e10vq

-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, P/uI8ZG8DoV/Vje2GFh42Bis2ZoHIIIA1YhMJLrYhv5javq7NzHDZnsAV9AklTKf 3XTq5GcATp9V7PjE2ey8Tg== 0000950134-04-017413.txt : 20041112 0000950134-04-017413.hdr.sgml : 20041111 20041112161435 ACCESSION NUMBER: 0000950134-04-017413 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20040630 FILED AS OF DATE: 20041112 DATE AS OF CHANGE: 20041112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SCHLOTZSKYS INC CENTRAL INDEX KEY: 0001002178 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-EATING PLACES [5812] IRS NUMBER: 742654208 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-14735 FILM NUMBER: 041139524 BUSINESS ADDRESS: STREET 1: 203 COLORADO ST STREET 2: SUITE 600 CITY: AUSTIN STATE: TX ZIP: 78701 BUSINESS PHONE: 5122363600 MAIL ADDRESS: STREET 1: 203 COLORADO ST STREET 2: SUITE 600 CITY: AUSTIN STATE: TX ZIP: 78701 10-Q 1 d20096e10vq.htm FORM 10-Q e10vq

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2004

Commission File Number: 0-27008

Schlotzsky’s, Inc.

(Exact name of registrant as specified in its charter)


Texas		74-2654208
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

203 Colorado Street, Suite 600, Austin, Texas 78701
(Address of principal executive offices)

(512) 236-3800
(Registrant’s telephone number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class		Shares Outstanding at November 5, 2004

Common Stock, no par value		7,341,079

SCHLOTZSKY’S, INC.

Index to Form 10-Q
Quarter Ended June 30, 2004


	Page No.
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets - June 30, 2004 and December 31, 2003		1
Condensed Consolidated Statements of Income - Three and Six Months Ended June 30, 2004 and June 30, 2003		2
Condensed Consolidated Statement of Stockholders’ Equity - Six Months Ended June 30, 2004 and Year Ended December 31, 2003		3
Condensed Consolidated Statements of Cash Flows - Six Months Ended June 30, 2004 and June 30, 2003		4
Notes to Condensed Consolidated Financial Statements		5
Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations		17
Item 3. Quantitative and Qualitative Disclosures About Market Risk		26
Item 4. Controls and Procedures		26
Part II OTHER INFORMATION
Item 1. Legal Proceedings		27
Item 2. Changes in Securities and Use of Proceeds		28
Item 3. Defaults Upon Senior Securities		28
Item 4. Submission of Matters to a Vote of Security Holders		28
Item 5. Other Information		28
Item 6. Exhibits and Reports on Form 8-K		28
Bylaws of the Company
Employment Agreement
Certification Pursuant to Section 302 - CEO
Certification Pursuant to Section 302 - CFO
Certification Pursuant to Section 906 - CEO
Certification Pursuant to Section 906 - CFO

PART I
FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SCHLOTZSKY’S, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS


	June 30,			December 31,
	2004			2003
	(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents	$	514,193		$	1,058,300
Accounts receivable, net:
Royalties		827,569			884,098
Brands		742,244			905,085
Other		350,842			1,494,513
Refundable income taxes		—			9,350
Prepaids, inventories and other assets		1,023,879			1,250,193
Real estate held for sale		3,050,000			3,208,533
Current Portion of:
Notes receivable		11,349			50,570
Notes receivable — related party		—			3,500

Total current assets		6,520,076			8,864,142
Property, equipment and leasehold improvements, net		23,712,634			42,396,145
Notes receivable, net, less current portion		3,144,990			4,121,951
Notes receivable — related party, net, less current portion		1,230,275			2,613,170
Investments		267,850			567,850
Intangible assets, net		6,153,543			62,523,367
Goodwill, net		—			3,519,242
Other noncurrent assets		1,056,642			1,179,687

Total assets	$	42,086,010		$	125,785,554

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Short-term debt	$	1,681,971		$	1,133,701
Current maturities of long-term debt		45,441,286			6,564,646
Accounts payable		4,160,576			5,768,117
Accrued liabilities		9,931,731			5,243,563
Deferred revenue, current portion		523,420			376,633

Total current liabilities		61,738,984			19,086,660
Long-term debt, less current portion		4,160,062			42,586,141
Deferred revenue, less current portion		964,439			1,450,300
Deferred tax liability		—			—

Total liabilities		66,863,485			63,123,101

Commitments and contingencies
Stockholders’ Equity:
Preferred stock, Class C, no par value, 1,000,000 shares authorized, none issued		—			—
Common stock, no par value, 30,000,000 shares authorized, 7,528,186 shares and 7,521,524 shares issued at June 30, 2004 and December 31, 2003, respectively		64,140			64,073
Additional paid-in capital		58,243,854			58,213,945
Retained earnings		(82,242,313	)		5,227,591
Treasury stock (189,525 shares at June 30, 2004 and December 31, 2003, respectively), at cost		(843,156	)		(843,156	)

Total stockholders’ equity		(24,777,475	)		62,662,453

Total liabilities and stockholders’ equity	$	42,086,010		$	125,785,554

The accompanying notes are an integral part of the condensed consolidated financial statements.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)


	Three months ended						Six months ended
	June 30,			June 30,			June 30,			June 30,
	2004			2003			2004			2003
Revenue:
Royalties	$	3,617,959		$	4,285,230		$	7,210,727		$	8,589,118
Franchise fees		—			3,333			—			3,333
Developer fees		35,935			44,228			72,242			94,387
Restaurant sales		7,668,137			8,000,609			15,449,922			15,612,838
Brand contribution		1,167,860			1,708,957			2,584,457			3,360,062
Other fees and revenue		207,443			219,390			427,438			432,039

Total revenue		12,697,334			14,261,747			25,744,786			28,091,777

Expenses:
Service costs:
Royalties		533,660			667,118			1,062,543			1,330,910
Franchise fees		—			—			—			—

		533,660			667,118			1,062,543			1,330,910

Restaurant operations:
Cost of sales		2,135,821			2,348,501			4,245,824			4,520,121
Personnel and benefits		2,901,252			3,445,067			5,851,749			6,810,228
Operating expenses		1,975,162			2,202,095			3,846,581			4,104,342

		7,012,235			7,995,663			13,944,154			15,434,691

Equity loss on investments		300,000			83,693			300,000			150,843

Impairment of franchising assets		59,938,180			—			59,938,180			—

Restaurant impairment		17,376,156			—			17,376,156			—

General and administrative		12,134,279			6,712,589			16,077,154			11,783,304

Depreciation and amortization		1,311,916			1,282,595			2,717,924			2,532,001

Total expenses		98,606,426			16,741,658			111,416,111			31,231,749

Income (loss) from operations		(85,909,092	)		(2,479,911	)		(85,671,325	)		(3,139,972	)
Other:
Interest income		62,638			103,609			125,031			207,257
Interest expense		(932,140	)		(1,009,968	)		(1,863,610	)		(2,025,873	)

Income (loss) before provision (credit) for income taxes		(86,778,594	)		(3,386,270	)		(87,409,904	)		(4,958,588	)
Provision (credit) for income taxes		20,000			(1,119,000	)		60,000			(1,625,000	)

Net income (loss)	$	(86,798,594	)	$	(2,267,270	)	$	(87,469,904	)	$	(3,333,588	)

Earnings per share-basic	$	(11.83	)	$	(0.31	)	$	(11.92	)	$	(0.46	)

Earnings per share-diluted	$	(11.83	)	$	(0.31	)	$	(11.92	)	$	(0.46	)

The accompanying notes are an integral part of the condensed consolidated financial statements

SCHLOTZSKY’S, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(Unaudited)


	Common Stock				Additional								Total
	Number of		Stated Capital		Paid-in		Retained			Treasury			Stockholders’
	Shares		Amount		Capital		Earnings			Stock			Equity
Balance, January 1, 2003		7,496,778	$	63,826	$	58,122,469	$	16,976,186		$	(843,156	)	$	74,319,325
Issuance of common stock in connection with employee stock purchase plan		24,746		247		76,766		—			—			77,013
Issuance of employee stock options		—		—		14,710		—			—			14,710
Net loss		—		—		—		(11,748,595	)		—			(11,748,595	)

Balance, December 31, 2003		7,521,524		64,073		58,213,945		5,227,591			(843,156	)		62,662,453
Issuance of common stock in connection with employee stock purchase plan		6,662		67		11,485		—			—			11,552
Issuance of employee stock options		—		—		18,424		—			—			18,424
Net loss		—		—		—		(87,469,904	)		—			(87,469,904	)

Balance, June 30, 2004		7,528,186	$	64,140	$	58,243,854		(82,242,313	)	$	(843,156	)	$	(24,777,475	)

The accompanying notes are an integral part of the condensed consolidated financial statements.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


	For the six months ended
	June 30,			June 30,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	(87,469,904	)	$	(3,333,588	)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Depreciation and amortization		2,717,924			2,532,001
Provision for deferred taxes		—			(1,683,020	)
Provision for stock option compensation		18,424			12,192
Provision for uncollectible accounts		3,434,752			1,539,563
Provision for impairment of assets		77,314,336			—
Amortization of deferred revenue		97,758			(91,064	)
Equity loss on investments		300,000			150,844
Changes in:
Accounts receivable		(652,966	)		1,058,418
Prepaid expenses and other assets		349,359			341,617
Accounts payable and accrued liabilities		3,844,045			3,728,710

Net cash provided by operating activities		(46,272	)		4,255,673

Cash flows from investing activities:
Purchase of property, equipment and real estate held for sale		(171,576	)		(3,025,961	)
Sale of property, equipment and real estate held for sale		2,536			1,195,824
Acquisition of investments and intangible assets		(43,426	)		(236,692	)
Issuance of notes receivable		(25,107	)		(198,740	)
Repayments on notes receivable		43,124			2,378,643

Net cash provided by (used in) investing activities		(194,449	)		113,074

Cash flows from financing activities:
Sale of stock		11,552			36,082
Acquisition of treasury stock		—			—
Proceeds from issuance of debt		2,607,500			710,000
Debt issuance costs		(247,103	)		(858,745	)
Repayment of debt		(2,675,335	)		(4,154,752	)

Net cash used in financing activities		(303,386	)		(4,267,415	)

Net increase (decrease) in cash and cash equivalents		(544,107	)		101,332
Cash and cash equivalents at beginning of period		1,058,300			678,895

Cash and cash equivalents at end of period	$	514,193		$	780,227

The accompanying notes are an integral part of the condensed consolidated financial statements.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1. — Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months and six months ended June 30, 2004, are not necessarily indicative of the results that may be expected for the year ended December 31, 2004. This information should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Schlotzsky’s, Inc. Annual Report on Form 10-K for the year ended December 31, 2003.

On August 3, 2004 (the “Petition Date”), Schlotzsky’s, Inc. (the “Company”) and its subsidiaries filed a voluntary petition for relief (the “Filing”) under Chapter 11 of Title 11 of the United States Code in the United States Bankruptcy Court for the Western District of Texas (the “Bankruptcy Court”), San Antonio division. The cases have been assigned No. 04-54504. The Company is operating its business and managing its property as a debtor in possession of its assets and the Company’s existing directors and officers continue to oversee operation of the Company’s business as a debtor-in-possession.

Financial Statement Presentation

The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue to operate as a going concern, which contemplates continuity of operations, timely payment by franchisees and licensees, control of operating expenses and the professional fees associated with reorganizing the Company, and the realization of asset sales and liquidation of liabilities and commitments. The Filing and related circumstances raise substantial doubts about the Company’s ability to continue as a going concern and accordingly such realization of assets and liquidation of liabilities are subject to uncertainty. In connection with its plan of reorganization, the Company may liquidate or settle liabilities for amounts other than those reflected in the Condensed Consolidated Financial Statements. In addition, a plan of reorganization could materially change the amounts and classifications reported in the consolidated historical financial statements, which do not give effect to any adjustments to the carrying value of assets or amounts of liabilities that might be necessary as a consequence of a plan of reorganization.

Pursuant to the Bankruptcy Code, schedules have been and will continue to be filed by the Company with the Bankruptcy Court setting forth the assets and liabilities of the Company. Differences between amounts recorded by the Company and claims filed by creditors will be investigated and resolved as part of the Chapter 11 Cases.

The Company has received approval from the Bankruptcy Court to pay or otherwise honor certain of its pre-petition obligations, including employee wages, salaries, benefits and other employee obligations and certain other pre-petition claims.

Reclassifications and Required Accounting Issues Discussion

Certain reclassifications have been made to the condensed consolidated financial statements for the periods ended June 30, 2003, to correspond with the presentation used at June 30, 2004, and for the periods then ended.

Quarterly Financials Not Reviewed by Independent Accountants

Due to the constraints of operating as a debtor-in-possession and the need to negotiate cash collateral orders with its secured creditors the Company is unable to control the timing and amount of payments to its professionals. Due to the uncertainty of the payment of professional fees, the Company has been unable to secure a review of this Form 10-Q by its independent accountants, thus it was unreviewed by independent accountants at the time of filing.

Note 2. — Review of Accounting for Reacquired Area Developer Rights

The Company has received from the Securities and Exchange Commission (the “Commission”) comments to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. This action has led to discussions between the Company, the Commission, and the Company’s auditors concerning the appropriateness of capitalizing as intangible assets those payments made over the past eight years to area developers to modify or cancel their area developer contracts. Although the Company continues to believe the classification as intangible assets is proper, the Company has not resolved this issue with the Commission at the time of filing this Form 10-Q. Were the Company to restate its financials to reflect expensing the payments to area developers at the time the transactions were executed, approximately $60.1 million in repurchase expense would be recognized between 1996 and 2004, and $4.7 million in amortization expense would be reversed off the income statement during that same period. Additionally, see Note 14 for information regarding the Company’s treatment of these intangible assets during the second quarter of 2004.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 3. — Stock-Based Compensation

Effective January 1, 2003, the Company adopted the cost recognition provisions for stock-based compensation of Statement of Financial Accounting Standards (“SFAS”) No. 123 under the prospective method of adoption authorized by SFAS No. 148. The amount charged to expense during the three and six-month periods ended June 30, 2004 were approximately $9,000 and $18,000, respectively. Had the Company adopted the cost recognition provisions of SFAS No. 123 in 1995, the Company’s net income and earnings per share would have been reduced to the pro forma amounts shown (in thousands, except per share amounts):


	For the three months ended						For the six months ended
	June 30, 2004			June 30, 2003			June 30, 2004			June 30, 2003
Net income (loss), as reported	$	(86,799	)	$	(2,267	)	$	(87,470	)	$	(3,334	)
Add: Stock-based employee compensation expense included in net income, net of related tax effects		9			4			18			8
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(24	)		(45	)		(44	)		(114	)

Pro forma net income (loss)	$	(86,814	)	$	(2,308	)	$	(87,496	)	$	(3,440	)

Earnings per share:
Basic-as reported	$	(11.83	)	$	(0.31	)	$	(11.92	)	$	(0.46	)

Basic-pro forma	$	(11.83	)	$	(0.32	)	$	(11.92	)	$	(0.47	)

Diluted-as reported	$	(11.83	)	$	(0.31	)	$	(11.92	)	$	(0.46	)

Diluted-pro forma	$	(11.83	)	$	(0.32	)	$	(11.92	)	$	(0.47	)

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 4. — Restaurant Operations

A summary of certain operating information for Company-operated restaurants is presented below for the three and six month periods ended June 30, 2004 and 2003 (dollars in thousands). The Company reviewed its 36 Company-operated restaurant units and determined it would close 18 underperforming units during the third and fourth quarters of 2004. Closure of these units was completed in October 2004. The results shown below do not reflect the impairment of certain intangible or real estate assets or recognition of liabilities related to the 18 closed restaurants.


	Retained		Closed			Total
Three months ended June 30, 2004
Restaurant sales	$	5,324	$	2,344		$	7,668

Restaurant operations:
Cost of sales		1,478		658			2,136
Personnel and benefits		1,836		1,065			2,901
Operating expenses		1,030		945			1,975

		4,344		2,668			7,012

Operating income (loss) before depreciation and amortization	$	980	$	(324	)	$	656

Three months ended June 30, 2003
Restaurant sales	$	5,375	$	2,626		$	8,001

Restaurant operations:
Cost of sales		1,590		759			2,349
Personnel and benefits		2,156		1,289			3,445
Operating expenses		1,036		1,166			2,202

		4,782		3,214			7,996

Operating income (loss) before depreciation and amortization	$	593	$	(588	)	$	5


	Retained		Closed			Total
Six months ended June 30, 2004
Restaurant sales	$	10,715	$	4,735		$	15,450

Restaurant operations:
Cost of sales		2,931		1,315			4,246
Personnel and benefits		3,731		2,121			5,852
Operating expenses		2,009		1,837			3,846

		8,671		5,273			13,944

Operating income (loss) before depreciation and amortization	$	2,044	$	(538	)	$	1,506

Six months ended June 30, 2003
Restaurant sales	$	10,504	$	5,109		$	15,613

Restaurant operations:
Cost of sales		3,047		1,473			4,520
Personnel and benefits		4,184		2,626			6,810
Operating expenses		1,999		2,106			4,105

		9,230		6,205			15,435

Operating income (loss) before depreciation and amortization	$	1,274	$	(1,096	)	$	178

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 4. — Restaurant Operations-Continued

As of June 30, 2004 and 2003, the net book value of property and equipment and intangible assets related to each of the above categories was as follows (dollars in thousands):


	June 30, 2004		June 30, 2003
Retained	$	13,824	$	24,201
Closed		7,571		13,282

	$	21,395	$	37,483

The assets remaining related to the closed restaurants are the estimated liquidation value of the real estate where the restaurants were located.

Note 5. — Segments

The Company and its subsidiaries are principally engaged in franchising and operating restaurants in the fast casual sector under the Schlotzsky’s^® brand. Schlotzsky’s restaurants offer a menu of distinctive, high quality foods featuring our proprietary breads, complemented by excellent customer service in a visually appealing setting. Our current menu includes upscale made-to-order hot sandwiches and pizza served on our proprietary buns and crusts, wraps, chips, salads, soups, fresh baked cookies and other desserts, and beverages. At June 30, 2004, the Schlotzsky’s system included Company-operated and franchised restaurants in 37 states, the District of Columbia and six foreign countries. The Company operated 36 restaurants as of June 30, 2004.

The Company identifies segments based on management responsibility within the corporate structure. The Restaurant Operations segment includes restaurants operated for the purposes of market leadership and redevelopment of certain markets, demonstrating sales potential and key operating metrics, operational leadership of the franchise system, product development, concept refinement, product and process testing, and training and building brand awareness. The Restaurant Operations segment also includes restaurants developed for or acquired from franchisees which are available for sale to franchisees. The Franchise Operations segment encompasses the franchising of restaurants, assisting franchisees in the development of restaurants, providing franchisee training and operating the national training center, communicating with franchisees, conducting regional and national franchisee meetings, developing and monitoring supplier and distributor relationships, planning and coordinating advertising and marketing programs, and the licensing of brand products for sale to the franchise system and retailers. The Company measures segment profit as operating income, which is defined as income before interest and income taxes. Segment information and a reconciliation to income before interest and income taxes are as follows (dollars in thousands):


	Restaurant Operations						Franchise
Three months ended June 30, 2004	Retained			Closed			Operations			Consolidated
Sales	$	5,324		$	2,344		$	5,029		$	12,697
Depreciation and amortization		397			294			621			1,312
Impairment		9,408			7,968			59,938			77,314
Operating income (loss)		(8,825	)		(7,938	)		(69,146	)		(85,909	)
Total assets		13,824			7,571			20,691			42,086


	Restaurant Operations					Franchise
Three months ended June 30, 2003	Retained		Closed			Operations			Consolidated
Sales	$	5,375	$	2,626		$	6,261		$	14,262
Depreciation and amortization		365		194			724			1,283
Operating income (loss)		228		(782	)		(1,926	)		(2,480	)
Total assets	$	24,201	$	13,282		$	96,344		$	133,827

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 5. — Segments-Continued

Of the Restaurant Operations depreciation and amortization for the three months ended June 30, 2004, $397,000 was allocated to the retained restaurants and $294,000 to the restaurants that were closed in the third and fourth quarters of 2004. For the three months ended June 30, 2003, $365,000 of depreciation and amortization was allocated to the retained restaurants and $194,000 to restaurants that were closed in the third and fourth quarters of 2004 or prior.


	Restaurant Operations						Franchise
Six months ended June 30, 2004	Retained			Closed			Operations			Consolidated
Sales	$	10,715			4,735		$	10,295		$	25,745
Depreciation and amortization		797			650			1,271			2,718
Impairment		9,408			7,968			59,938			77,314
Operating income (loss)		(8,161	)		(9,156	)		(68,354	)		(85,671	)
Total assets		13,824			7,571			20,691			42,086


	Restaurant Operations					Franchise
Six months ended June 30, 2003	Retained		Closed			Operations			Consolidated
Sales	$	10,504		5,109		$	12,479		$	28,092
Depreciation and amortization		704		376			1,452			2,532
Impairment		—		—			—			—
Operating income (loss)		570		(1,472	)		(2,238	)		(3,140	)
Total assets	$	24,201	$	13,282		$	96,344		$	133,827

Of the Restaurant Operations depreciation and amortization for the six months ended June 30, 2004, $797,000 was allocated to the retained restaurants and $650,000 to the restaurants that were closed in the third and fourth quarters of 2004. For the six months ended June 30, 2003, $704,000 of depreciation and amortization was allocated to the retained restaurants and $376,000 to the restaurants that were closed in the third and fourth quarters of 2004 or prior.

All general and administrative expenses are included in Franchise Operations for the periods presented.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 6. — Debt

The Company’s debt structure as of June 30, 2004, and December 31, 2003, is as follows (dollars in thousands):


	June 30, 2004			December 31, 2003
	(Unaudited)
Short-term debt:	$	1,682		$	1,134

Long-term debt:
Notes payable to former area developers	$	21,171		$	21,851
Mortgages on Company-operated restaurants and equipment		20,685			21,589
Capital leases		2,462			2,659
Notes payable to shareholders		2,344			2,500
Obligations secured by royalty and licensing contracts		2,608			—
Other obligations		331			551

		49,601			49,150
Less current maturities of long-term debt		(45,441	)		(6,654	)

Long-term debt	$	4,160		$	42,586

As of June 30, 2004, the Company was in default of the financial covenants specified in its debt agreements. Under these debt agreements, such defaults result in the debt becoming immediately due and payable. Related to these defaults, approximately $35.8 million in long-term debt was reclassified as a current maturity of long-term debt as of June 30, 2004.

Note 7. — Related Party Receivables

As of June 30, 2004 and December 31, 2003, receivables from related parties were as follows (dollars in thousands):


	June 30, 2004		December 31, 2003
	(Unaudited)
Included in accounts receivable — other	$	—	$	23
Included in other noncurrent assets		253		939
Included in notes receivable		1,230		2,617

Total related party receivables	$	1,483	$	3,579

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 8. — Earnings Per Share

Basic earnings per share are computed by dividing reported earnings available to common stockholders by weighted average common shares outstanding. Diluted earnings per share give effect to dilutive potential common shares. Earnings per share are calculated as follows (in thousands, except per share data):


	Three Months Ended						Six Months Ended
	June 30,			June 30,			June 30,			June 30,
	2004			2003			2004			2003
Basic earnings per share
Net income (loss)	$	(86,799	)	$	(2,267	)	$	(87,470	)	$	(3,334	)

Weighted average common shares outstanding		7,339			7,320			7,339			7,320

Basic earnings per share	$	(11.83	)	$	(0.31	)	$	(11.92	)	$	(0.46	)

Diluted earnings per share
Net income (loss)	$	(86,799	)	$	(2,267	)	$	(87,470	)	$	(3,334	)

Weighted average common shares outstanding		7,339			7,320			7,339			7,320
Dillutive stock options and warrants		—			—			—			—

Weighted average common shares outstanding - assuming dilution		7,339			7,320			7,339			7,320

Diluted earnings per share	$	(11.83	)	$	(0.31	)	$	(11.92	)	$	(0.46	)

Outstanding options and warrants that were not included in the diluted calculation because their effect would be anti-dilutive		883			1,142			883			1,142

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 9. — Intangible Assets

Intangible assets consist of the following (dollars in thousands):


			June 30, 2004				December 31, 2003
			(Unaudited)
	Amortization Period		Gross		Accumulated		Gross		Accumulated
	(Years)		Value		Amortization		Value		Amortization
Intangible assets subject to amortization:
Royalty value		20	$	2,385	$	956	$	2,474	$	897
Developer and franchise rights acquired		20 to 40		4,558		4,558		59,374		3,867
Restaurant development rights		13 to 25		951		718		1,653		568
Debt issue costs		3 to 20		747		264		529		211
Other intangible assets		5		652		472		646		438

				9,293		6,968		64,676		5,981

Intangible assets not subject to amortization:
Original franchise and royalty rights				5,689		1,860		5,689		1,860
Goodwill				331		331		3,850		331

				6,020		2,191		9,539		2,191

Total intangible assets			$	15,313	$	9,159	$	74,215	$	8,172

Amortization of intangible assets totaled approximately $483,000 and $439,000 for the three months ended June 30, 2004, and 2003, respectively. For the six months ended June 30, 2004, and 2003, amortization expense totaled $987,000 and $865,000 respectively. Estimated amortization expense through 2007 for intangible assets with determinable lives is as follows (dollars in thousands):


Remainder of 2004	$	132
2005		233
2006		160
2007		159
2008		158

	$	842

The changes in the gross value of goodwill for the six months ended June 30, 2004, are as follows (dollars in thousands):


	Restaurant			Franchise
	Operations			Operations			Total
Balance as of December 31, 2003	$	3,589		$	261		$	3,850
Goodwill acquired		—			—			—
Impairment		(3,299	)		(220	)		(3,519	)

Balance as of June 30, 2004	$	290		$	41		$	331

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 10. — Off-balance Sheet Arrangements

The Company has outstanding guarantees of indebtedness of others, including related parties, of approximately $20.5 million as of June 30, 2004. These guarantees include approximately $4.7 million of lease guarantees for the benefit of franchisees, approximately $13.8 million of mortgage loan guarantees for the benefit of franchisees and approximately $2.0 million of loan guarantees for the benefit of related parties.

The lease guarantees for the benefit of franchisees arose primarily through our former Turnkey program, in which the Company developed the restaurants, leased the restaurants to franchisees, and then sold them to a leasing company. The guarantees range from limited guarantees, either in dollar amount or term, to full guarantees for the life of the lease. The maximum guarantee for a single lease is approximately $1.2 million. Certain guarantees extend through 2018. The Company may be required by the lessor to make monthly rental payments or property tax and common area maintenance payments if the franchisee does not make the required payments in a timely manner. The Company has indemnification agreements with the franchisee under which the franchisee would be obligated to reimburse the Company for any amounts paid under such guarantees. As of June 30, 2004, the Company had accrued a liability of approximately $982,000 related to these guarantees. This accrual is due to a management determination that it would no longer be able to attempt to rehabilitate franchisee’s restaurants through direct financial assistance. The Company also has a net deferred gain related to the sale of these leases in the amount of approximately $342,000 as of June 30, 2004.

The mortgage loan guarantees for the benefit of franchisees also arose primarily through the Company’s former Turnkey program, in which we developed the related restaurants, sold the restaurant to a franchisee, and guaranteed all or a portion of the franchisee’s mortgage loan. The guarantees range from limited guarantees, either in dollar amount or term, to full guarantees of the mortgage. The maximum amount of a single guarantee is approximately $1.0 million. Certain guarantees extend through 2016. The Company may be required by the lender to make monthly mortgage payments if the franchisee does not make the required payments in a timely manner, or the Company may be required to make up any deficiency, up to the amount of the guarantee, if the related restaurant is sold for net proceeds less than the amount of the outstanding mortgage. The Company has indemnification agreements with the franchisees under which the franchisee would be obligated to reimburse the Company for any amount paid under such guarantees. In the event that the Company purchases the loan from the lender in the event of a default, the Company would succeed to the lender’s security interest in the related property. As of June 30, 2004, the Company had accrued $1,761,000 for certain mortgage guarantees that were called but not yet paid.

The loan guarantees in favor of related parties primarily arose when we guaranteed certain debt of related parties for which the proceeds of the loans were used to repay outstanding debt to us. One of the guarantees, for the benefit of our real estate venture, is of mortgage debt, totaling approximately $2.0 million. This guarantee extends through 2009. Another guarantee, in the amount of approximately $4.1 million at March 31, 2004, was for the benefit of NAMF, the advertising entity of the Schlotzsky’s restaurant system, for which we received the net proceeds of the loan in repayment of outstanding debt to us. This guarantee was released in May 2004.

The Company has been called upon, from time to time, to make payments on obligations the Company has guaranteed. During the first six months of 2004, the Company paid approximately $362,000 in various lease guarantees for the benefit of franchisees. As of the date of the bankruptcy filing, the Company has suspended payments of guarantee obligations. The status of these various guarantees likely will be addressed during the proceeding in the Bankruptcy Court.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 11. — Commitments and Contingencies

Litigation

The Company’s filing for Chapter 11 protection in federal bankruptcy court generally stayed all litigation pending as of August 3, 2004, although parties in some cases may either request that the bankruptcy judge lift the stay and allow the litigation to proceed or remove the case to the bankruptcy court to be heard by the judge in the bankruptcy proceeding.

New Florida Markets, Ltd. and Deli Keys, Ltd. v. Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership, Schlotzsky’s Franchisor, LLC, Schlotzsky’s Franchise Operations, LLC, Schlotzsky’s NAMF, Inc., and Schlotzsky’s NAMF Funding, LLC (Case No. 701140045603), was filed around June 23, 2003 with the American Arbitration Association. Claimants are the area developers for the Tampa, Orlando, Miami and West Palm Beach development areas. They alleged that Respondents frustrated their ability to develop their areas and breached the Area Developer Agreements, in addition to other claims. On May 9, 2004 the Respondents and Claimants settled all claims and entered into a binding settlement agreement. The Company was not able to make a required settlement payment on June 15, 2004, and around July 27, 2004, the claimants filed New Florida Markets, Ltd. and Deli Keys Ltd. v. Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership, Schlotzsky’s Franchisor, LLC, Schlotzsky’s Franchise Operations, LLC, Schlotzsky’s N.A.M.F. Inc. and Schlotzsky’s N.A.M.F. Funding, LLC, in the Circuit Court of the 11^th Judicial Circuit in and for Dade County, Florida, General Civil Division, Case No. 04-16303 seeking enforcement of the settlement agreement. On October 21, 2004, the Court granted a Motion to Dismiss the NAMF entities but allowed Plaintiffs’ 20 days to amend the complaint to state a cause of action against the NAMF entities that would not be barred by the bankruptcy or the binding terms of settlement, which provided that Plaintiffs’ exclusive remedy for a breach was against Schlotzsky’s, Inc. or the subsidiary that was to sign the note. Because of uncertainties inherent in this type of matter, no outcome can be confidently predicted with respect to the foregoing matter and no estimate of the possible loss or range of possible loss can be made.

Robert Coshott v. Schlotzsky’s, Inc. (Cause No. GN 1-02279), was filed on July 24, 2001, in the 200th Judicial District Court of Travis County, Texas. Plaintiff is the Master Licensee for Australia and New Zealand, and he opened a Schlotzsky’s Deli restaurant in Melbourne, Australia. Plaintiff brought causes of action for fraud and/or negligent misrepresentation. Plaintiff alleged that he experienced problems with certain equipment specified or approved by the Company, that the Company’s system and equipment did not generate enough finished food product to service his potential customers; that the Company misrepresented the level of revenue the restaurant could reasonably be expected to achieve, that the Company delayed his ability to develop restaurants by failing to timely secure certain trademarks and trade names; and that the Company misrepresented whether it would allow Plaintiff to franchise Schlotzsky’s Deli restaurants in certain gas station or convenience store locations in his territories. Plaintiff requested actual and punitive damages of $3.75 million plus lost profits and incidental and consequential damages of an unspecified amount. On July 23, 2003, Coshott also filed a Demand for Arbitration with the International Chamber of Commerce styled Robert Gilbert Coshott v. Schlotzsky’s, Inc. (Case. No. 12 838/JNK). The claims in the Demand are similar to those brought in the above-entitled action and include additional allegations that the Company required the purchase of goods and services from certain suppliers in violation of the Trade Practices Act of 1974 and that the Company failed to disclose the existence of a predecessor Master License Agreement, in violation of the Fair Trading Act of 1987 (New South) Wales, breach of contract, and equitable estoppel. Claimant seeks unspecified actual, compensatory and punitive damages, lost profits, attorneys’ fees, prejudgment interest, and costs. On February 26, 2004, the Company obtained a declaratory judgment in the state court case declaring that Plaintiff had waived any right to arbitrate his claim by filing suit against the Company in state court in Texas. On June 21, 2004, the parties were informed by the International Court of Arbitration that the case is considered withdrawn as of June 1, 2004 for failure to pay the required advance on costs. The state court case is not yet set for trial. Because of uncertainties inherent in this type of matter, no outcome can be confidently predicted with respect to the foregoing matter and no estimate of the possible loss or range of possible loss can be made.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

an unspecified amount of money damages plus exemplary damages, attorneys’ fees, pre-judgment interest, costs, and a jury trial. Defendants, except for Mr. Wooley who was previously dismissed from the case, answered and asserted counterclaims alleging breach of contract and that Plaintiffs’ claim under the Texas Deceptive Trade Practices Act is groundless in fact or in law and brought in bad faith or for the purpose of harassment, and seek money damages, costs of court, penalty fees, costs incurred in performing the accounting, attorneys’ fees, and pre- and post-judgment interest. Defendants (except for Mr. Wooley) removed the case to federal court. The case was remanded to state court on April 17, 2003. The case is not yet set for trial. Because of uncertainties inherent in this type of matter, no outcome can be confidently predicted with respect to the foregoing matter and no estimate of the possible loss or range of possible loss can be made.

U.S. Restaurant Properties Operating L.P. v. Schlotzsky’s, Inc. (Cause No. 03-01758) was filed on February 27, 2003, in the District Court of Dallas County, B-44th Judicial District. Plaintiff is a real estate investment company that owns certain Schlotzsky’s restaurants and leases them to franchisees. It alleges that in 1997 and 1998 we entered into several agreements where we agreed to guarantee certain lease agreements. Plaintiff claims that in 1998 the parties entered into an agreement whereby Plaintiff agreed to release Schlotzsky’s from its guaranty obligations pertaining to six properties in which the tenants had defaulted, in exchange for Schlotzsky’s agreement to purchase six other properties. Plaintiff is seeking an order requiring us to purchase six properties for a total purchase price of over $4.5 million. In the alternative, Plaintiff is seeking damages or an order reinstating the previously released guaranties. Plaintiff’s claims include breach of contract and a request for attorneys’ fees. The trial date has been scheduled for September 20, 2004, although the Chapter 11 proceeding is expected to stay the trial date. On June 25, 2004, Plaintiff filed U.S. Restaurant Properties Operating L.P. v. Schlotzsky’s, Inc. (Cause No. 04-05858-D), in the District Court of Dallas County, 95th Judicial District. Plaintiff alleges that Defendant owes unpaid balance on certain guaranty pool agreements allegedly defaulted by Defendant beginning in May 2004. Because of uncertainties inherent in this type of matter, no outcome can be confidently predicted with respect to the foregoing matter and no estimate of the possible loss or range of possible loss can be made.

John Wooley and Jeffrey Wooley vs. Schlotzsky’s Franchisor, LLC, Cause No. GN402261, was filed on July 20, 2004 in the 98^th Judicial District Court of Travis County, Texas, and John Wooley and Jeffrey Wooley v. Schlotzsky’s, Inc., Cause No. GN402596, was filed on August 12, 2004 in the 250^th Judicial District Court of Travis County, Texas. John Wooley and Jeffrey Wooley, former officers and directors of the Company, with John Wooley currently being the largest shareholder of the Company, filed a request for a Temporary Restraining Order on July 20, 2004 to request the Court to order the Company not to take any actions with regard to Schlotzsky’s Franchisor, LLC, a subsidiary of the Company. The Wooleys asserted that any action taken with regard to Schlotzsky’s Franchisor would harm them with regard to a loan they made to Franchisor in November 2003 for approximately $2.5 million. The Court rejected their request, and no further action has been taken to date by the Wooleys in the first listed lawsuit. On August 12, 2004, the Wooleys filed the second listed lawsuit above and requested that the Court order the Company to hold its annual shareholder meeting by August 30, 2004. The Wooleys subsequently filed a motion for non-suit in the state court case and then filed a motion with the bankruptcy court asking that the judge lift the automatic stay with regard to the annual meeting and grant the Wooleys permission to pursue their claim for injunctive relief in state court. In addition, the Wooleys have filed several other motions with the bankruptcy court challenging certain actions the Company has taken during the bankruptcy proceeding and objecting to requests made by the Company with regard to its retention of professionals during the bankruptcy process. Because of uncertainties inherent in this type of matter, no outcome can be confidently predicted with respect to the foregoing matter and no estimate of the possible loss or range of possible loss can be made.

In addition to the matters discussed above, we are defendants in various other legal proceedings arising from our business. Due to the bankruptcy filing, the early stages of some of the proceedings, and the general uncertainty surrounding the outcome of any litigation, it is not possible for the Company to provide any certain or meaningful analysis, projections, or expectations with respect to the proceedings discussed above.

Note 12. — Impairment of Real Estate Investments and Real Estate Held for Sale

At the start of the second quarter, 2004, the Company was developing four real estate pad sites as future Company-operated Schlotzsky’s restaurants, and had capitalized costs related to those sites, such as interest expense, site work and acquisition costs. Additionally, the Company had five pad sites held for sale, generally recorded on the books at historical cost. In June 2004 the Company discontinued all real estate development activity and began marketing all nine real estate sites for sale on an expedited basis. An impairment charge of $4.4 million was booked in June 2004 to write-off capitalized development costs and to adjust the value of the assets to the expected net cash proceeds from a sale of the real estate on an expedited basis.

SCHLOTZSKY’S, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
(Unaudited)

Note 13. — Discontinued Operations

When a restaurant is closed or held for sale, the Company makes an evaluation as to whether its results should be reflected as discontinued operations in accordance with Statement of Financial Accounting Standard 144 - “Accounting for the Impairment or Disposal of Long-Lived Assets.”

In the second quarter ended June 30, 2004, the Company recorded a non-cash impairment charge of $8.0 million for the write-down of buildings, leasehold improvements, equipment and goodwill to fair value for eighteen of the Company’s restaurants it intends to close. The Company determined a weighted fair value for its restaurant assets by estimating the sales price of the real estate value of the closed restaurants as determined through discussions with real estate brokers and potential investors, or determined there was no fair value related to the restaurant if the location was leased. This approach differs from prior periods in that previous testing, including that done at December 31, 2003, was primarily based on the projected cash flow generated by the restaurants, not their sale value. The Company closed those ten restaurants and five others in July 2004 and three others in October 2004, during the fourth quarter. Three of the closed restaurants are located in Georgia, three in North Carolina, two in Tennessee, two in Mississippi, three in Texas and one each in Arizona, Arkansas, Minnesota, New York and Utah. In the third quarter 2004, the Company will record a charge of approximately $1,139,000 for the expected liability from rejection of the leases for eight of the closed restaurants and one location, which never opened, under Section 502 (B)(6) of the Bankruptcy Code.

Note 14. — Impairment of Area Developer Rights

The Company reviews its intangible assets for impairment on an annual basis, or when a change in circumstances indicates that the carrying amount may not be recoverable. At the end of the second quarter of 2004, the Company tested its assets for impairment due to the events leading up to the August 3, 2004 bankruptcy filing. The Company determined, due to the likelihood that all existing area developer contracts would be rejected during the bankruptcy proceedings and the Company would terminate the area developer program, that the previously acquired area developer rights had no fair value and an impairment charge of $55.5 million was recorded during the second quarter of 2004.

Note 15. — Impairment of Restaurant Goodwill, Intangible assets, and Property, Plant, and Equipment

At the end of the second quarter of 2004, the Company tested its restaurant assets for impairment due to the events leading up to the August 3, 2004 bankruptcy filing. The Company determined a weighted fair value for the 18 Company-operated locations it intends to continue to operate by projecting a range of sale scenarios determined through discussions with investment bankers, real estate brokers and potential investors. This approach differs from prior periods in that previous testing, including that done at December 31, 2003, was primarily based on the cash flow generated by the restaurants, not their sale value. An impairment charge of $2.0 million of goodwill, approximately $500,000 of intangible assets, and $6.9 million of Property, Plant, and Equipment was indicated based on the weighted fair value of the operating restaurants.

Note 16. — Employment Contracts

On June 17, 2004, the Board of Directors terminated John C. Wooley from his position as President and Chief Executive Officer of the Company and Jeffrey J. Wooley from his position as Senior Vice President of the Company. At the time of termination, the Wooleys had active employment contracts and those contracts required salary and benefits continuation for four years and that certain bonus advances be deemed earned upon termination. In June 2004, the Company accrued expenses of $2,629,000 related to the future salaries and benefits obligation and expensed $527,000 related to the bonus advances.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent liabilities. We base our estimates on historical experience and various other assumptions that we believe are reasonable under the circumstances. Estimates and assumptions are reviewed periodically. Actual results may vary from these estimates.

We believe the following critical accounting policies require estimates about the effect of matters that are inherently uncertain and require subjective judgments. Changes in the estimates and judgments could significantly impact our results of operations and financial conditions in future periods.

• Determination of the appropriate valuation allowances for accounts and notes receivable.

Our accounts and notes receivable are primarily from franchisees of the Schlotzsky’s system. We require personal guarantees for all franchise accounts and, for notes receivable, generally obtain a secondary secured interest in the related property and equipment or rights. Many of the notes receivable are fully subordinated to the franchisee’s senior mortgage debt. In reviewing the adequacy of the valuation allowances for accounts and notes receivable, we consider factors such as historical collection experience, the estimated value of personal guarantees and real property collateral, the franchisee’s sales and operating trends, including potential for improvement in operations, and general and local economic conditions that may affect the franchisee’s ability to pay. Actual realization of amounts receivable could differ materially from our estimates.

• Determination of appropriate valuation allowance for intangible assets.

Amortizing intangible assets consist primarily of amounts paid to reacquire various developer and franchise rights. Annually, and whenever an event or circumstance indicating impairment may be present, we compare projected undiscounted cash flows to the carrying value of the related assets to determine if impairment has occurred. In estimating future cash flows, we consider such factors as current results, trends, future prospects, and other economic factors. Actual future cash flows could differ materially from our estimates.

Recoverability of intangible assets is primarily dependent on the continuing collection of franchise royalties. To the extent that there is doubt about the ability of the Company to successfully reorganize and emerge from Chapter 11 these assets may be unrecoverable. After our impairment of area developer contracts, approximately $5.9 million remained worth of intangible assets relating to the franchising business remained on the balance sheet at June 30, 2004.

Recent Events

On June 17, 2004, the Board of Directors terminated John C. Wooley from his position as President and Chief Executive Officer of the Company and Jeffrey J. Wooley from his position as Senior Vice President of the Company. They had served as senior management of the Company since 1981. That same day, David Samuel (“Sam”) Coats was named President and Chief Executive Officer of the Company. Subsequently, John and Jeff Wooley were removed from various positions with the subsidiaries of the Company. On June 24, 2004, the Board appointed Sam Coats to the Board of Directors and the Company announced that it had retained Trinity Capital, LLC (“Trinity”), a specialty investment banking firm focused on the multi-unit retail and food and beverage industries, to serve as financial advisor to the Company. Trinity had been retained by the Company in March 2004 on a limited basis to obtain waivers of certain covenants from specific lenders and to seek financing for the Company. The June 24 engagement expanded the scope of their engagement to include restructuring, corporate finance and other advisory services.

On June 30, 2004, both John and Jeff Wooley voluntarily resigned from their positions as members of the Board of Directors of the Company. They both remained on the Board of Schlotzsky’s N.A.M.F., Inc., (“NAMF”) a Texas not-for-profit, non-member corporation that collects payments from Schlotzsky’s franchisees to use for advertising and marketing purposes. The Board of the Company asked them to resign from NAMF but they have refused to do so to date.

On July 6, 2004, the Company reduced its workforce and eliminated approximately 20 percent of corporate staff, or 19 positions, within Schlotzsky’s, Inc. and Schlotzsky’s Franchise Operations, LLC, a subsidiary of Schlotzsky’s, Inc. Eight of the

people terminated were at the vice president or director level. On August 2, 2004, the Company terminated nine additional employees. Beginning on July 9, 2004 and continuing through July 26, 2004, the Company closed 15 Company-operated restaurants located in various states. In October 2004, three additional Company-operated restaurants were closed; two were in Mississippi and one was in Texas. None of these stores had been profitable prior to the closing.

On August 3, 2004, the Company filed for Chapter 11 as discussed in Note 1.

Consequences of the Chapter 11 Filing

As a consequence of the Filing, all pending claims against the Company are stayed automatically by Section 362 of the Bankruptcy Code, and absent further order of the Bankruptcy Court, no party may take any action to recover any pre-petition claims, enforce any lien against or obtain possession of any property from the Company. In addition, pursuant to Section 365 of the Bankruptcy Code, the Company may reject or assume pre-petition executory contracts and unexpired leases. The non-debtor parties to these contracts or leases may file claims with the Bankruptcy Court in accordance with the Chapter 11 reorganization process.

As provided by the Bankruptcy Code, the Company initially will have the exclusive right for 120 days following the Petition Date to propose a plan of reorganization. If the Company fails to file a plan of reorganization during such period or any extension thereof, or if such plan is not accepted by the requisite numbers of creditors and equity holders entitled to vote on the plan within 180 days after the Petition Date or any extension thereof, other parties in interest may be permitted to propose their own plan or plans of reorganization for the Company. The Company is unable to predict at this time what the treatment of creditors and equity holders of the Company will be under any proposed plan or plans of reorganization, although discussions with potential buyers have indicated that the recovery of unsecured creditors and equity holders may be minimal or non-existent.

The Bankruptcy Court may confirm a plan of reorganization only upon making certain findings required by the Bankruptcy Code, and a plan may be confirmed over the dissent of non-accepting creditors and equity security holders if certain requirements of the Bankruptcy Code are met. The payment rights and other entitlements of pre-petition creditors and the Company’s stockholders may be substantially altered by any plan of reorganization confirmed in the Chapter 11 Cases. There can be no assurance that there will be sufficient assets to satisfy the Company’s pre-petition liabilities in whole or that the Company’s equity securities will have any continuing value. Under a plan of reorganization, pre-petition creditors could receive less than 100% of the face value of their claims and the Company’s equity securities could be cancelled. In addition, the Company has not yet proposed a plan of reorganization. It is not possible to predict the outcome of the Chapter 11 Cases, the terms and provisions of any plan of reorganization, or the effect of the Chapter 11 reorganization process on the claims of the creditors of the Company or the interests of the Company’s equity security holders.

The Company, with the agreement of certain secured creditors, has been able to use franchising revenue to fund the operations to date during the Chapter 11 proceedings. The Company is currently operating under a temporary cash collateral order approved by the Bankruptcy Court that expires on November 17, 2004. It is attempting to finance its unmet capital needs after November 17, 2004 through some combination of real estate sales or securing the permission of certain creditors to use franchising revenue to meet the operating needs of the Company. If necessary, the Company would seek debtor-in-possession financing at that time, although there is no guarantee that such financing could be obtained. There can be no assurance that additional capital will be available on terms acceptable to the Company, or at all. Failure to raise sufficient additional capital or to secure the agreement of certain secured creditors to use franchising revenue to fund the operations would have a material adverse effect on the Company’s ability to operate as a going concern or to restructure under Chapter 11.

In addition, the ability of the Company to continue as a going concern (including its ability to meet post-petition obligations of the Company) and the appropriateness of using the going concern basis for its financial statements are dependent upon, among other things, any orders entered by the Bankruptcy Court concerning matters outside of the ordinary course of business, and obtaining confirmation of a plan of reorganization or a sale of assets under the Bankruptcy Code. If the assets of the Company are sold under Section 363 of the Bankruptcy Code, the Company itself likely would not continue as a going concern. The consolidated financial statements contain no adjustments related to this uncertainty.

On August 12, 2004, the Company’s securities were delisted from the NASDAQ National Market. The Company’s common stock currently trades on the NASD Over-the-Counter-Market under the symbol BUNZQ.PK.

Background of Filing

The Schlotzsky’s franchise system has been declining in store count since 2000 and has had negative same store sales since 2001, resulting in declining royalty and license fees to the Company. Since 1999, the Company has repurchased certain area developer rights, and often these repurchase agreements had some component of seller financing, which resulted in a significant debt service burden to the Company. Additionally, the Company guaranteed over $25 million of franchisee lease and mortgage liabilities during the 1997-2000 time period as part of the Turnkey program, in which the Company developed restaurant sites and then sold

them to franchisees. The Company, as a franchisor, also was subject to significant amounts of litigation over various matters by both the franchisees and area developers. While significant expenses related to litigation and guarantees had been incurred over the last four years, the Company anticipated that it would continue to incur material cash expenses related to litigation and guarantees in future periods.

From approximately August 2002 to June 2004, the Company attempted to secure financing with favorable repayment terms that would allow it to retire the area developer obligations and provide additional operating capital, but was unable to secure such financing. The Company was able, starting in January 2003, to extend vendor payment terms and secure limited amounts of financing, but these financing facilities were repayable in full in less than two years, and called for amortizing payments beginning in mid-2004. Because of the cash required to repay the short-term financing, the area developer notes, and guarantee and litigation costs, as well as expenses incurred in attempting to secure additional financing, the Company was unable to pay its obligations in a timely and consistent manner and was incurring additional liabilities it was unable to pay as well. The Company and its subsidiaries filed a voluntary petition for relief under the Bankruptcy Code on August 3, 2004.

Financial Statement Presentation

The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue to operate as a going concern, which contemplates continuity of operations, timely payment for services by customers, control of operating costs and expenses and the realization of asset sales and liquidation of liabilities and commitments. The bankruptcy filing and related circumstances, including the closure of 18 stores, the Company’s default on certain pre-petition debt, the losses from operations, as well as current competitive conditions within this retail space and the possibility that the assets of the Company will be sold in a Section 363 sale, raise substantial doubts about the Company’s ability to continue as a going concern, accordingly, such realization of assets and liquidation of liabilities are subject to uncertainty. In connection with its plan of reorganization, the Company may liquidate or settle liabilities for amounts other than those reflected in the Condensed Consolidated Financial Statements. Further, a plan of reorganization could materially change the amounts and classifications reported in the consolidated historical financial statements, which do not give effect to any adjustments to the carrying value of assets or amounts of liabilities that might be necessary as a consequence of a plan of reorganization.

Pursuant to the Bankruptcy Code, schedules will be filed by the Company with the Bankruptcy Court setting forth the assets and liabilities of the Company. Differences between amounts recorded by the Company and claims filed by creditors will be investigated and resolved as part of the Chapter 11 cases.

As part of the Filing, the Company anticipates it will reject certain leases and guarantees as allowed by the Bankruptcy Code. The Company will record an accrual of approximately $1.2 million, in the third quarter, for the estimated maximum amount of allowable claims under the Bankruptcy Code for the 15 restaurants closed in July 2004 whose leases were rejected.

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2004 AND 2003

REVENUE. Total revenue decreased 11.0% to $12,697,000 from $14,262,000.

ROYALTIES decreased 15.6% to $3,618,000 from $4,285,000. The decrease was due to a decreased number of franchised restaurants in 2004 compared to 2003 and a decrease in same store contractual sales by franchised restaurants of 5.1%.

The following table presents additional data concerning the domestic franchised restaurant system:


	For the three months ended
	June 30,			June 30,
Restaurant Data	2004			2003
Restaurants opened:
Domestic -
New		1			—
Re-openings		3			1

Total domestic openings		4			1
Domestic closings		(11	)		(28	)

Operating domestic restaurants at end of quarter		471			538

Average weekly sales for domestic franchised restaurants	$	10,195		$	10,511

Change in same store sales for domestic franchised restaurants		(5.1	%)		(12.3	%)

No FRANCHISE FEES were recognized, as compared to $3,000 in the comparable period from 2003.

DEVELOPER FEES decreased 18.2% to $36,000 from $44,000. The decrease was primarily due to the expiration of amortization on certain agreements.

RESTAURANT SALES decreased 4.2% to $7,668,000 from $8,001,000. The decrease was primarily due to a 7.7% decrease in same store sales, and a decrease in the average number of restaurants operated by the Company during the second quarter of 2004, compared to the second quarter of 2003, partially offset by the opening of a high-volume unit at the end of the second quarter of 2003. As of June 30, 2004, there were 36 Company-operated restaurants, compared to 38 at June 30, 2003.

SCHLOTZSKY’S BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 31.7% to $1,168,000 from $1,709,000. The decrease was primarily due to the decrease in systemwide sales for the quarter.

OTHER FEES AND REVENUE decreased 5.5% to $207,000 from $219,000. The decrease was due to a decrease in expired franchise fees.

OPERATING EXPENSES. Total operating expenses increased to $98,606,000 from $16,742,000.

SERVICE COSTS decreased 19.9% to $534,000 from $667,000, and as a percentage of royalties and franchise fees decreased to 14.8% from 15.6%. This decrease was primarily due to a decrease in royalty revenue.

RESTAURANT OPERATIONS EXPENSES decreased 12.3% to $7,012,000 from $7,996,000.

RESTAURANT COST OF SALES decreased 9.1% to $2,136,000 from $2,349,000 and decreased as a percentage of net restaurant sales to 27.9% from 29.4% due primarily to operating efficiencies.

RESTAURANT PERSONNEL AND BENEFITS COST decreased 15.8% to $2,901,000 from $3,445,000 and decreased as a percentage of net restaurant sales to 37.8% from 43.1%. The decrease, as a percentage of net restaurant sales, was due to reduction in the average number of managers at each location and improved labor scheduling.

RESTAURANT OPERATING EXPENSES decreased 10.3% to $1,975,000 from $2,202,000 and decreased as a percentage of net restaurant sales to 25.8% from 27.5%. The decrease in operating costs, as a percentage of net restaurant sales, was primarily due to previous year’s preopening costs on a restaurant opened during the comparable quarter of the previous year and a restaurant under development, as well as a tax assessment on one restaurant location.

EQUITY LOSS ON INVESTMENTS was $300,000, as compared to a loss of $84,000 in the comparable period from 2003. The Company recorded a loss on its investment in an international master licensee due to an anticipated decrease in future efforts to expand the presence of Schlotzsky’s restaurants outside the United States.

IMPAIRMENT OF FRANCHISING ASSETS was $59,938,000 for the quarter in the current year, as compared to no expense in the same period in the prior year. An impairment charge of $55,515,000 was booked to reflect the planned termination of the Company’s area developer program and the related decrease in the fair value of repurchased area developer rights. An additional $4,423,000 in impairment expense was recognized in the second quarter of 2004 to reflect impairment of certain held-for-sale and investment in real estate.

RESTAURANT IMPAIRMENT was $17,376,000 for the quarter in the current year, as compared to no expense in the same period in the prior year. $7,968,000 of this expense reflects the impairment of certain leasehold improvements, buildings, equipment, and franchise rights related to Company-operated restaurants that the Company determined to close in the second quarter of 2004. $9,408,000 of this expense relates to stores that are expected to continue operating, but whose fair value, given the Company’s intent to market and sell the stores in the immediate future, was lower than the book value of the restaurants.

GENERAL AND ADMINISTRATIVE EXPENSES increased 80.8% to $12,134,000 from $6,713,000. This increase was primarily due to a $3.2 million accrual related to the termination of executive employment contracts, $2.1 million in accrued guarantee costs recognized in the second quarter of 2004, and an increase in bad debt expense of approximately $1.4 million as compared to the same period in 2003, offset by savings due to overhead and salary expense reductions implemented in the second half of 2003.

DEPRECIATION AND AMORTIZATION increased 2.3% to $1,312,000 from $1,283,000. The increase was primarily due to the opening of a Company-operated restaurant in the second quarter of 2003, net of the retirement of certain assets.

INTEREST INCOME decreased 39.4% to $63,000 from $104,000.

INTEREST EXPENSE decreased 7.7% to $932,000 from $1,010,000 due primarily to improvement in terms on the seller-financed debt related to the reacquisition of the territorial rights of the Company’s largest area developer.

PROVISION (CREDIT) FOR INCOME TAXES, reflects the net expense after the impairment of deferred tax assets generated during the quarter. The Company began impairing its deferred tax assets in the second half of 2003.

NET INCOME decreased to a loss of $86,799,000 from a loss of $2,267,000 due to the factors discussed above. Earnings per share, both basic and diluted, were $(11.83) for the quarter ended June 30, 2004 compared to $(0.31) in the prior year quarter.

SIX MONTHS ENDED JUNE 30, 2004 AND 2003

REVENUE. Total revenue decreased 8.4% to $25,745,000 from $28,092,000.

ROYALTIES decreased 16.0% to $7,211,000 from $8,589,000. The decrease was due to a decreased number of franchised restaurants during the six-month period in 2004 compared to 2003, and a decrease in same store contractual sales by franchised restaurants of 6.2%.

The following table presents additional data concerning the domestic franchised restaurant system:


	For the six months ended
	June 30,			June 30,
Restaurant Data	2004			2003
Restaurants opened:
Domestic -
New		1			—
Re-openings		5			2

Total domestic openings		6			2
Domestic closings		(37	)		(53	)

Operating domestic restaurants at end of quarter		471			538

Average weekly sales for domestic franchised restaurants	$	10,080		$	10,342

Change in same store sales for domestic franchised restaurants		(6.2	%)		(12.0	%)

FRANCHISE FEES were zero, as compared to $3,000 in the comparable period from 2003.

DEVELOPER FEES decreased 23.4% to $72,000 from $94,000. The decrease was primarily due to the expiration of amortization on certain agreements.

RESTAURANT SALES decreased 1.0% to $15,450,000 from $15,613,000. The decrease was primarily due to a 7.4% decrease in same store sales during the first six months of 2004, and a decrease in the average number of restaurants operated by the Company during the six months ended June 30, 2004, compared to the comparable period of 2003, partially offset by a change in the store mix. As of June 30, 2004, there were 36 Company-operated restaurants compared to 38 at June 30, 2003.

SCHLOTZSKY’S BRAND LICENSING FEES (BRAND CONTRIBUTION) decreased 23.1% to $2,584,000 from $3,360,000. The decrease was primarily due to the decrease in systemwide sales for the period.

OTHER FEES AND REVENUE decreased 1.2% to $427,000 from $432,000. The decrease was due to a decrease in expired franchise fees.

OPERATING EXPENSES increased to $111,416,000 from $31,232,000.

SERVICE COSTS decreased 20.1% to $1,063,000 from $1,331,000, and as a percentage of royalties and franchise fees declined to 14.7% from 15.5%. This decrease was primarily due to a decrease in royalty revenue.

RESTAURANT OPERATIONS EXPENSES decreased 9.7% to $13,944,000 from $15,435,000. The use of certain Company-operated restaurants for product, process and equipment testing and for systemwide training also adversely impacts their operating performance. The decrease is mainly attributed to a change in the store mix.

RESTAURANT COST OF SALES decreased 6.1% to $4,246,000 from $4,520,000 and decreased as a percentage of net restaurant sales to 27.5% from 29.0% due primarily to operating efficiencies.

RESTAURANT PERSONNEL AND BENEFITS COST decreased 14.1 % to $5,852,000 from $6,810,000, and decreased as a percentage of net restaurant sales to 37.9% from 43.6%. The decrease, as a percentage of net restaurant sales, was due to reduction in the average number of managers at each location and operating efficiencies.

RESTAURANT OPERATING EXPENSES decreased 6.3% to $3,847,000 from $4,104,000 and decreased as a percentage of net restaurant sales to 24.9% from 26.3%. The decrease in operating costs, as a percentage of net restaurant sales, was primarily due to the change in the store mix and the previous year’s preopening costs on a restaurant opened during the quarter and a restaurant under development as well as a tax assessment on one restaurant location.

EQUITY LOSS ON INVESTMENTS was $300,000, as compared to a loss of $151,000 in the comparable period from 2003. The Company recorded a loss on its investment in an international master licensee due to an anticipated decrease in future efforts to expand the presence of Schlotzsky’s restaurants outside the United States.

IMPAIRMENT OF FRANCHISING ASSETS was $59,938,000 in the current year, as compared to no expense in the same period in the prior year. An impairment charge of $55,515,000 was booked to reflect the planned termination of the Company’s area developer program and the related decrease in the fair value of repurchased area developer rights. An additional $4,423,000 in impairment expense was recognized in the second quarter of 2004 to reflect impairment of certain held-for-sale and investment in real estate.

RESTAURANT IMPAIRMENT was $17,376,000 in the current year, as compared to no expense in the same period in the prior year. $7,968,000 of this expense reflects the impairment of certain leasehold improvements, buildings, equipment, and franchise rights related to Company-operated restaurants that the Company determined to close in the second quarter of 2004. $9,408,000 of this expense relates to stores that are expected to continue operating, but whose fair value given the Company’s intent to market and sell the stores in the immediate future, was lower than the book value of the restaurants.

GENERAL AND ADMINISTRATIVE EXPENSES increased 36.4% to $16,077,000 from $11,783,000. This increase was primarily due to a $3.2 million accrual related to the termination of executive employment contracts, $2.1 million in accrued guarantee costs recognized in the second quarter of 2004, and an increase in bad debt expense of approximately $1.9 million as compared to the same period in 2003, offset by savings due to overhead and salary expense reductions implemented in the second half of 2003.

DEPRECIATION AND AMORTIZATION increased 7.3% to $2,718,000 from $2,532,000. The increase was primarily due to the opening of additional Company restaurants in 2003.

INTEREST INCOME decreased 39.6% to $125,000 from $207,000. The decrease was due to the decrease in the amount of performing notes receivable.

INTEREST EXPENSE decreased 8.0% to $1,864,000 from $2,026,000 due primarily to improved terms on the seller financed debt related to the reacquisition of the territorial rights the Company’s largest area developer.

PROVISION (CREDIT) FOR INCOME TAXES reflects the net expense after the impairment of deferred tax assets generated during the six months ended June 30, 2004. The Company began impairing its deferred tax assets in the second half of 2003.

NET INCOME decreased to a loss of $87,470,000 for the six months ended June 30, 2004 from a loss of $3,334,000 for the comparable prior year period due to the factors discussed above. Earnings per share, both basic and diluted, were $(11.92) for the six months ended June 30, 2004 compared to $(0.46) in the comparable period in the prior year.

OFF-BALANCE SHEET ARRANGEMENTS

On August 9, 2004, the Company filed a motion with the Bankruptcy Court to discharge certain Area Developer contracts and remove area developers from the Schlotzsky’s, Inc. franchising model.

The loan guarantees in favor of related parties primarily arose when we guaranteed certain debt of related parties for which the proceeds of the loans were used to repay outstanding debt to the Company. One of the guarantees, for the benefit of the Company’s real estate venture, is of mortgage debt, totaling approximately $2.0 million. This guarantee extends through 2009. Another guarantee, in the amount of approximately $4.1 million at March 31, 2004, was for the benefit of NAMF, the advertising entity of the Schlotzsky’s restaurant system, for which we received the net proceeds of the loan in repayment of outstanding debt to the Company. This guarantee was released in May 2004.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents decreased $544,000 in the six months ended June 30, 2004, and increased $101,000 in the six months ended June 30, 2003. Cash flows are impacted by operating, investing and financing activities.

Operating activities used $46,000 of cash in the first six months of 2004 and provided $4,256,000 of cash in the first six months of 2003. The Company reported a loss of $87,470,000 for the first six months of 2004, and much of this loss was related to expenses the Company incurred but did not pay in the quarter, such as $3.2 million in executive compensation, or non-cash expenses, such as $83.3 million in depreciation, impairment, and bad debt expense. Without these expenses, the cash used by operations resulted from an increase in accounts receivable mostly offset by an increase in accounts payable.

Investing used $194,000 and provided $113,000 of cash in the first six months of 2004 and 2003, respectively. The cashed used in 2004 resulted from remodels at Company owned-restaurants and expenditures to protect trademarks.

Financing activities used $303,000 and $4,267,000 of cash in the first six months of 2004 and 2003, respectively. The decrease in cash used in the first six months of 2004 compared to the comparable period of 2003 is primarily the net result of increased borrowings and decreased debt payment in the first six months of 2004, partially offset by decreases in debt issuance costs.

At June 30, 2004, we had approximately $51,283,000 of total debt outstanding. Scheduled maturities of debt through June 30, 2005 currently approximate $47,123,000, including short-term debt and debt classified as current due to violations of the terms debt agreements.

Certain of our mortgage debt require the maintenance of certain financial ratios, including debt-to-equity and working capital. As of June 30, 2004, the Company was in default of many of the financial covenants specified in its debt agreements. While the Company has not sought waivers of these covenant violations, the Bankruptcy Filing stays, to date, any actions by these lenders to accelerate collections of these debts. Under these debt agreements, such defaults result in the debt becoming immediately due and payable. Related to these defaults, approximately $35.8 million in long-term debt was reclassified as a current maturity of long-term debt as of June 30, 2004. The following tables present certain of our obligations to make future payments, excluding interest payments, under contracts and contingent commitments as of June 30, 2004 (dollars in thousands):


	Payments Due by Period
	As of June 30, 2004
			Less than 1
Contractual Obligations	Total		year		1-3 years		4-5 years		After 5 years
Short-term Debt	$	1,682	$	1,682	$	—	$	—	$	—
Long-term Debt		49,601		45,441		2,515		278		1,367
Operating Leases		17,622		2,420		4,034		2,351		8,817


			Amount of Commitment Expiration Per Period
			As of June 30, 2004
	Total
	Amounts		Less than 1
Other Commercial Commitments	Committed		year		1-3 years		4-5 years		After 5 years
Guarantees	$	20,464	$	8,894	$	4,112	$	3,324	$	4,134

We have experienced net reductions in the number of restaurants systemwide quarterly since 2000 and have experienced negative same store contractual sales quarterly since mid-2001. While we have been developing and implementing strategies to reverse these trends, we expect that the number of restaurants will continue to decline in the near term, particularly due to the Company’s inability to support certain franchisees that were able to remain open due to the Company’s payment on lease and mortgage guarantees which were suspended after the Filing. Continuation of these trends will have a negative impact on our royalty revenue and brand contribution, which in turn would impact our cash flow and liquidity.

On July 6, 2004 and August 2, 2004 we effected a reduction in force eliminating 32 positions on the corporate staff, reducing the personnel employed at our corporate headquarters or as field personnel to approximately 70. These reductions will begin to impact operating results in the third quarter of 2004. The effects of these position reductions will continue in the fourth quarter of 2004. We also have developed and have implemented plans to reduce non-compensation general and administrative expense, and expect certain guarantees and litigation liabilities and expenses to be discharged during the Bankruptcy process. These reductions in expense likely will be offset by additional legal and professional fees incurred during the Bankruptcy process.

The Company is currently operating under a temporary cash collateral order approved by the Bankruptcy Court that expires on November 17, 2004. The Company is attempting to finance its cash needs after November 17, 2004 through some combination of real estate sales or securing the permission of certain creditors to continue to use collateralized franchising revenue to meet the operating needs of the Company. There can be no assurance that additional capital will be available on terms acceptable to the

Company, or at all. Failure to raise sufficient additional capital would have a material adverse effect on the Company’s ability to operate as a going concern or to restructure in Chapter 11.

On June 24, 2004, the Company announced that it had retained Trinity Capital, LLC, a specialty investment banking firm focused on the multi-unit retail and food and beverage industries, to serve as financial advisor to the Company. Through its financial advisor, the Company is exploring its restructuring alternatives involving strategic investors. The Company considers additional investment critical to successfully reorganizing the Company and emerging from bankruptcy, and there can be no assurance that additional capital can be secured on terms acceptable to the Company.

Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and other material included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Forward-Looking Statements

This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, or the Private Securities Litigation Reform Act of 1995. Any statements that are not statements of historical fact may be deemed forward-looking statements. Forward-looking statements are not meant to predict or guarantee actual results, performance, events, or circumstances and may not be realized because they are based on our current projections, plans, objectives, beliefs, expectations, estimates, and assumptions and are subject to a number of risk factors and uncertainties, many of which are beyond our control. Actual results and the timing of future events and circumstances may differ materially from those described or implied by the forward-looking statements as a result of these risk factors and uncertainties. Forward-looking statements may include, without limitation, statements concerning earnings or other financial item projections, the plans and objectives of management, future economic performance, new restaurant development, future Schlotzsky’s brand products, and assumptions underlying or relating to any other forward-looking statement. Factors that could cause actual results to differ materially from those described in the forward-looking statements may include, without limitation, the ability of the Company to develop one or more plans of reorganization with respect to the Chapter 11 proceeding and receiving approval from the Court and other interested third parties, an inability of the Company or our franchisees to obtain adequate financing, increased competition within the restaurant industry, the results of arbitration and litigation, an inability to sell restaurants, a failure to successfully recruit multi-unit and single-unit franchisees, and stock volatility and illiquidity.

Because of the risks and uncertainties related to these factors and the forward-looking statements, readers are cautioned not to place undue reliance on the forward-looking statements. There can be no assurance that any events or results described in any forward-looking statement will actually occur or be achieved. It is possible that the equity of the Company will be restructured in a manner that will substantially reduce or eliminate any remaining value. We undertake no obligation to publicly revise the forward-looking statements to reflect events or circumstances that arise after the date of this report or to reflect new information, future events or circumstances, changes in assumptions, or otherwise. Readers should carefully review the risk factors described above and in other documents filed by us with the Commission. Readers are specifically directed to the discussion under “Risk Factors” in our most recent annual report on Form 10-K.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Changes in short-term interest rates on loans from financial institutions could materially affect the Company’s earnings because the interest rates charged on certain underlying obligations are variable.

At June 30, 2004, a hypothetical 100 basis point increase in interest rates would result in a decrease of approximately $74,000 in annual pre-tax earnings. The estimated decrease is based upon the increased interest expense of the Company’s variable rate debt and assumes no change in the volume or composition of debt at June 30, 2004.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures. The term “disclosure controls and procedures” is defined in Rule 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, (the “Exchange Act”). This term refers to the controls and procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports it files under the Exchange Act is recorded, processed, summarized and reported within the required time periods. Our Chief Executive Officer and our Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report, and they have concluded that as of that date, our disclosure controls and procedures were effective at ensuring that required information will be disclosed on a timely basis in our reports filed under the Exchange Act.

(b) Changes in Internal Controls. We maintain a system of internal controls that are designed to provide reasonable assurance that our books and records accurately reflect, in all material respects, our transactions and that our established policies and procedures are followed. There were no changes to our internal controls over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Dae Kim, DWK Enterprises, Inc., and Aecon International, Inc. v. John Wooley, Schlotzsky’s, Inc., Schlotzsky’s Franchising Limited Partnership, Schlotzsky’s N.A.M.F., Inc., Schlotzsky’s National Advertising Association, Inc., and Schlotzsky’s, Brands, Inc., Schlotzsky’s Brand Products, L.P., Schlotzsky’s Real Estate, Inc., and Schlotzsky’s Restaurants, Inc. (Cause No. 2001-CI-13672) was originally filed in the 73rd Judicial District Court of Bexar County, Texas on or about September 25, 2001 (after a similar lawsuit was filed and later withdrawn in Harris County, Texas) against Schlotzsky’s, Inc., John Wooley, Schlotzsky’s Franchising Limited Partnership, and Schlotzsky’s NAMF, Inc. (“Defendants”). Plaintiffs are, or claim to be, franchisees in Houston and San Antonio Texas, and Plaintiff Kim was an area developer for those markets. Plaintiffs brought causes of action for breach of contract, breach of fiduciary duty, breach of the duty of good faith and fair dealing, civil conspiracy, tortuous interference with contract, tortuous interference with prospective business relationship, violation of the Texas Deceptive Trade Practices and Consumer Protection Acts, restraint of trade, detrimental reliance-fraud in the inducement, and defamation-business disparagement. They seek an unspecified amount of money damages plus exemplary damages, attorneys’ fees, pre-judgment interest, costs, and a jury trial. Defendants, except for Mr. Wooley who was previously dismissed from the case, answered and asserted counterclaims alleging breach of contract and that Plaintiffs’ claim under the Texas Deceptive Trade Practices Act is groundless in fact or in law and brought in bad faith or for the purpose of harassment, and seek money damages, costs of court, penalty fees, costs incurred in performing the accounting, attorneys’ fees, and pre- and post-judgment interest. Defendants (except for Mr. Wooley) removed the case to federal court. The case was remanded to state court on April 17, 2003. The case is not yet set for trial.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a) Exhibits:

3.1 Articles of Incorporation of the Company, as amended. (1)

3.2 Statement of Resolutions Regarding the Designation, Preferences and Rights of Class C Series A Junior Participating Preferred Stock of the Company. (2)

3.3 Bylaws of the Company, as amended. (4)

4.1 Specimen stock certificate evidencing the Common Stock of the Company. (1)

4.2 Rights Agreement dated December 18, 1998 between the Company and Harris Trust and Savings Bank. (2)

4.3 Warrant Certificate dated February 15, 2001 from the Company to Triad Media Ventures LLC. (3)

10.55 Employment Agreement dated as of June 17, 2004 between the Company and Sam Coats (4)*

31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by David Samuel Coats, Chief Executive Officer. (4)

31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by Matthew D. Osburn, Chief Financial Officer. (4)

32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by David Samuel Coats, Chief Executive Officer. (4)

32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Matthew D. Osburn, Chief Financial Officer. (4)

* Indicates a management contract or compensatory plan or arrangement.

(1) Incorporated by reference from the Company’s Registration Statement on Form S-1 filed on October 12, 1995, as amended.

(2) Incorporated by referenced from the Company’s Registration of certain Securities on Form 8-A filed on December 18, 1998.

(3) Incorporated by reference from the Company’s Annual Report on Form 10-K filed on April 2, 2001.

(4) Filed with this Quarterly Report on Form 10-Q.

b) Current Reports on Form 8-K:

The Registrant filed a Current Report on Form 8-K dated March 31, 2004, containing a press release dated March 30, 2004, announcing the Company’s release of financial results for the quarter and fiscal year ended December 31, 2003.

The Registrant filed a Current Report on Form 8-K dated May 13, 2004, containing a press release dated May 13, 2004, announcing the Company’s release of financial results for the quarter ended March 31, 2004.

The Registrant filed a Current Report on Form 8-K dated June 17, 2004, containing a press release dated June 17, 2004, announcing the removal by the Board of Directors of the Company of certain senior management and the election of a new interim Chief Executive Officer.

The Registrant filed a Current Report on Form 8-K dated August 3, 2004, containing a press release dated August 3, 2004, announcing the Chapter 11 bankruptcy filings by the Company and certain of its subsidiaries.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		SCHLOTZSKY’S, INC.

		By:		/s/ David Samuel Coats

				David Samuel Coats
				President and Chief Executive Officer

		By:		/s/ Matthew D. Osburn

				Matthew D. Osburn
				Vice President, Controller and
				Assistant Treasurer
				(Principal Financial Officer)

Austin, Texas
November 11, 2004

EX-3.3 2 d20096exv3w3.htm BYLAWS OF THE COMPANY exv3w3

EXHIBIT 3.3

AMENDED AND RESTATED
BYLAWS OF
SCHLOTZSKY’S, INC.

1. Offices

1.1 Principal Office. The principal office of the Corporation shall be located in Austin, Texas.

1.2 Other Office. The Corporation may also have offices at such other places within or without the State of Texas as the board of directors may from time to time determine or the business of the Corporation may require.

2. Meetings of Shareholders

2.1 Annual Meeting. The annual meeting of shareholders for the election of directors and such other business as may properly be brought before the meeting shall be held at such place within or without the State of Texas and at such date and time as shall be designated by the board of directors and stated in the notice of the meeting or in a duly executed waiver of notice thereof.

2.2 Special Meetings. Special meetings of the shareholders may be called (a) by the president or the board of directors, or (b) by the holders of at least 10% of all the shares entitled to vote at the proposed meeting; provided that when a meeting is to be called by the holders of at least one-tenth (1/10th) of all shares entitled to vote at the meeting for a purpose other than the removal of one or more directors in accordance with these Bylaws, prior notice of such meeting and the purposes therefor must be set forth in writing to, and timely filed with, the secretary of the Corporation. To be considered timely, such prior notice must be delivered either in person or by United States Certified Mail, postage prepaid, and received at the principal executive offices of the Corporation not less than 120 days nor more than 150 days before the proposed date of the special meeting of shareholders. Business transacted at any special meeting shall be confined to the purposes stated in the prior notice provided to the secretary of the Corporation and in the notice of the meeting provided to shareholders. A meeting called by the holders of at least one-tenth (1/10th) of all shares entitled to vote at the meeting for a purpose other than the removal of one or more directors, may be canceled or rescheduled by the board of directors if such a meeting would occur within 60 days of the Corporation’s annual meeting. The record date for determining shareholders entitled to call a special meeting shall be determined by the Board of Directors.

2.3 Notice and Waivers of Notice.

(a) Written notice stating the place, date and hour of the meeting and, in the case of a special meeting, the purpose or purposes for which the meeting is called, shall be delivered not less than 10 nor more than 60 days before the date of the meeting, either personally or by mail, by or at the direction of the president, the secretary, or the officer or persons calling the meeting, to

each shareholder entitled to vote at such meeting. If mailed, such notice shall be deemed to be delivered when deposited in the United States mail addressed to the shareholder at his address as it appears on the share transfer records of the Corporation.

(b) Notice may be waived in writing signed by the person or persons entitled to such notice. Such waiver may be executed at any time before or after the holding of such meeting. Attendance at a meeting shall constitute a waiver of notice, except where the person attends for the express purpose of objecting to the transaction of any business on the ground that the meeting is not lawfully called.

(c) Any notice required to be given to any shareholder, under any provision of the Texas Business Corporation Act, as amended (the “Act”), the Articles of Incorporation or these Bylaws, need not be given to the shareholder if (1) notice of two consecutive annual meetings and all notices of meetings held during the period between those annual meetings, if any, or (2) all (but in no event less than two) payments (if sent by first class mail) of distributions or interest on securities during a 12-month period have been mailed to that person, addressed at his address as shown on the records of the Corporation, and have been returned undeliverable. Any action or meeting taken or held without notice to such a person shall have the same force and effect as if the notice had been duly given and, if the action taken by the Corporation is reflected in any articles or document filed with the Secretary of State, those articles or that document may state that notice was duly given to all persons to whom notice was required to be given. If such a person delivers to the Corporation a written notice setting forth his then current address, the requirement that notice be given to that person shall be reinstated.

2.4 Record Date. For the purpose of determining shareholders entitled to notice of or to vote at any meeting of shareholders or any adjournment thereof, or entitled to receive payment of any dividend, the board of directors may in advance establish a record date which must be at least 10 but not more than 60 days prior to such meeting. If the board of directors fail to establish a record date, the record date shall be the date on which notice of the meeting is mailed.

2.5 Voting List.

(a) The officer or agent having charge of the stock transfer books for shares of the Corporation shall make, at least ten days before each meeting of shareholders, a complete list of the shareholders entitled to vote at such meeting or any adjournment thereof, arranged in alphabetical order, with the address of and the number of shares held by each, which list, for a period of ten days prior to such meeting, shall be kept on file at the registered office of the Corporation and shall be subject to inspection by any shareholder at any time during usual business hours. Such list shall also be produced and kept open at the time and place of the meeting and shall be subject to the inspection of any shareholder during the whole time of the meeting. The original stock transfer book shall be prima facie evidence as to who are the shareholders entitled to examine such list or transfer books or vote at any meeting of shareholders.

(b) Failure to comply with the requirements of this section shall not affect the validity of any action taken at such meeting.

(c) An officer or agent having charge of the stock transfer books who shall fail to prepare the list of shareholders or keep the same on file for a period of ten days, or produce and keep it open for inspection as provided in this section, shall be liable to any shareholder suffering damage on account of such failure, to the extent of such damage. In the event that such officer or agent does not receive notice of a meeting of shareholders sufficiently in advance of the date of such meeting reasonably to enable him to comply with the duties prescribed by these Bylaws, the Corporation, but not such officer or agent shall be liable to any shareholder suffering damage on account of such failure, to the extent of such damage.

2.6 Quorum of Shareholders. With respect to any matter, a quorum shall be present at a meeting of shareholders if the holders of a majority of the shares entitled to vote on that matter are represented at the meeting, in person or by proxy, unless otherwise provided in the Articles of Incorporation in accordance with the Act. Unless otherwise provided in the Articles of Incorporation, the shareholders represented in person or by proxy at a meeting of shareholders at which a quorum is not present may adjourn the meeting until such time and to such place as may be determined by a vote of the holders of a majority of the shares represented in person or by proxy at that meeting.

2.7 Withdrawal of Quorum. Unless otherwise provided in the Articles of Incorporation, once a quorum is present at a meeting of shareholders, the shareholders represented in person or by proxy at the meeting may conduct such business as may properly be brought before the meeting until it is adjourned, and the subsequent withdrawal from the meeting of any shareholder or the refusal of any shareholder represented in person or by proxy to vote shall not effect the presence of a quorum at the meeting.

2.8 Voting on Matters Other Than the Election of Directors. With respect to any matter, other than the election of directors or a matter for which the affirmative vote of the holders of a specified portion of the shares entitled to vote is required by the Act, the affirmative vote of the holders of a majority of the shares entitled to vote on that matter and represented in person or by proxy at a meeting of shareholders at which a quorum is present shall be the act of the shareholders, unless otherwise provided in the Articles of Incorporation.

2.9 Voting in the Election of Directors. Directors shall be elected in the manner provided in the Articles of Incorporation.

2.10 Method of Voting. The holders of outstanding shares of capital stock of the Corporation shall be entitled to vote on matters submitted to a vote of shareholders as provided in the Articles of Incorporation. Any shareholder may vote either in person or by proxy executed in writing by the shareholder. No proxy shall be valid after 11 months from the date of its execution, unless otherwise provided in the proxy.

2.11 Action Without Meetings.

(a) Any action that may be taken at any shareholders’ meeting may be taken without a meeting if consents in writing setting forth the action to be taken are signed by the holders of outstanding shares having not less than the number of votes that would be necessary to authorize such action at a meeting at which all shares entitled to vote thereon were present and voted are delivered to the Corporation. Any party desiring to present a matter to the shareholders for written consent shall give notice to the Secretary of the Corporation not less than 60 days prior to the date the consent solicitation is to be initiated. The Board may fix the record date for determining the shareholders who shall be entitled to vote on the matter presented for written consent at any time prior to the date such consent solicitation is to be initiated. The Board may also fix the expiration date of the consent solicitation period. In the event that the Board does not set a record date, the record date will be the date of the first consent. Upon receipt of a written consent from any shareholder, the Corporation shall determine the validity of such consent. Any shareholder’s written consent that cannot be validated within 10 days of the expiration of the consent solicitation period shall be deemed invalid, and shall not be counted in determining whether the requisite number of votes for the matter presented for consent have been obtained.

(b) A telegram, telex, cablegram, or similar transmission by a shareholder, or a photographic, photostatic, facsimile, or similar reproduction of a writing signed by a shareholder, shall be regarded as signed by the shareholder for purposes of this section.

(c) Prompt notice of the taking of any action by shareholders without a meeting by less than unanimous written consent shall be given to those shareholders who did not consent in writing to the action.

2.12 Conduct of Meeting. The Chairman of the Board, if such office has been filled, and, if not or if the Chairman of the Board is absent or otherwise unable to act, the President shall preside at all meetings of shareholders. The Secretary shall keep the records of each meeting of shareholders. In the absence or inability to act of any such officer, such officer’s duties shall be performed by the officer given the authority to act for such absent or non-acting officer under these by-laws or by a person appointed by the meeting.

2.13 Shareholder Proposals at Annual Meetings. At an annual meeting of the shareholders, only such business shall be conducted as shall have been properly brought before the meeting. To be properly brought before an annual meeting, business must be specified in the notice of meeting (or any supplement thereto) given by or at the direction of the board of directors, otherwise properly brought before the meeting by or at the direction of the board of directors or otherwise properly brought before the meeting by a shareholder. In addition to any other applicable requirements, for business to be properly brought before an annual meeting by a shareholder, the shareholder must have given timely notice thereof in writing to the Secretary of the Corporation. To be considered timely, a shareholder’s notice must be delivered either in person or by United States certified mail, postage prepaid, and received at the principal executive offices of the corporation (a) not less than one hundred twenty (120) days nor more than one hundred fifty (150) days before the first anniversary date of the corporation’s proxy statement in connection with the last annual meeting of shareholders, or (b) if no annual meeting has been called after the expiration of more than thirty (30) days from the date for such meeting

contemplated at the time of the previous year’s proxy statement, not less than a reasonable time, as determined by the board of directors, prior to the date of the applicable annual meeting. A shareholder’s notice to the Secretary shall set forth as to each matter the shareholder proposes to bring before the annual meeting, (i) a brief description of the business desired to be brought before the annual meeting and the reasons for conducting such business at the annual meeting, (ii) the name and record address of the shareholder proposing such business, (iii) the class and number of shares of the Corporation that are beneficially owned by the shareholder, and (iv) any material interest of the shareholder in such business. Notwithstanding anything in these by-laws to the contrary, no business shall be conducted at the annual meeting except in accordance with the procedures set forth in this section 2.13, provided, however, that nothing in this section 2.13 shall be deemed to preclude discussion by any shareholder of any business properly brought before the annual meeting in accordance with said procedure.

2.14 Nominations of Persons for Election to the Board of Directors. In addition to any other applicable requirements, only persons who are nominated in accordance with the following procedures shall be eligible for election as directors. Nominations of persons for election to the board of directors of the Corporation may be made at a meeting of shareholders by or at the direction of the board of directors, by any nominating committee or person appointed by the board of directors or by any shareholder of the Corporation entitled to vote for the election of directors at the meeting who complies with the notice procedures set forth in this section 2.14. Such nominations, other than those made by or at the direction of the board of directors, shall be made pursuant to timely notice in writing to the Secretary of the Corporation. To be considered timely, a shareholder’s notice must be delivered either in person or by United States certified mail, postage prepaid, and received at the principal executive offices of the Corporation (a) not less than one hundred twenty (120) days nor more than one hundred fifty (150) days before the first anniversary date of the Corporation’s proxy statement in connection with the last annual meeting of shareholders, or (b) if no annual meeting has been called after the expiration of more than thirty (30) days from the date for such meeting contemplated at the time of the previous year’s proxy statement, not less than a reasonable time, as determined by the board of directors, prior to the date of the applicable annual meeting. Such shareholder’s notice shall set forth (a) as to each person whom the shareholder proposes to nominate for election or re-election as a director, (i) the name, age, business address and residence address of the person, (ii) the principal occupation or employment of the person, (iii) the class and number of shares of the Corporation beneficially owned by the person, and (iv) any other information relating to the person that is required to be disclosed in solicitations for proxies for election of directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended; and (b) as to the shareholder giving the notice, (i) the name and record address of the shareholder, and (ii) the class and number of shares of the Corporation beneficially owned by the shareholder. The Corporation may require any proposed nominee to furnish such other information as may reasonably be required by the Corporation to determine the eligibility of such proposed nominee to serve as a director of the Corporation. No person shall be eligible for election as a director of the Corporation unless nominated in accordance with the procedures set forth herein. These provisions shall not apply to nomination of any persons entitled to be separately elected by holders of preferred stock.

2.15 Inspectors. The board of directors may, in advance of any meeting of shareholders, appoint one or more inspectors to act at such meeting or any adjournment thereof.

If any of the inspectors so appointed shall fail to appear or act, the chairman of the meeting shall, or if inspectors shall not have been appointed, the chairman of the meeting may, appoint one or more inspectors. Each inspector, before entering upon the discharge of his duties, shall take and sign an oath faithfully to execute the duties of inspector at such meeting with strict impartiality and according to the best of his ability. The inspectors shall determine the number of shares of capital stock of the Corporation outstanding and the voting power of each, the number of shares represented at the meeting, the existence of a quorum, and the validity and effect of proxies and shall receive votes, ballots, or consents, hear and determine all challenges and questions arising in connection with the right to vote, count and tabulate all votes, ballots, or consents, determine the results, and do such acts as are proper to conduct the election or vote with fairness to all shareholders after consultation with counsel to the Corporation as to any issues of law. On request of the chairman of the meeting, the inspectors shall make a report in writing of any challenge, request, or matter determined by them and shall execute a certificate of any fact found by them. No director or candidate for the office of director shall act as an inspector of an election of directors. Inspectors need not be shareholders.

3. Directors

3.1 Powers. The business and affairs of the Corporation shall be managed by or under the direction of the Board of Directors, except as otherwise provided by applicable law or the Articles of Incorporation, which may exercise all powers of the Corporation and perform all such lawful acts and do all such lawful things that are not, by applicable law or the Articles of Incorporation, directed or required to be exercised, performed, or done by the shareholders of the Corporation.

3.2 Number. Except as otherwise provided by or fixed pursuant to the provisions of Article IV, Section 8 (Class C Preferred Stock) of the Articles of Incorporation with respect to the right(s) of holders of any Preferred Stock or series of Preferred Stock to elect any additional director(s), the number of directors which shall constitute the “whole” (as defined below) Board of Directors shall be not less than three (3) and shall be fixed from time to time exclusively by the Board of Directors pursuant to a resolution adopted by the Board of Directors. For purposes of this Section 3.2 (Number), “whole” shall mean the total number of authorized directors, whether or not there exist any vacancies on the Board of Directors or unfilled previously authorized directorships, at the time such resolution is presented to the Board of Directors for adoption.

3.3 Staggered Board and Election. Except as otherwise provided by or fixed pursuant to the provisions of Article IV, Section 8 (Class C Preferred Stock) of the Articles of Incorporation with respect to the right(s) of holders of any Preferred Stock or series of Preferred Stock to elect any additional director(s), the directors shall be divided into three (3) classes, designated as Class A, Class B, and Class C (which at all times shall be as nearly equal in number as possible), with the term of office of Class A directors to expire at the 2005 Annual Meeting of Shareholders, the term of office of Class B directors to expire at the 2003 Annual Meeting of Shareholders, and the term of office of Class C directors to expire at the 2004 Annual Meeting of Shareholders, upon election and qualification of their successors. At each annual meeting of shareholders after such classification, qualification, and election, directors elected to succeed those directors whose terms shall have expired shall be elected for a full term of office,

as applicable, to expire at the third ensuing annual meeting of shareholders after their election, upon election and qualification of their successors. The directors of the Corporation, except for any director(s) who may be elected as otherwise provided by or fixed pursuant to the provisions of Article IV, Section 8 (Class C Preferred Stock) of the Articles of Incorporation with respect to the right(s) of holders of any Preferred Stock or series of Preferred Stock to elect any additional director(s), shall be elected in accordance with this Section 3.3 (Staggered Board and Election) by the shareholders of the Corporation entitled to vote thereon at each annual meeting of shareholders. Each director shall be at least 21 years of age. Directors need not be shareholders of the Corporation. In any election of directors, the persons receiving a plurality of the votes cast, up to the number of directors to be elected in such election, shall be deemed elected.

3.4 Resignation or Removal. Directors may resign at any time by giving notice to the Corporation in writing or by electronic transmission. “Electronic transmission” means a form of communication that: (a) does not directly involve the physical transmission of paper; (b) creates a record that may be retained, retrieved, and reviewed by the recipient; and (c) may be directly reproduced in paper form by the recipient through an automated process. Subject to the right of the holders of any Preferred Stock or series of Preferred Stock then outstanding, any director, or the entire Board of Directors, may be removed from office at any time, but only for “cause” (as defined below) and only by the affirmative vote of the holders of at least sixty-six and two-thirds percent (66 2/3%) of the voting power of the Voting Stock (as defined below), voting together as a single class. Except as may otherwise be provided by law, “cause” for removal shall exist only if any director whose removal has been proposed:

(a) has been convicted of a felony by a court of competent jurisdiction and such conviction is no longer subject to direct appeal,

(b) has been adjudged by a court of competent jurisdiction to be liable for gross negligence or misconduct in the performance of the duties of such director to the Corporation in connection with a matter of substantial importance to the Corporation, and such adjudication has become final and non-appealable, or

For purposes of these Bylaws, the term “Voting Stock” shall mean all issued and outstanding shares of stock of the Corporation entitled to vote generally in the election of directors or that otherwise are entitled to vote with such stock on the specific matter in question.

3.5 Vacancies. Subject to the rights of the holders of any Preferred Stock or series of Preferred Stock then outstanding, any vacancy occurring in the Board of Directors by reason of resignation or removal or any directorship to be filled by reason of an increase in the number of directors may be filled by election at an annual or special meeting of shareholders called for that purpose or may be filled by the affirmative vote of a majority of the remaining directors though less than a quorum of the board of directors; provided, however, that a directorship to be filled by reason of an increase in the number of directors may be filled by the Board of Directors for a term of office continuing only until the next election of one or more directors by the shareholders and the Board of Directors may not fill more than two such directorships during the period between any two successive annual meetings of shareholders. A director elected to fill a

vacancy, other than a vacancy filled by the Board of Directors by reason of an increase in the number of directors, shall be elected for the unexpired term of his predecessor in office.

3.6 Nominations, Ballots, and Cumulative Voting. Advance notice of nominations for the election of directors of the Corporation shall be given in accordance with Section 2.14 of these Bylaws. Election of directors need not be by written ballot unless these Bylaws shall so provide. No holders of shares of stock of the Corporation shall have any right(s) to cumulate votes in the election of directors of the Corporation.

3.7 Preferred Stock Directors. Notwithstanding the foregoing, whenever the holders of any Preferred Stock or series of Preferred Stock shall be entitled to elect any additional director(s) at an annual or special meeting of shareholders, the election, term of office, filling of vacancies, and other terms and features of such directorship(s) shall be governed by the terms and features of the Articles of Incorporation, and any resolution(s) adopted pursuant thereto, and the director(s) so elected shall not be divided into classes pursuant to this Section 3 (Board of Directors) unless expressly provided by such terms and features.

4. Meetings of the Board of Directors

4.1 Place. Meetings of the board of directors, regular or special, may be held either within or without the State of Texas.

4.2 Regular Meetings. Regular meetings of the board of directors shall be held at such dates and times and at such places as shall from time to time be determined by the board of directors. Regular meetings may be held with or without notice, as determined by the board of directors.

4.3 Special Meetings. Special meetings of the board of directors may be called by the chairman of the board of directors or the president and shall be called by the secretary on the written request of any two directors. Notice of each special meeting of the board of directors shall be given to each director at least 48 hours before the meeting is scheduled to convene.

4.4 Notice and Waiver of Notice. Notice of the date, time, place or purpose of a regular or special meeting of the board of directors may be given to the director by “electronic transmission” (as defined in Section 3.4 above). Such director may revoke this method of notice in writing at any time. The director’s consent is deemed to be revoked if the Corporation is unable to deliver by electronic transmission two consecutive notices, and the secretary of the Corporation or other person responsible for delivering the notice on behalf of the Corporation knows that the delivery of these two electronic transmissions was unsuccessful. The inadvertent failure to treat the unsuccessful transmissions as a revocation of the director’s consent does not invalidate a meeting or other action. An affidavit of the secretary or other agent of the Corporation that notice has been given by electronic transmission is, in the absence of fraud, prima facie evidence that notice was given. Attendance of a director at any meeting shall constitute a waiver of notice of such meeting, except where a director attends for the express purpose of objecting to the transaction of any business on the ground that the meeting is not lawfully called or convened. Except as may be otherwise provided by law or by the Articles of Incorporation or by these Bylaws, neither the business to be transacted at, nor the purpose of, any

regular or special meeting of the board of directors need be specified in the notice or waiver of notice of such meeting.

4.5 Quorum of Directors; Vote Required. At all meetings of the Board of Directors a majority of the Directors shall constitute a quorum for the transaction of business and the act of a majority of the Directors present at any meeting at which there is a quorum shall be the act of the Board of Directors. If a quorum shall not be present at any meeting of Directors, the Directors present thereat may adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present.

4.6 Action Without Meetings. Any action required or permitted to be taken at a meeting of the board of directors or any committee may be taken without a meeting if a consent in writing, setting forth the action so taken, is signed by all the members of the board of directors or committee, as the case may be.

4.7 Committees.

(a) The board of directors, by resolution adopted by a majority of the directors present at a meeting called specifically for such purpose, may designate from among its members one or more committees, each of which shall be comprised of one or more of its members, and may designate one or more of its members as alternate members of any committee, who may, subject to any limitations imposed by the board of directors, replace absent or disqualified members at any meeting of that committee. Any such committee, to the extent provided in such resolution shall have and may exercise all of the authority of the board of directors, subject to the limitations set forth below and in the Act.

(b) No committee of the board of directors shall have the authority of the board of directors in reference to:

1. amending the Articles of Incorporation, except that a committee may, to the extent provided in the resolution designating that committee or in the Articles of Incorporation or the Bylaws, exercise the authority of the board of directors vested in it in accordance with Article 2.13 of the Act;

2. proposing a reduction of the stated capital of the Corporation in the manner permitted by Article 4.12 of the Act;

3. approving a plan of merger or share exchange of the Corporation;

4. recommending to the shareholders the sale, lease, or exchange of all or substantially all of the property and assets of the Corporation otherwise than in the usual and regular course of its business;

5. recommending to the shareholders a voluntary dissolution of the Corporation or a revocation thereof;

6. amending, altering, or repealing these Bylaws of the Corporation or adopting new Bylaws of the Corporation;

7. filling vacancies in the board of directors;

8. filling vacancies in or designating alternate members of any such committee;

9. filling any directorship to be filled by reason of an increase in the number of directors;

10. electing or removing officers of the Corporation or members or alternate members of any such committee;

11. fixing the compensation of any member or alternate members of such committee; or

12. altering or repealing any resolution of the board of directors that by its terms provides that it shall not be so amendable or repealable.

(c) Unless the resolution designating a particular committee, the Articles of Incorporation, or these Bylaws expressly so provide, no committee of the board of directors shall have the authority to authorize a distribution or to authorize the issuance of shares of the Corporation.

(d) The designation of a committee of the board of directors and the delegation thereto of authority shall not operate to relieve the board of directors, or any member thereof, of any responsibility imposed by law.

4.8 Compensation. The Directors shall receive such compensation for their services as directors as may be determined by resolution of the board of directors. Each Director shall be reimbursed for travel and other reasonable out-of-pocket expenses incurred by such Director in attending regular and special meetings of the board of directors or any committee. The receipt of compensation or reimbursement of expenses shall not preclude any director from serving the Corporation in any other capacity and receiving compensation therefor.

5. Officers

5.1 Election, Number, Qualification, Term, Compensation. The officers of the Corporation shall be elected by the board of directors and shall consist of a president, a vice-president, a secretary and a treasurer. The board of directors may also elect a chairman of the board, additional vice-presidents, one or more assistant secretaries and assistant treasurers and such other officers and assistant officers and agents as it shall deem necessary, who shall hold their offices for such terms and shall have such authority and exercise such powers and perform such duties as shall be determined from time to time by the board by resolution not inconsistent with these Bylaws. Two or more offices may be held by the same person. None of the officers need be directors except the president. The board of directors shall have the power to enter into contracts for the employment and compensation of officers for such terms as the board deems advisable.

5.2 Removal. The officers of the Corporation shall hold office until their successors are elected or appointed and qualify, or until their death or until their resignation or removal from office. Any officer elected or appointed by the board of directors may be removed at any time by the board, with or without cause. Such removal shall be without prejudice to the contract rights, if any, of the person so removed. Election or appointment of an officer shall not of itself create contract rights.

5.3 Vacancies. Any vacancy occurring in any office of the Corporation by death, resignation, removal or otherwise shall be filled by the board of directors.

5.4 Authority. Officers and agents shall have such authority and perform such duties in the management of the Corporation as may be provided in these Bylaws.

5.5 Chairman of the Board. The chairman of the board, if one is elected, shall preside at all meetings of the board of directors and of the shareholders and shall have such other powers and duties as may from time to time be prescribed by the board of directors upon written directions given to him pursuant to resolutions duly adopted by the board of directors.

5.6 President. The president shall be the chief executive officer of the Corporation, shall have general and active management of the business and affairs of the Corporation and shall see that all orders and resolutions of the board of directors are carried into effect. He shall preside at all meetings of the shareholders and of the board of directors, unless a chairman of the board has been elected, in which event the president shall preside at meetings of the shareholders and of the board of directors in the absence or disability of the chairman of the board.

5.7 Vice-President. Vice-presidents, including executive vice-presidents and senior vice-presidents, in the order of their seniority, unless otherwise determined by the board of directors, shall, in the absence or disability of the president, perform the duties and have the authority and exercise the powers of the president. They shall perform such other duties and have such other authority and powers as the board of directors may from time to time prescribe or as the president may from time to time delegate.

5.8 Secretary. The secretary shall attend all meetings of the board of directors and all meetings of shareholders and record all of the proceedings of the meetings of the board of directors and of the shareholders in a minute book to be kept for that purpose and shall perform like duties for the standing committees when required. He shall give, or cause to be given, notice of all meetings of the shareholders and special meetings of the board of directors, and shall perform such other duties as may be prescribed by the board of directors or president, under whose supervision he shall be. He shall keep in safe custody the seal of the Corporation and, when authorized by the board of directors, shall affix the same to any instrument requiring it and, when so affixed, it shall be attested by his signature or by the signature of an assistant secretary or of the treasurer.

5.9 Treasurer.

(a) The treasurer shall have custody of the corporate funds and securities and shall keep full and accurate accounts and records of receipts, disbursements and other transactions in books belonging to the Corporation, and shall deposit all moneys and other valuable effects in the name and to the credit of the Corporation in such depositories as may be designated by the board of directors.

(b) The treasurer shall disburse the funds of the Corporation as may be ordered by the board of directors, taking proper vouchers for such disbursements, and shall render to the president and the board of directors, at its regular meetings, or when the president or board of directors so requires, an account of all his transactions as treasurer and of the financial condition of the Corporation.

(c) If required by the board of directors, the treasurer shall give the Corporation a bond of such type, character and amount as the board of directors may require.

5.10 Assistant Secretary and Assistant Treasurer. In the absence of the secretary or treasurer, an assistant secretary or assistant treasurer, respectively shall perform the duties of the secretary or treasurer. Assistant treasurers may be required to give bond as provided in section 5.9(c). The assistant secretaries and assistant treasurers, in general shall have such powers and perform such duties as the treasurer or secretary, respectively, or the board of directors or president may prescribe.

6. Certificates Representing Shares

6.1 Certificates. The shares of the Corporation shall be represented by certificates signed by the president or a vice-president and the secretary or an assistant secretary of the Corporation, and may be sealed with the seal of the Corporation or a facsimile thereof. The signatures of the president or vice-president and the secretary or assistant secretary upon a certificate may be facsimiles if the certificate is countersigned by a transfer agent, or registered by a registrar, other than the Corporation itself or an employee of the Corporation. The certificates shall be consecutively numbered and shall be entered in the books of the Corporation as they are issued. Each certificate shall state on the face thereof the holder’s name, the number and class of shares, and the par value of such shares or a statement that such shares are without par value.

6.2 Payment, Issuance. Shares may be issued for such consideration, not less than the par value thereof, as may be fixed from time to time by the board of directors. The consideration for the payment of shares shall consist of money paid, labor done or property actually received. Shares may not be issued until the full amount of the consideration fixed therefor has been paid.

6.3 Lost, Stolen or Destroyed Certificates. The board of directors may direct a new certificate to be issued in place of any certificate theretofore issued by the Corporation alleged to have been lost, stolen or destroyed upon the making of an affidavit of that fact by the person claiming the certificate to be lost, stolen or destroyed. When authorizing such issue of a new certificate, the board of directors may, in its discretion and as a condition precedent to the issuance thereof, prescribe such terms and conditions as it deems expedient and may require such indemnities as it deems adequate to protect the Corporation from any claim that may be made against it with respect to any such certificate alleged to have been lost or destroyed.

6.4 Registration of Transfer. Shares of stock shall be transferable only on the books of the Corporation by the holder thereof in person or by his duly authorized attorney. Upon surrender to the Corporation or the transfer agent of the Corporation of a certificate for shares duly endorsed or accompanied by proper evidence of succession, assignment or authority to transfer, a new certificate shall be issued to the person entitled thereto and the old certificate canceled and the transaction recorded upon the books of the Corporation.

6.5 Registered Owner. The Corporation shall be entitled to recognize the exclusive right of a person registered on its books as of the record date as the owner of shares to receive dividends or other distributions, and to vote as such owner, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of the State of Texas. The person in whose name the shares are or were registered in the stock transfer books of the Corporation as of the record date shall be deemed to be the owner of the shares registered in his name at that time. Neither the Corporation nor any of its officers, directors, or agents shall be under any liability for making such a distribution to a person in whose name shares were registered in the stock transfer books as of the record date or to the heirs, successors, or assigns of the person, even though the person, or his heirs, successors, or assigns, may not possess a certificate for shares.

7. Dividends

7.1 Declaration and Payment. Subject to the Act and the Articles of Incorporation, dividends may be declared by the board of directors, in its discretion, at any regular or special meeting, pursuant to law and may be paid in cash, in property or in the Corporation’s own shares.

7.2 Reserves. Before payment of any dividend, the board of directors, by resolution, may create a reserve or reserves out of the Corporation’s surplus or designate or allocate any part or all of such surplus in any manner for any proper purpose or purposes, and may increase, create, or abolish any such reserve, designation, or allocation in the same manner.

8. Protection of Officers, Directors and Employees

8.1 Indemnification. The Corporation shall indemnify any person who was, is, or is threatened to be made a named defendant or respondent in a proceeding (which term shall mean any threatened or pending, or completed action, suit, or proceeding, whether civil, criminal, administrative, arbitrative, or investigative, any appeal in such an action, suit, or proceeding, and any inquiry or investigation that could lead to such an action, suit, or proceeding) because the person is or was a director of the Corporation, or who, while a director of the Corporation, is or was serving at the request of the Corporation as a director, officer, employee or agent of another foreign or domestic corporation, partnership, joint venture, sole proprietorship, trust, employee benefit plan or other enterprise (such person being referred to in this part 8 as an indemnified person) as follows:

(a) An indemnified person shall be indemnified against judgments, penalties (including excise and similar taxes), fines, settlements and reasonable expenses (including, without limitation, court costs and attorneys fees) actually incurred by the indemnified person in connection with the proceeding; but if an indemnified person (i) is found liable to the Corporation or (ii) is found liable on the basis that personal benefit was improperly received by him, whether or not the benefit resulted from an action taken in his official capacity (as such term is defined in Art. 2.02-1.A of the Act), the indemnification (x) shall be limited to reasonable expenses actually incurred by the director in connection with the proceeding and (y) shall not be made in respect of any proceeding in which the indemnified person shall have been found liable for willful or intentional misconduct in the performance of his duty to the Corporation.

(b) An indemnified person shall be indemnified against obligations resulting from the proceedings referred to in paragraph (a) above only if it is determined in accordance with paragraph (c) below that he conducted himself in good faith and reasonably believed, in the case of conduct in his official capacity, that his conduct was in the Corporation’s best interest, and in all other cases that his conduct was at least not opposed to the Corporation’s best interests. In the case of any criminal proceeding, an additional determination must be made that such indemnified person had no reasonable cause to believe his conduct was unlawful.

(i) by a majority vote of a quorum consisting of directors who at the time of the vote are not named defendants or respondents in the proceeding;

(ii) if such a quorum cannot be obtained, by a majority vote of a committee of the Board of Directors, designated to act in the matter by a majority vote of all directors, consisting solely of two or more directors who at the time of the vote are not named defendants or respondents in the proceeding;

(iii) by special legal counsel selected by the Board of Directors or a committee of the Board by vote as set forth in (i) or (ii) above, or, if such quorum cannot be obtained and such a committee cannot be established, by a majority vote of all directors, or

(iv) by the shareholders in a vote that excludes the shares held by directors who are named defendants or respondents in the proceeding.

(d) Authorization of indemnification and determination as to reasonableness of expenses must be made in the same manner as is the determination that indemnification is permissible, as set forth in paragraph (c) above, except that if the determination that indemnification is permissible is made by special legal counsel, authorization of indemnification and determination as to the reasonableness of expenses must be made in the manner specified in clause (iii) of paragraph (c) above for the selection of special counsel.

(e) The indemnification permitted under this section 8.1 shall be mandatory and this paragraph (e) shall be deemed, in accordance with Article 2.02-1.G. of the Act, to constitute authorization of indemnification in the manner required by this section 8.01 and by Article 2.02-1.G. of the Act.

8.2 Indemnification for Reasonable Expenses. The Corporation shall indemnify an indemnified person against reasonable expenses (including, without limitation, court costs and attorneys fees) incurred by him in connection with a proceeding in which he is named defendant or respondent because he is or was an indemnified person if he has been wholly successful, on the merits or otherwise, in the defense of the proceeding.

8.3 Expenses Advanced. The Corporation may pay or reimburse in advance of the final disposition of a proceeding any reasonable expenses (including, without limitation, court costs and attorneys fees) incurred by an indemnified person who was, is, or is threatened to be made a named defendant or respondent in a proceeding, and without the necessity of making any of the determinations specified in section 8.1(c) and 8.1(d) hereof, after the Corporation receives a written affirmation by the indemnified person of his good faith belief that he has met the standard of conduct necessary for indemnification as set forth herein and a written undertaking by or on behalf of the indemnified person containing the unlimited general obligation of the indemnified person to repay the amount paid or reimbursed if it is ultimately determined that he has not met those requirements. Notwithstanding any other provision of this part 8, the Corporation may pay or reimburse expenses incurred by an indemnified person in connection with his appearance as a witness or other participation in a proceeding at a time when he is not a named defendant or respondent in the proceeding.

8.4 Insurance. The Corporation may purchase and maintain insurance or another arrangement on behalf of any person who is or was a director or an officer, employee, agent of the Corporation or who is or was serving at the request of the Corporation as a director, officer, employee, agent or similar functionary of another foreign or domestic corporation, partnership, joint venture, sole proprietorship, trust, employee benefit plan, or other enterprise, against any liability asserted against him and incurred by him in such a capacity or arising out of his status as such a person, whether or not the Corporation would have the power to indemnify such person against that liability under these Bylaws or the Act.

8.5 Officers, Employees and Agents. An officer of the Corporation shall be indemnified to the same extent as a director, and is entitled to seek indemnification under this part 8 to the same extent as a director. The Corporation may indemnify and advance expenses to

an employee or agent of the Corporation, and persons who are not or were not officers, employees, or agents of the Corporation but who are or were serving at the request of the Corporation as a director, officer, partner, venturer, proprietor, trustee, employee, agent or similar functionary of another foreign or domestic corporation, partnership, joint venture, sole proprietorship, trust, employee benefit plan, or other enterprise, to the same extent that it may indemnify and advance expenses to directors under this part 8 or to such further extent as may be permitted or required by law.

8.6 Other Protection and Indemnification. The protection and indemnification provided hereunder shall not be deemed exclusive of any other rights to which such person may be entitled under any agreement, insurance policy, vote of shareholders, law, or otherwise.

8.7 Notice of Indemnification of or Advance of Expenses. Any indemnification of or advance of expenses to a person in accordance with this part 8 shall be reported in writing to the shareholders with or before the notice or waiver of notice of the next shareholders’ meeting or with or before the next submission to shareholders of a consent to action without a meeting pursuant to Article 9.10.A, of the Act, and, in any case, within the 12-month period immediately following the date of the indemnification or advance.

9. General Provisions

9.1 Fiscal Year. The fiscal year of the Corporation shall be fixed by resolution of the board of directors.

9.2 Seal. The corporate seal shall be in such form as may be prescribed by the board of directors. The seal may be used by causing it or a facsimile thereof to be impressed or affixed or in any manner reproduced.

9.3 Minutes. The Corporation shall keep correct and complete books and records of account and shall keep minutes of the proceedings of its shareholders and board of directors, and shall keep at its registered office or principal place of business, or at the office of its transfer agent or registrar, a record of its shareholders, giving names and addresses of all shareholders and the number and class of the shares held by each.

9.4 Amendment. (a) By the Board of Directors. In furtherance, and not in limitation, of the powers granted to the Corporation by applicable law, without any action on the part of the shareholders and even though the shareholders may also amend or repeal these Bylaws, or adopt new bylaws, the Board of Directors (unless (i) the Articles of Incorporation or the Act reserves the power exclusively to the shareholders in whole or part or (ii) the shareholders in amending, repealing, or adopting a particular bylaw expressly provide that the Board of Directors may not amend or repeal that bylaw) is hereby expressly authorized to amend or repeal these Bylaws, or adopt new bylaws, by the act of the majority of the directors present at a meeting at which a quorum is present.

(b) By the Shareholders. In furtherance, and not in limitation, of the powers granted to the Corporation by applicable law, in addition to any provisions of applicable law, any provisions of the Articles of Incorporation, and any resolution(s) of the Board of Directors

adopted pursuant to Section 8 of ARTICLE FOUR of the Articles of Incorporation (and notwithstanding the fact that a lesser vote or no vote may be permitted by applicable law), without any action on the part of the directors and even though the directors may also amend or repeal these Bylaws, or adopt new bylaws, the shareholders (unless the Articles of Incorporation or a bylaw adopted by the shareholders provides otherwise as to all or some portion of the bylaws of the Corporation) may only amend or repeal these Bylaws, or adopt new bylaws, in any case, by the affirmative vote of the holders of at least three-fourths (3/4) of the shares entitled to vote on the matter and represented in person or by proxy at a meeting of shareholders at which a quorum is present and that was called for such purpose shall be necessary for the shareholders to amend or repeal any provision of these Bylaws, or adopt any new bylaw.

9.5 Notice. Except as provided in Section 4.4 above, any notice to directors or shareholders shall be in writing and shall be delivered personally or mailed to the directors or shareholders at their respective addresses appearing on the books of the Corporation. Notice by mail shall be deemed to be given at the time when the same shall be deposited in the United States mail, postage prepaid. Notice to directors may also be given by facsimile transmittal. Whenever any notice is required to be given under the provisions of applicable statutes or of the Articles of Incorporation or of these Bylaws, a waiver thereof in writing signed by the person or persons entitled to such notice, whether before or after the time stated therein, shall be deemed equivalent to the giving of such notice.


Dated: August 18, 2004		/s/ DARRELL R. KING

		Darrell R. King, Secretary

EX-10.55 3 d20096exv10w55.htm EMPLOYMENT AGREEMENT exv10w55

Exhibit 10.55

EMPLOYMENT AGREEMENT

AGREEMENT by and between Schlotzsky’s, Inc., a Texas corporation (the “Company”), and Sam Coats (the “Executive”), dated as of the 17th day of June, 2004 (the “Effective Date”).

WHEREAS, the Company has determined that it is in the best interests of the Company to employ the Executive as the President and Chief Executive Officer of the Company, and the Executive desires to serve the Company in that capacity pursuant to the terms set forth herein.

NOW, THEREFORE, IT IS HEREBY AGREED AS FOLLOWS:

1. Employment Period. The Company shall employ the Executive, and the Executive shall serve the Company, on the terms and conditions set forth in this Agreement, during the employment period, which shall begin on the Effective Date and continue on a month to month basis pursuant to the terms of this Agreement (the “Employment Period”), The Company and/or Executive may terminate this Agreement at any time by giving the other party 30 days prior written notice.

2. Position and Duties. During the Employment Period, the Executive shall serve as President and Chief Executive Officer of the Company and in appropriate positions in the subsidiaries and affiliates of the Company, with the duties, functions, responsibilities and authority customarily associated with such positions. Executive will report to the Schlotzsky’s, Inc. Board of Directors. During the Employment Period, the Executive will devote substantially all of his attention and time to the business and affairs of the Company, excluding any periods of vacation and sick leave to which Executive is entitled, and will not engage in any other business activities that will unreasonably interfere with the Executive’s employment pursuant to this Agreement. It is understood by the parties hereto that Executive presently serves on the Board of Directors of Safety-Kleen Holdco and nothing in this Agreement shall preclude Executive from continuing to serve as a member of the Board of Directors of Safety-Kleen. During the Employment Period, Executive will be based out of the Company’s offices in Austin, Texas, and the Executive’s services shall be performed at such locations where the Company conducts business throughout North America as the needs and exigencies of the business of the Company from time to time reasonably require. It is understood and agreed that Executive will continue to maintain his primary residence in Dallas, Texas during the term of this Agreement and shall not be required to permanently relocate from his current residence to the Austin, Texas area. The Company will reimburse Executive for reasonable commuting and living expenses (including business meal expenses, but not normal “living” meal expenses) during the term of this agreement.

3. Compensation. (a) Salary. From the Effective Date through the end of the Employment Period, the Executive shall receive a monthly base salary (the “Salary”) of $30,000, payable in accordance with the Company’s normal payroll practices for executives.

(b) Performance Bonus. Executive will have a Performance Bonus opportunity, within parameters set by the Board of Directors, that will vest upon the occurrence of a refinancing, recapitalization, judicial reorganization, or change of control relating to the Company.

(c) Insurance and Other Benefits. The Executive shall receive all standard benefits afforded to Company employees except that the Company shall also pay all medical and dental premiums for his spouse. The Company agrees to reimburse Executive for all medical, dental and drug costs incurred by Executive or his spouse beginning at the Effective Date of this Agreement until July 1, 2004. During the Employment Period: (i) the Executive shall be entitled to participate in the Company’s 401k Plan, applicable fringe benefit programs and other benefit plans, policies and programs of the Company applicable to all Company employees, as may be amended by the Company from time to time; and (ii) the Executive shall be entitled to one week of vacation per year, effective and vested as of the Effective Date, and shall be entitled to one additional week of vacation per year, effective and vested as of August 17, 2004.

(d) Programs, Procedures and Policies. Executive will comply with and be bound by the Company’s applicable current and future programs, procedures, plans and policies, as may be amended by the Company from time to time, except to the extent such programs, procedures, plans or policies are contrary to the terms and conditions of this Agreement.

(e) Hold Harmless and Indemnity. The Company shall provide Executive with its standard indemnification agreement for its officers and directors.

4. Termination of Employment. (a) Death or Disability. In the event of the Executive’s death during the Employment Period, the Executive’s employment with the Company shall terminate automatically. In addition, the Company shall have the right to terminate the Executive’s employment because of the Executive’s Disability (as defined in the Company’s Long Term Disability Benefit Plan) during the Employment Period. A termination of the Executive’s employment by the Company for Disability shall be communicated to the Executive by written notice, and shall be effective on the 5th day after receipt of such notice by the Executive (the “Disability Effective Date”), unless the Executive returns to full-time performance of the Executive’s duties before the Disability Effective Date.

(b) Date of Termination. The “Date of Termination” means the last day of the Employment Period, the date of the Executive’s death, the Disability Effective Date, the date on which the termination of the Executive’s employment by the Company is effective, or the date on which the voluntary termination of the Executive’s employment by Executive is effective, as the case may be.

5. Obligations of the Company on Termination. (a) If the Executive’s employment is terminated for any reason, the Company shall, upon execution by Executive of the Company’s settlement agreement and general release, pay to the Executive within 10 days after

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the Date of Termination, a lump-sum cash amount equal to the sum of any portion of the Salary for the period up to the Date of Termination that has not yet been paid.

(b) In addition to the payments and benefits to which the Executive or the Executive’s estate may be entitled under Section 5(a) above, the Executive shall be entitled to receive any vested or other benefits to which he may be entitled pursuant to the terms and conditions of the Company’s 401k Plan and any Company Life, Disability or Health Insurance Plan in which he may participate, and any other amounts due under this Agreement.

6. Successors. (a) This Agreement is personal to the Executive and, without the prior written consent of the Company, shall not be assignable by the Executive otherwise than by will or the laws of descent and distribution. This Agreement shall inure to the benefit of and be enforceable by the Executive’s legal representatives.

(b) This Agreement shall inure to the benefit of and be binding upon the Company and its successors and assigns. The Company shall not assign this Agreement without the prior written consent of the Executive, which consent shall not be unreasonably withheld.

7. Miscellaneous. (a) The captions of this Agreement are not part of the provisions hereof and shall have no force or effect. This Agreement may not be amended or modified except by a written agreement executed by the parties hereto or their respective successors and legal representatives.

(b) All notices and other communications under this Agreement shall be in writing and shall be given by hand delivery to the other party or by registered or certified mail, return receipt requested, postage prepaid, addressed as follows:


If to the Executive:		Sam Coats
		[Address on file with the Company]

If to the Company:		Schlotzsky’s, Inc.
		203 Colorado Street, Suite 600
		Austin, Texas 78701
		Attention: General Counsel &
		Chairman of the Board

or to such other address as either party furnishes to the other in writing in accordance with this paragraph (b) of Section 8. Notices and communications shall be effective when actually received by the addressee.

(c) The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement. If any provision of this Agreement shall be held invalid or unenforceable in part, the remaining portion of such

Page 3 of 4

provision, together with all other provisions of this Agreement, shall remain valid and enforceable and continue in full force and effect to the fullest extent consistent with law.

(d) Notwithstanding any other provision of this Agreement, the Company may withhold from amounts payable under this Agreement all federal, state, local and foreign taxes that are required to be withheld by applicable laws or regulations.

(e) The Executive’s or the Company’s failure to insist upon strict compliance with any provision of, or to assert any right under, this Agreement shall not be deemed to be a waiver of such provision or right or of any other provision of or right under this Agreement.

(f) The Executive and the Company acknowledge that this Agreement supersedes any other agreement, whether written or oral, between them concerning the subject matter hereof.

(g) This Agreement may be executed in several counterparts, each of which shall be deemed an original and said counterparts shall constitute but one and the same instrument.

IN WITNESS WHEREOF, the Executive has hereunto set the Executive’s hand, and the Company has caused this Agreement to be executed in its name on its behalf, all as of the day and year first above written.


		/s/ SAM COATS

		Sam Coats (“Executive”)

		Schlotzsky’s, Inc.

		/s/ ALICE KLEPAC

		By: Alice Klepac
		Title: Vice President – Human Resources

Page 4 of 4

EX-31.1 4 d20096exv31w1.htm CERTIFICATION PURSUANT TO SECTION 302 - CEO exv31w1

Exhibit 31.1

CERTIFICATION

I, David Samuel Coats, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Schlotzsky’s, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 11, 2004


		By:		/s/ DAVID SAMUEL COATS

				David Samuel Coats
				President and Chief Executive Officer
				(Principal Executive Officer)

EX-31.2 5 d20096exv31w2.htm CERTIFICATION PURSUANT TO SECTION 302 - CFO exv31w2

Exhibit 31.2

CERTIFICATION

I, Matthew D. Osburn, certify that:

Date: November 11, 2004


		By:		/s/ MATTHEW D. OSBURN

				Matthew D. Osburn
				Vice President and Controller
				(Principal Financial Officer)

EX-32.1 6 d20096exv32w1.htm CERTIFICATION PURSUANT TO SECTION 906 - CEO exv32w1

Exhibit 32.1

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code), the undersigned officer of Schlotzsky’s, Inc. (the “Company”), does hereby certify, to such officer’s knowledge, that:

The Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 (the “Form 10-Q”) of the Company fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of the Company as of, and for, the periods presented in the Form 10-Q.

Date: November 11, 2004


		/s/ DAVID SAMUEL COATS

		Name:		David Samuel Coats
		Title:		President and Chief Executive Officer
				(Principal Executive Officer)

The foregoing certification is being furnished as an exhibit to the Form 10-Q pursuant to Item 601(b)(32) of Regulation S-K and Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code) and, accordingly, is not being filed as part of the Form 10-Q for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

EX-32.2 7 d20096exv32w2.htm CERTIFICATION PURSUANT TO SECTION 906 - CFO exv32w2

Exhibit 32.2

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Date: November 11, 2004


		/s/ MATTHEW D. OSBURN

		Name:		Matthew D. Osburn
		Title:		Vice President and Controller
				(Principal Financial Officer)

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•		Determination of the appropriate valuation allowances for accounts and notes receivable.

		Our accounts and notes receivable are primarily from franchisees of the Schlotzsky’s system. We require personal guarantees for all franchise accounts and, for notes receivable, generally obtain a secondary secured interest in the related property and equipment or rights. Many of the notes receivable are fully subordinated to the franchisee’s senior mortgage debt. In reviewing the adequacy of the valuation allowances for accounts and notes receivable, we consider factors such as historical collection experience, the estimated value of personal guarantees and real property collateral, the franchisee’s sales and operating trends, including potential for improvement in operations, and general and local economic conditions that may affect the franchisee’s ability to pay. Actual realization of amounts receivable could differ materially from our estimates.

•		Determination of appropriate valuation allowance for intangible assets.

		Amortizing intangible assets consist primarily of amounts paid to reacquire various developer and franchise rights. Annually, and whenever an event or circumstance indicating impairment may be present, we compare projected undiscounted cash flows to the carrying value of the related assets to determine if impairment has occurred. In estimating future cash flows, we consider such factors as current results, trends, future prospects, and other economic factors. Actual future cash flows could differ materially from our estimates.

		Recoverability of intangible assets is primarily dependent on the continuing collection of franchise royalties. To the extent that there is doubt about the ability of the Company to successfully reorganize and emerge from Chapter 11 these assets may be unrecoverable. After our impairment of area developer contracts, approximately $5.9 million remained worth of intangible assets relating to the franchising business remained on the balance sheet at June 30, 2004.

		RESTAURANT COST OF SALES decreased 9.1% to $2,136,000 from $2,349,000 and decreased as a percentage of net restaurant sales to 27.9% from 29.4% due primarily to operating efficiencies.

		RESTAURANT PERSONNEL AND BENEFITS COST decreased 15.8% to $2,901,000 from $3,445,000 and decreased as a percentage of net restaurant sales to 37.8% from 43.1%. The decrease, as a percentage of net restaurant sales, was due to reduction in the average number of managers at each location and improved labor scheduling.

		RESTAURANT OPERATING EXPENSES decreased 10.3% to $1,975,000 from $2,202,000 and decreased as a percentage of net restaurant sales to 25.8% from 27.5%. The decrease in operating costs, as a percentage of net restaurant sales, was primarily due to previous year’s preopening costs on a restaurant opened during the comparable quarter of the previous year and a restaurant under development, as well as a tax assessment on one restaurant location.

3.1		Articles of Incorporation of the Company, as amended. (1)

3.2		Statement of Resolutions Regarding the Designation, Preferences and Rights of Class C Series A Junior Participating Preferred Stock of the Company. (2)

3.3		Bylaws of the Company, as amended. (4)

4.1		Specimen stock certificate evidencing the Common Stock of the Company. (1)

4.2		Rights Agreement dated December 18, 1998 between the Company and Harris Trust and Savings Bank. (2)

4.3		Warrant Certificate dated February 15, 2001 from the Company to Triad Media Ventures LLC. (3)

10.55		Employment Agreement dated as of June 17, 2004 between the Company and Sam Coats (4)*

31.1		Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by David Samuel Coats, Chief Executive Officer. (4)

31.2		Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by Matthew D. Osburn, Chief Financial Officer. (4)

32.1		Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by David Samuel Coats, Chief Executive Officer. (4)

32.2		Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Matthew D. Osburn, Chief Financial Officer. (4)

*		Indicates a management contract or compensatory plan or arrangement.

(1)		Incorporated by reference from the Company’s Registration Statement on Form S-1 filed on October 12, 1995, as amended.

(2)		Incorporated by referenced from the Company’s Registration of certain Securities on Form 8-A filed on December 18, 1998.

(3)		Incorporated by reference from the Company’s Annual Report on Form 10-K filed on April 2, 2001.

(4)		Filed with this Quarterly Report on Form 10-Q.

1.		I have reviewed this quarterly report on Form 10-Q of Schlotzsky’s, Inc.;

2.		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.		The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a.		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b.		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c.		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

a.		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b.		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.