    $
    2,743,000Current maturities of capital lease obligations (Note 6)
    
    
    13,000
    
    
    
    58,000Accounts payable
    
    
    4,034,000
    
    
    
    3,642,000Accrued liabilities (Note 4)
    
    
    3,542,000
    
    
    
    3,348,00051,271,000
    
    
    
    9,791,000Long-term debt (Note 5)
    
    
    
    
    
    
    43,370,000Long-term capital lease obligations (Note 6)
    
    
    368,000
    
    
    
    379,000Other long-term liabilities
    
    
    1,725,000
    
    
    
    1,848,000Commitments and contingencies (Notes 5 and 6)SHAREHOLDERS EQUITY (DEFICIENCY)Preferred shares, 1,000,000 shares authorized,
no shares outstandingCommon Stock:Authorized shares - 25,000,000
Issued shares - 2,969,405
    
    
    30,000
    
    
    
    30,000Treasury shares - 250,910 in 2005 and 250,964 in 2004
    
    
    (284,000
    )
    
    
    (284,000
    )Capital in excess of stated value
    
    
    28,829,000
    
    
    
    28,829,000Accumulated deficit
    
    
    (33,149,000
    )
    
    
    (31,291,000
    )Total shareholders deficiency
    
    
    (4,574,000
    )
    
    
    (2,716,000
    )$
    48,790,000
    
    
    $
    52,672,000
 See notes to consolidated financial statements. 23




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##### Table of Contents



MORGANS FOODS, INC.
Consolidated Statements of Operations
Years Ended February 27, 2005, February 29, 2004 and March 2, 2003 2005
    
    
    2004
    
    
    2003Revenues
    
    $
    80,960,000
    
    
    $
    81,738,000
    
    
    $
    82,326,000Cost of sales:Food, paper and beverage
    
    
    25,222,000
    
    
    
    24,712,000
    
    
    
    25,645,000Labor and benefits
    
    
    22,803,000
    
    
    
    22,816,000
    
    
    
    22,329,000Restaurant operating expenses
    
    
    21,015,000
    
    
    
    21,320,000
    
    
    
    21,018,000Depreciation and amortization
    
    
    3,419,000
    
    
    
    3,518,000
    
    
    
    3,499,000General and administrative expenses
    
    
    4,870,000
    
    
    
    5,574,000
    
    
    
    5,749,000Loss on restaurant assets (Note 2)
    
    
    574,000
    
    
    
    567,000
    
    
    
    551,000Operating income
    
    
    3,057,000
    
    
    
    3,231,000
    
    
    
    3,535,000Interest expense:Bank debt and notes payable
    
    
    (4,341,000
    )
    
    
    (4,578,000
    )
    
    
    (4,802,000
    )Capital leases
    
    
    (45,000
    )
    
    
    (49,000
    )
    
    
    (62,000
    )Other income and expense, net
    
    
    78,000
    
    
    
    106,000
    
    
    
    147,000Income (loss) from continuing
operations before income taxes
    
    
    (1,251,000
    )
    
    
    (1,290,000
    )
    
    
    (1,182,000
    )Provision for income taxes (Note 8)
    
    
    607,000
    
    
    
    4,000
    
    
    
    10,000Net income (loss)
    
    $
    (1,858,000
    )
    
    $
    (1,294,000
    )
    
    $
    (1,192,000Basic and diluted net income (loss)
per common share:
    
    $
    (.68
    )
    
    $
    (.48
    )
    
    $
    (.44
    )
 See notes to consolidated financial statements. 24




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##### Table of Contents



MORGANS FOODS, INC.
Consolidated Statements of Shareholders Equity (Deficiency)
Years Ended February 27, 2005, February 29, 2004, and March 2, 2003 TotalCapital in
    
    
    
    
    
    
    ShareholdersCommon Shares
    
    
    Treasury Shares
    
    
    excess of
    
    
    Accumulated
    
    
    EquityShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    stated value
    
    
    Deficit
    
    
    (Deficiency)Balance, March 3, 2002
    
    
    2,969,405
    
    
    $
    30,000
    
    
    
    (241,564
    )
    
    $
    (251,000
    )
    
    $
    28,829,000
    
    
    $
    (28,805,000
    )
    
    $
    (197,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,192,000
    )
    
    
    (1,192,000
    )Purchase of common shares
    
    
    
    
    
    
    
    
    
    
    (9,400
    )
    
    
    (33,000
    )
    
    
    
    
    
    
    
    
    
    
    (33,000
    )Balance, March 2, 2003
    
    
    2,969,405
    
    
    
    30,000
    
    
    
    (250,964
    )
    
    
    (284,000
    )
    
    
    28,829,000
    
    
    
    (29,997,000
    )
    
    
    (1,422,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,294,000
    )
    
    
    (1,294,000
    )Balance, February 29, 2004
    
    
    2,969,405
    
    
    
    30,000
    
    
    
    (250,964
    )
    
    
    (284,000
    )
    
    
    28,829,000
    
    
    
    (31,291,000
    )
    
    
    (2,716,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,858,000
    )
    
    
    (1,858,000
    )Adjustment of treasury
shares (Note 9)
    
    
    
    
    
    
    
    
    
    
    54
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance, February 27, 2005
    
    
    2,969,405
    
    
    $
    30,000
    
    
    
    (250,910
    )
    
    $
    (284,000
    )
    
    $
    28,829,000
    
    
    $
    (33,149,000
    )
    
    $
    (4,574,000
    )
 See notes to consolidated financial statements. 25




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##### Table of Contents



MORGANS FOODS, INC.
Consolidated Statements of Cash Flows
Years Ended February 27, 2005, February 29, 2004, and March 2, 2003 2005
    
    
    2004
    
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    (1,858,000
    )
    
    $
    (1,294,000
    )
    
    $
    (1,192,000
    )Adjustments to reconcile to net cash
provided by operating activities:Depreciation and amortization
    
    
    3,419,000
    
    
    
    3,518,000
    
    
    
    3,499,000Amortization of deferred
financing costs
    
    
    121,000
    
    
    
    134,000
    
    
    
    139,000Amortization of supply agreement
advances (Note 1)
    
    
    (709,000
    )
    
    
    (845,000
    )
    
    
    (771,000
    )Funding from supply agreements (Note 1)
    
    
    641,000
    
    
    
    1,200,000
    
    
    
    719,000Loss on restaurant assets
    
    
    574,000
    
    
    
    567,000
    
    
    
    551,000Provision for deferred taxes
    
    
    600,000
    
    
    
    
    
    
    
    Changes in assets and liabilities:Decrease (Increase) in receivables
    
    
    (150,000
    )
    
    
    58,000
    
    
    
    (68,000
    )Decrease (Increase) in inventories
    
    
    (15,000
    )
    
    
    (81,000
    )
    
    
    28,000Decrease (Increase) in prepaid expenses
    
    
    (265,000
    )
    
    
    238,000
    
    
    
    (261,000
    )Decrease in other assets
    
    
    25,000
    
    
    
    6,000
    
    
    
    36,000Increase (Decrease) in accounts payable
    
    
    392,000
    
    
    
    449,000
    
    
    
    (568,000
    )Increase (Decrease) in
accrued liabilities
    
    
    139,000
    
    
    
    (283,000
    )
    
    
    (283,000
    )Net cash provided by operating activities
    
    
    2,914,000
    
    
    
    3,667,000
    
    
    
    1,829,000Cash flows from investing activities:Capital expenditures
    
    
    (2,141,000
    )
    
    
    (1,170,000
    )
    
    
    (2,053,000
    )Insurance proceeds
    
    
    740,000
    
    
    
    
    
    
    
    Purchase of franchise agreement
    
    
    (25,000
    )
    
    
    (35,000
    )
    
    
    Redemption (purchase) of short
term investment
    
    
    300,000
    
    
    
    (300,000
    )
    
    
    Net cash used in investing activities
    
    
    (1,126,000
    )
    
    
    (1,505,000
    )
    
    
    (2,053,000
    )Cash flows from financing activities:Proceeds from issuance of long-term debt,
net of financing costs
    
    
    414,000
    
    
    
    
    
    
    
    Principal payments on long-term debt
    
    
    (2,845,000
    )
    
    
    (2,603,000
    )
    
    
    (2,178,000
    )Principal payments on capital
lease obligations
    
    
    (56,000
    )
    
    
    (107,000
    )
    
    
    (105,000
    )Purchase of treasury shares
    
    
    
    
    
    
    
    
    
    
    (33,000
    )Net cash used in financing activities
    
    
    (2,487,000
    )
    
    
    (2,710,000
    )
    
    
    (2,316,000
    )Net change in cash and equivalents
    
    
    (699,000
    )
    
    
    (548,000
    )
    
    
    (2,540,000
    )Cash and equivalents, beginning balance
    
    
    4,353,000
    
    
    
    4,901,000
    
    
    
    7,441,000Cash and equivalents, ending balance
    
    $
    3,654,000
    
    
    $
    4,353,000
    
    
    $
    4,901,000
 See notes to consolidated financial statements. 26




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##### Table of Contents



MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004, and March 2, 2003 Note 1. Description of Business and Summary of Significant Accounting Policies. Description of Business.Morgans Foods, Inc. and its subsidiaries (the Company) operate 73
KFC restaurants, 7 Taco Bell restaurants, 14 KFC/Taco Bell 2n1 restaurants, 3 Taco Bell/Pizza Hut
Express 2n1 restaurants, 1 KFC/Pizza Hut Express 2n1 and 1 KFC/A&W 2n1, in the states of
Illinois, Missouri, Ohio, Pennsylvania, West Virginia and New York. The Companys fiscal year is a
52-53 week year ending on the Sunday nearest the last day of February. Use of Estimates.The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires management to make estimates
and assumptions pending completion of related events. These estimates and assumptions include the
recoverability of tangible and intangible asset values, the probability of receiving insurance
proceeds, projected compliance with financing agreements and the realizability of deferred tax
assets. These estimates and assumptions affect the amounts reported at the date of the financial
statements for assets, liabilities, revenues and expenses and the disclosure of contingencies.
Actual results could differ from those estimates. Principles of Consolidation.The consolidated financial statements include the accounts of
the Company. All significant intercompany transactions and balances have been eliminated. Revenue Recognition.The Company recognizes revenue as customers pay for products at the time
of sale. Advertising Costs.The Company expenses advertising costs as incurred. Advertising expense
was $4,623,000, $4,645,000 and $4,697,000 for fiscal years 2005, 2004 and 2003, respectively. Cash and Investments.The Company considers all highly liquid debt instruments purchased with
an initial maturity of three months or less to be cash equivalents. At February 29, 2004 the
Company held a $300,000 certificate of deposit as a restricted short-term investment to secure a
letter of credit that expired June 18, 2004. Inventories.Inventories, principally food, beverages and paper products, are stated at the
lower of aggregate cost (first-in, first-out basis) or market. Property and Equipment.Property and equipment are stated at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the related assets as follows:
buildings and improvements  3 to 20 years; equipment, furniture and fixtures  3 to 10 years.
Leasehold improvements are amortized over 3 to 15 years, which is the shorter of the life of the
asset or the life of the lease. The asset values of the capitalized leases are amortized using the
straight-line method over the lives of the respective leases which range from 15 to 20 years. 27




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##### Table of Contents



MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004, and March 2, 2003 Management assesses the carrying value of property and equipment whenever there is an
indication of potential impairment, including quarterly assessments of any restaurant with negative
cash flows. If the property and equipment of a restaurant on a held and used basis are not
recoverable based upon forecasted, undiscounted cash flows, the assets are written down to their
fair value. Management uses a valuation methodology (believed to be consistent with methodologies
commonly used in the industry) to determine fair value, which is the sum of the restaurants
business value and real estate value. Business value is determined using a cash flow multiplier
based upon market conditions and estimated cash flows of the restaurant. Real estate value is
generally determined based upon the discounted market value of implied rent of the owned assets.
Management believes the carrying value of property and equipment, after impairment write-downs (see
Note 2), will be recovered from future cash flows. Deferred Financing Costs.Costs related to the acquisition of long-term debt are capitalized
and expensed as interest over the term of the related debt. Amortization expense was $121,000,
$134,000 and $139,000 for fiscal years 2005, 2004 and 2003, respectively. The balance of deferred
financing costs was $867,000 at February 27, 2005 and $988,000 at February 29, 2004 and is included
in other assets in the consolidated balance sheets. Franchise Agreements.Franchise agreements are recorded at cost. Amortization is computed on
the straight-line method over the term of the franchise agreement. The Companys franchise
agreements are predominantly 20 years in length. Goodwill.Goodwill represents the cost of acquisitions in excess of the fair value of
identifiable assets. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets,
goodwill is not amortized, but is subject to assessment for impairment whenever there is an
indication of impairment or at least annually as of fiscal year end by applying a fair value based
test. Advance on Supply Agreements. In conjunction with entering into contracts that require the
Company to sell exclusively the specified beverage products for the term of the contract, the
Company has received advances from the supplier. The Company amortizes advances on supply
agreements as a reduction of food, paper and beverage cost of sales over the term of the related
contract using the straight-line method. These advances of $1,286,000 and $1,412,000 at February
27, 2005 and February 29, 2004, respectively, are included in other long-term liabilities in the
Consolidated Balance Sheets. Lease Accounting.Operating lease expense is recognized on the straight-line basis over the
term of the lease for those leases with fixed escalations. These accruals of $439,000 and $436,000
at February 27, 2005 and February 29, 2004, respectively, are included in other long-term
liabilities in the Consolidated Balance Sheets. Income Taxes.The provision for income taxes is based upon income or loss before tax for
financial reporting purposes. Deferred tax assets or liabilities are recognized for the expected
future tax consequences 28




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##### Table of Contents



MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004, and March 2, 2003 of temporary differences between the tax basis of assets and liabilities and their carrying values
for financial reporting purposes. Deferred tax assets are also recorded for operating loss and tax
credit carryforwards. A valuation allowance is recorded to reduce deferred tax assets to the
amount more likely than not to be realized in the future, based on an evaluation of historical and
projected profitability. Stock-Based Compensation.The Companys outstanding stock options are accounted for using the
intrinsic value method, under which compensation cost is measured as the excess, if any, of the
quoted market price of the stock at the grant date over the amount an employee must pay to acquire
the stock. Had compensation cost for the options granted been determined based on their fair
values at the grant dates in accordance with the fair value method of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, the Companys
proforma net income (loss) and earnings (loss) per share would not have differed from the reported
amounts for fiscal 2005, 2004 or 2003. Note 2. Loss on Restaurant Assets. During fiscal 2005, 2004 and 2003, the Company recognized losses totaling $574,000, $567,000
and $551,000, respectively, from the sale, disposal or loss of restaurant assets, the closing of
unprofitable restaurants and the impairment of restaurant assets. The 2005 amounts include
impairment losses of $823,000 on nine restaurants to reduce their carrying values to their
estimated fair values. These impairment losses were offset by gains recognized totaling $167,000
recognized for property damage insurance proceeds received in excess of the net book value of the
related property, and $178,000 for business interruption insurance proceeds received. These
insurance proceeds relate to two restaurants damaged from the Hurricane Ivan storm system and one
fire-damaged restaurant. Insurance proceeds which will result in a gain are recognized in the
financial statements only when such gains are realized, which is generally upon receipt of the
proceeds. The Company anticipates recognizing gains in fiscal 2006 in excess of $250,000 from
additional insurance proceeds that have been, or are expected to be, received after February 27,
2005. The 2004 amounts include impairment losses of $254,000 on two restaurants to reduce their
carrying values to their estimated fair values. The impairment losses recognized in fiscal 2005
and 2004 were a result of management determining that future operating cash flows would not fully
recover the carrying value of the restaurants property and equipment. Three restaurants were
closed during fiscal 2005 and one restaurant was closed during fiscal year 2004. No restaurants
were closed during fiscal year 2003. At February 27, 2005 the accrual for closed restaurants
consisted of remaining exit costs for one restaurant and was almost entirely lease termination
costs. This restaurant did not have a material effect upon the Companys consolidated results of
operations or financial position. Note 3. Intangible Assets. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets,goodwill and
intangibles with indefinite lives are not subject to amortization, but are subject to assessment
for impairment whenever there is an indication of impairment or, at least annually as of the
Companys fiscal 29




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##### Table of Contents



MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004, and March 2, 2003 year end by applying a fair value based test. The Company has five reporting units for the purpose
of evaluating goodwill impairment which are based on the geographic market areas of its
restaurants. These five reporting units are Youngstown, OH, West Virginia, Pittsburgh, PA, St
Louis, MO and Erie, PA. The Company has performed the annual goodwill impairment tests during
fiscal 2005, 2004 and 2003 and determined that the fair value of each reporting unit was greater
than its carrying value at each date. Intangible AssetsAs of February 27, 2005
    
    
    As of February 29, 2004Gross Carrying
    
    
    Accumulated
    
    
    Gross Carrying
    
    
    AccumulatedAmount
    
    
    Amortization
    
    
    Amount
    
    
    AmortizationFranchise Agreements
    
    $
    2,441,000
    
    
    $
    (748,000
    )
    
    $
    2,502,000
    
    
    $
    (626,000
    )Goodwill
    
    
    10,593,000
    
    
    
    (1,366,000
    )
    
    
    10,707,000
    
    
    
    (1,380,000
    )Total
    
    $
    13,034,000
    
    
    $
    (2,114,000
    )
    
    $
    13,209,000
    
    
    $
    (2,006,000
    )
 The Companys intangible asset amortization expense relating to its franchise agreements
was $122,000, $123,000 and $115,000 for fiscal 2005, 2004 and 2003, respectively. The estimated
intangible amortization expense for each of the next five years is $125,000. The decrease in franchise agreements resulted from a $75,000 reduction associated with the
closing of three restaurants which was partially offset by renewals paid on several locations. The
decrease in goodwill was due to the $114,000 reduction in goodwill associated with the closing of
one restaurant. Note 4. Accrued Liabilities. Accrued liabilities consist of the following at February 27, 2005 and February 29, 2004: 2005
    
    
    2004Accrued compensation
    
    $
    1,817,000
    
    
    $
    1,747,000Accrued taxes other than income taxes
    
    
    820,000
    
    
    
    700,000Accrued liabilities related to closed restaurants
    
    
    268,000
    
    
    
    310,000Other accrued expenses
    
    
    637,000
    
    
    
    591,000$
    3,542,000
    
    
    $
    3,348,000
 30




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##### Table of Contents



MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 Note 5. Debt. Debt consists of the following at February 27, 2005 and February 29, 2004: 2005
    
    
    2004Mortgage debt, including
interest at 8.3% to 10.6%, through 2021,
collateralized by seventy-five restaurants having a
net book value at February 27, 2005 of $22,818,000
    
    $
    42,127,000
    
    
    $
    44,140,000Equipment loans, including
interest at 9.9% to 11.1% through October 2007
collateralized by equipment at several KFC restaurants
    
    
    1,518,000
    
    
    
    1,851,000Note payable at 8%,
including interest through July 2005
    
    
    37,000
    
    
    
    122,00043,682,000
    
    
    
    46,113,000Less long term debt, current
    
    
    43,682,000
    
    
    
    2,743,000$
    
    
    
    $
    43,370,000
 The combined aggregate amounts of scheduled future maturities for all long-term debt, (as
described below, all debt has been classified as current in the consolidated balance sheet), as of
February 27, 2005 are as follows: 2006
    
    $
    3,110,0002007
    
    
    3,109,0002008
    
    
    2,927,0002009
    
    
    3,033,0002010
    
    
    3,299,000Later years
    
    
    28,204,000$
    43,682,000
 The Company paid interest relating to long-term debt of approximately $4,262,000,
$4,476,000, and $4,324,000 in fiscal 2005, 2004 and 2003, respectively. The Companys debt arrangements require the maintenance of a consolidated fixed charge
coverage ratio of 1.2 to 1 regarding all of the Companys mortgage loans and the maintenance of
individual restaurant fixed charge coverage ratios of between 1.2 and 1.5 to 1 on certain of the
Companys mortgage loans. The consolidated and individual coverage ratios are computed quarterly,
based upon financial results for the preceding twelve months. At the end of fiscal 2004 and 2005
and each of the fiscal 2005 quarters, the Company was not in compliance with the consolidated ratio
or with individual restaurant ratios relating to a substantial portion of its debt. The Company
obtained waivers of these violations from the applicable lenders at the end of fiscal 2004 and the
first and second quarters of fiscal 2005, in each case with the lenders agreeing to forebear
exercising their rights and remedies through the following twelve months. Based upon projected 31




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 operating results, the Company believed at the time it received the foregoing waivers that it
would comply with the terms thereof throughout the respective forbearance periods and,
accordingly, the Company classified the debt for which it received waivers as long-term as of the
end of fiscal 2004 and the first and second quarters of fiscal 2005. As of the end of the third
quarter of fiscal 2005 and year ended February 27, 2005, waivers of the fixed charge coverage
ratio violations were not obtained from the lenders. Due to noncompliance with the fixed charge
coverage ratios and as required by Emerging Issues Task Force No. 86-30, the Company has
classified all of its debt as current as of February 27, 2005. As described below, the Company
has initiated an operational and financial restructuring process which management believes, but
cannot assure, will allow the Company to satisfy the lenders without a forced repayment of the
debt prior to its scheduled maturities. On November 30, 2004 the Company announced an organizational restructuring and discussions
with its lenders which the Company believes will lead to a financial restructuring. Both actions,
which are described below, are intended to substantially improve cash flow for the Company. Weak
revenues and cash flows in the first quarter of fiscal 2005 caused by a failed new product
introduction by the Companys KFC franchisor were compounded by the flooding of two of the
Companys more profitable restaurants in the third quarter of fiscal 2005. Both of the flooded
restaurants reopened in the fourth quarter of fiscal 2005. As a result of the above mentioned
items, the Companys cash balances in the fourth quarter of fiscal 2005 were projected to drop
below the levels considered adequate to fund cash obligations during the traditionally low revenue
winter months. The organizational and financial restructurings were initiated to provide both the
short term cash flow improvements necessary to navigate the difficult winter season and the
permanent cash flow improvements to allow the Company to function appropriately. Organizational and Operational Restructuring.The organizational restructuring contains
several elements. First, substantial cost reduction measures were put in place for both restaurant
and administrative operations. Early in the fourth quarter of fiscal 2005, three senior officers
of the Company reduced their salaries and other benefits to near zero while the remainder of the
Companys executive team and some of its management took pay cuts. These salary and benefit
reductions reduced expenses during the fourth quarter of fiscal 2005 approximately $300,000. The
Company is assessing the timing and extent of restoring some or all of these reductions. Second,
on November 24, 2004 the Company completed previously planned closures of three unprofitable
restaurants (two in the St. Louis market and one in the Pittsburgh market) which improved cash flow
in the fourth quarter of fiscal 2005. Last, several members of management were reassigned and
several positions were eliminated. The Companys Vice President of Operations Services is now
directly responsible for the operation of all restaurants and the Companys former Director of
Operations was reassigned to the extremely challenging Missouri market to streamline supervision
and improve operations of those restaurants. Also, several restaurant supervision and support
positions were eliminated. As a result of these organizational restructuring activities and
successful product promotions by the franchisors in the fourth quarter, the Company recorded
positive operating income and operating cash flows in the fourth quarter of fiscal 2005. This
represents a significant improvement, as the Company has historically recognized losses during the
fourth quarter. As indicated above, some of these 32




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 operational improvements are intended to be temporary measures (e.g., salary and benefit
reductions). The Company cannot assure that the other organizational changes described above and
future product promotions by the franchisors will yield sustained improvement of future operating
results. Accordingly, the Company continues to pursue the financial restructuring described below. Financial Restructuring. Beginning in the second half of fiscal 2005, the Company has engaged
in discussions with its three primary lenders with the intent of securing short term, temporary
reductions in its debt service payments to conserve cash and to allow the Company to execute
sale/leaseback financing on a number of its owned restaurant properties. On February 7, 2005, the
Company reduced its debt service payments to interest only on loans with one lender representing
50.2% of the principal balance of all of the Companys loans. The Company expects to continue this
reduced payment schedule until the financial restructuring is completed. Scheduled principal
payments that have not been paid total approximately $110,000 per month. The Company has received
a letter of understanding from this lender, acknowledging the financial restructuring and
confirming its intent to negotiate a formal agreement of forbearance. As of May 31, 2005,
negotiation of a forbearance agreement has been initiated but not completed. Accordingly, the
reduced payment schedule remains an event of default although the Company has no reason to believe
that the lender intends to take actions permitted by such default. On April 12, 2005 the Company
signed an Agreement of Sale relating to a sale/ leaseback of ten of its restaurants; however,
certain due diligence items remain before this transaction is finalized including inspections,
appraisals, title work and finalization of the related leases. In addition, the prepayment penalty
on the mortgage debt for these restaurants must be waived for the transaction to be financially
viable for the Company. The sale leaseback transactions, if successful, will generate proceeds to
prepay a portion of the Companys debt and will result in cash flow improvement by replacing debt
service with rent payments of a lesser amount. Management expects that it will be able to complete
the financial restructuring successfully and is encouraged by the improved financial results
generated by the previously disclosed organizational restructuring. Nonetheless, given the level
of the Companys indebtedness and other demands on its cash resources, there can be no assurance
that the Companys lenders will consent to the restructuring, that the restructuring will be
accomplished, or that other actions might not be taken by creditors that would impede the Companys
ability to satisfy its obligations. The Companys reduced debt payment schedule and covenant violations discussed above could
result in the exercise of certain remedies available to the lender which may include calling of the
debt, acceleration of payments or foreclosure on the Companys assets which secure the debt. The
Companys other lenders have similar remedies available to them based on covenant violations and
the cross default provisions of those debt agreements. The lenders have not initiated any of these
remedies and management believes, but cannot assure, that these actions will not be taken prior to
the Company completing the financial restructuring described above. However, the recurring losses
from operations and shareholders deficiency that the Company has sustained result in significant
uncertainty as to the Companys ability to complete the financial restructuring if the lenders
initiate these remedies. Consequently, there is substantial doubt that the Company will be able to
continue as a going concern and therefore, if applicable, the 33




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 Company may be unable to realize its assets and discharge its liabilities in the normal course of
business. The financial statements do not include any adjustments relating to recoverability and
classification of recorded asset amounts and classification of liabilities that may be necessary if
the Company is unable to continue as a going concern. Note 6. Lease Obligations and Other Commitments. Property under capital leases at February 27, 2005 and February 29, 2004 are as follows: 2005
    
    
    2004Leased property:Buildings
    
    $
    435,000
    
    
    $
    435,000Equipment, furniture and fixtures
    
    
    
    
    
    
    341,000Total
    
    
    435,000
    
    
    
    776,000Less accumulated amortization
    
    
    127,000
    
    
    
    410,000$
    308,000
    
    
    $
    366,000
 Amortization of leased property under capital leases was $57,000, $131,000 and $103,000
in fiscal 2005, 2004 and 2003, respectively. Related obligations under capital leases at February 27, 2005 and February 29, 2004 are as
follows: 2005
    
    
    2004Capital lease obligations
    
    $
    381,000
    
    
    $
    437,000Less current maturities
    
    
    13,000
    
    
    
    58,000Long-term capital lease obligations
    
    $
    368,000
    
    
    $
    379,000
 The Company paid interest of approximately $45,000, $49,000 and $62,000 relating to
capital lease obligations in fiscal 2005, 2004 and 2003, respectively. Future minimum rental payments to be made under capital leases at February 27, 2005 are as
follows: 2006
    
    $
    50,0002007
    
    
    50,0002008
    
    
    50,0002009
    
    
    50,0002010
    
    
    50,000Later years
    
    
    467,000717,000Less amount representing
interest at 10.0%
    
    
    330,000Total obligations under
capital leases
    
    $
    381,000
 34




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 The Companys operating leases for restaurant land and buildings are noncancellable and expire
on various dates through 2019. The leases have renewal options ranging from 1 to 16 years.
Certain restaurant land and building leases require the payment of additional rent equal to an
amount by which a percentage of annual sales exceeds annual minimum rentals. Total contingent
rentals were $71,000, $64,000 and $71,000 in fiscal 2005, 2004 and 2003, respectively. Future
noncancellable minimum rental payments under operating leases at February 27, 2005 are as follows:
2006  $1,988,000; 2007  $1,721,000; 2008  $1,444,000; 2009  $1,393,000; 2010  $1,044,000 and
an aggregate $3,633,000 for the years thereafter. Rental expense for all operating leases was
$2,129,000, $2,191,000 and $2,214,000 for fiscal 2005, 2004 and 2003, respectively, and is included
in operating expenses in the consolidated statements of operations. For KFC products, the Company is required to pay royalties of 4% of gross revenues and to
expend an additional 5.5% of gross revenues on national and local advertising pursuant to its
franchise agreements. For Taco Bell products in KFC/Taco 2n1 restaurants operated under license
agreements from Taco Bell Corporation and franchise agreements from KFC Corporation, the Company is
required to pay royalties of 10% of Taco Bell gross revenues and to make advertising fund
contributions of 1/2% of Taco Bell gross revenues. For Taco Bell product sales in restaurants
operated under Taco Bell franchises the Company is required to pay royalties of 5.5% of gross
revenues and to expend an additional 4.5% of gross revenues on national and local advertising. For
Pizza Hut products in Taco Bell/Pizza Hut Express 2n1 restaurants the Company is required to pay
royalties of 5.5% of Pizza Hut gross revenues and to expend an additional 4.5% of Pizza Hut gross
revenues on national and local advertising. For A&W products in 2n1 restaurants the Company is
required to pay royalties of 7% of A&W gross revenues and to expend an additional 4% of A&W gross
revenues on national and local advertising. Total royalties and advertising, which are included in
the Consolidated Statements of Operations as part of restaurant operating expenses, were
$8,033,000, $8,083,000 and $8,141,000 in fiscal 2005, 2004 and 2003, respectively. In fiscal year 2000 the Company signed an agreement and prepaid franchise fees of $170,000
which granted it the rights to develop 20 KFC, Taco Bell or KFC 2n1 restaurants in specific
geographic areas. Under the agreement five restaurants are required to be developed each year over
a four year period. As of February 27, 2005 the Company has developed only five restaurants under
this agreement. The status of the development agreements has been discussed with the franchisors
and the Company has not been declared in default of the KFC agreement. If the Company should
default on the KFC agreement, it could lose the rights to develop certain KFC restaurants and could
forfeit the remaining balance of prepaid franchise fees, which was $60,000 at February 27, 2005.
The Company was declared in default under the terms of its Taco Bell development agreement which
had a related deposit of $30,000. The Taco Bell franchisor allowed the Company to use $25,000 of
the deposits towards other franchise/license agreement extension fees and returned the remaining
amount to the Company. The Company believes that noncompliance with the development agreement will
not have a material impact on its financial position, results of operations or cash flows. The franchise agreements with KFC and Taco Bell Corporation require the Company to upgrade and
remodel its restaurants to comply with the franchisors current standards within agreed upon
timeframes. The 35




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 Company does not expect to commit funds to image enhancements and expansions during fiscal 2006.
In order to meet the terms and conditions of the franchise agreements, the Company has the
following obligations: NumberFiscal Year
    
    of Units
    
    
    Obligation (1)2007 image enhancements
    
    
    9
    
    
    $
    1,710,0002008 image enhancements
    
    
    10
    
    
    
    1,880,0002008 relocations
    
    
    1
    (2)
    
    
    1,200,0002009 image enhancements
    
    
    13
    
    
    
    3,250,0002010 image enhancements
    
    
    11
    
    
    
    1,975,0002010 relocations
    
    
    2
    (2)
    
    
    2,000,000Thereafter to 2014Image Enhancements
    
    
    19
    
    
    
    3,550,000Relocations
    
    
    5
    (2)
    
    
    5,200,000Total
    
    
    70
    
    
    $
    20,765,000
   (1)
    
    These amounts are based on current construction cost estimates and actual costs may vary.(2)
    
    Generally at the time relocation of an existing restaurant is required, the related assets
have been depreciated or amortized to a low net book value. If an economically suitable new
location cannot be obtained, the Company may choose to close the restaurant and abandon the
remaining assets. There can be no assurance that the Company will be able to accomplish the development
required in the franchise and development agreements on terms acceptable to the Company. If the
Company is unable to meet the requirements of a franchise agreement, the franchisor may choose to
extend the time allowed for compliance or may terminate the franchise agreement. Note 7. Net Income (Loss) Per Common Share. Basic net income (loss) per common share is computed by dividing net income (loss) by the
weighted average number of common shares outstanding during the period which totaled 2,718,441,
2,718,441 and 2,720,182 for fiscal 2005, 2004 and 2003, respectively. Diluted net income (loss)
per common share is based on the combined weighted average number of shares outstanding during the
period which totaled 2,718,441, 2,718,441 and 2,720,182 for fiscal 2005, 2004 and 2003,
respectively. For fiscal years 2005, 2004 and 2003, 286,500 options were excluded from the
computation of diluted earnings per share due to their antidulutive effect. In computing diluted
net income (loss) per common share, the Company has utilized the treasury stock method. Note 8. Income Taxes. The current tax provision consists of state and local taxes for fiscal 2005, 2004 and 2003 of
$7,000, $4,000 and $10,000, respectively. The deferred tax provision was $600,000 during fiscal
2005 and resulted from a change in the valuation allowance for deferred tax assets at the beginning
of the year, as described below. There was no deferred tax provision during fiscal years 2004 and
2003. 36




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 A reconciliation between the provision for income taxes and income taxes calculated at the
statutory tax rate of 35% is as follows: 2005
    
    
    2004
    
    
    2003Tax provision (benefit)
at statutory rate
    
    $
    (650,000
    )
    
    $
    (451,000
    )
    
    $
    (414,000
    )State and local taxes,
net of federal benefit
    
    
    5,000
    
    
    
    3,000
    
    
    
    7,000Deferred tax provision-change in
valuation allowance
    
    
    600,000
    
    
    
    
    
    
    
    Losses and temporary differences
with no
tax benefit
    
    
    650,000
    
    
    
    442,000
    
    
    
    412,000Other
    
    
    2,000
    
    
    
    10,000
    
    
    
    5,000$
    607,000
    
    
    $
    4,000
    
    
    $
    10,000
 The components of deferred tax assets (liabilities) at February 27, 2005 and February 29, 2004
are as follows: 2005
    
    
    2004Operating loss carryforwards
    
    $
    3,054,000
    
    
    $
    2,899,000Tax credit carryforwards
    
    
    56,000
    
    
    
    56,000Property and equipment
    
    
    2,691,000
    
    
    
    2,336,000Accrued expenses not currently deductible
    
    
    915,000
    
    
    
    676,000Inventory valuation
    
    
    5,000
    
    
    
    5,000Advance payments
    
    
    333,000
    
    
    
    382,000Intangible assets
    
    
    (1,117,000
    )
    
    
    (830,000
    )Deferred tax asset valuation allowance
    
    
    (5,937,000
    )
    
    
    (4,924,000
    )Net deferred tax asset
    
    $
    
    
    
    $
    600,000
 The valuation allowance increased $1,013,000 during fiscal year 2005 and resulted from a
change in judgment about the realizability of deferred tax assets and from timing differences
attributable to the depreciation of property and accrued expenses offset by the difference
attributable to the amortization of intangible assets for tax purposes. During fiscal year 2005
management concluded that realization of deferred tax assets was no longer more likely than not due
to continuing operating losses. Accordingly, a valuation allowance was recorded to reduce net
deferred tax assets to zero. The valuation allowance increased $398,000 during fiscal year 2004
principally due to the timing difference attributable to the depreciation of property and accrued
expenses not currently deductible which were offset by the difference attributable to the
amortization of intangible assets for tax purposes. The valuation allowance increased $116,000
during fiscal year 2003 principally due to the timing difference attributable to the depreciation
of property, the increase in accrued expenses not deductible for tax purposes and the receipt of
income which has been recognized for tax purposes but not yet for financial statement purposes. 37




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 At February 27, 2005, the Company has net operating loss carryforwards which, if not utilized,
will expire as follows: 2008
    
    $
    90,0002009
    
    
    752,0002012
    
    
    744,0002013
    
    
    690,0002019
    
    
    235,0002020
    
    
    1,312,0002021
    
    
    863,0002022
    
    
    1,085,0002023
    
    
    753,0002024
    
    
    383,0002025
    
    
    728,000Total
    
    $
    7,635,000
 The Company also has alternative minimum tax net operating loss carry forwards of
$6,179,000 that will expire, if not utilized, in varying amounts through fiscal 2025. These carry
forwards are available to offset up to 90% of alternative minimum taxable income that would
otherwise be taxable. As of February 27, 2005, the Company has alternative minimum tax credit
carry forwards of $56,000. Note 9. Stock Options and Shareholders Equity. On April 2, 1999, the Board of Directors of the Company approved a Stock Option Plan for
Executives and Managers. Under the plan 145,500 shares were reserved for the grant of options.
The Stock Option Plan for Executives and Managers provides for grants to eligible participants of
nonqualified stock options only. The exercise price for any option awarded under the Plan is
required to be not less than 100% of the fair market value of the shares on the date that the
option is granted. Options are granted by the Stock Option Committee of the Company. Options for
the 145,500 shares were granted to executives and managers of the Company on April 2, 1999 at an
exercise price of $4 1/8. The plan provides that the options are exercisable after a waiting
period of 6 months and that each option expires 10 years after its date of issue. At the Companys annual meeting on June 25, 1999 the shareholders approved the Key Employees
Stock Option Plan. This plan allows the granting of options covering 291,000 shares of stock and
has essentially the same provisions as the Stock Option Plan for Executives and Managers which was
discussed above. Options for 129,850 shares were granted to executives and managers of the Company
on January 7, 2000 at an exercise price of $3.00. Options for 11,500 shares were granted to
executives on April 27, 2001 at an exercise price of $.85. The Company applies APB No. 25 and related interpretations in accounting for its option grants
for employees. Accordingly, no compensation cost has been recognized for options granted as the
options were granted at fair market value at the date of grant. See Note 1 for pro forma
disclosures of compensation cost for the options granted determined based on their fair values at
the grant dates in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. 38




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 No options were granted during fiscal years 2005, 2004 or 2003 and there were no changes in
outstanding options during these years. As of February 27, 2005, February 29, 2004 and March 2,
2003 there were 286,500 options outstanding and exercisable at a weighted average exercise price of
$3.48 per share. The following table summarizes information about stock options outstanding at February 27, 2005. Number
    
    
    Average
    
    
    NumberOutstanding
    
    
    Remaining
    
    
    ExercisableExercise Prices
    
    at 2/27/05
    
    
    Life
    
    
    at 2/27/05$0.85
    
    
    11,500
    
    
    
    5.9
    
    
    
    11,500$3.00
    
    
    129,850
    
    
    
    4.9
    
    
    
    129,850$4.13
    
    
    145,150
    
    
    
    4.1
    
    
    
    145,150286,500
    
    
    
    4.5
    
    
    
    286,500
 On April 8, 1999, the Company adopted a Shareholder Rights Plan in which the Board of
Directors declared a distribution of one Right for each of the Companys outstanding Common Shares.
Each Right entitles the holder to purchase from the Company one one-thousandth of a Series A
Preferred Share (a Preferred Share) at a purchase price of $30.00 per Right, subject to
adjustment. One one-thousandth of a Preferred Share is intended to be approximately the economic
equivalent of one Common Share. The Rights will expire on April 7, 2009, unless redeemed by the
Company as described below. The Rights are neither exercisable nor traded separately from the Common Shares. The Rights
will become exercisable and begin to trade separately from the Common Shares if a person or group,
unless approved in advance by the Company Board of Directors, becomes the beneficial owner of 21%
or more of the then-outstanding Common Shares or announces an offer to acquire 21% or more of the
then-outstanding Common Shares. If a person or group acquires 21% or more of the outstanding Common Shares, then each Right
not owned by the acquiring person or its affiliates will entitle its holder to purchase, at the
Rights then-current exercise price, fractional Preferred Shares that are approximately the
economic equivalent of Common Shares (or, in certain circumstances, Common Shares, cash, property
or other securities of the Company) having a market value equal to twice the then-current exercise
price. In addition, if, after the Rights become exercisable, the Company is acquired in a merger
or other business combination transaction with an acquiring person or its affiliates or sells 50%
or more of its assets or earnings power to an acquiring person or its affiliates, each Right will
entitle its holder to purchase, at the Rights then-current exercise price, a number of shares of
the acquiring persons common stock having a market value of twice the Rights exercise price. The
Board of Directors may redeem the Rights in whole, but not in part, at a price of $.01 per Right,
subject to certain limitations. Effective April 14, 2003 the Company amended its Shareholder Rights Plan to exempt Mr.
Stein-Sapir and his affiliates and associates (including Mortgage Information Services, Inc., a
privately-held company controlled by Mr. Stein-Sapir, who also serves as its chief executive
officer) from the definition of Acquiring Person under the Shareholder Rights Plan unless Mr.
Stein-Sapir and his affiliates and 39




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 associates collectively own 38% or more of the Companys outstanding Common Shares. As of May 11,
2005, Mr. Stein-Sapir and his affiliates and associates beneficially owned 33.9% of the Companys
outstanding Common Shares. As of February 27, 2005, the Company issued 54 treasury shares to adjust calculations made by
a prior stock transfer agent of fractional shares to be issued in 1997 for a reverse stock split.
The effects of this adjustment were not significant to the Company or its shareholders. Note 10. 401(k) Retirement Plan. The Company has a 401(k) Retirement Plan in which employees age 21 or older are eligible to
participate. The Company matches a percentage of employee contributions. During fiscal 2005, 2004
and 2003, the Company incurred $80,000, $82,000 and $91,000, respectively, in expenses for matching
contributions to the plan. Note 11. Fair Value of Financial Instruments. The Companys debt is reported at historical cost, based upon stated interest rates which
represented market rates at the time of borrowing. Due to subsequent declines in credit quality
throughout the restaurant industry resulting from weak and volatile operating performance and
related declines in restaurant values, the market for fixed rate mortgage debt for restaurant
financing is currently extremely limited. In addition, as described in Note 5 to the Consolidated
Financial Statements, the Company was not in compliance with its debt agreements at February 27,
2005 and has initiated a financial restructuring. The Companys debt is not publicly traded and
there are very few, if any, lenders or financing transactions for similar debt in the marketplace
at this time. Consequently, management has not been able to identify a market for fixed rate
restaurant mortgage debt with a similar risk profile, and has concluded that it is not practicable
to estimate the fair value of the Companys debt as of February 27, 2005. Note 12. New Accounting Standards. In December 2004, the FASB issued SFAS No. 123®, Share-Based Payment. This standard will
require compensation costs related to share-based payment transactions to be recognized in the
financial statements. With limited exceptions, the amount of compensation cost will be measured
based on the grant-date fair value of the equity or liability instruments issued. In addition,
liability awards will be measured based on the grant date fair value of the equity or liability
instruments issued and will be remeasured each reporting period. Compensation costs will be
recognized over the period that an employee provides service in exchange for the award. This
standard replaces SFAS No. 123 and supersedes Accounting Principles Board (APB) Opinion No. 25
Accounting for Stock Issued to Employees, and applies to all awards granted, modified,
repurchased or cancelled after February 26, 2006. The Company is currently evaluating the
provisions of this standard to determine the impact on its consolidated financial statements. To
the extent that the Company grants options or other share-based payments after February 26, 2006,
SFAS No. 123(R) is expected to reduce operating results of the Company. 40




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MORGANS FOODS, INC.
Notes to Consolidated Financial Statements
February 27, 2005, February 29, 2004 and March 2, 2003 Note 13. Selected Quarterly Financial Data (Unaudited). Fiscal 2005 Quarter EndedMay 23,
    
    
    August 15,
    
    
    November 7,
    
    
    February 27,2004
    
    
    2004
    
    
    2004
    
    
    2005Revenues
    
    $
    18,343,000
    
    
    $
    19,791,000
    
    
    $
    19,190,000
    
    
    $
    23,636,000Operating costs and expenses, net
    
    
    18,160,000
    
    
    
    18,692,000
    
    
    
    18,887,000
    
    
    
    22,164,000Operating income
    
    
    183,000
    
    
    
    1,099,000
    
    
    
    303,000
    
    
    
    1,472,000Net income (loss)
    
    
    (847,000
    )
    
    
    99,000
    
    
    
    (1,277,000
    )
    
    
    167,000Basic and diluted net
income (loss) per share
    
    
    (.31
    )
    
    
    .04
    
    
    
    (.47
    )
    
    
    .06
 Fiscal 2004 Quarter EndedMay 25,
    
    
    August 17,
    
    
    November 9,
    
    
    February 29,2003
    
    
    2003
    
    
    2003
    
    
    2004Revenues
    
    $
    19,828,000
    
    
    $
    19,663,000
    
    
    $
    19,382,000
    
    
    $
    22,865,000Operating costs and expenses, net
    
    
    18,545,000
    
    
    
    18,653,000
    
    
    
    18,253,000
    
    
    
    23,056,000Operating income (loss)
    
    
    1,283,000
    
    
    
    1,010,000
    
    
    
    1,129,000
    
    
    
    (191,000
    )Net income (loss)
    
    
    180,000
    
    
    
    (26,000
    )
    
    
    90,000
    
    
    
    (1,538,000
    )Basic and diluted net
income (loss) per share
    
    
    .07
    
    
    
    (.01
    )
    
    
    .03
    
    
    
    (.57
    )
 Results for the fourth quarter of fiscal 2005 include a gain on restaurant assets of
$152,000 which was primarily the result of the receipt during the fourth quarter of fiscal 2005 of
insurance proceeds relating to two flooded restaurants and one fire-damaged restaurant. Results
for the fourth quarter of fiscal 2004 include impairment losses of $254,000 on two operating
restaurants to reduce their carrying values to their estimated fair values. Although asset
impairment calculations prepared in prior quarters did not require a write down, acceleration in
the deterioration of the operating results and trade areas of these restaurants during the fourth
quarters of fiscal 2004 necessitated the recording of the write downs during that quarter. 41




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##### Table of Contents



MORGANS FOODS, INC.
INDEX TO EXHIBITS
Item 14 (a) (3) ExhibitNumber
    
    Exhibit Description3.1
    
    Amended Articles of Incorporation, as amended (1)3.2
    
    Amended Code of Regulations (1)4.1
    
    Specimen Certificate for Common Shares (2)4.2
    
    Shareholder Rights Plan (3)4.3
    
    Amendment to Shareholder Rights Agreement10.1
    
    Specimen KFC Franchise Agreements (4)10.2
    
    Specimen Taco Bell Franchise Agreement (5)10.3
    
    Executive and Manager Nonqualified Stock Option Plan (6)10.4
    
    Key Employee Nonqualified Stock Option Plan (6)10.5
    
    Asset Purchase Agreements with Taco Bell Corp. and KFC Corporation and their
Various Affiliated Companies (7)10.6
    
    Form of Mortgage Loan Agreement with Captec Financial Group, Inc. (8)14
    
    Code of Ethics for Senior Financial Officers (9)19
    
    Form of Indemnification Contract between Registrant and its Officers and Directors (6)21
    
    Subsidiaries23
    
    Consent of Independent Registered Public Accounting Firm31.1
    
    Certification of the Chairman and Chief Executive Officer pursuant to Rule
13a-14(a) of Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Senior Vice President, Chief Financial Officer & Secretary
pursuant to Rule 13a-14(a) of Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chairman of the Board and Chief Executive Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of the Senior Vice President, Chief Financial Officer and Secretary pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   (1)
    
    Filed as an exhibit to Registrants Form 10-K for the 1992 fiscal year and incorporated
herein by reference.(2)
    
    Filed as an exhibit to the Registrants Registration Statement (No. 33-35772) on Form S-2
and incorporated herein by reference.(3)
    
    Filed as an exhibit to the Registrants Form 8-A dated May 7, 1999 and incorporated herein
by reference.(4)
    
    Filed as an exhibit to the Registrants Registration Statement (No. 2-78035) on Form S-1
and incorporated herein by reference.(5)
    
    Filed as an exhibit to Registrants Form 10-K for the 2000 fiscal year and incorporated
herein by reference.(6)
    
    Filed as an exhibit to the Registrants Form S-8 filed November 17, 1999 and incorporated
herein by reference.(7)
    
    Filed as an exhibit to Registrants Form 8-KA filed September 27, 1999 and incorporated
herein by reference.(8)
    
    Filed as an exhibit to the Registrants Form 10-K for the 1996 fiscal year and incorporated
herein by reference.(9)
    
    Filed as an exhibit to the Registrants Form 10-K for the 2004 fiscal year and incorporated
herein by reference. 42




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized. Morgans Foods, Inc.Dated: May 31, 2005
    
    /s/
    
    Leonard R. Stein-SapirBy:
    
    Leonard R. Stein-SapirChairman of the Board,Chief Executive Officer & Director
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has
been signed below by the following persons on behalf of the Registrant and in the capacities and
on the dates indicated. /s/
    
    Leonard R. Stein-Sapir
    
    /s/
    
    Lawrence S. DolinBy:
    
    Leonard R. Stein-Sapir
    
    By:
    
    Lawrence S. DolinChairman of the Board,
    
    
    
    DirectorChief Executive Officer & Director
    
    
    
    Dated: May 31, 2005Dated: May 31, 2005/s/
    
    James J. Liguori
    
    /s/
    
    Bahman GuyuronBy:
    
    James J. Liguori
    
    By:
    
    Bahman GuyuronDirector, President &
    
    
    
    DirectorChief Operating Officer
    
    
    
    Dated: May 31, 2005Dated: May 31, 2005/s/
    
    Kenneth L. Hignett
    
    /s/
    
    Steven S. KaufmanBy:
    
    Kenneth L. Hignett
    
    By:
    
    Steven S. KaufmanDirector, Senior Vice President,
    
    
    
    DirectorChief Financial Officer & Secretary
    
    
    
    Dated: May 31, 2005Dated: May 31, 2005/s/
    
    Bernard LernerBy:
    
    Bernard LernerDirectorDated: May 31, 2005
 43