10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on November 9, 2005
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 25, 2005.
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[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
COMMISSION FILE NUMBER 0-12919
PIZZA INN, INC.
(EXACT NAME OF REGISTRANT IN ITS CHARTER)
MISSOURI 47-0654575
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
3551 PLANO PARKWAY
THE COLONY, TEXAS 75056
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES,
INCLUDING ZIP CODE)
(469) 384-5000
(REGISTRANT'S TELEPHONE NUMBER,
INCLUDING AREA CODE)
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 SUCH SHORTER PERIOD THAT THE REGISTRANT
WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS. YES [X] NO [ ]
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS
DEFINED IN RULE 12 B-2 OF THE EXCHANGE ACT). YES [ ] NO [X]
AT NOVEMBER 1, 2005, AN AGGREGATE OF 10,108,494 SHARES OF THE REGISTRANT'S
COMMON STOCK, PAR VALUE OF $.01 EACH (BEING THE REGISTRANT'S ONLY CLASS OF
COMMON STOCK), WERE OUTSTANDING.
PIZZA INN, INC.
Index
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements Page
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Condensed Consolidated Statements of Operations for the three months
ended September 25, 2005 and September 26, 2004 (unaudited) 3
Condensed Consolidated Statements of Comprehensive Income for the three
months ended September 25, 2005 and September 26, 2004 (unaudited) 3
Condensed Consolidated Balance Sheets at September 26, 2005 (unaudited)
and June 26, 2005 4
Condensed Consolidated Statements of Cash Flows for the three months ended
September 25, 2005 and September 26, 2004 (unaudited) 5
Notes to Condensed Consolidated Financial Statements (unaudited) 7
Item 2. Management's Discussion and Analysis of
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Financial Condition and Results of Operations 13
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Item 3. Quantitative and Qualitative Disclosures about Market Risk 24
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Item 4. Controls and Procedures 24
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
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Item 2. Unregistered Sales of Equity Securities and the Use of Proceeds 27
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Item 3. Defaults Upon Senior Securities 27
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Item 4. Submission of Matters to a Vote of Security Holders 27
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Item 5. Other Information 28
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Item 6. Exhibits 28
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Signatures 29
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
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PIZZA INN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) The accompanying condensed consolidated financial statements of Pizza
Inn, Inc. (the "Company") have been prepared without audit pursuant to the rules
and regulations of the Securities and Exchange Commission. Certain information
and footnote disclosures normally included in the financial statements have been
omitted pursuant to such rules and regulations. The condensed consolidated
financial statements should be read in conjunction with the notes to the
Company's audited condensed consolidated financial statements in its Form 10-K
for the fiscal year ended June 26, 2005. Certain prior year amounts have been
reclassified to conform with current year presentation.
In the opinion of management, the accompanying unaudited condensed consolidated
financial statements contain all adjustments necessary to fairly present the
Company's financial position and results of operations for the interim periods.
All adjustments contained herein are of a normal recurring nature.
In December 2004, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment,
("FAS 123R"). This Statement requires companies to expense the estimated fair
value of stock options and similar equity instruments issued to employees over
the requisite service period. FAS 123R eliminates the alternative to use the
intrinsic method of accounting provided for in Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), which
generally resulted in no compensation expense recorded in the financial
statements related to the grant of stock options to employees if certain
conditions were met. Additionally, the pro forma impact from recognition of the
estimated fair value of stock options granted to employees has been disclosed in
our footnotes as required under previous accounting rules.
Effective for the quarter ended September 25, 2005, the Company adopted FAS 123R
using the modified prospective method, which requires us to record compensation
expense for all awards granted after the date of adoption, and for the unvested
portion of previously granted awards that remain outstanding at the date of
adoption. Accordingly, prior period amounts presented herein have not been
restated to reflect the adoption of FAS 123R.
Prior to the adoption of FAS 123R, the Company reported all tax benefits
resulting from the exercise of stock options as operating cash flows in our
consolidated statements of cash flows. In accordance with FAS 123R, for the
period beginning with first quarter of fiscal 2006, the Company will report the
excess tax benefits from the exercise of stock options as financing cash flows.
Such benefits are presented as a component of operating cash flows for periods
prior to the first quarter of 2006.
The fair value concepts were not changed significantly in FAS 123R; however, in
adopting this Standard, companies must choose among alternative valuation models
and amortization assumptions. After assessing alternative valuation models and
amortization assumptions, the Company will continue using both the Black-Scholes
valuation model and straight-line amortization of compensation expense over the
requisite service period for each separately vesting portion of the grant. The
Company will reconsider use of this model if additional information becomes
available in the future that indicates another model would be more appropriate
for us, or if grants issued in future periods have characteristics that cannot
be reasonably estimated using this model. The Company had previously estimated
forfeitures in the expense calculation for pro forma footnote disclosure and no
change in that methodology was made upon adoption of FAS 123R.
Amortization of the fair value of the stock option grants has been included in
our results since the grant date and totaled approximately $103,000 for the
quarter ended September 25, 2005. The current period expense related to the
unvested portion of previously granted awards that remain outstanding at the
date of adoption and one grant of options to a director in the current quarter.
Similar amounts for these options are expected to be expensed in future
quarters.
The previously disclosed pro forma effects of recognizing the estimated fair
value of stock-based compensation in the first quarter of fiscal 2005 are
presented below.
(2) The Company entered into an agreement on August 29, 2005, effective June
26, 2005 (the "Revolving Credit Agreement"), with Wells Fargo to provide a $6.0
million revolving credit line that will expire October 1, 2007, replacing a
$3.0 million line that was due to expire December 23, 2005. The amendment
provides, among other terms, for modifications to certain financial covenants.
Interest is provided for at a rate equal to a range of Prime less an interest
rate margin of 0.75% to Prime plus an interest rate margin of 1.75% or, at the
Company's option, at the LIBOR rate plus an interest rate margin of 1.25% to
3.75%. The interest rate margin is based on the Company's performance under
certain financial ratio tests. An annual commitment fee is payable on any
unused portion of the revolving credit line at a rate from 0.35% to 0.50% based
on the Company's performance under certain financial ratio tests. As of
September 25, 2005 and September 26, 2004, the variable interest rates were
7.25% and 4.50%, using a Prime interest rate basis. Amounts outstanding under
the revolving credit line as of September 25, 2005 and September 26, 2004 were
$923,000 and $99,000, respectively. Property, plant and equipment, inventory
and accounts receivable have been pledged for the above referenced loan
agreement.
The Company entered into an agreement effective December 28, 2000, as
amended (the "Term Loan Agreement"), with Wells Fargo to provide up to $8.125
million of financing for the construction of the Company's new headquarters,
training center and distribution facility. The construction loan converted to a
term loan effective January 31, 2002 with the unpaid principal balance to mature
on December 28, 2007. The term loan amortizes over a term of twenty years, with
principal payments of $34,000 due monthly. Interest on the term loan is also
payable monthly. Interest is provided for at a rate equal to a range of Prime
less an interest rate margin of 0.75% to Prime plus an interest rate margin of
1.75% or, at the Company's option, at the LIBOR rate plus an interest rate
margin of 1.25% to 3.75%. The interest rate margin is based on the Company's
performance under certain financial ratio tests. The Company, to fulfill the
requirements of Wells Fargo, fixed the interest rate on the term loan by
utilizing an interest rate swap agreement. The $8.125 million term loan had an
outstanding balance of $6.6 million at September 25, 2005 and $7.0 million at
September 26, 2004. Property, plant and equipment, inventory and accounts
receivable have been pledged for the above referenced loan agreement.
On October 18, 2005 the Company notified Wells Fargo that as of September 25,
2005 the Company was in violation of certain financial ratio covenants in the
Third Amendment to the Third Amended and Restated Loan Agreement between the
Company and the Bank dated August 29, 2005 but effective as of June 26, 2005
("the Loan Agreement") and that as a result an event of default exists under the
Loan Agreement. As a result of the event of default all outstanding principal
of the Company's obligations under the Loan Agreement have been reclassified as
a current liability on the Company's balance sheet. The Company has requested
that Wells Fargo agree to waive the event of default. However, Wells Fargo is
not obligated under the Loan Agreement to grant such a waiver. As of November
1, 2005 Wells Fargo has not exercised any of the rights or remedies available to
it under the Loan Agreement in these circumstances.
(3) The Company entered into an interest rate swap effective February 27,
2001, as amended, designated as a cash flow hedge, to manage interest rate risk
relating to the financing of the construction of the Company's new headquarters
and to fulfill bank requirements. The swap agreement has a notional principal
amount of $8.125 million with a fixed pay rate of 5.84%, which began November 1,
2001 and will end November 19, 2007. The swap's notional amount amortizes over
a term of twenty years to parallel the terms of the term loan. Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" requires that for cash flow hedges, which hedge the
exposure to variable cash flow of a forecasted transaction, the effective
portion of the derivative's gain or loss be initially reported as a component of
other comprehensive income in the equity section of the balance sheet and
subsequently reclassified into earnings when the forecasted transaction affects
earnings. Any ineffective portion of the derivative's gain or loss is reported
in earnings immediately. As of September 25, 2005, there was no hedge
ineffectiveness. The Company's expectation is that the hedging relationship will
be highly effective at achieving offsetting changes in cash flows.
(4) On December 11, 2004, the Board of Directors of the Company terminated
the Executive Compensation Agreement dated December 16, 2002 between the Company
and its then Chief Executive Officer, Ronald W. Parker ("Parker Agreement").
Mr. Parker's employment was terminated following ten days written notice to Mr.
Parker of the Company's intent to discharge him for cause as a result of
violations of the Parker Agreement. Written notice of termination was
communicated to Mr. Parker on December 13, 2004. The nature of the cause
alleged was set forth in the notice of intent to discharge and based upon
Section 2.01(c) of the Parker Agreement, which provides for discharge for "any
intentional act of fraud against the Company, any of its subsidiaries or any of
their employees or properties, which is not cured, or with respect to which
Executive is not diligently pursuing a cure, within ten (10) business days of
the Company giving notice to Executive to do so." Mr. Parker was provided with
an opportunity to cure as provided in the Parker Agreement as well as the
opportunity to be heard by the Board of Directors prior to the termination.
On January 12, 2005, the Company instituted an arbitration proceeding
against Mr. Parker with the American Arbitration Association in Dallas, Texas
pursuant to the Parker Agreement seeking declaratory relief that Mr. Parker is
not entitled to severance payments or any other further compensation from the
Company. In addition, the Company is seeking compensatory damages,
consequential damages and disgorgement of compensation paid to Mr. Parker under
the Parker Agreement. On January 31, 2005, Mr. Parker filed claims against the
Company for breach of the Parker Agreement, seeking the severance payment
provided for in the Parker Agreement for a termination of Mr. Parker by the
Company for reason other than for cause (as defined in the Parker Agreement),
plus interest, attorney's fees and costs. The arbitration hearing is scheduled
to begin April 3, 2006.
Due to the preliminary stages of the arbitration proceeding and the general
uncertainty surrounding the outcome of this type of legal proceeding, it is not
possible for the Company to provide any certain or meaningful analysis,
projections or expectations at this time regarding the outcome of this matter.
Although the ultimate outcome of the arbitration proceeding cannot be projected
with certainty at this time, the Company believes that its claims against Mr.
Parker are well founded and intends to vigorously pursue all relief to which it
may be entitled. An adverse outcome to the proceeding could materially affect
the Company's financial position and results of operations. In the event the
Company is unsuccessful, it could be liable to Mr. Parker for approximately $5.4
million under the Parker Agreement plus accrued interest and legal expenses. No
accrual for any amount has been made as of September 25, 2005.
(5) On June 15, 2004, B. Keith Clark provided the Company with notice of his
intent to resign as Senior Vice President - Corporate Development, Secretary and
General Counsel of the Company effective as of July 7, 2004. By letter dated
June 24, 2004, Mr. Clark notified the Company that he reserved his right to
assert that the election of Ramon D. Phillips and Robert B. Page to the Board of
Directors of the Company at the February 11, 2004 annual meeting of shareholders
constituted a "change of control" of the Company under his executive
compensation agreement (the "Clark Agreement"). As a result of the alleged
"change of control" under the Clark Agreement, Clark claims that he was entitled
to terminate the Clark Agreement within twelve (12) months of February 11, 2004
for "good reason" (as defined in the Clark Agreement) and is entitled to
severance. On August 6, 2004, the Company instituted an arbitration proceeding
against Mr. Clark with the American Arbitration Association in Dallas, Texas
pursuant to the Clark Agreement seeking declaratory relief that Mr. Clark is not
entitled to severance payments or any other further compensation from the
Company. On January 18, 2005, the Company amended its claims against Mr. Clark
to include claims for compensatory damages, consequential damages and
disgorgement of compensation paid to Mr. Clark under the Clark Agreement. Mr.
Clark has filed claims against the Company for breach of the Clark Agreement,
seeking the severance payment provided for in the Clark Agreement plus a bonus
payment for 2003 of approximately $12,500. On November 8, 2005 the parties
approved entering into a confidential settlement agreement and release of
claims, which provides, among other things, that the Company will pay Mr. Clark
$150,000, the parties will dismiss with prejudice all claims in the pending
arbitration action and each party will bear its or his own costs and expenses.
(6) On April 22, 2005, the Company provided PepsiCo, Inc. ("PepsiCo")
written notice of PepsiCo's breach of the beverage marketing agreement the
parties had entered into in May 1998 (the "Beverage Agreement"). In the notice,
the Company alleged that PepsiCo had not complied with the terms of the Beverage
Agreement by failing to (i) provide account and equipment service, (ii) maintain
and repair fountain dispensing equipment, (iii) make timely and accurate account
payments, and by providing the Company beverage syrup containers that leaked in
storage and in transit. The notice provided PepsiCo 90 days within which to
cure the instances of default. On May 18, 2005 the parties entered into a
"standstill" agreement under which the parties agreed to a 60-day extension of
the cure period to attempt to renegotiate the terms of the Beverage Agreement
and for PepsiCo to compete its cure.
The parties were unable to renegotiate the Beverage Agreement, and the Company
contends that PepsiCo did not cure each of the instances of default set forth in
the Company's April 22, 2005 notice of default. On September 15, 2005, the
Company provided PepsiCo notice of termination of the Beverage Agreement. On
October 11, 2005, PepsiCo served the Company with a Petition in the matter of
PepsiCo, Inc. v. Pizza Inn Inc., filed in District Court in Collin County,
Texas. In the Petition, PepsiCo alleges that the Company breached the Beverage
Agreement by terminating it without cause. PepsiCo seeks damages of
approximately $2.6 million an amount PepsiCo believes represents the value of
gallons of beverage products that the Company is required to purchase under the
terms of the Beverage Agreement, plus return of any marketing support funds that
PepsiCo advanced to the Company but that the Company has not earned.
The Company believes that it had good reason to terminate the Beverage Agreement
and that it terminated the Beverage Agreement in good faith and in compliance
with its terms. The Company further believes that under such circumstances it
has no obligation to purchase additional quantities of beverage products. The
Company is preparing its response to the Petition, which may include claims
against PepsiCo for amounts earned by the Company under the Beverage Agreement
but not yet paid by PepsiCo. Due to the preliminary nature of this matter and
the general uncertainty surrounding the outcome of any form of legal proceeding,
it is not possible for the Company to provide any certain or meaningful
analysis, projection or expectation at this time regarding the outcome of this
matter. Although the outcome of the legal proceeding cannot be projected with
certainty, the Company believes that PepsiCo's allegations are without merit.
The Company intends to vigorously defend against such allegations and to pursue
all relief to which it may be entitled. An adverse outcome to the proceeding
could materially affect the Company's financial position and results of
operation. In the event the Company is unsuccessful, it could be liable to
PepsiCo for approximately $2.6 million plus costs and fees. No accrual for such
amounts has been made as of September 25, 2005.
(7) The following table shows the reconciliation of the numerator and
denominator of the basic EPS calculation to the numerator and denominator of the
diluted EPS calculation (in thousands, except per share amounts).
The Company previously reported on October 25, 2005 a net loss for its quarter
ended September 25, 2005 of a net loss of ($393,000) and a net loss per share of
($0.04). On November 8, 2005 the Executive Committee of the board of directors
approved entering into with Mr. Clark a confidential settlement agreement and
release of claims, which provides, among other things, that the Company will pay
Mr. Clark $150,000, the parties will dismiss with prejudice all claims in the
pending arbitration action and each party will bear its or his own costs and
expenses. As a result of the settlement between the Company and Mr. Clark and
in accordance with generally accepted accounting principles regarding subsequent
events, the Company has adjusted its net loss for the quarter ending September
25, 2005 by ($97,000) to ($490,000) from ($393,000) and its net loss per share
for the quarter ending September 25, 2005 by ($0.01) to ($0.05) per share from
($0.04) per share.
(8) Summarized in the following tables are net sales and operating revenues,
operating profit and geographic information (revenues) for the Company's
reportable segments for the three month period ended September 25, 2005 and
September 26, 2004 (in thousands).
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
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RESULTS OF OPERATIONS
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The following discussion should be read in conjunction with the
consolidated financial statements, accompanying notes and selected financial
data appearing elsewhere in this Quarterly Report on Form 10-Q and in our Annual
Report on Form 10-K and may contain certain forward-looking statements that are
based on current management expectations. Generally, verbs in the future tense
and the words "believe," "expect," "anticipate," "estimate," "intends,"
"opinion," "potential" and similar expressions identify forward-looking
statements. Forward-looking statements in this report include, without
limitation, statements relating to the strategies underlying our business
objectives, our customers and our franchisees, our liquidity and capital
resources, the impact of our historical and potential business strategies on our
business, financial condition, and operating results and the expected effects of
potentially adverse litigation outcomes. Our actual results could differ
materially from our expectations. Further information concerning our business,
including additional risk factors and uncertainties that could cause actual
results to differ materially from the forward-looking statements contained in
this Quarterly Report on Form 10-Q, are set forth below under the heading "Risk
Factors." These risks and uncertainties should be considered in evaluating
forward-looking statements and undue reliance should not be placed on such
statements. The forward-looking statements contained herein speak only as of
the date of this Quarterly Report on Form 10-Q and, except as may be required by
applicable law and regulation, we do not undertake, and specifically disclaim
any obligation to, publicly update or revise such statements to reflect events
or circumstances after the date of such statements or to reflect the occurrence
of anticipated or unanticipated events.
RESULTS OF OPERATIONS
OVERVIEW
We are a franchisor and food and supply distributor to a system of
restaurants operating under the trade name "Pizza Inn". Our distribution
division is Norco Restaurant Services Company ("Norco"). At September 25, 2005,
there were 385 Pizza Inn restaurants, consisting of four Company-owned
restaurants and 381 franchised restaurants. Domestic restaurants are operated
as: (i) 191 buffet restaurants ("Buffet Units") that offer dine-in, carry-out,
and, in many cases, delivery services; (ii) 51 restaurants that offer delivery
and carry-out services only ("Delco Units"); and (iii) 71 express units
("Express Units") typically located within a convenience store, college campus
building, airport terminal, or other commercial facility that offers quick
carry-out service from a limited menu. The 313 domestic restaurants were
located in 18 states predominately situated in the southern half of the United
States. Additionally, we have 72 international restaurants located in 9
foreign countries.
Diluted earnings per share decreased 267% to ($0.05) from $0.03 in the
prior year. Net income decreased $775,000 or 272% to ($490,000) from $285,000
in the prior year, on revenues of $12,706,000 in the current year and
$14,417,000 in the prior year. The decrease in net income is primarily the
result of lower food and supply sales and royalties resulting from lower
comparable chainwide retail sales, fewer net stores and the impact of Hurricane
Katrina. In addition to lower revenues, legal fees increased $513,000 for
ongoing litigation and related matters and energy costs increased $156,000, due
to higher rates.
REVENUES
Our revenues are primarily derived from sales of food, paper products, and
equipment and supplies by Norco to franchisees, franchise royalties and area
development rights. Management believes that key performance indicators in
evaluating financial results include chainwide retail sales, the number and type
of operating restaurants and the percentage of products and supplies such
restaurants purchase from Norco. Our financial results are dependent in large
part upon the pricing and cost of these products and supplies to franchisees,
and the level of chainwide retail sales, which are driven by changes in same
store sales and restaurant count.
FOOD AND SUPPLY SALES
Food and supply sales by Norco include food and paper products, equipment,
marketing material and other distribution revenues. Food and supply sales for
the three month period ended September 25, 2005 decreased 12%, or $1,514,000, to
$11,308,000 from $12,822,000 compared to the comparable period last year. The
decrease in revenues for the three month period ended September 25, 2005
compared to the quarter ended September 26, 2004 is primarily due to a decline
of 5.6% in overall domestic chainwide retail sales, fewer net stores and the
impact of Hurricane Katrina, all of which combined, negatively impacted Norco
product sales by approximately $1,190,000. In addition, equipment sales
decreased $240,000 due to fewer store openings, international sales decreased
$119,000 and the sale of restaurant-level marketing materials decreased $70,000.
FRANCHISE REVENUE
Franchise revenue, which includes income from royalties, license fees and
area development and foreign master license sales, decreased 12%, or $160,000 to
$1,180,000 from $1,340,000 for the three month period ended September 25, 2005
compared to the comparable period last year, primarily due to the decline of
5.6% in overall domestic chainwide retail sales. Additionally, domestic
franchise fees were lower compared to the comparable period last year due to
fewer store openings. The following chart summarizes the major components of
franchise revenue (in thousands):
RESTAURANT SALES
Restaurant sales, which consist of revenue generated by Company-owned
restaurants, decreased 15% or $37,000 to $218,000 from $255,000 for the three
month period ended September 25, 2005, compared to the comparable period of the
prior year due to lower comparable sales at both stores.
COSTS AND EXPENSES
COST OF SALES
Cost of sales decreased 9% or $1,060,000 to $11,132,000 from $12,192,000 for the
three month period ended September 25, 2005 compared to the comparable period in
the prior year. This decrease is primarily the result of lower food and supply
sales resulting from lower retail sales as previously discussed. Cost of sales,
as a percentage of sales for the three month ended September 25, 2005 increased
to 97% from 93% from the comparable period last year. This percentage increase
is primarily due to higher energy costs and to pre-opening expenses, including
payroll, rent and utilities for the three new Company-owned restaurants under
development. The Company experiences fluctuations in commodity prices (most
notably, block cheese prices), increases in transportation costs (particularly
in the price of diesel fuel) and net gains or losses in the number of
restaurants open in any particular period, among other things, all of which have
impacted operating margins over the past several quarters to some extent.
Future fluctuations in these factors are difficult for the Company to
meaningfully predict with any certainty.
FRANCHISE EXPENSES
Franchise expenses include selling, general and administrative expenses
directly related to the sale and continuing service of domestic and
international franchises. These costs increased 29% or $182,000 for the three
month period ended September 25, 2005 compared to the comparable period last
year. This increase is primarily the result of field research study costs and
higher payroll due to additional staffing levels.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses increased 52% or $529,000 to $1,551,000
from $1,022,000 for the three month period ended September 25, 2005 compared to
the comparable period last year. The following chart summarizes the major
components of general and administrative expenses (in thousands):
The current year includes legal expenses related to ongoing litigation and
related matters described previously. The Company anticipates that higher than
normal legal expenses will continue until all such matters are resolved. Stock
compensation expense is the result of the implementation of FAS 123R as
previously discussed.
INTEREST EXPENSE
Interest expense increased 24% or $33,000 to $169,000 from $136,000 for the
three month period ended September 25, 2005 compared to the comparable period of
the prior year due to higher interest rates and higher debt balances under the
Revolving Credit Agreement.
PROVISION FOR INCOME TAX
Provision for income taxes decreased 303% or $473,000 for the three month
period ended September 25, 2005 compared to the comparable period in the prior
year due to lower income in the current quarter. The effective tax rate was 40%
compared to 35% for the comparable period in the previous year. The change in
the effective tax rate is primarily due to the effect of permanent differences.
RESTAURANT OPENINGS AND CLOSINGS
A total of six new Pizza Inn franchise restaurants opened, including one
domestic and five international, during the three month period ended September
25, 2005. Domestically, twelve restaurants were closed by franchisees or
terminated by the Company, typically because of unsatisfactory standards of
operation or performance. Additionally, seven international restaurants were
closed. We do not believe that these closings had any material impact on
collectibility of any outstanding receivables and royalties due to us because
(i) these amounts have been previously reserved for by us with respect to
restaurants that were closed during fiscal 2005 and (ii) these closed
restaurants were lower volume restaurants whose financial impact on our business
as a whole was immaterial. For those restaurants that are anticipated to close
or are exhibiting signs of financial distress, credit terms are typically
restricted, weekly food orders are required to be paid for on delivery and/or
with certified funds and royalty and advertising fees are collected as add-ons
to the delivered price of weekly food orders. The following chart summarizes
restaurant activity for the period ended September 25, 2005 compared to the
comparable period in the prior year:
LIQUIDITY AND CAPITAL RESOURCES
Cash flows from operating activities are generally the result of net income
adjusted for deferred taxes, depreciation and amortization and changes in
working capital. In the three month period ending September 25, 2005 the
Company generated cash flows of $5,000 from operating activities as compared to
$1,126,000 in the prior year. Reduction in cash flows from operating activities
for the quarter ended September 25, 2005 as compared to the prior year resulted
primarily from a decrease in net income of $775,000 to ($490,000) for the
quarter ended September 25, 2005 from $285,000 for the quarter ended September
26, 2004, with the remaining reduction from normal changes in working capital.
Cash flows from investing activities primarily reflect the Company's
capital expenditure strategy. In the first three months of fiscal 2006,
$127,000 cash was provided by investing activities as compared to cash used for
investing activities of $307,000 for the comparable period in fiscal 2005.
Proceeds from the sale of land in Prosper, Texas were partially offset by cash
used primarily for costs associated with development of the new Company-owned
restaurants and purchase of warehouse equipment.
Cash flows from financing activities generally reflect changes in the
Company's borrowings during the period, treasury stock transactions and exercise
of stock options. Net cash used for financing activities was $126,000 in the
first three months of fiscal 2006 as compared to cash used for financing
activities of $1,205,000 for the comparable period in fiscal 2005.
Management believes that future operations will generate sufficient taxable
income, along with the reversal of temporary differences, to fully realize the
deferred tax asset, net of a valuation allowance of $137,000 primarily related
to the potential expiration of certain foreign tax credit carryforwards.
Additionally, management believes that taxable income based on the Company's
existing franchise base should be more than sufficient to enable the Company to
realize its net deferred tax asset without reliance on material non-routine
income. The Company's prior net operating loss carryforwards and alternative
minimum tax carryforwards have now been fully utilized and the Company began
making estimated quarterly tax payments in January 2004.
The Company entered into an agreement on August 29, 2005, effective June
26, 2005 (the "Revolving Credit Agreement"), with Wells Fargo to provide a $6.0
million revolving credit line that will expire October 1, 2007, replacing a $3.0
million line that was due to expire December 23, 2005. The amendment provides,
among other terms, for modifications to certain financial covenants. Interest
is provided for at a rate equal to a range of Prime less an interest rate margin
of 0.75% to Prime plus an interest rate margin of 1.75% or, at the Company's
option, at the LIBOR rate plus an interest rate margin of 1.25% to 3.75%. The
interest rate margin is based on the Company's performance under certain
financial ratio tests. An annual commitment fee is payable on any unused
portion of the revolving credit line at a rate from 0.35% to 0.50% based on the
Company's performance under certain financial ratio tests. As of September 25,
2005 and September 26, 2004, the variable interest rates were 7.25% and 4.50%,
using a Prime interest rate basis. Amounts outstanding under the revolving
credit line as of September 25, 2005 and September 26, 2004 were $923,000 and
$99,000, respectively. Property, plant and equipment, inventory and accounts
receivable have been pledged for the above referenced loan agreement.
The Company entered into an agreement effective December 28, 2000, as
amended (the "Term Loan Agreement"), with Wells Fargo to provide up to $8.125
million of financing for the construction of the Company's new headquarters,
training center and distribution facility. The construction loan converted to a
term loan effective January 31, 2002 with the unpaid principal balance to mature
on December 28, 2007. The term loan amortizes over a term of twenty years, with
principal payments of $34,000 due monthly. Interest on the term loan is also
payable monthly. Interest is provided for at a rate equal to a range of Prime
less an interest rate margin of 0.75% to Prime plus an interest rate margin of
1.75% or, at the Company's option, at the LIBOR rate plus an interest rate
margin of 1.25% to 3.75%. The interest rate margin is based on the Company's
performance under certain financial ratio tests. The Company, to fulfill the
requirements of Wells Fargo, fixed the interest rate on the term loan by
utilizing an interest rate swap agreement. The $8.125 million term loan had an
outstanding balance of $6.6 million at September 25, 2005 and $7.0 million at
September 26, 2004. Property, plant and equipment, inventory and accounts
receivable have been pledged for the above referenced loan agreement.
On October 18, 2005 the Company notified Wells Fargo that as of September
25, 2005 the Company was in violation of certain financial ratio covenants in
the Third Amendment to the Third Amended and Restated Loan Agreement between the
Company and the Bank dated August 29, 2005 but effective as of June 26, 2005
("the Loan Agreement") and that as a result an event of default existed under
the Loan Agreement. As a result of the event of default all outstanding
principal of the Company's obligations under the Loan Agreement have been
reclassified as a current liability on the Company's balance sheet. The Company
has requested that Wells Fargo agree to waive the event of default. However,
Wells Fargo is not obligated under the Loan Agreement to grant such a waiver.
As of November 1, 2005 Wells Fargo has not exercised any of the rights or
remedies available to it under the Loan Agreement in these circumstances.
The Company entered into an interest rate swap effective February 27,
2001, as amended, designated as a cash flow hedge, to manage interest rate risk
relating to the financing of the construction of the Company's new headquarters
and to fulfill bank requirements. The swap agreement has a notional principal
amount of $8.125 million with a fixed pay rate of 5.84%, which began November 1,
2001 and will end November 19, 2007. The swap's notional amount amortizes over
a term of twenty years to parallel the terms of the term loan. Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" requires that for cash flow hedges, which hedge the
exposure to variable cash flow of a forecasted transaction, the effective
portion of the derivative's gain or loss be initially reported as a component of
other comprehensive income in the equity section of the balance sheet and
subsequently reclassified into earnings when the forecasted transaction affects
earnings. Any ineffective portion of the derivative's gain or loss is reported
in earnings immediately. As of September 25, 2005, there was no hedge
ineffectiveness. The Company's expectation is that the hedging relationship will
be highly effective at achieving offsetting changes in cash flows.
The Company is in an arbitration proceeding with Mr. Parker as
previously described. Although the ultimate outcome of the arbitration
proceeding cannot be projected with certainty at this time, the Company believes
that its claims against Mr. Parker are well founded and intends to vigorously
pursue all relief to which it may be entitled. An adverse outcome to the
proceeding could materially affect the Company's financial position, results of
operations and liquidity. In the event the Company is unsuccessful, it could be
liable to Mr. Parker for approximately $5.4 million under the Parker Agreement
plus accrued interest and legal expenses. The Company maintains that it does
not owe Mr. Parker severance payments or any other compensation, but believes it
has the ability to make any payments required by an adverse determination. No
accrual for any amount has been made as of September 25, 2005. We are also a
party to a lawsuit brought against us by PepsiCo, described earlier. We believe
that the allegations made against the Company by PepsiCo are unfounded, although
the ultimate outcome of the lawsuit cannot be predicted with certainty at this
time. We intend to vigorously contest all of PepsiCo's claims and to pursue all
relief to which we may be entitled. However, in the event the Company is
unsuccessful, it could be liable to PepsiCo for approximately $2.6 million plus
fees and costs. We believe that we have the ability to make any payments
required by an adverse determination. No accrual has been made as of September
25, 2005. The Company anticipates a higher level of legal expenses from the
ongoing litigation and related matters described previously, until all such
matters are resolved.
In July 2005 the Company acquired the assets of two existing Pizza Inn
buffet restaurants from Houston, Texas area franchisees. We are currently in
the process of remodeling these restaurants and anticipate reopening them in
November or December 2005. One location has approximately 4,100 square feet and
the other has approximately 2,750 square feet. Both are leased at rates of
approximately $18.00 per square foot. The leases expire in 2015 and each has at
least one renewal option. The cost of acquiring and remodeling these
restaurants is expected to range between $965,000 and $1,050,000.
In July 2005 the Company leased approximately 4,100 square feet of space in
a retail development in Dallas, Texas for the operation of a buffet concept at a
rate of approximately $30.00 per square foot. The restaurant opened October 28,
2005 and we are currently in the process of completing the finish out of the
space. The lease has a five-year term with multiple renewal options. The cost
of finishing out the space is expected to range between $450,000 and $525,000.
We also owned property in Prosper, Texas that was purchased in August
2004 with the intention of constructing and operating a buffet restaurant. We
decided not to pursue development at that location and sold the property to a
third party on September 23, 2005.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
The following chart summarizes all of the Company's material obligations
and commitments to make future payments under contracts such as debt and lease
agreements as of September 25, 2005 (in thousands):
(1) Does not include amounts representing interest.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires our management to make estimates and
assumptions that affect our reported amounts of assets, liabilities, revenues,
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 could differ materially from estimates.
The Company believes the following critical accounting policies require
estimates about the effect of matters that are inherently uncertain, are
susceptible to change, and therefore require subjective judgments. Changes in
the estimates and judgments could significantly impact our results of operations
and financial conditions in future periods.
Accounts receivable consist primarily of receivables generated from food
and supply sales to franchisees and franchise royalties. The Company records a
provision for doubtful receivables to allow for any amounts which may be
unrecoverable and is based upon an analysis of the Company's prior collection
experience, general customer creditworthiness, and the franchisee's ability to
pay, based upon the franchisee's sales, operating results, and other general and
local economic trends and conditions that may affect the franchisee's ability to
pay. Actual realization of amounts receivable could differ materially from our
estimates.
Inventory, which consists primarily of food, paper products, supplies and
equipment located at the Company's distribution center, are stated at the lower
of FIFO (first-in, first-out), cost or market. The valuation of inventory
requires us to estimate the amount of obsolete and excess inventory. The
determination of obsolete and excess inventory requires us to estimate the
future demand for our products within specific time horizons, generally six
months or less. If the Company's demand forecast for specific products is
greater than actual demand and the Company fails to reduce purchasing
accordingly, the Company could be required to write down additional inventory,
which would have a negative impact on our gross margin.
The Company has recorded a valuation allowance to reflect the estimated
amount of deferred tax assets that may not be realized based upon the Company's
analysis of existing tax credits by jurisdiction and expectations of the
Company's ability to utilize these tax attributes through a review of estimated
future taxable income and establishment of tax strategies. These estimates
could be materially impacted by changes in future taxable income and the results
of tax strategies.
The Company assesses its exposures to loss contingencies including legal
and income tax matters based upon factors such as the current status of cases
and consultations with external counsel and provides for an exposure by accruing
an amount if it is judged to be probable and can be reasonably estimated. If
the actual loss from a contingency differs from management's estimate, operating
results could be impacted.
RISK FACTORS
Investing in our common stock involves a high degree of risk. You should
carefully consider the following factors, as well as other information contained
in this report, before deciding to invest in shares of our common stock. These
risks could materially adversely affect our business, financial condition or
results of operations. The trading price of our common stock could also be
materially adversely affected by any of these risks.
IF WE ARE NOT ABLE TO COMPETE EFFECTIVELY, OUR BUSINESS, SALES AND EARNINGS
COULD BE MATERIALLY ADVERSELY AFFECTED.
The restaurant industry in general, as well as the pizza segment of the
industry, is intensely competitive, both internationally and domestically, with
respect to price, service, location and food quality. We compete against many
regional and local businesses. There are many well-established competitors with
substantially greater brand awareness and financial and other resources than we
have. Some of these competitors have been in existence for a longer period than
we have and may be better established in markets where we operate restaurants or
that are operated by our franchisees, or where they may be located. Experience
has shown that a change in the pricing or other marketing or promotional
strategies, including new product and concept developments, of one or more of
our major competitors can have an adverse impact on sales and earnings and our
systemwide restaurant operations.
We could also experience increased competition from existing or new
companies in the pizza segment of the restaurant industry. If we are unable to
compete, we could experience downward pressure on prices, lower demand for our
products, reduced margins, the inability to take advantage of new business
opportunities and the loss of market share, all of which would have a material
adverse effect on our operating results.
We also compete on a broader scale with quick service and other
international, national, regional and local restaurants. The overall food
service market and the quick service restaurant sector are intensely competitive
with respect to food quality, price, service, convenience and concept.
We compete within the food service market and the restaurant industry not
only for customers, but also for management and hourly employees, suitable real
estate sites and qualified franchisees. Norco is also subject to competition
from outside suppliers. If other suppliers, who meet our qualification
standards, offer lower prices or better service to our franchisees for their
ingredients and supplies and, as a result, our franchisees choose not to
purchase from Norco, our financial condition, business and results of operations
would be adversely affected.
IF WE ARE NOT ABLE TO IMPLEMENT OUR GROWTH STRATEGY SUCCESSFULLY, WHICH
INCLUDES OPENING NEW DOMESTIC AND INTERNATIONAL RESTAURANTS AND REIMAGING
EXISTING RESTAURANTS, OUR ABILITY TO INCREASE OUR REVENUES AND OPERATING PROFITS
COULD BE MATERIALLY ADVERSELY AFFECTED.
A significant component of our growth strategy is opening new domestic and
international franchise restaurants. We and our franchisees face many
challenges in opening new restaurants, including, among other things, selection
and availability of suitable restaurant locations and qualified franchisees,
increases in food, paper, labor, utilities, fuel, employee benefits, insurance
and similar costs, negotiation of suitable lease or financing terms, constraints
on permitting and construction of restaurants, higher than anticipated
construction costs, the hiring, training and retention of management and other
personnel and securing required domestic or foreign governmental permits and
approvals.
The opening of additional franchise restaurants and our reimaging program also
depends, in part, upon the availability of prospective franchisees who meet our
criteria. Our reimaging program may require considerable management time as
well as start-up expenses for market development before any significant revenues
and earnings are generated.
Accordingly, there can be no assurance that we will be able to meet planned
growth targets, open restaurants in markets now targeted for expansion or
operate in existing markets profitably. In addition, even if we are able to
continue to open new restaurants, we may not be able to keep restaurants from
closing at a faster rate than we are able to open restaurants.
AN INCREASE IN THE COST OF CHEESE OR OTHER COMMODITIES, INCLUDING FUEL AND
LABOR, COULD ADVERSELY AFFECT OUR PROFITABILITY AND OPERATING RESULTS.
An increase in our operating costs could adversely affect our
profitability. Factors such as inflation, increased food costs, increased labor
and employee benefit costs and increased energy costs may adversely affect our
operating results. Most of the factors affecting costs are beyond our control
and, in many cases, we may not be able to pass along these increased costs to
our customers or franchisees even if we attempted to do so. Most ingredients
used in our pizza, particularly cheese, are subject to significant price
fluctuations as a result of seasonality, weather, availability, demand and other
factors. Sustained increases in fuel and utility costs could adversely affect
the profitability of our restaurant and distribution businesses. Labor costs
are largely a function of the minimum wage for a majority of our restaurant and
distribution center personnel and, generally, are a function of the availability
of labor.
SHORTAGES OR INTERRUPTIONS IN THE SUPPLY OR DELIVERY OF FOOD PRODUCTS COULD
ADVERSELY AFFECT OUR OPERATING RESULTS.
We and our franchisees are dependent on frequent deliveries of food
products that meet our specifications. Shortages or interruptions in the supply
of food products caused by unanticipated demand, problems in production or
distribution by Norco or otherwise, inclement weather (including hurricanes and
other natural disasters) or other conditions could adversely affect the
availability, quality and cost of ingredients, which would adversely affect our
operating results.
CHANGES IN CONSUMER PREFERENCES AND PERCEPTIONS COULD DECREASE THE DEMAND FOR
OUR PRODUCTS, WHICH WOULD REDUCE SALES AND HARM OUR BUSINESS.
Restaurant businesses are affected by changes in consumer tastes, national,
regional and local economic conditions, demographic trends, disposable
purchasing power, traffic patterns and the type, number and location of
competing restaurants. For example, if prevailing health or dietary preferences
cause consumers to avoid pizza and other products we offer in favor of foods
that are perceived as more healthy, our business and operating results would be
harmed. Moreover, because we are primarily dependent on a single product, if
consumer demand for pizza should decrease, our business would suffer more than
if we had a more diversified menu, as many other food service businesses do.
HEALTH CONCERNS OR DISEASE-RELATED DISRUPTIONS ABOUT COMMODITIES THAT WE
USE TO MAKE PIZZA COULD MATERIALLY ADVERSELY AFFECT THE AVAILABILITY AND COST OF
SUCH COMMODITIES.
Health- or disease-related disruptions or consumer concerns about the
commodity supply could materially adversely impact the availability and/or cost
of such commodities, thereby materially adversely impacting restaurant
operations and our financial results.
WE ARE SUBJECT TO EXTENSIVE GOVERNMENT REGULATION, AND ANY FAILURE TO COMPLY
WITH EXISTING OR INCREASED REGULATIONS COULD ADVERSELY AFFECT OUR BUSINESS AND
OPERATING RESULTS.
We are subject to numerous federal, state, local and foreign laws and
regulations, including those relating to the preparation and sale of food;
building and zoning requirements; environmental protection; minimum wage,
citizenship, overtime and other labor requirements; compliance with the
Americans with Disabilities Act; and working and safety conditions.
A significant number of hourly personnel employed by our franchisees and by us
are paid at rates related to the federal minimum wage. Accordingly, further
increases in the federal minimum wage or the enactment of additional state or
local wage proposals may increase labor costs for our systemwide operations.
Additionally, labor shortages in various markets could result in higher required
wage rates.
If we fail to comply with existing or future laws and regulations, we may
be subject to governmental or judicial fines or sanctions. In addition, our
capital expenditures could increase due to remediation measures that may be
required if we are found to be noncompliant with any of these laws or
regulations.
We are also subject to a Federal Trade Commission rule and to various state
and foreign laws that govern the offer and sale of franchises. Additionally,
these laws regulate various aspects of the franchise relationship, including
terminations and the refusal to renew franchises. The failure to comply with
these laws and regulations in any jurisdiction or to obtain required government
approvals could result in a ban or temporary suspension on future franchise
sales, fines or other penalties or require us to make offers of rescission or
restitution, any of which could adversely affect our business and operating
results.
IF WE ARE NOT ABLE TO CONTINUE TO PURCHASE OUR KEY PIZZA INGREDIENTS FROM OUR
CURRENT SUPPLIERS OR FIND SUITABLE REPLACEMENT SUPPLIERS OUR FINANCIAL RESULTS
COULD BE MATERIALLY ADVERSELY AFFECTED.
We are dependent on a few suppliers for our key ingredients. Domestically, we
rely upon sole suppliers for our cheese, flour mixture and certain other key
ingredients. Alternative sources for these ingredients may not be available on
a timely basis to supply these key ingredients or be available on terms as
favorable to us as under our current arrangements. Our domestic restaurants
purchase substantially all food and related products from our distribution
division. Accordingly, both our Company-operated and franchised restaurants
could be harmed by any prolonged disruption in the supply of products from
Norco. Additionally, domestic franchisees are only required to purchase the
flour mixture, spice blend and certain other items from Norco and changes in
purchasing practices by domestic franchisees could adversely affect the
financial results of our distribution operation.
OUR INTERNATIONAL AND DOMESTIC OPERATIONS COULD BE MATERIALLY ADVERSELY
AFFECTED BY SIGNIFICANT CHANGES IN INTERNATIONAL, REGIONAL AND LOCAL ECONOMIC
AND POLITICAL CONDITIONS.
Our international and domestic operations are subject to many factors,
including currency regulations and fluctuations, culture and consumer
preferences, diverse government regulations and structures, availability and the
cost of land and construction, ability to source ingredients and other
commodities in a cost-effective manner and differing interpretation of the
obligations established in franchise agreements with international franchisees.
Accordingly, there can be no assurance that our operations will achieve or
maintain profitability or meet planned growth rates.
EACH OF THE FOREGOING RISK FACTORS THAT COULD AFFECT RESTAURANT SALES OR
COSTS COULD DISPROPORTIONATELY AFFECT THE FINANCIAL VIABILITY OF NEWLY OPENED
RESTAURANTS AND FRANCHISEES IN UNDER-PENETRATED OR EMERGING MARKETS AND,
CONSEQUENTLY, OUR OVERALL RESULTS OF OPERATIONS.
A decline in or failure to improve financial performance for this group of
restaurants or franchisees could lead to an inability to successfully recruit
new franchisees and open new restaurants and lead to restaurant closings at
greater than anticipated levels and therefore impact contributions to marketing
funds, our royalty stream, our distribution operations and support services
efficiencies and other system-wide results of operations.
WE FACE RISKS OF LITIGATION FROM CUSTOMERS, FRANCHISEES, EMPLOYEES AND OTHERS IN
THE ORDINARY COURSE OF BUSINESS, WHICH DIVERTS OUR FINANCIAL AND MANAGEMENT
RESOURCES. ANY ADVERSE LITIGATION OR PUBLICITY MAY NEGATIVELY IMPACT OUR
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Claims of illness or injury relating to food quality or food handling are
common in the food service industry. In addition to decreasing our sales and
profitability and diverting our management resources, adverse publicity or a
substantial judgment against us could negatively impact our financial condition,
results of operations and brand reputation, hindering our ability to attract and
retain franchisees and grow our business.
Further, we may be subject to employee, franchisee and other claims in the
future based on, among other things, discrimination, harassment, wrongful
termination and wage, rest break and meal break issues, including those relating
to overtime compensation. If one or more of these claims were to be successful
or if there is a significant increase in the number of these claims, our
business, financial condition and operating results could be harmed.
For example, an adverse outcome to the proceedings involving Ronald W.
Parker, the Company's former Chief Executive Officer or PepsiCo could materially
affect the Company's financial position and results of operations. In the event
the Company is unsuccessful, it could be liable to Mr. Parker for approximately
$5.4 million under his employment agreement plus accrued interest and legal
expenses. We could also be liable to PepsiCo for approximately $2.6 million
plus costs and legal expenses. No accrual for any amount has been made as of
September 25, 2005. See the discussion under "Legal Proceedings" in this
report.
OUR EARNINGS AND BUSINESS GROWTH STRATEGY DEPENDS ON THE SUCCESS OF OUR
FRANCHISEES, AND WE MAY BE HARMED BY ACTIONS TAKEN BY OUR FRANCHISEES THAT ARE
OUTSIDE OF OUR CONTROL.
A significant portion of our earnings comes from royalties generated by our
franchised restaurants. Franchisees are independent operators, and their
employees are not our employees. We provide limited training and support to
franchisees, but the quality of franchised restaurant operations may be
diminished by any number of factors beyond our control. Consequently,
franchisees may not successfully operate restaurants in a manner consistent with
our standards and requirements, or may not hire and train qualified managers and
other restaurant personnel. If they do not, our image and reputation may
suffer, and revenues could decline. While we try to ensure that our franchisees
maintain the quality of our brand and branded products, our franchisees may take
actions that adversely affect the value of our intellectual property or
reputation. Our domestic and international franchisees may not operate their
franchises successfully. If one or more of our key franchisees were to become
insolvent or were unable or unwilling to pay us our royalties, our business and
results of operations would be adversely affected.
LOSS OF KEY PERSONNEL OR OUR INABILITY TO ATTRACT AND RETAIN NEW QUALIFIED
PERSONNEL COULD HURT OUR BUSINESS AND INHIBIT OUR ABILITY TO OPERATE AND GROW
SUCCESSFULLY.
Our success will depend to a significant extent on our leadership team and
other key management personnel. We may not be able to retain our executive
officers and key personnel or attract additional qualified management. Our
success also depends on our ability to attract and retain qualified personnel to
operate our restaurants, distribution center and international operations. The
loss of these employees or our inability to recruit and retain qualified
personnel could have a material adverse effect on our operating results.
OUR CURRENT INSURANCE COVERAGE MAY NOT BE ADEQUATE, AND INSURANCE PREMIUMS
FOR SUCH COVERAGE MAY INCREASE AND WE MAY NOT BE ABLE TO OBTAIN INSURANCE AT
ACCEPTABLE RATES, OR AT ALL.
Our insurance policies may not be adequate to protect us from liabilities
that we incur in our business. In addition, in the future our insurance
premiums may increase and we may not be able to obtain similar levels of
insurance on reasonable terms, or at all. Any such inadequacy of, or inability
to obtain, insurance coverage could have a material adverse effect on our
business, financial condition and results of operations.
Our annual and quarterly financial results are subject to significant
fluctuations depending on various factors, many of which are beyond our control,
and if we fail to meet the expectations of securities analysts or investors, our
share price may decline significantly.
Our sales and operating results can vary significantly from
quarter-to-quarter and year to year depending on various factors, many of which
are beyond our control. These factors include variations in the timing and
volume of our sales and our franchisees' sales; the timing of expenditures in
anticipation of future sales; sales promotions by us and our competitors;
changes in competitive and economic conditions generally; and changes in the
cost or availability of our ingredients (including cheese), fuel or labor. As a
result, our results of operations may decline quickly and significantly in
response to changes in order patterns or rapid decreases in demand for our
products. We anticipate that fluctuations in operating results will continue in
the future.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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The Company has market risk exposure arising from changes in interest
rates. The Company's earnings are affected by changes in short-term interest
rates as a result of borrowings under its credit facilities, which bear interest
based on floating rates.
At September 25, 2005, the Company had approximately $7.6 million of
variable rate debt obligations outstanding with a weighted average interest rate
of 6.43%. A hypothetical 10% increase in the effective interest rate for these
borrowings, assuming debt levels at September 25, 2005, would have increased
interest expense by approximately $12,000 for the three month period ending
September 25, 2005. As discussed previously, the Company has entered into an
interest rate swap designed to manage the interest rate risk relating to $6.6
million of the variable rate debt.
ITEM 4. CONTROLS AND PROCEDURES
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The Company's management, including the Company's principal executive
officer and principal financial officer, has evaluated the Company's disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934) as of the end of the period covered By this
Quarterly Report on Form 10-Q.Based upon that evaluation, the Company's
principal executive officer and principal financial officer have concluded that
the disclosure controls and procedures were effective as of the end of the
period covered by this Quarterly Report on Form 10-Q.
There were no changes in the Company's internal control 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 control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
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On December 11, 2004, the Board of Directors of the Company terminated
the Executive Compensation Agreement dated December 16, 2002 between the Company
and its then Chief Executive Officer, Ronald W. Parker ("Parker Agreement").
Mr. Parker's employment was terminated following ten days written notice to Mr.
Parker of the Company's intent to discharge him for cause as a result of
violations of the Parker Agreement. Written notice of termination was
communicated to Mr. Parker on December 13, 2004. The nature of the cause
alleged was set forth in the notice of intent to discharge and based upon
Section 2.01(c) of the Parker Agreement, which provides for discharge for "any
intentional act of fraud against the Company, any of its subsidiaries or any of
their employees or properties, which is not cured, or with respect to which
Executive is not diligently pursuing a cure, within ten (10) business days of
the Company giving notice to Executive to do so." Mr. Parker was provided with
an opportunity to cure as provided in the Parker Agreement as well as the
opportunity to be heard by the Board of Directors prior to the termination.
On January 12, 2005, the Company instituted an arbitration proceeding
against Mr. Parker with the American Arbitration Association in Dallas, Texas
pursuant to the Parker Agreement seeking declaratory relief that Mr. Parker is
not entitled to severance payments or any other further compensation from the
Company. In addition, the Company is seeking compensatory damages,
consequential damages, and disgorgement of compensation paid to Mr. Parker under
the Parker Agreement. On January 31, 2005, Mr. Parker filed claims against the
Company for breach of the Parker Agreement, seeking the severance payment
provided for in the Parker Agreement for a termination of Mr. Parker by the
Company for reason other than for cause (as defined in the Parker Agreement),
plus interest, attorney's fees and costs. The arbitration hearing is scheduled
to begin April 3, 2006.
Due to the preliminary stages of the arbitration proceeding and the
general uncertainty surrounding the outcome of this type of legal proceeding, it
is not possible for the Company to provide any certain or meaningful analysis,
projections, or expectations at this time regarding the outcome of this matter.
Although the ultimate outcome of the arbitration proceeding cannot be projected
with certainty at this time, the Company believes that its claims against Mr.
Parker are well founded and intends to vigorously pursue all relief to which it
may be entitled. An adverse outcome to the proceeding could materially affect
the Company's financial position and results of operations. In the event the
Company is unsuccessful, it could be liable to Mr. Parker for approximately $5.4
million under the Parker Agreement plus accrued interest and legal expenses. No
accrual for any amount has been made as of September 25, 2005.
On October 5, 2004 the Company filed a lawsuit against the law firm Akin,
Gump, Strauss, Hauer & Feld, ("Akin Gump") and J. Kenneth Menges, one of the
firm's partners. Akin Gump served as the Company's principal outside lawyers
from 1997 through May 2004, when the Company terminated the relationship. The
petition alleges that during the course of representation of the Company, the
firm and Mr. Menges, as the partner in charge of the firm's services for the
Company, breached certain fiduciary responsibilities to the Company by giving
advice and taking action to further the personal interests of certain of the
Company's executive officers to the detriment of the Company and its
shareholders. Specifically, the petition alleges that the firm and Mr. Menges
assisted in the creation and implementation of so-called "golden parachute"
agreements, which, in the opinion of the Company's current counsel, provided for
potential severance payments to those executives in amounts greatly
disproportionate to the Company's ability to pay, and that, if paid, could
expose the Company to significant financial liability which could have a
material adverse effect on the Company's financial position. This matter is in
its preliminary stages, and the Company is unable to provide any meaningful
analysis, projections or expectations at this time regarding the outcome of this
matter. However, the Company believes that its claims against Akin Gump and Mr.
Menges are well founded and intends to vigorously pursue all relief to which it
may be entitled. On January 25, 2005, Akin Gump filed a motion with the court
asking for this matter to be abated pending a determination in the Clark and
Parker arbitrations. The court denied the motion but ruled that it would not
set a trial date until after completion of the Clark and Parker arbitration
hearings.
On June 15, 2004, B. Keith Clark provided the Company with notice of
his intent to resign as Senior Vice President - Corporate Development, Secretary
and General Counsel of the Company effective as of July 7, 2004. By letter
dated June 24, 2004, Mr. Clark notified the Company that he reserved his right
to assert that the election of Ramon D. Phillips and Robert B. Page to the Board
of Directors of the Company at the February 11, 2004 annual meeting of
shareholders constituted a "change of control" of the Company under his
executive compensation agreement (the "Clark Agreement"). As a result of the
alleged "change of control" under the Clark Agreement, Clark claims that he was
entitled to terminate the Clark Agreement within twelve (12) months of February
11, 2004 for "good reason" (as defined in the Clark Agreement) and is entitled
to severance. On August 6, 2004, the Company instituted an arbitration
proceeding against Mr. Clark with the American Arbitration Association in
Dallas, Texas pursuant to the Clark Agreement seeking declaratory relief that
Mr. Clark is not entitled to severance payments or any other further
compensation from the Company. On January 18, 2005, the Company amended its
claims against Mr. Clark to include claims for compensatory damages,
consequential damages and disgorgement of compensation paid to Mr. Clark under
the Clark Agreement. Mr. Clark has filed claims against the Company for breach
of the Clark Agreement, seeking the severance payment provided for in the Clark
Agreement plus a bonus payment for 2003 of approximately $12,500. On November
8, 2005 the parties approved entering into a confidential settlement agreement
and release of claims, which provides, among other things, that the Company will
pay Mr. Clark $150,000, the parties will dismiss with prejudice all claims in
the pending arbitration action and each party will bear its or his own costs and
expenses.
On April 22, 2005, the Company provided PepsiCo, Inc. ("PepsiCo") with
written notice of PepsiCo's breach of the beverage marketing agreement the
parties had entered into in May 1998 (the "Beverage agreement"). In the notice,
the Company alleged that PepsiCo had not complied with the terms of the Beverage
Agreement by failing to (i) provide account and equipment service, (ii) maintain
and repair fountain dispensing equipment, (iii) make timely and accurate account
payments, and by providing the Company with beverage syrup containers that
leaked in storage and in transit. The notice provided PepsiCo 90 days with
which to cure the instances of default. On May 18, 2005 the parties entered
into a "standstill" agreement under which the parties agreed to a 60-day
extension of the cure period to attempt to renegotiate the terms of the Beverage
Agreement and for PepsiCo to compete its cure.
The parties did not reach an agreement regarding renegotiation of the
Beverage Agreement and the Company contends that PepsiCo did not cure each of
the instances of default set forth in the Company's original notice of default.
On September 15, 2005 the Company provided PepsiCo with notice of termination of
the Beverage Agreement effective immediately. On October 11, 2005 PepsiCo
served the Company with a Petition in the matter of PepsiCo, Inc. v. Pizza Inn,
Inc. filed in District Court in Collin County, Texas. In the Petition, PepsiCo
alleges that the Company breached the Beverage Agreement by terminating it
without cause. PepsiCo seeks damages of $2,651,582, an amount PepsiCo believes
represents the value of gallons of beverage products that the Company is
required to purchase under the terms of the Beverage Agreement, plus return of
any marketing support funds that PepsiCo advanced to the Company but that the
Company has not earned.
The Company believes that it had good reason to terminate the Beverage
Agreement and that it terminated the Beverage Agreement in good faith and in
compliance with its terms. The Company further believes that under such
circumstances it has no obligation to purchase additional quantities of beverage
products. The Company is preparing its response to the Petition, which may
include claims against PepsiCo for amounts earned by the Company under the
Beverage Agreement but not yet paid by PepsiCo. Due to the preliminary nature
of this matter and the general uncertainty surrounding the outcome of any form
of legal proceeding, it is not possible for the Company to provide any certain
or meaningful analysis, projection, or expectation at this time regarding the
outcome of this matter. Although the outcome of the legal proceeding cannot be
projected with certainty, the Company believes that its actions in terminating
the Beverage Agreement were proper and that PepsiCo's allegations are without
merit. The Company intends to vigorously defend against such allegations and to
pursue all relief to which it may be entitled. An adverse outcome to the
proceeding could materially affect the Company's financial position and results
of operation. In the event the Company is unsuccessful, it could be liable to
PepsiCo for gallons of beverage products valued at approximately $2.6 million
plus costs and fees. No accrual for such amounts has been made as of September
25, 2005.
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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND THE USE OF PROCEEDS
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The Company did not make any share repurchases in the quarter covered by
this report:
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
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On October 18, 2005 the Company notified Wells Fargo that as of September
25, 2005 the Company was in violation of certain financial ratio covenants in
the Loan Agreement and that as a result an event of default existed under the
Loan Agreement.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
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None
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ITEM 5. OTHER INFORMATION
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None
ITEM 6. EXHIBITS
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3.1 Restated Articles of Incorporation as filed on September 5, 1990
and amended on June 23, 2005 (filed as exhibit 3.6 to the Company's Annual
Report on Form 10-K for the fiscal year ended June 26, 2005 and incorporated
herein by reference).
3.2 Amended and Restated By-laws as adopted by the Board of Directors on
February 11, 2004 (file as Item 5 on Form 8-K on February 11, 2004 and
incorporated herein by reference).
31.1 Certification of Chief Executive Officer as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES
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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.
PIZZA INN, INC.
Registrant
By: /s/Timothy P. Taft
--------------------
Timothy P. Taft
Chief Executive Officer
By: /s/Shawn M. Preator
---------------------
Shawn M. Preator
Chief Financial Officer
Dated: November 9, 2005