10KSB 1 a5344135.txt BAB, INC. 10-KSB FORM 10-KSB U.S. SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 (Mark one) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the year ended: November 30, 2006 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number: 0-31555 BAB, Inc. (Name of small business issuer in its charter) Delaware 36-4389547 (State or other jurisdiction of incorporation) (IRS Employer or organization Identification No.) 500 Lake Cook Road, Suite 475 Deerfield, Illinois 60015 (Address of principal executive offices) (Zip Code) Issuer's telephone number: (847) 948-7520 Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the small business issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of small business issuer's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [X] State issuer's revenues for its most recent fiscal year: $3,917,391 The aggregate market value of the voting stock held by nonaffiliates computed by reference to the price at which the stock was sold, or the average bid and asked prices of such stock, as of a specified date within the past 60 days: $3,741,662 based on 3,704,616 shares held by nonaffiliates as of February 16, 2007; Closing price ($1.01), bid ($0.96) and ask ($1.01) prices for said shares in the NASDAQ OTC Bulletin Board as of such date. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 7,263,099 shares of Common Stock, as of February 16, 2007. Transitional Small Business Disclosure Format (check one): [ ] Yes [X] No -1- FORM 10-KSB INDEX PART I
Item 1 Description of Business 3 ----------------------- Overview -------- Customers --------- Suppliers --------- Locations --------- Store Operations ---------------- Franchising ----------- Competition ----------- Trademarks and Service Marks ---------------------------- Government Regulation --------------------- Employees --------- Item 2 Description of Property 7 ----------------------- Item 3 Legal Proceedings 7 ----------------- Item 4 Submission of Matters to a Vote of Security Holders 7 --------------------------------------------------- PART II Item 5. Market for the Common Equity and Related Stockholder Matters 8 ------------------------------------------------------------ Item 6. Management's Discussion and Analysis of Financial Condition and Results of 9 Operations --------------------------------------------------------------------------- Item 7. Financial Statements 13 -------------------- Item 8. Changes in and Disagreement with Accountants on Accounting and Financial Disclosure 33 ----------------------------------------------------------------------------------- Item 8A. Controls and Procedures 33 ----------------------- PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with 33 Section 16(a) of the Exchange Act ------------------------------------------------------------------------------ Code of Ethics -------------- Item 10. Executive Compensation 36 ---------------------- Item 11. Security Ownership of Certain Beneficial Owners and Management 37 --------------------------------------------------------------- Item 12. Certain Relationships and Related Transactions 38 ---------------------------------------------- Item 13. Exhibits and Reports on Form 8-K 39 -------------------------------- Item 14. Principal Accountant Fees and Services 39 -------------------------------------- Exhibits
-2- PART I ITEM 1. DESCRIPTION OF BUSINESS OVERVIEW BAB, Inc. (the "Company") was incorporated under the laws of the State of Delaware on July 12, 2000. The Company currently operates, franchises and licenses bagel, muffin and coffee retail units under the Big Apple Bagels ("BAB"), My Favorite Muffin ("MFM") and Brewster's Coffee trade names. At November 30, 2006, the Company had 140 units in operation in 26 states, and 2 International units in United Arab Emirates. The Company additionally derives income from the sale of its trademark bagels, muffins and coffee through nontraditional channels of distribution including under licensing agreements with Mrs. Fields Famous Brands (Mrs. Fields), Kohr Bros. Frozen Custard and through direct home delivery of specialty muffin gift baskets and coffee. The BAB brand franchised and Company-owned store features daily baked bagels, flavored cream cheeses, premium coffees, gourmet bagel sandwiches and other related products. Licensed BAB units serve the Company's par-baked frozen bagel and related products baked daily. BAB units are primarily concentrated in the Midwest and Western United States. The MFM brand consists of units operating as "My Favorite Muffin," featuring a large variety of freshly baked muffins, coffees and related products, and units operating as "My Favorite Muffin and Bagel Cafe," featuring these products as well as a variety of specialty bagel sandwiches and related products. MFM units are primarily in the Middle Atlantic States. Although the Company doesn't actively market Brewster's stand-alone franchises, Brewster's coffee products are sold in the Company-owned store, and most franchised units. The Company has grown significantly since its initial public offering in November 1995 through growth in franchise units and the development of alternative distribution channels for its branded products. The Company is leveraging on the natural synergy of distributing muffin products in existing BAB units and, alternatively, bagel products and Brewster's Coffee in existing MFM units. The Company expects to continue to realize efficiencies in servicing the combined base of BAB and MFM franchisees. Operating Income The Company reported net income of $717,000 for the year ended November 30, 2006, and net income of $693,000 for the year ended November 30, 2005. The Company believes that with its continued focus on franchising and licensing operations, it will continue to be profitable. The Company will also continue to review and institute cost controls where deemed necessary. Food Service Industry Food service businesses are often affected by changes in consumer tastes; national, regional, and local economic conditions; demographic trends; traffic patterns; and the type, number and location of competing restaurants. Multi-unit food service chains, such as the Company's, can also be substantially adversely affected by publicity resulting from problems with food quality, illness, injury or other health concerns or operating issues stemming from one store or a limited number of stores. The food service business is also subject to the risk that shortages or interruptions in supply caused by adverse weather or other conditions could negatively affect the availability, quality and cost of ingredients and other food products. In addition, factors such as inflation, increased food and labor costs, regional weather conditions, availability and cost of suitable sites and the availability of experienced management and hourly employees may also adversely affect the food service industry in general and the Company's results of operations and financial condition in particular. -3- CUSTOMERS The Company-owned store sells to the general public; therefore the Company is not dependent on a particular customer or small group of customers. Regarding the Company's franchising operation, the franchisees represent a varied geographic and demographic group. Among some of the primary services the Company provides to its franchisees are marketing assistance, training, time-tested, successful recipes, bulk purchasing discounts, food service knowledgeable personnel and brand recognition. SUPPLIERS The Company's major suppliers are Coffee Bean International, Dawn Food Products, Inc., Schreiber Foods, Hawkeye Foodservice, and Coca-Cola. The Company is not dependent on any of these suppliers for future growth and profitability since the products purchased from these suppliers are readily available from other sources. LOCATIONS The Company has 136 franchised locations, 3 licensees and 1 Company-owned store. Of the 136 locations, 134 are located in 26 states and 2 International units are located in the United Arab Emirates. STORE OPERATIONS BIG APPLE BAGELS--BAB franchised and Company-owned stores daily bake a variety of fresh bagels and offer up to 11 varieties of cream cheese spreads. Stores also offer a variety of breakfast and lunch bagel sandwiches, salads, soups, various dessert items, fruit smoothies, gourmet coffees and other beverages. A typical BAB store is in an area with a mix of both residential and commercial properties and ranges from 1,500 to 2,000 square feet. The Company's current store design is approximately 2,000 square feet, with seating capacity for 30 to 40 persons, and includes 750 square feet devoted to production and baking. A satellite store is typically smaller than a production store, averaging 600 to 1,000 square feet. Although franchise stores may vary in size from Company-owned store, and from other franchise stores, store layout is generally consistent. MY FAVORITE MUFFIN--MFM franchised stores bake 20 to 25 varieties of muffins daily, from over 250 recipes, plus a variety of bagels. They also serve gourmet coffees, beverages and, at My Favorite Muffin and Bagel Cafe locations, a variety of bagel sandwiches and related products. While some MFM units are located in shopping mall locations with minimal square footage of 400 to 800 square feet, the typical retail center prototype unit is approximately 2,000 square feet with seating for 30 to 40 persons. A typical MFM franchise store is located within a three-mile radius of at least 25,000 residents in an area with a mix of both residential and commercial properties. BREWSTER'S COFFEE--Although the Company doesn't have, or actively market Brewster's stand-alone franchises, Brewster's coffee products are sold in all Company-owned and most of the franchised units. FRANCHISING The Company requires payment of an initial franchise fee per store, plus an ongoing 5% royalty on net sales. Additionally, BAB and MFM franchisees are members of a marketing fund requiring an ongoing 1% contribution based on net sales. The Company currently requires a franchise fee of $25,000 on a franchisee's first BAB or MFM store. The fee for subsequent production stores is $20,000 and $15,000 for a satellite location and $10,000 for a kiosk. The Company's current Uniform Franchise Offering Circular provides for, among other things, the opportunity for prospective franchisees to enter into a preliminary agreement for their first production store. This agreement enables a prospective franchisee a period of 60 days in which to locate a site. The fee for this preliminary agreement is $10,000. If a site is not located and approved by the franchiser within the 60 days, the prospective franchisee will receive a refund of $7,000. If a site is approved, the entire $10,000 will be applied toward the initial franchise fee. See also last paragraph under "Government Regulation" section in this 10-KSB. -4- The Company's franchise agreements provide a franchisee with the right to develop one store at a specific location. Each franchise agreement is for a term of 10 years with the right to renew. Franchisees are expected to be in operation no later than 10 months following the signing of the franchise agreement. The Company currently advertises its franchising opportunities at franchise trade shows and in directories, newspapers, the internet and business opportunity magazines worldwide. In addition, prospective franchisees contact the Company as a result of patronizing an existing store. COMPETITION The quick service restaurant industry is intensely competitive with respect to product quality, concept, location, service and price. There are a number of national, regional and local chains operating both owned and franchised stores which may compete with the Company on a national level or solely in a specific market or region. The Company believes that because the industry is extremely fragmented, there is a significant opportunity for expansion in the bagel, muffin and coffee concept chains. The Company believes the primary direct competitors of its bagel concept units are Bruegger's Bagel Bakery and New World Coffee-Manhattan Bagel Inc. which operates under Einstein Bros. Bagels, Noah's NY Bagel, Manhattan Bagel Bakery and Chesapeake Bagel Bakery brands. There are several other regional bagel chains with fewer than 50 stores, all of which may be expected to compete with the Company. There is not a major national competitor in the muffin business, but there are a number of local and regional operators. Additionally, the Company competes directly with a number of national, regional and local coffee concept stores and brand names. The Company competes against numerous small, independently owned bagel bakeries, and national fast food restaurants, such as Dunkin' Donuts, McDonald's, Panera, and Starbucks, that offer bagels, muffins, coffee and related products as part of their product offerings. In the supermarket bakery sections, the Company's bagels compete against Thomas' Bagels and other brands of fresh and frozen bagels. Certain of these competitors may have greater product and name recognition and larger financial, marketing and distribution capabilities than the Company. In addition, the Company believes the startup costs associated with opening a retail food establishment offering similar products on a stand-alone basis are competitive with the startup costs associated with opening its concept stores and, accordingly, such startup costs are not an impediment to entry into the retail bagel, muffin or coffee businesses. The Company believes that its stores compete favorably in terms of food quality and taste, convenience, customer service and value, which the Company believes are important factors to its targeted customers. Competition in the food service industry is often affected by changes in consumer taste, national, regional and local economic and real estate conditions, demographic trends, traffic patterns, the cost and availability of labor, consumer purchasing power, availability of product and local competitive factors. The Company attempts to manage or adapt to these factors, but not all such factors are within the Company's control and such factors could cause the Company and some, or all, of its franchisees to be adversely affected. The Company competes for qualified franchisees with a wide variety of investment opportunities in the restaurant business, as well as other industries. Investment opportunities in the bagel bakery cafe business include franchises offered by New World Coffee-Manhattan Bagel Inc. The Company's continued success is dependent to a substantial extent on its reputation for providing high quality and value with respect to its service, products and franchises. This reputation may be affected not only by the performance of the Company-owned store but also by the performance of its franchise stores, over which the Company has limited control. -5- TRADEMARKS AND SERVICE MARKS The trademarks, tradenames and service marks used by the Company contain common descriptive English words and thus may be subject to challenge by users of these words, alone or in combination with other words, to describe other services or products. Some persons or entities may have prior rights to these names or marks in their respective localities. Accordingly, there is no assurance that such marks are available in all locations. Any challenge, if successful, in whole or in part, could restrict the Company's use of the marks in areas in which the challenger is found to have used the name prior to the Company's use. Any such restriction could limit the expansion of the Company's use of the marks into that region, and the Company and its franchisees may be materially and adversely affected. The trademarks and service marks "Big Apple Bagels," "Brewster's Coffee" and "My Favorite Muffin" are registered under applicable federal trademark law. These marks are licensed by the Company to its franchisees pursuant to franchise agreements. In February 1999 the Company acquired the trademark of "Jacobs Bros. Bagels" upon purchasing certain assets of Jacobs Bros. The "Jacobs Bros. Bagels" mark is also registered under applicable federal trademark law. The Company is aware of the use by other persons and entities in certain geographic areas of names and marks which are the same as or similar to the Company's marks. Some of these persons or entities may have prior rights to those names or marks in their respective localities. Therefore, there is no assurance that the marks are available in all locations. It is the Company's policy to pursue registration of its marks whenever possible and to vigorously oppose any infringement of its marks. GOVERNMENT REGULATION The Company is subject to the Trade Regulation Rule of the Federal Trade Commission (the "FTC") entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures" (the "FTC Franchise Rule") and state and local laws and regulations that govern the offer, sale and termination of franchises and the refusal to renew franchises. Continued compliance with this broad federal, state and local regulatory network is essential and costly; the failure to comply with such regulations may have a material adverse effect on the Company and its franchisees. Violations of franchising laws and/or state laws and regulations regulating substantive aspects of doing business in a particular state could limit the Company's ability to sell franchises or subject the Company and its affiliates to rescission offers, monetary damages, penalties, imprisonment and/or injunctive proceedings. In addition, under court decisions in certain states, absolute vicarious liability may be imposed upon franchisers based upon claims made against franchisees. Even if the Company is able to obtain insurance coverage for such claims, there can be no assurance that such insurance will be sufficient to cover potential claims against the Company. The Company and its franchisees are required to comply with federal, state and local government regulations applicable to consumer food service businesses, including those relating to the preparation and sale of food, minimum wage requirements, overtime, working and safety conditions, citizenship requirements, as well as regulations relating to zoning, construction, health and business licensing. Each store is subject to regulation by federal agencies and to licensing and regulation by state and local health, sanitation, safety, fire and other departments. Difficulties or failures in obtaining the required licenses or approvals could delay or prevent the opening of a new Company-owned or franchise store, and failure to remain in compliance with applicable regulations could cause the temporary or permanent closing of an existing store. The Company believes that it is in material compliance with these provisions. Continued compliance with these federal, state and local laws and regulations is costly but essential, and failure to comply may have an adverse effect on the Company and its franchisees. -6- The Company's franchising operations are subject to regulation by the FTC under the Uniform Franchise Act which requires, among other things, that the Company prepare and periodically update a comprehensive disclosure document known as a Uniform Franchise Offering Circular ("UFOC") in connection with the sale and operation of its franchises. In addition, some states require a franchiser to register its franchise with the state before it may offer a franchise to a prospective franchisee. The Company believes its UFOC, together with any applicable state versions or supplements, comply with both the FTC guidelines and all applicable state laws regulating franchising in those states in which it has offered franchises. The Company is also subject to a number of state laws, as well as foreign laws (to the extent it offers franchises outside of the United States), that regulate substantive aspects of the franchiser-franchisee relationship, including, but not limited to, those concerning termination and non-renewal of a franchise. EMPLOYEES As of November 30, 2006, the Company employed 33 persons, consisting of 14 working in the Company-owned store, of which 10 are part-time employees. The remaining employees are responsible for Corporate management and oversight, advertising and franchising. None of the Company's employees are subject to any collective bargaining agreements and management considers its relations with its employees to be good. ITEM 2. DESCRIPTION OF PROPERTY The Company's principal executive office, consisting of approximately 7,150 square feet, is located in Deerfield, Illinois and is leased pursuant to a lease expiring January 31, 2011. Additionally, the Company leases space for its Company-owned store. The lease term for the store is for an initial term of five years and contains an option for renewal for two five-year terms. (See Note 7 in the audited consolidated financial statements included herein.) ITEM 3. LEGAL PROCEEDINGS None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None -7- PART II ITEM 5. MARKET FOR THE COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The following table sets forth the quarterly high and low sale prices for the Company's Common Stock, as reported in the Nasdaq Small Cap Market for the two years ended November 30, 2006. The Company's Common Stock is traded on the NASDAQ OTC-Bulletin Board under the symbol "BABB."
Year Ended: November 30, 2005 Low High ------------------------------------------------------------------------------------------------------- First quarter 0.75 1.00 Second quarter 0.78 0.97 Third quarter 0.85 1.30 Fourth quarter 0.90 1.45 Year Ended: November 30, 2006 Low High ------------------------------------------------------------------------------------------------------- First quarter 0.90 1.22 Second quarter 0.73 1.01 Third quarter 0.85 1.01 Fourth quarter 0.95 1.07
As of February 16, 2007, the Company's Common Stock was held by 185 holders of record. Registered ownership includes nominees who may hold securities on behalf of multiple beneficial owners. The Company estimates that the number of beneficial owners of its common stock at February 16, 2007, is approximately 1,400 based upon information provided by a proxy services firm. STOCK OPTIONS In May 2001, the Company's Board of Directors approved a Long-Term Incentive and Stock Option Plan ( Plan), with an amendment in May 2003 to increase the Plan from the reserve of 1,100,000 shares to 1,400,000 shares of common stock for grant. A total of 1,400,000 stock options have been granted since plan inception. In 2006, 2005, 2004 and 2003, 290,000, 95,000, 115,000, and 300,000 stock options, respectively, were granted to directors, officers and employees. As of November 30, 2006, 1,400,000 stock options were granted to directors, officers and employees, leaving zero options available for grant. As of February 16, 2007, there were 1,007,218 stock options exercised or forfeited under the stock option plan. (See Note 6 of the audited consolidated financial statements included herein.) -8- DIVIDEND POLICY The Board of Directors of the Company declared quarterly cash dividends of $.02 per share on March 13, 2006, May 25, 2006, September 6, 2006, and November 16, 2006. A $.02 per share special dividend was also declared on November 16, 2006. These dividends were payable on April 13, 2006, July 5, 2006, October 9, 2006, and January 11, 2007, respectively, in the amounts of $144,445, $144,459, $144,459, and $290,524. (See Note 5 of the audited consolidated financial statements included herein.) The Board of Directors of the Company declared semi-annual cash dividends of $0.02 per share on May 12, 2005, payable June 21, 2005 to common stockholders of record as of May 31, 2005. On October 7, 2005, the Board of Directors of the Company declared a $0.02 semi-annual dividend and a special dividend of $0.06 per share, payable January 3, 2006 to common stockholders of record as of December 7, 2005. This transaction was recorded as a dividend payable of $577,781 as of November 30, 2005. Although there can be no assurances that the Company will be able to pay dividends in the future, it is the Company's intent that future dividends will be considered after reviewing returns to shareholders, profitability expectations and financing needs and will be declared at the discretion of the Board of Directors. It is the Company's intent going forward to declare and pay cash dividends on a quarterly basis. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The selected financial data contained herein has been derived from the consolidated financial statements of the Company included elsewhere in this Report on Form 10-KSB. The data should be read in conjunction with the consolidated financial statements and notes thereto. Certain statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations, including statements regarding the development of the Company's business, the markets for the Company's products, anticipated capital expenditures, and the effects of completed and proposed acquisitions, and other statements and disclosures contained herein and throughout this Annual Report regarding matters that are not historical facts, are forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995). In such cases, we may use words such as "believe," "intend," "expect," "anticipate" and the like. Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Certain risks and uncertainties are wholly or partially outside the control of the Company and its management, including its ability to attract new franchisees; the continued success of current franchisees; the effects of competition on franchisee and Company-owned store results; consumer acceptance of the Company's products in new and existing markets; fluctuation in development and operating costs; brand awareness; availability and terms of capital; adverse publicity; acceptance of new product offerings; availability of locations and terms of sites for store development; food, labor and employee benefit costs; changes in government regulation (including increases in the minimum wage); regional economic and weather conditions; the hiring, training, and retention of skilled corporate and restaurant management; and the integration and assimilation of acquired concepts; Accordingly, readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis only as of the date hereof. The Company undertakes no obligation to publicly release the results of any revision to these forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. -9- GENERAL The Company has 136 franchised, 3 licensed units, and 1 Company-owned store as of the end of 2006. Units in operation at the end of 2005 included 145 franchised, 3 licensed, and 2 Company-owned stores. System-wide revenues in 2006 were $ 47 million compared to $48 million in 2005. The Company's revenues are derived primarily from the ongoing royalties paid to the Company by its franchisees, from the operation of the Company-owned store and receipt of initial franchise fees. Additionally, the Company derives revenue from the sale of licensed products (My Favorite Muffin mix, Big Apple Bagels cream cheese and Brewster's coffee), and through licensing agreements (Kohr Bros. and Mrs. Fields). During 2006, even though revenue declined due to fewer Company-owned stores and slightly lower franchising revenues, the Company continued to control costs. Total operating expenses decreased to $3,228,000, or 82.4% of total revenue in 2006 compared to $4,398,000, or 85.8% in 2005. YEAR 2006 COMPARED TO YEAR 2005 Total revenues from all sources decreased $1,208,000, or 23.6%, to $3,917,000 in 2006 from $5,125,000 in the prior year primarily due to fewer Company-owned store locations in 2006 versus 2005. Net sales at Company-owned stores decreased $939,000, or 65.2% to $501,000 in 2006, versus $1,440,000 in 2005 because the Company had one Company-owned store in 2006, versus three in 2005. Royalty revenue from franchise stores was down $2,000, or .1%, to $2,275,000 in 2006 as compared to $2,277,000 in 2005. Franchise fee revenue increased $55,000, or 25.2%, to $272,000, in 2006 versus $218,000 in 2005. The Company opened 8 stores in 2006 versus 5 in 2005. At November 30, 2006, the Company had 8 units under development, the same as November 30, 2005. More new franchises are opening in developing centers which leads to longer timeframes between execution of franchise agreements and occupancy. Licensing fees and other income decreased $321,000, or 27.0%, to $869,000 in 2006 as compared to $1,190,000 in 2005. A trademark infringement lawsuit against a former franchisee resulted in $90,000 of income in 2005. Sign Shop revenue was $130,000 higher in 2005 as a result of 2004 post convention sales. The Company received $34,000 for the sale of assets from a franchise location temporarily managed by the Company-owned store division in 2005, and the Company had $29,000 more sublease rental income in 2005. Total operating expenses of $3,227,890, were 82.4% of total revenues for 2006 versus $4,398,112, or 85.8%, for 2005. Expenses declined because there was only one Company-owned store operating for a majority of 2006, versus three stores in 2005, and because of continued tight cost controls. Corporate office payroll and payroll related expenses increased $49,000, or 3.4%, to $1,481,000, from $1,432,000, in 2005. Occupancy expense increased $12,000, or 9.7% in 2006, to $137,000, from $125,000 in 2005. Professional fees decreased $21,000, or 10.1%, to $187,000 in 2006, from $208,000 in 2005, and Other expenses decreased $135,000, or 22.3%, to $472,000 in 2006 from $607,000 in 2005. There was a reduction in depreciation and amortization expense of $15,000, or 17.7% in 2006, to $70,000, from $85,000, in 2005. Provision for uncollectible accounts decreased $44,000, to ($8,000), in 2006 compared to $36,000, in 2005. Income from operations for the period ended November 30, 2006 was $690,000 as compared to $727,000 in 2005. Interest income increased $47,000, to $57,000, in 2006, compared to $10,000, in 2005, as a result of the Company investing excess cash in higher yielding investments. Interest expense decreased $14,000 to $30,000 in 2006, compared to $44,000 in 2005, primarily due to a decrease in outstanding debt. Net income totaled $717,000, or 18.3% of revenue in 2006 as compared to $693,000, or 13.5% of revenue in the prior year. -10- LIQUIDITY AND CAPITAL RESOURCES The net cash provided from operating activities totaled $868,000 during 2006. Cash provided from operating activities principally represents net income of $717,000, plus depreciation and amortization of $70,000, plus the loss on the sale of equipment of $18,000, less the change in the provision for doubtful accounts of ($8,000), plus a reduction in trade accounts receivable of $12,000, less an increase in restricted cash of $30,000, plus a decrease in Marketing Fund contributions receivable of $900, plus a decrease in inventory of $19,000, plus a decrease in notes receivable of $69,000, plus a decrease in prepaid expenses of $35,000, less a decrease in accounts payable of $37,000, a decrease in accrued liabilities of $62,000, plus an increase in unexpended Marketing Fund contributions of $28,000, and less a decrease in deferred revenue of $36,000. Cash provided from operating activities in 2005 totaled $974,000. This cash principally represented net income of $693,000, plus depreciation and amortization of $85,000, plus the increase in provision for doubtful accounts of $36,000, plus a reduction in trade accounts receivable of $94,000, plus a reduction in restricted cash of $118,000, plus a reduction in Marketing Fund contributions receivable of $34,000, plus a reduction in notes receivable of $31,000, plus an increase in deferred revenue of $191,000, offset by a decrease in accrued liabilities of $93,000, a decrease in Marketing Fund obligations of $151,000, an increase in prepaid and other assets of $22,000, an increase in inventories of $1,000, and a decrease in accounts payable of $39,000. Cash used for investing activities during 2006 totaled $10,000, consisting of the purchase of equipment of $14,000, offset by proceeds from the sale of equipment of $4,000. Cash used for investing activities during 2005 totaled $16,000, for the purchase of property and equipment. Financing activities used $1,272,000 during 2006, due to the repayment of notes payable of $267,000 and the payment of dividends equal to $1,011,000, offset by proceeds of $6,000 from the exercise of options. Financing activities used $946,000 during 2005, due to the repayment of notes payable of $253,000 and the payment of dividends of $717,000, offset by proceeds of $24,000 from the exercise of stock options. It is the Company's intent that future dividends will be considered after reviewing returns to shareholders, profitability expectations and financing needs and will be declared at the discretion of the Board of Directors. It is the Company's intent going forward to declare and pay dividends on a quarterly basis. The Company believes execution of this policy will not have any material adverse effects on its cash or its ability to fund current operations or future capital investments. The Company has no financial covenants on any of its outstanding debt. OFF BALANCE SHEET ARRANGEMENTS The Company has no off balance sheet arrangements, other than the lease commitments disclosed in Note 7 of the audited consolidated financial statements included herein. -11- CRITICAL ACCOUNTING POLICIES The Company's significant accounting policies are presented in the Notes to the Consolidated Financial Statements (see Note 2 of the audited consolidated financial statements included herein). While all of the significant accounting policies impact the Company's Consolidated Financial Statements, some of the policies may be viewed to be more critical. The more critical policies are those that are most important to the portrayal of the Company's financial condition and results of operations and that require management's most difficult, subjective and/or complex judgments and estimates. Management bases its judgments and estimates on historical experience and various other factors that are believed to be reasonable under the circumstances. The results of judgments and estimates form the basis for making judgments about the Company's value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. Management believes the following are its' most critical accounting policies because they require more significant judgments and estimates in preparation of its' consolidated financial statements. Revenue Recognition Systems royalty fees from franchised stores represent a fee of 5% of net retail sales of franchised units. Royalty revenues are recognized on the accrual basis using estimates based on past history and seasonality. The Company recognizes franchise fee revenue upon the opening of a franchise store. Direct costs associated with the franchise sales are deferred until the franchise fee revenue is recognized. These costs include site approval, construction approval, commissions, blueprints and training costs. The Company earns a licensing fee from the sale of par-baked bagels from a third-party commercial bakery and from the sale of coffee from a coffee bean roaster for the sale of BAB branded product to the franchised and licensed units. Long-Lived Assets Property and equipment are recorded at cost. Improvements and replacements are capitalized, while expenditures for maintenance and routine repairs that don't extend the life of the asset are charged to expense as incurred. Depreciation is calculated on the straight-line basis over the estimated useful lives of the assets. Property, equipment and leasehold improvements are stated at cost, less accumulated depreciation. Estimated useful lives for the purpose of depreciation and amortization are 3 to 7 years for property and equipment and 10 years, or the term of the lease if less, for leasehold improvements. The Company's intangible assets consist primarily of trademarks and goodwill. Beginning in 2003, SFAS 142, "Goodwill and Other Intangible Assets" was adopted by the Company. This requires that assets with indefinite lives no longer be amortized, but instead be subject to annual impairment tests. The Company no longer amortizes goodwill or trademarks. (See Note 2 of the audited consolidated financial statements included herein.) Concentrations of Credit Risk Certain financial instruments potentially subject the Company to concentrations of credit risk. These financial instruments consist primarily of royalty and wholesale accounts receivables. Amounts due from franchisees represented approximately 60% and 55% of the receivable balance at November 30, 2006 and 2005, respectively. The Company believes it has maintained adequate reserves for doubtful accounts. The Company reviews the collectibility of receivables periodically, taking into account payment history and industry conditions. Valuation Allowance and Deferred Taxes A valuation allowance is the portion of a deferred tax asset for which it is more likely than not that a tax benefit will not be realized. -12- As of November 30, 2006, the Company has cumulative net operating loss carryforwards expiring between 2017 and 2021 for U.S. federal income tax purposes of approximately $6,578,000. The net operating loss carryforwards are subject to limitation in any given year as a result of the Company's initial public offering and may be further limited if certain other events occur. A valuation allowance has been established for $2,032,000 at November 30, 2006 for the deferred tax benefit related to those loss carryforwards and other deferred tax assets for which it is considered more likely than not that the benefit will not be realized. (See Note 3 of the audited consolidated financial statements included herein.) In prior years, the Company established a full valuation allowance because it believed there was uncertainty as to realization of the net operating loss carryforward deferred tax asset based on historical operating results. The full valuation allowance still exists at the end of 2006 because the Company believes it is appropriate. Recent Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment." SFAS No. 123(R) establishes accounting standards for transactions in which a company exchanges its equity instruments for goods or services. In particular, this Statement will require companies to record compensation expense for all share-based payments, such as employee stock options, at fair market value. This Statement is effective as of the beginning of the first annual reporting period that begins after December 15, 2005 (the Company's period beginning December 1, 2006). Adoption of SFAS No. 123(R) is not expected to have a material impact on the Company's consolidated financial position, results of operations or cash flows. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections, - a replacement of APB Opinion No. 20 and FASB Statement No. 3." This Statement replaces APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements," and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and correction of errors made in fiscal years beginning after the date this Statement is issued. Adoption of SFAS No. 154 is not expected to have a material impact on the Company's consolidated financial position, results of operations or cash flows. In July 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN No. 48 clarifies the accounting and reporting for uncertainties in income tax law. FIN No. 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation, and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined the impact, if any, that may result from the adoption of FIN No. 48. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. Where applicable, SFAS No. 157 simplifies and codifies related guidance within GAAP and does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier adoption is encouraged. The adoption of SFAS No. 157 is not expected to have a material impact on the Company's financial position or results of operations. ITEM 7. FINANCIAL STATEMENTS The Consolidated Financial Statements and Report of Independent Registered Public Accounting Firm is included immediately following. -13- BAB, Inc. Years Ended November 30, 2006 and November 30, 2005 C o n t e n t s Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements -14- Report of Independent Registered Public Accounting Firm Stockholders and Board of Directors of BAB, Inc. We have audited the accompanying consolidated balance sheet of BAB, Inc. as of November 30, 2006 and the related consolidated statements of income, stockholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BAB, Inc. as of November 30, 2006, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. As disclosed in Note 2 to the consolidated financial statements, the Company adopted the provisions of Securities and Exchange Commission Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements", on November 30, 2006. By: /s/ McGladrey and Pullen, LLP Chicago, Illinois February 27, 2007 -15- Report of Independent Registered Public Accounting Firm Stockholders and Board of Directors of BAB, Inc. We have audited the accompanying consolidated balance sheet of BAB, Inc. as of November 30, 2005, and the related consolidated statements of income, stockholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BAB, Inc. as of November 30, 2005, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. By: /s/ ALTSCHULER, MELVOIN AND GLASSER LLP Chicago, Illinois January 20, 2006 -16- BAB, Inc Consolidated Balance Sheets November 30 2006 and 2005
2006 2005 ------------ ------------ ASSETS Current Assets Cash $1,792,666 $2,206,524 Restricted cash 234,114 204,055 Receivables Trade accounts receivable (net of allowance for doubtful accounts of $32,352 in 2006 and $83,220 in 2005) 92,377 104,110 Marketing fund contributions receivable from franchisees and stores 29,478 30,389 Notes receivable (net of allowance for doubtful accounts of $10,690 in 2006 and $7,769 in 2005) 8,262 33,700 Inventories 46,048 65,255 Prepaid expenses and other current assets 100,439 135,488 ------------ ------------ Total Current Assets 2,303,384 2,779,521 ------------ ------------ Property, plant and equipment 100,761 169,081 Notes receivable (net of allowance for doubtful accounts of $5,906 in 2006) 5,282 40,849 Trademarks 763,667 763,666 Goodwill 3,542,772 3,542,772 Other (net of accumulated amortization of $302,486 in 2006 and $293,329 in 2005) 2,896 12,053 ------------ ------------ Total Noncurrent Assets 4,415,378 4,528,421 ------------ ------------ Total Assets $6,718,762 $7,307,942 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Current portion of long-term debt $192,740 $266,824 Accounts payable 55,961 93,428 Accrued expenses and other current liabilities 445,506 507,279 Dividends payable 290,524 577,781 Unexpended marketing fund contributions 186,479 158,913 Deferred franchise fee revenue 210,000 210,000 Deferred licensing revenue 76,579 71,579 ------------ ------------ Total Current Liabilities 1,457,789 1,885,804 ------------ ------------ Long-term debt (net of current portion) 251,567 444,307 Deferred revenue (net of current portion) 45,818 86,980 ------------ ------------ Total Noncurrent Liabilities 297,385 531,287 ------------ ------------ Total Liabilities 1,755,174 2,417,091 ------------ ------------ Stockholders' Equity Common stock ($.001 par value; 15,000,000 shares authorized; 8,426,377 and 8,412,391 shares issued, and 7,222,932 and 7,208,946 shares outstanding as of November 30, 2006 and 2005, respectively) 13,508,216 13,508,202 Additional paid-in capital 876,999 870,935 Treasury stock (222,781) (222,781) Accumulated deficit (9,198,846) (9,265,505) ------------ ------------ Total Stockholders' Equity 4,963,588 4,890,851 ------------ ------------ Total Liabilities and Stockholders' Equity $6,718,762 $7,307,942 ============ ============ See accompanying notes
-17- BAB, Inc Consolidated Statements of Income November 30, 2006 and 2005
2006 2005 ---------------- ---------------- Revenues Net sales by Company-owned stores $ 500,689 $ 1,440,118 Royalty fees from franchised stores 2,275,483 2,277,099 Franchise fees 272,219 217,500 Licensing fees and other income 869,000 1,190,378 ---------------- ---------------- Total Revenues 3,917,391 5,125,095 ---------------- ---------------- Operating Expenses Food, beverage and paper costs 159,615 500,374 Store payroll and other operating expenses 472,029 1,148,849 Selling, general and administrative expenses: Payroll-related expenses 1,481,174 1,431,847 Occupancy 137,268 125,185 Advertising and promotion 110,055 149,648 Professional service fees 186,644 207,529 Travel expenses 139,337 142,657 Depreciation and amortization 69,653 84,664 Other 472,115 607,359 ---------------- ---------------- Total Operating Expenses 3,227,890 4,398,112 ---------------- ---------------- Income from operations 689,501 726,983 ---------------- ---------------- Interest income 56,790 9,881 Interest expense (29,684) (44,007) ---------------- ---------------- Income before provision for income taxes 716,607 692,857 ---------------- ---------------- Provision for income taxes Current - - Deferred - - ---------------- ---------------- ---------------- ---------------- Net Income $ 716,607 $ 692,857 ================ ================ Net Income per share - Basic $ 0.10 $ 0.10 ---------------- ---------------- Net Income per share - Diluted $ 0.10 $ 0.10 ---------------- ---------------- Weighted average number of shares outstanding - Basic 7,222,560 7,183,783 Weighted average number of shares outstanding - Diluted 7,259,149 7,240,721 See accompanying notes
-18- BAB, Inc Consolidated Statements of Stockholders' Equity November 30, 2006 and 2005
Additional Common Stock Paid-In Treasury Stock Accumulated Shares Amount Capital Shares Amount Deficit Total ------------------------ ---------- --------------------------- -------------- ---------------- November 30, 2004 $8,232,939 $13,508,023 $847,562 $(1,203,445) $ (222,781) $ (9,236,402) $ 4,896,402 Stock Options Exercised 179,452 179 23,373 23,552 Dividends Declared (721,960) (721,960) Net Income 692,857 692,857 November 30, 2005, ----------- ------------ ---------- ------------ -------------- -------------- ---------------- as previously reported 8,412,391 13,508,202 870,935 (1,203,445) (222,781) (9,265,505) 4,890,851 ----------- ------------ ---------- ------------ -------------- -------------- ---------------- Cumulative effect of adjustment to reflect adoption of SEC Staff Accounting Bulletin No. 108 (See Note 2) 73,938 73,938 ----------- ------------ ---------- ------------ -------------- -------------- ---------------- November 30, 2005, as restated 8,412,391 13,508,202 870,935 (1,203,445) (222,781) (9,191,567) 4,964,789 ----------- ------------ ---------- ------------ -------------- -------------- ---------------- Stock Options Exercised 13,986 14 6,064 6,078 Dividends Declared (723,886) (723,886) Net Income 716,607 716,607 ----------- ------------ ---------- ------------ -------------- -------------- ---------------- November 30, 2006 $8,426,377 $13,508,216 $876,999 $(1,203,445) $ (222,781) $ (9,198,846) $ 4,963,588 ----------- ------------ ---------- ------------ -------------- -------------- ----------------
See accompanying notes -19- BAB, Inc Consolidated Statements of Cash Flow November 30, 2006 and 2005
2006 2005 ---------------- ---------------- Operating activities Net income $ 716,607 $ 692,857 Depreciation and amortization 69,653 84,664 Loss on sale of equipment 17,651 - Provision for uncollectible accounts, net of recoveries (8,346) 36,000 Changes in: Trade accounts receivable 11,733 93,640 Restricted cash (30,059) 117,550 Marketing fund contributions receivable 911 34,017 Notes Receivable 69,352 30,597 Inventories 19,207 (1,148) Prepaid expenses and other 35,050 (22,233) Accounts payable (37,466) (39,102) Accrued liabilities 12,164 (92,991) Unexpended marketing fund contributions 27,566 (151,084) Deferred revenue (36,162) 191,059 ---------------- ---------------- Net Cash Provided by Operating Activities 867,861 973,826 ---------------- ---------------- Investing activities Purchase of equipment (14,327) (15,959) Proceeds from sale of equipment 4,500 - ---------------- ---------------- Net Cash Used In Investing Activities (9,827) (15,959) ---------------- ---------------- Financing activities Repayment of borrowings (266,825) (252,568) Proceeds from exercise of stock options 6,077 23,552 Payment of dividend (1,011,144) (717,161) ---------------- ---------------- Net Cash Used In Financing Activities (1,271,892) (946,177) ---------------- ---------------- Net Increase (Decrease) in Cash (413,858) 11,690 Cash, Beginning of Period 2,206,524 2,194,834 ---------------- ---------------- Cash, End of Period $ 1,792,666 $ 2,206,524 ================ ================ Supplemental disclosure of cash flow information: Interest paid $ 30,977 $ 45,232 ================ ================ Income taxes paid $ - $ - ================ ================
Supplemental disclosure of noncash investing and financing activities: On November 16, 2006, a quarterly $0.02 per share cash dividend and a $0.02 per share special dividend was declared, payable January 11, 2007, and recorded as a dividend payable in the amount of $290,524 at November 30, 2006. On October 7, 2005 a semi-annual $0.02 per share cash dividend and a special dividend of $0.06 per share was declared, payable January 3, 2006, and was recorded as a dividend payable in the amount of $577,781 at November 30, 2005. See accompanying notes -20- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 1 - Nature of Operations BAB, Inc. (the "Company") was incorporated under the laws of the State of Delaware on July 12, 2000. The Company currently operates, franchises and licenses bagel, muffin and coffee retail units under the Big Apple Bagels ("BAB"), My Favorite Muffin ("MFM") and Brewster's Coffee trade names. The Company additionally derives income from the sale of its trademark bagels, muffins and coffee through nontraditional channels of distribution, including under license agreements and through direct home delivery of specialty muffin baskets and coffee. The Company has four wholly owned subsidiaries: BAB Systems, Inc. (Systems); BAB Operations, Inc. (Operations); Brewster's Franchise Corporation (BFC); and My Favorite Muffin Too, Inc. Systems was incorporated on December 2, 1992, and was primarily established to franchise BAB specialty bagel retail stores. Operations was formed on August 30, 1995, primarily to operate Company-owned stores, including one which currently serves as the franchise training facility. BFC was established on February 15, 1996 to franchise "Brewster's Coffee" concept coffee stores. My Favorite Muffin Too, Inc., a New Jersey corporation, was acquired on May 13, 1997. My Favorite Muffin Too, Inc. franchises "MFM" concept muffin stores. The assets of Jacobs Bros. Bagels (Jacobs Bros.) were acquired on February 1, 1999. (See Note 6.) Note 2 - Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its direct and indirect wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition Systems royalty fees from franchised stores represent a fee of 5% of net sales of franchised units. Royalty revenues are recognized on the accrual basis using estimates based on past history and seasonality. The Company recognizes franchise fee revenue upon the opening of a franchise store. Direct costs associated with franchise sales are deferred until the franchise fee revenue is recognized. These costs include site approval, construction approval, commissions, blueprints and training costs. -21- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 2 - Summary of Significant Accounting Policies (Continued) The Company earns a licensing fee from the sale of par-baked bagels from a third-party commercial bakery and from the sale of coffee from a coffee bean roaster for the sale of BAB branded product to the franchised and licensed units noted in the table below. Stores which have been opened, and unopened stores for which a Franchise Agreement has been executed at November 30, 2006 and 2005 are as follows: 2006 2005 ------------- ------------- Stores opened Company-owned 1 2 Franchisee-owned 136 145 Licensed 3 3 ------------- ------------- 140 150 Unopened stores Franchise Agreement 8 8 ------------- ------------- 148 158 ------------- ------------- Segments In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard (SFAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information," which established annual reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. The Company's operations are within two reportable segments operating in the United States: Company Store Operations and Franchise Operations. Marketing Fund Systems established a Marketing Fund (Fund) during 1994. Franchisees and the Company-owned store are required to contribute to the Fund based on their retail sales. The Fund also earns revenues from commissions paid by certain vendors on the sale of BAB licensed products to franchisees. Cash Bank deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. Deposits may from time to time exceed federally insured limits. As of November 30, 2006 and 2005, the Fund cash balances, which are restricted, were $155,300 and $128,129 respectively. Also included in restricted cash at November 30, 2006 and 2005 is a $78,814 and $75,926 certificate of deposit, respectively, that serves as collateral for a Letter of Credit for the Corporate Office facility lease entered with IL-Corporate 500 Centre, L.L.C., as required by the lease. -22- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 2 - Summary of Significant Accounting Policies (Continued) Accounts Receivable Receivables are carried at original invoice amount less estimates made for doubtful accounts. Management determines the allowances for doubtful accounts by reviewing and identifying troubled accounts on a periodic basis and by using historical experience applied to an aging of accounts. A receivable is considered to be past due if any portion of the receivable balance is outstanding 90 days past the due date. Receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded as income when received. Certain receivables have been converted to unsecured interest bearing notes. Inventories Inventories are valued at the lower of cost or market under the first-in, first-out (FIFO) method. Property, Plant and Equipment Property and equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. Estimated useful lives are 3 to 7 years for property and equipment and 10 years, or term of lease, if less, for leasehold improvements. Maintenance and repairs are charged to expense as incurred. Expenditures that materially extend the useful lives of assets are capitalized. Goodwill and Other Intangible Assets The Company's intangible assets consist primarily of trademarks and goodwill. SFAS No. 142, "Goodwill and Other Intangible Assets" was adopted beginning with the quarter ended February 29, 2003. This requires that assets with indefinite lives no longer be amortized, but instead be subject to annual impairment tests using a discounted cash flow model to determine the assets fair value. The Company no longer amortizes goodwill or trademarks, but instead, the Company's intangible assets are tested annually for impairment. No impairment has been recorded for the years ended November 30, 2006 or 2005. The net book value of intangible assets with definite lives totaled $2,896 and $12,053 at November 30, 2006 and 2005, respectively. The gross value of definite lived intangible assets and their respective accumulated amortization are as follows:
Accumulated Amortization Definite Lived Intangible Assets Original Cost November 30, 2006 -------------------------------------------------------------------------------------- Master Lease Origination Fees $95,382 $92,486 --------------------------------------------------------------------------------------
Definitive lived intangible assets are being amortized over their useful lives. The Company recorded amortization expense for definitive lived intangible assets of $9,157 for both years ended November 30, 2006 and 2005. The amortization expense on these intangible assets will be $2,896 for the year ending November 30, 2007. -23- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 2 - Summary of Significant Accounting Policies (Continued) Advertising and Promotion Costs The Company expenses advertising and promotion costs as incurred. Advertising and promotion expense was $110,055 and $149,648 in 2006 and 2005, respectively. Included in advertising expense was $73,171 and $66,331 in 2006 and 2005, respectively, related to the Company's franchise operations. Income Taxes Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The benefits from net operating losses carried forward may be impaired or limited in certain circumstances. In addition, a valuation allowance can be provided for deferred tax assets when it is more likely than not that all or some portion of the deferred tax asset will not be realized. The Company has established a full valuation allowance on the net deferred tax assets due to the uncertainty of realization. (See Note 3.) Earnings Per Share The Company computes earnings per share ("EPS") under SFAS No. 128, "Earnings per Share." Basic net earnings are divided by the weighted average number of common shares outstanding during the year to calculate basic net earnings per common share. Diluted net earnings per common share are calculated to give effect to the potential dilution that could occur if warrants, options or other contracts to issue common stock were exercised and resulted in the issuance of additional common shares. 2006 2005 ----------- ----------- Numerator: Net income available to common shareholders $ 716,607 $ 692,857 Denominator: Weighted average outstanding shares Basic 7,222,560 7,183,783 ----------- ----------- Earnings per Share - Basic $ 0.10 $ 0.10 ----------- ----------- Effect of dilutive common stock 36,589 56,938 Weighted average outstanding shares Diluted 7,259,149 7,240,721 ----------- ----------- Earnings per share - Diluted $ 0.10 $ 0.10 ----------- ----------- There are 267,500 unexercised options at November 30, 2006 that are not included in the computation of dilutive EPS because their impact would be antidilutive based on current market prices. Stock Options The Company uses the intrinsic method, as allowed by SFAS No. 123, "Accounting for Stock-Based Compensation," to account for stock options granted to employees and directors. No compensation expense is recognized for stock options because the exercise price of the options is at least equal to the market price of the underlying stock on the grant date. -24- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 2 - Summary of Significant Accounting Policies (Continued) Stock Warrants Stock warrants granted as consideration in purchase acquisitions have been recorded as an addition to additional paid-in capital in the accompanying balance sheet based on the fair value of such stock warrants on the date of the acquisition. Fair Value of Financial Instruments The carrying amounts of financial instruments including cash, accounts receivable, notes receivable, accounts payable and short-term debt approximate their fair values because of the relatively short maturity of these instruments. The carrying value of long-term debt, including the current portion, approximate fair value based upon market prices for the same or similar instruments. Reclassification Certain items in prior year Notes to the Consolidated Financial Statements have been reclassified to conform to the presentation used in 2006. Adoption of SEC Staff Bulletin No. 108 During the year the Company adopted the SEC Staff issued Staff Accounting Bulletin (SAB) No. 108 Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. The adjustment to Stockholders' Equity, in the amount of $73,938, relates to the accrual for accounting fees and the period in which services for the respective fiscal period are performed, and there is no income statement effect because the related accrual was overstated by the same amount at the beginning and end of the year. -25- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 2 - Summary of Significant Accounting Policies (Continued) Recent Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment." SFAS No. 123(R) establishes accounting standards for transactions in which a company exchanges its equity instruments for goods or services. In particular, this Statement will require companies to record compensation expense for all share-based payments, such as employee stock options, at fair market value. This Statement is effective as of the beginning of the first annual reporting period that begins after December 15, 2005 (the Company's period beginning December 1, 2006). Adoption of SFAS No. 123(R) is not expected to have a material impact on the Company's consolidated financial position, results of operations or cash flows. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections, - a replacement of APB Opinion No. 20 and FASB Statement No. 3." This Statement replaces APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements," and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Adoption of SFAS No. 154 is not expected to have a material impact on the Company's consolidated financial position, results of operations or cash flows. In July 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN No. 48 clarifies the accounting and reporting for uncertainties in income tax law. FIN No. 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation, and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined the impact, if any, that may result from the adoption of FIN No. 48. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. Where applicable, SFAS No. 157 simplifies and codifies related guidance within GAAP and does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier adoption is encouraged. The adoption of SFAS No. 157 is not expected to have a material impact on the Company's financial position or results of operations. -26- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005
Note 3 - Income Taxes The components of the income tax (benefit) provision are as follows: 2006 2005 ---------------- ---------------- Federal income tax provision computed at federal statutory rate $ 243,646 $ 235,571 State income taxes net of federal tax provision 34,526 33,382 Other adjustments 6,544 98,469 Change in valuation allowance (151,566) (230,564) Utilization of net operating losses (133,150) (136,858) ---------------- ---------------- ---------------- ---------------- Provision for Deferred Income Taxes $ - $ - ================ ================ Deferred income tax assets (liabilities) are as follows: 2006 2005 ---------------- ---------------- Deferred revenue 129,030 143,068 Deferred rent revenue 15,811 15,318 Marketing Fund net contributions 60,285 49,737 Allowance for doubtful accounts 12,558 32,304 Allowance for doubtful accounts-notes receivable 6,442 3,016 Accrued expenses 12,577 3,882 Net operating loss carryforwards 2,553,375 2,686,525 Other - - Valuation allowance (2,031,875) (2,316,591) ---------------- ---------------- Total Deferred Income Tax Assets $ 758,205 $ 617,259 ---------------- ---------------- Depreciation and amortization (751,583) (611,126) Franchise Costs (6,622) (6,133) ---------------- ---------------- Total Deferred Income Tax Liabilities $ (758,205) $ (617,259) ---------------- ---------------- ---------------- ---------------- Total Net Deferred Tax Assets/Liabilities $ - $ - ================ ================
As of November 30, 2006, the Company has net operating loss carryforwards expiring between 2017 and 2021 for U.S. federal income tax purposes of approximately $6,578,000. The net operating loss carryforwards are subject to limitation in any given year as a result of the Company's initial public offering and may be further limited if certain other events occur. A valuation allowance has been established for $2,031,875 and $2,316,591 as of November 30, 2006 and 2005, respectively, for the deferred tax benefit related to those loss carryforwards and other deferred tax assets. -27- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 4 - Long-Term Obligations Long-term debt consisted of the following: 2006 2005 ----------- ----------- Bank note payable $ 170,735 $ 416,552 Note payable to former stockholder $ 273,572 $ 294,579 ----------- ----------- $ 444,307 $ 711,131 Less current portion ($192,740) ($266,824) ----------- ----------- Long-Term Debt, Net of Current Portion $ 251,567 $ 444,307 ----------- ----------- On June 25, 2004, the Company entered into a Business Loan and Security Agreement ("Bank Agreement") with Associated Bank which provided for a term loan in the original amount of $723,700. The term loan under the Bank Agreement is secured by substantially all of the assets of the Company and is to be repaid in monthly installments of $21,900, including interest at a rate of 5.5 % per annum, with a final payment due July 1, 2007. The balance of this note payable was $170,735 and $416,552 as of November 30, 2006 and 2005, respectively. On September 6, 2002, the Company signed a note payable requiring annual installments of $35,000, including interest at a rate of 4.75% per annum, for a term of 15 years, in the original amount of $385,531. The Company purchased and retired 1,380,040 shares of BAB common stock from a former stockholder. The balance of this note payable was $273,572 and $294,579 as of November 30, 2006 and 2005, respectively. As of November 30, 2006, annual maturities on long-term obligations due are as follows: Year Ending November 30: ---------------------------- -------------- 2007 $192,740 2008 $23,051 2009 $24,146 2010 $25,292 2011 $26,494 Thereafter $152,585 ---------------------------- ---------- Total $444,308 -28- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 5 - Stockholders' Equity On March 13, 2006, May 25, 2006, and September 6, 2006, a $.02 per share dividend was declared, and was paid on April 13, 2006, July 5, 2006, and October 9, 2006, respectively. On November 16, 2006, a $.02 quarterly dividend and a $.02 special dividend was declared, payable January 11, 2007. A dividend payable, in the amount of $290,524, was recorded at November 30, 2006. On May 12, 2005, a $0.02 per share dividend was declared and was paid on June 21, 2005. On October 7, 2005, an $0.08 cash dividend was declared consisting of a $0.02 semi-annual and a $0.06 special dividend payable January 3, 2006. This transaction was recorded as a dividend payable in the amount of $577,781 at November 30, 2005. Note 6 - Stock Options and Warrants In May 2001, the Company approved a Long-Term Incentive and Stock Option Plan (Plan). The Plan reserves 1,400,000 shares of common stock for grant. The Plan will terminate on May 25, 2011. The Plan permits granting of awards to employees and non-employee Directors and agents of the Company in the form of stock appreciation rights, stock awards and stock options. The Plan is currently administered by a Committee of the Board of Directors appointed by the Board. The Plan gives broad powers to the Board or Committee to administer and interpret the Plan, including the authority to select the individuals to be granted options and rights, and to prescribe the particular form and conditions of each option or right granted. Under the Plan, the exercise price of each option equals the market price of the Company's stock on the date of grant. The options granted vary in vesting from immediate to a vesting period over five years. The options granted are exercisable within a 10 year period from the date of grant. All stock issued from the granted options must be held for one year from date of exercise. Options issued and outstanding expire on various dates through November 28, 2016. Range of exercise prices of options granted as of November 30, 2006 are $0.065 to $1.27. Activity under the Plan during the two years ended November 30, is as follows:
2006 2005 ------------------------------------------------------------------------ Options Weighted average Options Weighted average exercise price exercise price -------------------------------------- ---------- -------------------- ---------- -------------------- Options outstanding at beginning of year 163,034 $0.722 258,486 $0.246 Granted 290,000 $1.221 95,000 $0.914 Forfeited (6,099) $0.833 (11,000) $0.727 Exercised (13,986) $0.434 (179,452) $0.132 -------------------------------------- ---------- -------------------- ---------- -------------------- Outstanding at end of year 432,949 $1.064 163,034 $0.722
-29- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 6 - Stock Options and Warrants (Continued)
Options Outstanding Options Exercisable -------------------------------------------------------------------------------------------------------------- Weighted average Range of Options remaining Weighted average Options Weighted average exercise price outstanding contractual life exercise price exercisable exercise price ---------------- -------------- -------------------- -------------------- -------------- -------------------- $0.46 - $0.51 50,049 7.0 $0.500 28,634 $0.507 $0.60 10,000 7.6 $0.600 10,000 $0.600 $0.88 - $0.97 65,400 8.0 $0.935 21,800 $0.935 $0.86 20,000 8.5 $0.860 20,000 $0.860 $1.15 - $1.27 72,500 9.0 $1.216 -- -- $0.97 20,000 10.0 $0.970 20,000 $0.970 $1.25 100,000 10.0 $1.250 -- -- $1.25 95,000 10.0 $1.250 -- -- -------------- -------------------- -------------- -------------------- 432,949 $1.064 100,434 $0.772
The Company has adopted the disclosure-only provisions of SFAS No. 123, "Accounting and Disclosure of Stock-Based Compensation." Accordingly, no employee compensation expense has been recognized for the Plan in the financial statements. Had employee compensation expense for the Company's Plan been recorded in the financial statements, consistent with provisions of SFAS No. 123, net earnings would have been reduced by $43,460 in fiscal 2006 and $31,710 in fiscal 2005 based on the Black-Scholes option-pricing model. The Company's net income and net income per share for 2006 and 2005 would have been as follows: 2006 2005 ----------- ----------- Pro forma impact of fair value method Reported net income $ 716,607 $ 692,857 Less: Fair value impact of employee stock compensation (43,460) (31,710) ----------- ----------- Pro forma net income $ 673,147 $ 661,147 ----------- ----------- Earnings per common share Basic - as reported $ 0.10 $ 0.10 Diluted - as reported $ 0.10 $ 0.10 Basic - pro forma $ 0.09 $ 0.09 Diluted - pro forma $ 0.09 $ 0.09 Weighted average Black Scholes fair value assumptions Risk free interest rate 4.67% 4.00% Expected life 10.0 yrs 5.3 yrs Expected volatility 0.527 2.548 Expected dividend yield 6.4% 5.5% Fair Value of grants $ 0.29 $ 0.60 On February 1, 1999, the Company purchased certain assets of a related group of entities doing business as Jacobs Bros. Bagels, a chain operating retail bagel stores in the Chicago, Illinois area. The assets acquired included 8 retail locations and a central commissary facility paid for with $950,000 in cash and issuance of warrants to acquire 333,332 shares of the Company's common stock. The warrants provide for the purchase of 183,332 and 150,000 shares of common stock at an exercise price of $1.88 and $2.25 per share, respectively. The warrants were first exercisable on February 1, 2000 and expired on January 31, 2006. None of the warrants were exercised. -30- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 Note 7 - Commitments The Company rents its Corporate Office and the Company-owned store under leases which require it to pay real estate taxes, insurance and general repairs and maintenance. Rent expense for the years ended November 30, 2006 and November 30, 2005 was $122,128 and $212,739, net of sublease income of $123,950 and $140,108, respectively. Monthly rent is recorded on a straight-line basis over the term of the lease with a deferred rent liability being recognized. As of November 30, 2006, future minimum annual rental commitments under leases, net of sublease income of $126,423 in 2007, $128,648 in 2008, $130,913 in 2009 and $10,941 in 2010 are as follows: Year Ending November30: ------------------------------------- 2007 $120,672 2008 $125,858 2009 $137,394 2010 $149,911 Thereafter $67,818 ------------------------------------- Total $601,653 Note 8 - Related Party Transactions Michael K. Murtaugh, the Company's Vice President and General Counsel, was the sole stockholder of Bagel One, Inc., which owned and operated a Big Apple Bagels franchise store in Illinois. A note receivable owed by Bagel One, Inc. to Systems, guaranteed by Mr. Murtaugh, effective March 2000 in the amount of $30,025 for a term of six years bearing 9% interest, had an outstanding balance of $0 and $2,244 as of November 30, 2006 and 2005, respectively. There are no payments in arrears. Interest income recognized and received by Systems amounted to $47 and $300 in 2006 and 2005, respectively. The note was paid off in full in 2006. Note 9 - Employee Benefit Plan The Company maintains a qualified 401(k) plan which allows eligible participants to make pretax contributions. Company contributions are discretionary. The Company contributed $15,000 in both 2006 and 2005. Note 10 - Segment Information Segment information has been reclassified to reflect licensing fees revenue, goodwill and certain definite lived assets and the amortization expense related to these intangibles in Systems so as to reflect a truer segment income stream and asset relationship as the business has changed focus to the franchise division. -31- BAB, Inc Notes to the Consolidated Financial Statements November 30, 2006 and 2005 The following tables present segment information for the years ended November 30, 2006 and 2005:
Net Revenues Operating Income (Loss) 2006 2005 2006 2005 ---------------- ---------------- ---------------- ---------------- Company Store Operations $ 759,490 $ 1,906,888 $ (246,238) $ (364,624) Franchise Operations and Licensing Fees 3,157,901 3,218,207 1,783,954 1,805,089 ---------------- ---------------- ---------------- ---------------- $ 3,917,391 $ 5,125,095 $ 1,537,716 $ 1,440,465 ---------------- ---------------- Corporate Expenses (848,215) (713,482) Interest Expense, Net of Interest Income 27,106 (34,126) ---------------- ---------------- Net Income $ 716,607 $ 692,857 ================ ================ Operating Segment Data Identifiable Capital Depreciation and Assets Expenditures Amortization ---------------- ---------------- ---------------- Year Ended November 30, 2006: Company Store Operations $ 95,910 $ 7,464 $ 48,080 Franchise Operations (other than goodwill) 189,194 6,863 21,573 Goodwill and Other Indefinite Lived Intangible Assets 4,306,439 ---------------- ---------------- ---------------- $ 4,591,543 $ 14,327 $ 69,653 ================ ================ ================ Year Ended November 30, 2005: Company Store Operations $ 187,467 $ 14,422 $ 66,752 Franchise Operations (other than goodwill) 267,969 1,537 17,912 Goodwill and Other Indefinite Lived Intangible Assets 4,306,439 ---------------- ---------------- ---------------- $ 4,761,875 $ 15,959 $ 84,664 ================ ================ ================ Reconciliation to Total Assets as Reported 2006 2005 ---------------- ---------------- Assets-Total reportable segments - Identifiable assets $ 4,591,543 $ 4,761,875 Unallocated Amounts Cash 2,026,780 2,410,579 Prepaid expenses and other current assets 100,439 135,488 ---------------- ---------------- Total Consolidated Assets $ 6,718,762 $ 7,307,942 ================ ================
There were no sales to any individual customer during either year in the two-year period ended November 30, 2006 that represented 10% or more of net sales. -32- ITEM 8. CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None ITEM 8A. CONTROLS AND PROCEDURES Disclosure controls The Chief Executive Officer and the Chief Financial Officer have evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as amended) as of November 30, 2006. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on that evaluation, Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of such date to ensure that information required to be disclosed in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. Internal control over financial reporting The Chief Executive Officer and the Chief Financial Officer confirm that there was no change in the Company's internal control over financial reporting during the year ended November 30, 2006 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors, and persons who beneficially own more than ten percent of the Company's Common Stock, to file initial reports of ownership and reports of changes in ownership with the Securities and Exchange Commission (the "SEC"). Executive officers, directors and greater than ten percent beneficial owners are required by the SEC to furnish the Company with copies of all Section 16(a) forms they file. Based upon a review of the copies of such forms furnished to the Company, the Company believes that all Section 16(a) filing requirements applicable to its executive officers and directors were met during the year ended November 30, 2006. -33- CODE OF ETHICS BAB, Inc. Code of Ethics November 30, 2006 BAB, Inc. (the Company) is formally establishing, although it believes it has complied with the tenants of such a document during its existence, a Code of Ethics, pursuant to Section 406 of the Sarbanes-Oxley Act, which is designed to deter wrongdoing and to promote: o Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; o Full, fair, accurate, timely and understandable disclosure in reports and documents that the Company files with, or submits to, the Securities and Exchange Commission, and in other public communications made by the Company; o Compliance with applicable government laws, rules and regulations; o The prompt internal reporting of violations of the Code to the appropriate person or persons identified in the Code; and o Accountability for adherence to the Code. The Code of Ethics promulgated by Sarbanes-Oxley, expects the highest standard of ethical conduct and fair dealing of its Senior Financial Officers (SFO), defined as the Chief Executive Officer and Chief Financial Officer. While, per Sarbanes-Oxley, this policy is intended to only cover the actions of the SFO, the Company expects it's Controller, other officers, directors and employees will also review this Code and abide by its provisions. The Company's reputation is a valuable asset and as such must continually be guarded by all associated with the Company so as to earn the trust, confidence and respect of our suppliers, customers and shareholders. The Company's SFO are committed to conducting business in accordance with the highest ethical standards. The SFO must comply with all applicable laws, rules and regulations. Furthermore, SFO must not commit an illegal or unethical act, or instruct or authorize others to do so. CONFLICTS OF INTEREST The SFO must act in the best interests of the Company, and should avoid any situation that presents an actual, potential or apparent conflict between their personal interests and the interests of the Company. The SFO have a conflict when their personal interests, relationships or activities, or those of a member of their immediate family, interfere or conflict, or even appear to interfere or conflict, with the Company's interests. A conflict of interest prevents one from acting objectively with the Company's best interests in mind, or prevents one from exercising sound, ethical business judgment. PUBLIC COMMUNICATIONS The Company is committed to providing Company information to the public in a manner that complies with all applicable legal and regulatory requirements and that promotes investor confidence by facilitating fair, orderly and efficient behavior. The Company's reports and documents filed with the Securities and Exchange Commission, as well as any other public communications, must be complete, fair, accurate and timely. The SFO must do everything in their power to comply with these standards. -34- CODE OF ETHICS (Continued) GIFTS The SFO may not give or receive kickbacks, rebates, gifts, services or any other benefits, other than gifts of nominal value (amounts would be considered in excess of nominal value if they create the appearance of impropriety, or actually influence the Company to give preferential, versus arms-length, treatment to the provider) from a supplier, competitor, government official, customer or any other person the Company does, or expects to do business with. LOANS SFO may not accept loans, or loan guarantees, from the Company, or from any persons or entities, either doing business with, or seeking business with the Company. The Company will not make any loans to SFO, officers, directors, employees or any outside parties doing business with, or seeking business with the Company. CONFIDENTIAL INFORMATION SFO, officers, directors and employees are to respect the confidentiality of Company, employee, supplier, customer, competitor and any other persons or entities' information that is not a matter of public record. Confidential information must not be used for personal gain. COMPLIANCE WITH THIS CODE SFO are expected to fully comply with this Code. This Code will be strictly enforced and any violations will be dealt with immediately, and depending on the severity of noncompliance, could lead to disciplinary action including termination. Furthermore, violations involving unlawful behavior will be reported to appropriate outside authorities. If anyone is unclear as to the possibility of a violation of this Code, he should seek the opinion of the Company's Vice President and General Counsel, the Audit Committee and/or outside legal counsel. If SFO, officers, directors and employees have knowledge, or are suspicious of any non-compliance with this Code, or are concerned that circumstances could lead to a violation of this Code, they should discuss this with their immediate supervisor, the Company's Vice President and General Counsel, the Audit Committee and/or outside legal counsel. The Company will not allow any retaliation against an employee, officer, or director who acts in good faith in reporting any actual or suspected violation. Open communication of issues and concerns without fear of retribution or retaliation is vital to the success of this Code. ADHERENCE TO THE CODE The Vice President and General Counsel will have primary authority and responsibility for the enforcement of this Code, subject to the supervision of the Audit Committee of the Board of Directors, and shall promptly notify the Audit Committee of any violation of this Code. -35- ITEM 10. EXECUTIVE COMPENSATION The following table sets forth the cash compensation earned by executive officers that received annual salary and bonus compensation of more than $100,000 during years 2006, 2005 and 2004 (the "Named Executive Officers"). The Company has no employment agreements with any of its executive officers. Summary Compensation Table
Annual Compensation Long Term Compensation ------------------------------------------------------------------------------------------ Awards Payouts ------------------------------------------------------------------------------------------ Restricted Securities Stock Underlying LTIP All Other ------------------------------ Name and Year Salary Bonus Other Awards Options/SARS(#) Payouts Compensation Principal Position End ($) ($) ($) ($) ($) ($) ------------------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------------------ 2006 245,571 72,178 -- -- 70,000 -- -- Michael W. Evans, ---------------------------------------------------------------------------------------------------- President and CEO 2005 233,492 35,851 -- -- 20,000 -- -- ---------------------------------------------------------------------------------------------------- 2004 221,209 39,600 -- -- 20,000 -- -- ------------------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------------------ 2006 184,033 54,135 -- -- 70,000 -- -- Michael K. Murtaugh,---------------------------------------------------------------------------------------------------- Vice President and 2005 175,902 26,888 -- -- 20,000 -- -- General Counsel ---------------------------------------------------------------------------------------------------- 2004 165,906 29,700 -- -- 20,000 -- -- ------------------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------------------ 2006 132,957 9,500 -- -- 30,000 -- -- Jeffrey M. Gorden, ---------------------------------------------------------------------------------------------------- Chief Financial 2005 126,430 -- -- -- 6,000 -- -- Officer ---------------------------------------------------------------------------------------------------- 2004 121,919 5,000 -- -- 5,500 -- -- ------------------------------------------------------------------------------------------------------------------------
Stock options were issued at fair market value on the issue date to officers owning less than 10% of the Company stock and 110% of fair market value at issue date to those officers having a 10% or greater ownership of Company stock. All options expire 10 years after date of grant. Options issued during 2006 were as follows: (1) 75,000 on December 7, 2005 with a fair market issue price of $1.15 and vests 1/3 in 12 months, 1/3 in 24 months, and 1/3 in 36 months from the issue date; (2) 20,000 issued November 15, 2006 with a fair market value of $.97 with immediate vesting; (3) 100,000 issued November 15, 2006 with a fair market value of $1.25 that vest after 5 years; and (4) 95,000 issued November 28, 2006 with a fair market value of $1.25 that vest after 5 years. Options issued to the above officers totaled 170,000 shares or 58.6% of total options issued. During 2005, 75,000 options were issued on January 25, 2005 with a fair market issue price of $0.88 and vests as follows: 1/3 in 12 months, 1/3 in 24 months and 1/3 in 36 months from issue date and 20,000 options issued June 1, 2005 with a fair market issue price of $0.86 and vests immediately. Options issued to the above officers totaled 52,000 shares or 54.7% of total options issued. During 2004, 95,000 options were issued on December 2, 2003 with a fair market issue price of $0.46 and vests as follows: 1/3 in 12 months, 1/3 in 24 months and 1/3 in 36 months from the issue date and 20,000 options were issued July 1, 2004 with a fair market issue price of $.60 and vests immediately. Options issued to the above officers totaled 48,500 or 42.2% of options granted in 2004. Options and percentages issued to officers, as discussed above, include amounts issued to John J. Bracken (former Vice President Operations), who retired November, 2005. -36- Indemnification of Directors and Officers The Company's Certificate of Incorporation limits personal liability for breach of fiduciary duty by its directors to the fullest extent permitted by the Delaware General Corporation Law (the "Delaware Law"). Such Certificate eliminates the personal liability of directors to the Company and its shareholders for damages occasioned by breach of fiduciary duty, except for liability based on breach of the director's duty of loyalty to the Company, liability for acts omissions not made in good faith, liability for acts or omissions involving intentional misconduct, liability based on payments or improper dividends, liability based on violation of state securities laws, and liability for acts occurring prior to the date such provision was added. Any amendment to or repeal of such provisions in the Company's Articles of Incorporation shall not adversely affect any right or protection of a director of the Company for with respect to any acts or omissions of such director occurring prior to such amendment or repeal. In addition to the Delaware Law, the Company's Bylaws provide that officers and directors of the Company have the right to indemnification from the Company for liability arising out of certain actions to the fullest extent permissible by law. Insofar as indemnification for liabilities arising under the Securities Act of 1933 (the "Act") may be permitted to directors, officers or persons controlling the Company pursuant to such indemnification provisions, the Company has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is therefore unenforceable. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth as of February 16, 2007 the record and beneficial ownership of Common Stock held by (i) each person who is known to the Company to be the beneficial owner of more than 5% of the Common Stock of the Company; (ii) each current director; (iii) each "named executive officer" (as defined in Regulation S-B, Item 402 under the Securities Act of 1933); and (iv) all executive officers and directors of the Company as a group. Securities reported as "beneficially owned" include those for which the named persons may exercise voting power or investment power, alone or with others. Voting power and investment power are not shared with others unless so stated. The number and percent of shares of Common Stock of the Company beneficially owned by each such person as of February 16, 2007 includes the number of shares, which such person has the right to acquire within sixty (60) days after such date. All shares have been adjusted for a 4:1 stock dividend as of January 20, 2003. -37-
-------------------------------------------------------------------------------------------------------------------- Name and Address Shares Percentage -------------------------------------------------------------------------------------------------------------------- Michael W. Evans 500 Lake Cook Road, Suite 475 2,829,946 (1)(2)(3)(4) 38.45 Deerfield, IL 60015 -------------------------------------------------------------------------------------------------------------------- Michael K. Murtaugh 500 Lake Cook Road, Suite 475 2,760,133 (1)(2)(4)(5) 37.50 Deerfield, IL 60015 -------------------------------------------------------------------------------------------------------------------- Holdings Investment, LLC 220 DeWindt Road 2,096,195 (1)(6) 28.48 Winnetka, IL 60093 -------------------------------------------------------------------------------------------------------------------- Jeffrey M. Gorden 500 Lake Cook Road, Suite 475 87,167 (7) 1.18 Deerfield, IL 60015 -------------------------------------------------------------------------------------------------------------------- Steven G. Feldman 750 Estate Drive, Suite 104 40,000 (8) .54 Deerfield, IL 60015 -------------------------------------------------------------------------------------------------------------------- James A. Lentz 1415 College Lane South 34,932 (9) .47 Wheaton, IL 60187 -------------------------------------------------------------------------------------------------------------------- All executive officers and directors as a group (5 persons) 3,655,983 (1)(2)(3)(4)(5)(6)(7)(8)(9) 49.67 --------------------------------------------------------------------------------------------------------------------
(1) Includes all shares held of record by Holdings Investments, LLC. Messrs. Evans and Murtaugh are members and managers of the LLC and together control all voting power of the stock owned by the LLC. (2) Includes 20,000 stock options fully exercisable as of 2/16/07. (3) Includes 3,500 shares inherited by spouse (4) Includes 22,222 shares held by children (5) Includes 2,540 shares held by 401 (k) trust. (6) Mr. Thomas F. Pick has beneficial ownership of 25.18% of Holdings Investment, LLC, which is the equivalent of 527,884 shares of BAB, Inc. Common stock. (7) Includes 7,500 stock options fully exercisable as of 2/16/07. (8) Includes 30,000 stock options fully exercisable as of 2/16/07. (9) Includes 20,000 stock options fully exercisable as of 2/16/07. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The following information relates to certain relationships and transactions between the Company and related parties, including officers and directors of the Company. It is the Company's policy that it will not enter into any transactions with officers, directors or beneficial owners of more than 5% of the Company's Common Stock, or any entity controlled by or under common control with any such person, on terms less favorable to the Company than could be obtained from unaffiliated third parties and all such transactions require the consent of the majority of disinterested members of the Board of Directors. -38- Management believes that the following transactions were effected on terms no less favorable to the Company than could have been realized in arm's length transactions with unaffiliated parties. Executive Officers and Directors Michael K. Murtaugh, the Company's Vice President and General Counsel, was the sole stockholder of Bagel One, Inc., which owned and operated a Big Apple Bagels franchise store in Illinois. A note receivable owed by Bagel One, Inc. to Systems, guaranteed by Mr. Murtaugh, effective March 2000 in the amount of $30,025 for a term of 6 years bearing 9% interest, had an outstanding balance at November 30, 2005 of $2,244 and there are no payments in arrears. This note was paid off in full during fiscal year 2006. ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K REPORTS ON FORM 8-K ------------------- 12/4/06 On December 4, 2006, the Company announced a change in small business issuer's certifying accountant. A majority of the partners at AM&G, LLP have become partners of McGladrey & Pullen, LLP. McGladrey & Pullen, LLP was appointed as the Company's new auditor. 9/6/06 On September 6, 2006, the Board of Directors of BAB, Inc. authorized a $0.02 per share quarterly cash dividend. The dividend is payable October 9, 2006 to stockholders of record as of September 18, 2006. 5/25/06 On May 25, 2006, the Board of Directors of BAB, Inc. authorized a $0.02 per share quarterly cash dividend. The dividend is payable July 5, 2006 to stockholders of record as of June 14, 2006. 3/13/06 On March 10, 2006, the Board of Directors of BAB, Inc. authorized a $0.02 per share quarterly cash dividend. The dividend is payable April 13, 2006 to stockholders of record as of March 23, 2006. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The Board of Directors, upon recommendation of the Audit Committee, appointed the firm Altschuler, Melvoin & Glasser LLP ("AM&G") certified public accountants for 2005. On November 29, 2006, BAB, Inc. ("Company") was notified that a majority of the partners of Altschuler, Melvoin and Glasser LLP (AM&G), including the lead audit partner for the Company, had become partners of McGladrey & Pullen, LLP and, as a consequence, that AM&G was compelled to resign and would no longer be the auditor for the Company. McGladrey & Pullen, LLP was appointed as the Company's new auditor. The audit reports of AM&G on the consolidated financial statements of BAB, Inc. and Subsidiaries as of and for the years ended November 30, 2005 and 2004 did not contain an adverse opinion or a disclaimer of opinion, and were not qualified or modified as to uncertainty, audit scope or accounting principles. The decision to engage McGladrey & Pullen, LLP was approved by the board of directors. In connection with the audits of the Company's consolidated financial statements for each of the fiscal years ended November 30, 2005 and 2004, and through the date of this Current Report, there were: (1) no disagreements between the Company and AM&G on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which disagreements, if not resolved to the satisfaction of AM&G, would have caused AM&G to make reference to the subject matter of the disagreement in their reports on the Company's financial statements for such years, and (2) no reportable events within the meaning set forth in Item 304(a)(1)(iv)(B) of Regulation S-B. -39- ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES (Continued) AM&G had, at the time it was initially appointed to be the Company's auditor, a relationship with American Express Tax and Business Services, Inc. (TBS) from which it leased auditing staff who were full time, permanent employees of TBS and through which its partners provided non-audit services. As a result of this arrangement, AM&G had no full time employees and therefore, none of the audit services performed were provided by permanent full-time employees of AM&G. Effective October 1, 2005, TBS was acquired by RSM McGladry, Inc. (RSM) and AM&G's relationship with TBS has been replaced with a similar relationship with RSM. AM&G manages and supervises the audit and audit staff, and is exclusively responsible for the opinion rendered in connection with its examination. Audit fees relate to audit work performed on the financial statements as well as work that generally only the independent auditor can reasonably be expected to provide including discussions surrounding the proper application of financial accounting and/or reporting standards and reviews of the financial statements included in quarterly reports filed on Form 10-Q. Fees for audit services provide by AM&G for the years ended November 30, 2006 and 2005 amounted to $17,000 and $70,000, respectively, and fees for audit services provided by McGladrey and Pullen, LLP amounted to $62,000 for the year ended November 30, 2006. Tax compliance services were provided by RSM McGladrey for 2006 and fees billed amounted to $20,000. In 2005, tax compliance services were provided by TBS for which fees amounted to $24,000. During the year ended November 30, 2006 and 2005, McGladrey & Pullen, LLP, AM&G, and TBS did not perform any management consulting services for the Company. Preapproval of Policies and Procedures by Audit Committee The accountants provide a quote for services to the Audit Committee before work begins for the fiscal year. After discussion, the Audit Committee then makes a recommendation to the Board of Directors on whether to accept the proposal. Percentage of Services Approved by Audit Committee All services were approved by the Audit Committee -40- INDEX TO EXHIBITS The following Exhibits are filed herewith: INDEX NUMBER DESCRIPTION ------------ ----------- 3.1 Articles of Incorporation as included within 3.2 Bylaws of the Company 21.1 List of Subsidiaries of the Company 31.1, 31.2 Section 302 of the Sarbanes-Oxley Act of 2002 32.1, 32.2 Section 906 of the Sarbanes-Oxley Act of 2002 SIGNATURES ---------- In accordance with Section 13 of the Exchange Act, the Small business issuer has duly caused this report on Form 10-KSB to be signed on its behalf by the undersigned, thereunto duly authorized. BAB, INC. Dated: February 28, 2007 By /s/ Michael W. Evans -------------------- Michael W. Evans, Chief Executive Officer and President (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-KSB has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. Dated: February 28, 2007 By /s/ Michael W. Evans -------------------- Michael W. Evans, Chief Executive Officer and President (Principal Executive Officer) Dated: February 28, 2007 By /s/ Michael K. Murtaugh ----------------------- Michael K. Murtaugh, Director and Vice President/General Counsel and Secretary Dated: February 28, 2007 By /s/ Jeffrey M. Gorden --------------------- Jeffrey M. Gorden, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) Dated: February 28, 2007 By /s/ Steven G. Feldman --------------------- Steven G. Feldman, Director Dated: February 28, 2007 By /s/ James A. Lentz ------------------ James A. Lentz, Director -41-