10-Q 1 f10q-07112004.txt JULY 11, 2004 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED JULY 11, 2004 COMMISSION FILE NUMBER 333-90817 SBARRO, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) NEW YORK 11-2501939 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER I.D. NO.) INCORPORATION OR ORGANIZATION) 401 BROAD HOLLOW ROAD, MELVILLE, NEW YORK 11747-4714 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (631) 715-4100 INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS, AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES NO ----------------- -------------- INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS DEFINED IN RULE 12B-2 OF THE EXCHANGE ACT). YES NO X ----------------- -------------- THE NUMBER OF SHARES OF COMMON STOCK OF THE REGISTRANT OUTSTANDING AS OF AUGUST 13, 2004 WAS 7,064,328. ============================================================================== SBARRO, INC. FORM 10-Q INDEX PART I. FINANCIAL INFORMATION PAGES Consolidated Financial Statements: Balance Sheets - July 11, 2004 (unaudited) and December 28, 2003....3-4 Statements of Operations (unaudited) - Twenty Eight and Twelve Weeks ended July 11, 2004 and July 13, 2003.....................5-6 Statements of Cash Flows (unaudited) - Twenty Eight Weeks ended July 11, 2004 and July 13, 2003.................................7-8 Notes to Unaudited Consolidated Financial Statements...............9-24 Management's Discussion and Analysis of Financial Condition and Results of Operations.............................................................25-35 Qualitative and Quantitative Disclosures of Market Risk.......................36 Controls and Procedures.......................................................36 PART II. OTHER INFORMATION................................................37 Page 2 PART I - FINANCIAL INFORMATION ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(In thousands) -------------- ASSETS July 11, 2004 December 28, 2003 ------------- ----------------- (unaudited) Current assets: Cash and cash equivalents $39,265 $56,409 Receivables, net of allowance for doubtful accounts of $455 in 2004 and $488 in 2003: Franchisees 2,192 1,700 Other 1,268 1,171 Inventories 2,931 2,707 Prepaid expenses 10,126 3,865 Current portion of loans receivable from officers 2,589 2,810 ---------- ----------- Total current assets 58,371 68,662 ---------- ----------- Property and equipment, net 91,571 96,604 Intangible assets: Trademarks, net 195,916 195,916 Goodwill, net 9,204 9,204 Deferred financing costs and other, net 4,964 5,482 Loans receivable from officers, less current portion 3,062 3,347 Other assets 7,654 7,614 ---------- ----------- $370,742 $386,829 ========== ===========
SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 3 SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED)
(In thousands except share data) -------------------------------- LIABILITIES & SHAREHOLDERS' EQUITY July 11, 2004 December 28, 2003 ------------- ----------------- (unaudited) Current liabilities: Accounts payable $11,600 $13,734 Accrued expenses 14,128 18,795 Accrued interest payable 9,260 8,181 Current portion of mortgage payable 176 168 --------- ---------- Total current liabilities 35,164 40,878 --------- ---------- Deferred rent 8,955 8,711 --------- ---------- Long-term debt, net 268,252 268,152 --------- ---------- Contingencies: Shareholders' equity: Preferred stock, $1 par value; authorized 1,000,000 shares; none issued - - Common stock, $.01 par value; authorized 40,000,000 shares; issued and outstanding 7,064,328 shares 71 71 Additional paid-in capital 10 10 Retained earnings 58,290 69,007 --------- ---------- Total shareholders' equity 58,371 69,088 --------- ---------- $370,742 $386,829 ========= ==========
SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 4 SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands) -------------- For the twenty eight weeks ended July 11, 2004 July 13, 2003 ------------- ------------- Revenues: Restaurant sales $159,530 $156,754 Franchise related income 5,991 5,330 Real estate and other 3,407 3,074 ----------- ---------- Total revenues 168,928 165,158 ----------- ---------- Costs and expenses: Cost of food and paper products 35,946 33,547 Payroll and other employee benefits 45,851 45,827 Other operating costs 59,444 59,529 Depreciation and amortization 8,674 10,409 General and administrative costs 13,458 14,066 Provision for restaurant closings 375 1,057 ----------- ---------- Total costs and expenses 163,748 164,435 ----------- ---------- Operating income 5,180 723 ----------- ---------- Other (expense) income: Interest expense (16,583) (16,763) Interest income 324 411 Equity in net income of unconsolidated affiliates 748 511 ----------- ---------- Net other (expense) (15,511) (15,841) ----------- ---------- (Loss) before minority interest (10,331) (15,118) Minority interest (17) (10) ----------- ---------- (Loss) before income taxes (10,348) (15,128) Income taxes 369 574 ----------- ---------- Net (loss) ($10,717) ($15,702) =========== ===========
SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 5 SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands) -------------- For the twelve weeks ended July 11, 2004 July 13, 2003 ------------- ------------- Revenues: Restaurant sales $68,684 $68,245 Franchise related income 2,587 2,391 Real estate and other 1,446 1,407 ----------- ---------- Total revenues 72,717 72,043 ----------- ---------- Costs and expenses: Cost of food and paper products 15,937 14,243 Payroll and other employee benefits 19,704 19,816 Other operating costs 25,637 25,797 Depreciation and amortization 3,678 4,513 General and administrative costs 5,344 5,347 Provision for restaurant closings 200 528 ----------- ---------- Total costs and expenses 70,500 70,244 ----------- ---------- Operating income 2,217 1,799 ----------- ---------- Other (expense) income: Interest expense (7,106) (7,180) Interest income 128 197 Equity in net income of unconsolidated affiliates 350 230 ----------- ---------- Net other (expense) (6,628) (6,753) ----------- ---------- (Loss) before minority interest (4,411) (4,954) Minority interest (17) (5) ----------- ---------- (Loss) before income taxes (4,428) (4,959) Income taxes 128 253 ----------- ---------- Net (loss) ($4,556) ($5,212) =========== ===========
SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Page 6 SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands) -------------- For the twenty eight weeks ended July 11, 2004 July 13, 2003 ------------- ------------- Operating activities: Net (loss) ($10,717) ($15,702) Adjustments to reconcile net (loss) to net cash used in operating activities: Depreciation and amortization 8,674 10,409 Accretion of original issue discount 204 204 Amortization of deferred financing costs 518 579 Increase in deferred rent, net 165 212 Loss on sale of other concept units - 50 Restaurant closing costs 375 71 Minority interest 17 10 Equity in net income of unconsolidated affiliates (748) (511) Dividends received from unconsolidated affiliate 305 119 ----------- ----------- (1,207) (4,559) Changes in operating assets and liabilities: Receivables (289) 422 Inventories (224) 1,005 Prepaid expenses (6,147) (5,694) Other assets 70 (130) Accounts payable and accrued expenses (5,942) 1,160 Accrued interest payable 1,079 1,079 ----------- ----------- Net cash used in operating activities (12,660) (6,717) ----------- -----------
SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 7 SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (CONTINUED)
(In thousands) -------------- For the twenty eight weeks ended July 11, 2004 July 13, 2003 ------------- ------------- Investing activities: Purchases of property and equipment ($4,211) ($4,739) ----------- ---------- Net cash used in investing activities (4,211) (4,739) ----------- ---------- Financing activities: Mortgage principal repayments (96) (88) Tax distributions (682) (1,10l) Reduction in loans receivable from officers 505 - ----------- ---------- Net cash used in financing activities (273) (1,189) ----------- ---------- Decrease in cash and cash equivalents (17,144) (12,645) Cash and cash equivalents at beginning of period 56,409 55,150 ----------- ---------- Cash and cash equivalents at end of period $39,265 $42,505 ========== ========== Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $223 $330 ========== ========== Cash paid during the period for interest $14,796 $14,867 ========== ==========
SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 8 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION: The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Regulation S-X related to interim period financial statements and, therefore, do not include all information and footnotes required by generally accepted accounting principles. However, in the opinion of our management, all adjustments (consisting of normal recurring adjustments and accruals) considered necessary for a fair presentation of the consolidated financial position of Sbarro and our subsidiaries at July 11, 2004 and our consolidated results of operations and cash flows for the twenty-eight and twelve week periods ended July 11, 2004 and July 13, 2003 have been included. The results of operations for interim periods are not necessarily indicative of the results that may be expected for the entire year. Reference should be made to the annual financial statements, including footnotes thereto, included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2003. Certain items in the financial statement presented have been reclassified to conform to the fiscal 2004 presentation. 2. RECENT ACCOUNTING PRONOUNCEMENTS: Financial Accounting Standards Board (FASB) Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities," was effective immediately upon its issuance during fiscal 2003 for all enterprises with variable interests in entities created after January 31, 2003. In December 2003, the FASB staff issued FIN No. 46(R) which changes the effective date for interests in variable interest entities created before February 1, 2003 beginning with the first interim reporting period after March 15, 2004. If an entity is determined to be a variable interest entity, it must be consolidated by the enterprise that absorbs the majority of the entity's expected losses if they occur, receives a majority of the entity's expected residual returns if they occur, or both. Where it is reasonably possible that the enterprise will consolidate or disclose information about a variable interest entity, the enterprise must disclose the nature, purpose, size and activity of the variable interest entity and the enterprise's maximum exposure to loss as a result of its involvement with the variable interest entity in all financial statements issued after January 31, 2003. The FASB has specifically exempted traditional franchise arrangements from the evaluations required under FIN No. 46(R). We have also reviewed our corporate relationships for possible coverage under FIN No. 46(R). The application of FIN No. 46(R) did not have a material effect on our disclosures and our financial position or results of operations. We have several variable interest entities, for which we provide disclosures. However, we are not the primary beneficiary and therefore do not need to consolidate these entities. Page 9 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 3. DEBT: In March 2004, we obtained an uncommitted line of credit to replace our former revolving credit facility. Under the new line, we currently have the ability, subject to bank approval, to borrow up to $3 million, including outstanding letters of credit. The new line of credit contains no financial covenants or unused line fees. Interest applicable to the loans under the new line of credit is at the bank's prime rate at the time of any borrowings. The line expires in May 2005. There currently are $1.7 million of letters of credit outstanding and we have $1.3 million of undrawn availability. Under our senior notes indenture, there are various covenants that limit our ability to borrow funds, in addition to lending arrangements that existed at the date the indenture was entered into and replacements of those arrangements, to make "restricted payments" including, among other things, dividend payments (other than as distributions pursuant to the tax payment agreement), and to make investments in, among other things, unrestricted subsidiaries. Among other covenants, the indenture requires that, in order for us to borrow, our consolidated interest ratio coverage (as defined in the indenture), after giving pro forma effect to the interest on the new borrowing, for the four most recently ended fiscal quarters must be at least 2.5 to 1. As of July 11, 2004, that ratio was 1.3 to 1. As a result, we are not presently able to borrow funds except for the specifically permitted indebtedness, including up to $75 million of revolving credit loans. In order to make restricted payments, that ratio must be at least 2.0 to 1, after giving pro forma effect to the restricted payment and, in any event, is limited in dollar amount pursuant to a formula contained in the indenture. We refer to the amount that is available for us to make dividends and other restricted payments as the "restricted payment availability". We cannot make restricted payments (other than distributions pursuant to the tax payment agreement) until we increase the restricted payment availability by approximately $20.5 million, and then only to the extent of any excess over that amount. In March 2000, one of our subsidiaries obtained a $16 million, 8.4% loan due in 2010, secured by a mortgage on our corporate headquarters building. The loan is payable in monthly installments of principal and interest of $0.1 million. The outstanding principal balance of the loan as of July 11, 2004 was $15.4 million. The mortgage agreement contains various covenants, including a requirement that the subsidiary maintain a minimum ratio of EBITDA to annual debt service of at least 1.2 to 1.0. We were in compliance with all covenants in the indenture for the senior notes and our mortgage as of July 11, 2004. Page 10 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 4. INCOME TAXES: We made Subchapter S tax distributions in the amount of $1.8 million to our shareholders related to our fiscal 2002 tax basis income. Of such amount, $1.1 million was paid in the first quarter of 2003 and $0.7 million was paid in the first quarter of 2004. 5. LITIGATION: On December 20, 1999, Antonio Garcia and thirteen current and former general managers of Sbarro restaurants in California filed a complaint in the Superior Court of California for Orange County. The complaint alleges that the plaintiffs were improperly classified as exempt employees under the California wage and hour law. The plaintiffs are seeking actual damages, punitive damages and costs of the lawsuit, including reasonable attorney's fees, each in unspecified amounts. Plaintiffs filed a motion to certify the lawsuit as a class action, but the Court denied the motion. The court issued a ruling in December 2003 which was unfavorable but failed to specify the amount of damages. We are appealing the ruling due to errors that we believe were made by the trial judge. On September 6, 2000, Manuel Jimenez and seven other current and former general managers of Sbarro restaurants in California filed a complaint against Sbarro in the Superior Court of California for Orange County alleging that the plaintiffs were improperly classified as exempt employees under California wage and hour law. The plaintiffs sought actual damages, punitive damages and costs of the lawsuit, including reasonable attorney's fees, each in unspecified amounts. Plaintiffs are represented by the same counsel who is representing the plaintiffs in the case discussed in the preceding paragraph. We have separately settled with two of the managers for immaterial amounts. The remaining parties to this case have agreed that it will be settled upon the same terms and conditions that the court orders in connection with its decision in the case discussed in the preceding paragraph. On March 22, 2002, five former general managers of Sbarro restaurants in California filed a complaint against Sbarro in the Superior Court of California for Los Angeles County. The complaint alleges that the plaintiffs were required to perform labor services without proper premium overtime compensation from at least May of 1999. The plaintiffs are seeking actual damages, punitive damages and attorney's fees and costs, each in unspecified amounts. In addition, plaintiffs have requested class action status for all managerial employees who worked overtime and/or were not otherwise paid regular wages due and owing from May 1999 to present. The case is currently in the discovery phase. In August 2002, a subcontractor and the general contractor, pursuant to a construction contract to build a joint venture location that we closed in fiscal 2002 and is also the subject of the lawsuit discussed below, filed a complaint against the limited liability joint venture company alleging that they are owed approximately $800,000, plus interest. We are a defendant in the suit by reason of the fact that we guaranteed the bonds under which mechanics liens for the plaintiffs were bonded. The parties have agreed to binding Page 11 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS arbitration. We believe that our maximum liability that would result from the binding arbitration could be approximately $400,000. In May 2002, the landlord of the joint venture described above filed a complaint against Sbarro in the Supreme Court of the State of New York for Westchester County alleging that we were obligated to it, pursuant to a Guaranty Agreement we executed, for all rent during the remaining lease based on an alleged breach of the lease by the tenant, a subsidiary of the joint venture. We believe that our guarantee is limited in amount, while the landlord alleges that the guarantee covered all amounts that would become due during the remaining lease term. The court issued a ruling in November 2003 which established our liability at $500,000 and we have accrued for this amount. The landlord has appealed this decision. We believe that we have substantial defenses in each of these actions and we are vigorously defending these actions. In addition to the above complaints, from time to time, we are a party to certain claims and legal proceedings in the ordinary course of business. In our opinion, the results of the complaints and other claims and legal proceedings are not expected to have a material adverse effect on our consolidated financial position or results of operations. 6. GUARANTOR AND NON-GUARANTOR FINANCIAL STATEMENTS: Certain subsidiaries have guaranteed amounts outstanding under our senior notes and new line of credit. Each of the guaranteeing subsidiaries is our direct or indirect wholly owned subsidiary and each has fully and unconditionally guaranteed the senior notes and the credit agreement on a joint and several basis. The following condensed consolidating financial information presents: (1) Condensed consolidating balance sheets as of July 11, 2004 (unaudited) and December 28, 2003 and statements of operations and cash flows for the twenty-eight and twelve weeks ended July 11, 2004 (unaudited) and July 13, 2003 (unaudited) of (a) Sbarro, Inc., the parent, (b) the guarantor subsidiaries as a group, (c) the non-guarantor subsidiaries as a group and (d) Sbarro on a consolidated basis. (2) Elimination entries necessary to consolidate Sbarro, Inc., the parent, with the guarantor and non guarantor subsidiaries. The principal elimination entries eliminate intercompany balances and transactions. Investments in subsidiaries are accounted for by the parent on the cost method. Page 12 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF JULY 11, 2004 (IN THOUSANDS EXCEPT SHARE DATA) (UNAUDITED)
GUARANTOR NONGUARANTOR ASSETS PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------ ------------ ------------ ------------ ------------ Current assets: Cash and cash equivalents $34,548 $3,594 $1,123 $39,265 Receivables less allowance for doubtful accounts of $455 Franchisees 2,192 - - 2,192 Other (228) 1,127 369 1,268 Inventories 1,229 1,557 145 2,931 Prepaid expenses 8,110 1,629 387 10,126 Current portion of loans receivable from officers 2,589 - 2,589 ---------- ----------- --------- ----------- Total current assets 48,440 7,907 2,024 58,371 Intercompany receivables 2,948 311,057 - ($314,005) - Investment in subsidiaries 65,469 - - (65,469) - Property and equipment, net 34,703 52,606 4,262 91,571 Intangible assets: Trademarks, net 195,916 - - 195,916 Goodwill, net 9,101 - 103 9,204 Deferred financing costs and other, net 4,752 212 - 4,964 Loans receivable from officers less current portion 3,062 - - 3,062 Other assets 8,504 1,781 (649) (1,982) 7,654 ---------- ----------- --------- ------------- ----------- $372,895 $373,563 $5,637 ($381,353) $370,742 ========== =========== ========= ============= ===========
Page 13 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF JULY 11, 2004 (IN THOUSANDS EXCEPT SHARE DATA) (UNAUDITED)
GUARANTOR NONGUARANTOR LIABILITIES & SHAREHOLDERS' EQUITY PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ---------------------------------- ------ ------------ ------------ ------------ ------------ Current liabilities: Accounts payable $10,485 $177 $340 $598 $11,600 Accrued expenses 11,023 1,293 1,812 14,128 Accrued interest payable 9,260 - - 9,260 Current portion of mortgage payable - 176 - - 176 ---------- ----------- --------- ------------ --------- Total current liabilities 30,768 1,646 2,152 598 35,164 ---------- ----------- --------- ------------ --------- Intercompany payables 311,057 - 2,948 (314,005) - ---------- ----------- --------- ------------ --------- Deferred rent 8,284 - 671 8,955 --------- ---------- ------ --------- Long-term debt, net 253,032 15,220 - 268,252 ---------- ----------- --------- --------- Shareholders' equity (deficit): Preferred stock, $1 par value; authorized 1,000,000 shares; None issued - - - - Common stock, $.01 per value: authorized 40,000,000 shares; issued and outstanding 7,064,328 shares 71 - - 71 Additional paid-in capital 10 65,469 2,477 (67,946) 10 Retained earnings (deficit) (230,327) 291,228 (2,611) - 58,290 ---------- ----------- --------- ------------ --------- (230,246) 356,697 (134) (67,946) 58,371 ---------- ----------- --------- ------------ --------- Total shareholders' equity (deficit) $372,895 $373,563 $5,637 ($381,353) $370,742 ========== =========== ========= ============ =========
Page 14 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF DECEMBER 28, 2003 (IN THOUSANDS)
GUARANTOR NONGUARANTOR ASSETS PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ Current assets: Cash and cash equivalents $49,515 $5,595 $1,299 $56,409 Receivables less allowance for doubtful accounts of $488 Franchisees 1,700 - - 1,700 Other (191) 966 396 1,171 Inventories 1,177 1,387 143 2,707 Prepaid expenses 4,039 (227) 53 3,865 Current portion of loans receivable from officers 2,810 2,810 ---------- ----------- --------- --------- Total current assets 59,050 7,721 1,891 68,662 Intercompany receivables 6,697 317,237 - ($323,934) - Investment in subsidiaries 65,469 - - (65,469) - Property and equipment, net 36,189 55,706 4,709 96,604 Intangible assets: Trademarks, net 195,916 - - 195,916 Goodwill, net 9,204 - - 9,204 Deferred financing costs and other, net 5,369 233 - (120) 5,482 Loans receivable from officers less current portion 3,347 - - 3,347 Other assets 7,034 1,822 (212) (1,030) 7,614 ---------- ----------- --------- ------------ --------- $388,275 $382,719 $6,388 $(390,553) $386,829 ========== =========== ========= ============ =========
Page 15 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF DECEMBER 28, 2003 (IN THOUSANDS EXCEPT SHARE DATA)
GUARANTOR NONGUARANTOR LIABILITIES & SHAREHOLDERS'EQUITY PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ Current liabilities: Accounts payable $11,859 $129 $419 $1,327 $13,734 Accrued expenses 15,542 1,447 1,806 18,795 Accrued interest payable 8,181 - - 8,181 Current portion of mortgage payable - 168 - - 168 ---------- ----------- --------- ------------ --------- Total current liabilities 35,582 1,744 2,225 1,327 40,878 ---------- ----------- --------- ------------ --------- Intercompany payables 317,236 2,958 3,740 (323,934) - ---------- ----------- --------- ------------ --------- Deferred rent 8,009 - 702 8,711 ---------- ----------- --------- --------- Long-term debt, net 252,827 15,325 - 268,152 ---------- ----------- --------- --------- Shareholders' equity (deficit): Preferred stock, $1 par value; authorized 1,000,000 shares; None issued Common stock, $.01 par value: authorized 40,000,000 shares; issued and outstanding 7,064,328 shares 71 - - 71 Additional paid-in capital 10 65,469 2,477 (67,946) 10 Retained earnings (deficit) (225,460) 297,223 (2,756) - 69,007 ---------- ----------- --------- ------------ --------- Total shareholders' equity (deficit) (225,379) 362,692 (279) (67,946) 69,088 ---------- ----------- --------- ------------ --------- $388,275 $382,719 $6,388 ($390,553) $386,829 ========== =========== ========= ============ ========
Page 16 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE TWENTY EIGHT WEEKS ENDED JULY 11, 2004 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ Revenues: Restaurant sales $68,652 $83,148 $7,730 $159,530 Franchise related income 5,991 - - 5,991 Real estate and other 1,865 1,542 - 3,407 Intercompany charges 4,985 - - $(4,985) - --------- ------------ ------------ ------------ ------------- Total revenues 81,493 84,690 7,730 (4,985) 168,928 --------- ------------ ------------ ------------ ------------- Cost and expenses: Cost of food and paper products 14,414 19,392 2,140 35,946 Payroll and other employee benefits 18,335 24,890 2,626 45,851 Other operating costs 27,277 29,996 2,171 59,444 Depreciation and amortization 3,773 4,415 486 8,674 General and administrative 7,290 6,017 151 13,458 Provision for restaurant closings 375 - - 375 Intercompany charges - 4,985 - (4,985) - --------- ------------ ------------ ------------ ------------- Total costs and expenses 71,464 89,695 7,574 (4,985) 163,748 --------- ------------ ------------ ------------ ------------- Operating income (loss) 10,029 (5,005) 156 5,180 --------- ------------ ------------ ------------- Other (expense) income: Interest expense (15,800) (783) (16,583) Interest income 324 - 324 Equity in net income of unconsolidated affiliates 748 - 748 --------- ------------ ------------ ------------- Net other expense (14,728) (783) (15,511) --------- ------------ ------------ ------------- (Loss) income before minority interest (4,699) (5,788) 156 (10,331) Minority interest - - (17) (17) --------- ------------ ------------ ------------- (Loss) income before income taxes (4,699) (5,788) 139 (10,348) Income taxes (benefit) 168 207 (6) 369 --------- ------------ ------------ ------------- Net (loss) income ($4,867) ($5,995) $145 ($10,717) ========= ============ ============ =============
Page 17 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE TWENTY EIGHT WEEKS ENDED JULY 13, 2003 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ Revenues: Restaurant sales $66,633 $82,261 $7,860 $156,754 Franchise related income 5,330 - - 5,330 Real estate and other 1,489 1,551 34 3,074 Intercompany charges 5,492 - - $(5,492) - ------------- ------------ ---------- ----------- ------------ Total revenues 78,944 83,812 7,894 (5,492) 165,158 ------------- ------------ ---------- ----------- ------------ Cost and expenses: Restaurant operating expenses: Cost of food and paper products 13,578 17,914 2,055 33,547 Payroll and other employee benefits 18,866 24,245 2,716 45,827 Other operating costs 27,024 30,378 2,127 59,529 Depreciation and amortization 4,697 5,173 539 10,409 General and administrative 8,454 5,706 (94) 14,066 Provision for restaurant closings 900 - 157 1,057 Intercompany charges - 5,492 - (5,492) - ------------- ------------ ---------- ----------- ------------ Total costs and expenses 73,519 88,908 7,500 (5,492) 164,435 ------------- ------------ ---------- ----------- ------------ Operating income (loss) 5,425 (5,096) 394 723 ------------- ------------ ---------- ------------ Other (expense) income: Interest expense (15,978) (785) (16,763) Interest income 411 - 411 Equity in net income of Unconsolidated affiliates 511 - 511 ------------- ------------ ------------ Net other expense (15,056) (785) (15,841) ------------- ------------ ------------ (Loss) income before minority interest (9,631) (5,881) 394 (15,118) Minority interest - - (10) (10) ------------- ------------ ---------- ------------ (Loss) income before income taxes (9,631) (5,881) 384 (15,128) Income taxes (benefit) 373 215 (14) 574 ------------- ------------ ---------- ------------ Net (loss) income $(10,004) $(6,096) $398 $(15,702) ============= ============ ========== ============
Page 18 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE TWELVE WEEKS ENDED JULY 11, 2004 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ Revenues: Restaurant sales $29,669 $35,636 $3,379 $68,684 Franchise related income 2,587 - - 2,587 Real estate and other 854 592 - 1,446 Intercompany charges 2,461 - - ($2,461) - ------------- ------------ ---------- --------- ------------ Total revenues 35,571 36,228 3,379 (2,461) 72,717 ------------- ------------ ---------- --------- ------------ Cost and expenses: Cost of food and paper products 6,377 8,602 958 15,937 Payroll and other employee benefits 7,888 10,687 1,129 19,704 Other operating costs 11,732 12,962 943 25,637 Depreciation and amortization 1,617 1,853 208 3,678 General and administrative 3,004 2,241 99 5,344 Provision for restaurant closings 200 - - 200 Intercompany charges - 2,461 - (2,461) - ------------- ------------ ---------- --------- ------------ Total costs and expenses 30,818 38,806 3,337 (2,461) 70,500 ------------- ------------ ---------- --------- ------------ Operating (loss) income 4,753 (2,578) 42 2,217 ------------- ------------ ---------- ------------ Other (expense) income: Interest expense (6,768) (338) (7,106) Interest income 128 - 128 Equity in net income of unconsolidated affiliates 350 - 350 ------------- ------------ ------------ Net other expense (6,290) (338) (6,628) ------------- ------------ ------------ (Loss) income before minority interest (1,537) (2,916) 42 (4,411) Minority interest - - (17) (17) ------------- ------------ ---------- ------------ (Loss) income before income taxes (1,537) (2,916) 25 (4,428) Income taxes 33 95 - 128 ------------- ------------ ---------- ------------ Net (loss) income ($1,570) ($3,011) $25 ($4,556) ============= ============ =========== ============
Page 19 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE TWELVE WEEKS ENDED JULY 11, 2003 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ Revenues: Restaurant sales $29,217 $35,667 $3,361 $68,245 Franchise related income 2,391 - - 2,391 Real estate and other 709 664 34 1,407 Intercompany charges 2,333 - - $(2,333) - ----------- --------- ----------- --------- ------------- Total revenues 34,650 36,331 3,395 (2,333) 72,043 ----------- --------- ----------- --------- ------------- Cost and expenses: Cost of food and paper products 5,780 7,590 873 14,243 Payroll and other employee benefits 8,235 10,451 1,130 19,816 Other operating costs 11,886 13,041 870 25,797 Depreciation and amortization 2,053 2,233 227 4,513 General and administrative 3,455 2,081 (189) 5,347 Provision for restaurant closings 500 - 28 528 Intercompany charges - 2,333 - (2,333) - ----------- --------- ----------- --------- ------------- Total costs and expenses 31,909 37,729 2,939 (2,333) 70,244 ----------- --------- ----------- --------- ------------- Operating income (loss) 2,741 (1,398) 456 1,799 -------- -------- ------- -------- Other (expense) income: Interest expense (6,847) (333) (7,180) Interest income 197 - 197 Equity in net income of unconsolidated affiliates 230 - 230 ----------- --------- ------------- Net other expense (6,420) (333) (6,753) ----------- --------- ------------- (Loss) income before minority interest (3,679) (1,731) 456 (4,954) Minority interest - - (5) (5) ----------- --------- ----------- ------------- (Loss) income before income taxes (3,679) (1,731) 451 (4,959) Income taxes (benefit) 186 83 (16) 253 ----------- --------- ----------- ------------- Net (loss) income $(3,865) $(1,814) $467 $(5,212) =========== ========= =========== =============
Page 20 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE TWENTY EIGHT WEEKS ENDED JULY 11, 2004 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ OPERATING ACTIVITIES: --------------------- Net (loss) income ($4,866) ($5,995) $144 ($10,717) Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 3,773 4,415 486 8,674 Accretion of original issue discount 204 - - 204 Amortization of deferred financial costs 498 20 518 Increase in deferred rent, net 160 36 (31) 165 Provision for restaurant closing 375 - - 375 Minority interest - - 17 17 Equity in net income of unconsolidated affiliates (748) - - (748) Dividends received from unconsolidated affiliates 305 - - 305 -------- ------------- -------- ---------- (299) (1,524) 616 (1,207) Changes in operating assets and liabilities: Receivables (155) (161) 27 (289) Inventories (52) (170) (2) (224) Prepaid expenses (3,956) (1,857) (334) (6,147) Other assets (1,176) 80 438 $728 70 Accounts payable and accrued expenses (5,018) (105) (91) (728) (5,942) Accrued interest payable 1,079 - - 1,079 -------- ------------- -------- ---------- Net cash (used in) provided by operating activities (9,577) (3,737) 654 (12,660) -------- ------------- -------- ----------
Page 21 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE TWENTY EIGHT WEEKS ENDED JULY 11, 2004 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ INVESTING ACTIVITIES: --------------------- Purchases of property and equipment (2,453) (1,720) (38) (4,211) ---------- --------- ----------- --------- Net cash used in investing activities (2,453) (1,720) (38) (4,211) ---------- --------- ----------- --------- FINANCING ACTIVITIES: --------------------- Mortgage principal repayments - (96) - (96) Tax distribution (682) - - (682) Loans receivable from officers 505 - - 505 Intercompany balances (2,760) 3,552 (792) - ---------- --------- ----------- --------- Net cash provided by (used in) financing activities (2,937) 3,456 (792) (273) ---------- --------- ----------- --------- Decrease in cash and cash equivalents (14,967) (2,001) (176) (17,144) Cash and cash equivalents at beginning of period 49,515 5,595 1,299 56,409 ---------- --------- ----------- --------- Cash and cash equivalents at end of period $34,548 $3,594 $1,123 $39,265 ========== ========= =========== ========= SS Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $112 $95 $16 $223 ========== ========= =========== ========= Cash paid during the period for interest $14,025 $771 - $14,796 ========== ========= =========== ==========
Page 22 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE TWENTY EIGHT WEEKS ENDED JULY 13, 2003 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ OPERATING ACTIVITIES: --------------------- Net (loss) income ($10,004) ($6,096) $398 ($15,702) Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 4,697 5,173 539 10,409 Amortization of deferred financing costs 579 - - 579 Accretion of original issue discount 204 - - 204 Provision for restaurant closing 71 - - 71 Increase (decrease) in deferred rent 215 (27) 24 212 Loss on sale of other concept units - - 50 50 Minority interest - - 10 10 Equity in net income of unconsolidated affiliates (511) - - (511) Dividends received from unconsolidated affiliates 119 - - 119 ----------- ---------- --------- ------------ (4,630) (950) 1,021 (4,559) Changes in operating assets and liabilities: Receivables 88 355 (21) 422 Inventories 452 547 6 1,005 Prepaid expenses (3,711) (1,782) (201) (5,694) Other assets (592) (27) 489 (130) Accounts payable and accrued expenses 852 375 (67) 1,160 Accrued interest payable 1,079 - - 1,079 ----------- ---------- --------- ------------ Net cash (used in) provided by operating activities (6,462) (1,482) 1,227 (6,717) ----------- ---------- --------- ------------
Page 23 SBARRO, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE TWENTY EIGHT WEEKS ENDED JULY 13, 2003 (IN THOUSANDS) (UNAUDITED)
GUARANTOR NONGUARANTOR PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ INVESTING ACTIVITIES: --------------------- Purchase of property and equipment (3,080) (1,508) (151) (4,739) ----------- -------- ------- --------- Net cash used in investing activities (3,080) (1,508) (151) (4,739) ----------- -------- ------- --------- FINANCING ACTIVITIES: --------------------- Mortgage principal repayments - (88) - (88) Tax distribution (1,101) - - (1,101) Intercompany balances 733 553 (1,286) - ----------- -------- ------- --------- Net cash (used in) provided by financing activities (368) 465 (1,286) (1,189) ----------- -------- ------- --------- Decrease in cash and cash equivalents (9,910) (2,525) (210) (12,645) Cash and cash equivalents at beginning of period 47,636 6,539 975 55,150 ----------- -------- ------- --------- Cash and cash equivalents at end of period $37,726 $4,014 $765 $42,505 =========== ======== ======= ========= Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $244 $73 $13 $330 =========== ======== ======= ========= Cash paid during the period for Interest $14,102 $765 - $14,867 =========== ======== ======= =========
Page 24 SBARRO, INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS --------------------- The following table provides information concerning the number of Company-owned and franchised restaurants in operation during each indicated period:
28 WEEKS 28 WEEKS 12 WEEKS 12 WEEKS --------- --------- --------- --------- ENDED ENDED ENDED ENDED FISCAL YEAR ----- ----- ----- ----- ----------------- 7/11/2004 7/13/03 7/11/04 7/13/03 2003 2002 Company-owned restaurants: Opened during period 2 1 - 1 4 13 Acquired from (sold to) franchisees during period, net (2) (6) - (2) (12) (6) Closed during period (15) (16) (3) (7) (22) (51) Open at end of period (1) 513 537 513 537 528 558 Franchised restaurants: Opened during period 23 22 14 12 39 42 Purchased from (sold to) Company during period, net 2 6 - 2 12 6 Closed or terminated during period (5) (13) - (5) (17) (20) Open at end of period 407 368 407 368 387 353 All restaurants: Opened during period 25 23 14 13 43 55 Closed or terminated during period (20) (29) (3) (12) (39) (71) Opened at end of period (1) 920 905 920 905 915 911 Kiosks (all franchised) open at end of period 3 3 3 3 3 3
(1) Excludes 29, 31, 29 and 32 other concept units as of July 11, 2004 and July 13, 2003, the end of fiscal 2003 and the end of fiscal 2002, respectively. Page 25 SBARRO, INC. AND SUBSIDIARIES Our business is subject to seasonal fluctuations, and the effects of weather and economic conditions. Earnings have been highest in our fourth fiscal quarter due primarily to increased volume in shopping malls during the holiday shopping season. As a result, our annual earnings can fluctuate due to the length of the holiday shopping period between Thanksgiving and New Year's Day and the number of weeks in our fourth quarter. In recent years, our fourth quarter income has fluctuated significantly due to a number of other factors, including the adverse effect of the general economic downturn and significant year end adjustments relating to asset impairment and store closing costs. Due to the seasonality of our business, we are not able to perform the testing for impairment on our goodwill and intangible assets with indefinite lives acquired prior to July 1, 2001 as required by SFAS No. 142, "Goodwill and Other Intangible Assets" until after our fourth quarter is completed. Our annual impairment test is performed at that time unless impairment factors are present earlier. RELEVANT FINANCIAL INFORMATION
Twenty eight weeks ended Twelve weeks ended July 11, 2004 July 13, 2003 July 11, 2004 July 13, 2003 ------------- ------------- ------------- ------------- in millions except number of locations Comparable Sbarro - owned quick service sales(1) $150.4 $142.8 $64.8 $62.6 Comparable Sbarro - owned quick service sales - percentage change (1) 5.3% 4.5% 3.6% 2.6% Franchise location sales $127.1 $120.4 $55.2 $54.5 Franchise revenues $6.0 $5.3 $2.6 $2.4 Cost of food and paper products as a percentage of restaurant sales 22.5% 21.4% 23.2% 20.9% Payroll and other benefits as a percentage of restaurant sales 28.7% 29.2% 28.7% 29.0% Other operating expenses as a percentage of restaurant sales 37.3% 38.0% 37.3% 37.8% General and administrative costs as a percentage of revenues 8.0% 8.5% 7.4% 7.4% Provision for asset impairment and restaurant closings $0.4 $1.1 $0.2 $0.5 EBITDA $14.6 $11.6 $6.2 $6.5
(1) Comparable Sbarro-owned quick service sales dollar and annual percentage changes are based on locations that were comparable as of July 11, 2004 in each of the periods presented based on locations opened prior to December 29, 2002. Page 26 SBARRO, INC. AND SUBSIDIARIES Our consolidated EBITDA for the first half of 2004 was $14.6 million compared to $11.6 million for the first half of 2003. Our consolidated EBITDA for the second quarter of 2004 was $6.2 million compared to $6.5 million for the second quarter of 2003. EBITDA represents earnings (losses) before interest income, interest expense, taxes, depreciation and amortization. EBITDA should not be considered in isolation from, or as a substitute for, net income, cash flow from operations or other cash flow statement data prepared in accordance with generally accepted accounting principles of the United States ("GAAP") measure of a company's profitability or liquidity. Rather, we believe that EBITDA provides relevant and useful information for analysts and investors in our senior notes in that EBITDA is one of the factors in the calculation of our compliance with the ratios in the indenture under which our senior notes are issued. We also internally use EBITDA as one of the measures to determine whether to continue operating or close restaurant units since it provides us with a measurement of whether we are receiving an adequate cash return on our cash investment. Our calculation of EBITDA may not be comparable to a similarly titled measure reported by other companies, since all companies do not calculate this non-GAAP measure in the same manner. Our EBITDA calculations are not intended to represent cash provided by (used in) operating activities since they do not include interest and taxes and changes in operating assets and liabilities, nor are they intended to represent a net increase in cash since they do not include cash provided by (used in) investing and financing activities. The following table reconciles EBITDA to our net loss for each of the periods presented which we believe is the most direct comparable GAAP financial measure to EBITDA (in thousands):
Twenty eight weeks ended: Twelve weeks ended: 7/11/2004 7/13/2003 7/11/2004 7/13/2003 --------- --------- --------- --------- EBITDA $14,573 $11,633 $6,228 $6,537 Interest expense (16,583) (16,763) (7,106) (7,180) Interest income 324 411 128 197 Income taxes (369) (574) (128) (253) Depreciation and amortization (8,662) (10,409) (3,678) (4,513) ========== ========== =========== ======== Net loss ($10,717) ($15,702) ($4,556) ($5,212) ========== ========== =========== ========
Page 27 SBARRO, INC. AND SUBSIDIARIES Restaurant sales increased $2.7 million, or 1.8%, to $159.5 million for the first half of fiscal 2004 from $156.8 million for the first half of fiscal 2003. The increase in sales included $2.9 million of higher sales of the quick service business offset by $0.2 million of lower sales of consolidated other concepts. The increase in quick service business included an approximate $7.6 million (5.3%) increase in comparable sales offset by the loss of approximately $6.6 million of sales from the closure, since the end of the first quarter of 2003, of generally low volume locations that did not have a material impact on our operating results. Sales for locations that opened during fiscal 2004 and an increase in sales of the locations that were opened during the first half of fiscal 2003 comprised the remaining $1.9 million increase in quick service sales. Restaurant sales increased $0.5 million, or 0.6%, to $68.7 million for the second quarter of fiscal 2004 from $68.2 million in the second quarter of 2003. This increase in sales is primarily a result of $0.5 million of higher sales of the quick service business. The increase in the quick service business included an approximate $2.2 million (3.6%) increase in comparable sales offset by the loss of approximately $2.8 million of sales from the closure, since the end of the first quarter of 2003, of generally low volume locations that did not have a material impact on our operating results. Second quarter sales for both locations that opened during fiscal 2004 and the increase in sales of the locations that were opened during the first half of fiscal 2003 comprised the remaining $1.1 million increase in quick service sales. We believe that the increases in comparable sales are primarily due to economic trends, the strengthening of operational management and training programs which generated operational efficiencies, as well as a series of selective price increases that became effective during the second quarter of fiscal 2004 and during the last half of the first quarter of 2004. We believe that the price increases will have an approximate 2% effect on sales on an annual basis. Franchise related income increased 12.4% to $6.0 million for the first half of 2004 from $5.3 million in the first half of fiscal 2003. The increase in franchise related income is comprised of increases in royalties from comparable locations that resulted from sales increases of 12.5% for international locations and 3.1% for domestic locations as well as royalty income derived from locations opened during the first and second quarters of 2004 and 2003. Franchise related income increased 8.2% to $2.6 million for the second quarter of 2004 from $2.4 million for the second quarter of 2003. The increase in franchise related income is comprised of increases in royalties from comparable locations that resulted from sales increases of 3.6% for international locations and 3.7% for domestic locations as well as royalty income derived during the second quarter from locations opened during the first and second quarters of 2004 and 2003. Real estate and other revenues increased 10.8% and 2.8% in the first half and second quarter of fiscal 2004 from the same periods in fiscal 2003, respectively, primarily due to variations in certain vendor rebates relating to franchises and marketing allowances. Cost of food and paper products as a percentage of restaurant sales increased to 22.5% for the first half of fiscal 2004 from 21.4% for the comparable 2003 fiscal period. These costs increased to 23.2% for the second quarter of 2004 from 20.9% for the comparable period in 2003. While Page 28 SBARRO, INC. AND SUBSIDIARIES the cost of sales percentages in 2004 were positively impacted by operating efficiencies resulting from the increase in comparable unit sales and the price increases implemented during 2004, cheese prices increased to record high levels during the second fiscal quarter of 2004 but moderated significantly during the latter part of that quarter. These fluctuations in cheese prices resulted in 1.7% and 2.7% increases in the cost of sales in the first half and second quarter of fiscal 2004, respectively, when compared to the same periods in fiscal 2003. Payroll and other employee benefits decreased to 28.7% of restaurant sales for the first half of 2004 from 29.2% of restaurant sales in the first half of 2003. Payroll and other employee benefits decreased to 28.7% of restaurant sales for the second quarter of fiscal 2004 from 29.0% of restaurant sales for the second quarter of fiscal 2003. These percentage decreases were primarily due to increased revenues as a result of both unit sales and price increases as well as the elimination of locations with higher payroll costs as a percentage of restaurant sales. Other operating expenses decreased to 37.3% of restaurant sales in the first half of fiscal 2004 from 38.0% of restaurant sales in the first half of 2003. Other operating expenses decreased to 37.3% of restaurant sales for the second quarter of 2004 from 37.8% of restaurant sales for the second quarter of 2003. As a percentage of restaurant sales, these costs improved primarily as a result of the higher level of sales. Depreciation and amortization expense was $1.7 million lower for the first half and $0.8 million lower for the second quarter of fiscal 2004, as compared to the same periods in 2003. Of the reduction in the first half of the year, $0.4 million was due to the reduction in the number of units in operation, $0.6 million was for locations that had been included in the provision for asset impairment in fiscal 2003 for which no depreciation was taken in fiscal 2004, $0.4 million related to locations that became fully depreciated during fiscal 2003 and $0.3 million related to depreciable assets at our former administrative office building on which the lease was terminated May 2004. Of the reduction in the second quarter of this year, $0.1 million was due to the reduction in the number of units in operation, $0.2 million was for locations that had been included in the provision for asset impairment in fiscal 2003, $0.2 million related to locations that became fully depreciated during fiscal 2003 and $0.2 million related to depreciable assests at our former administrative office building on which the lease was terminated May 2004. General and administrative expenses were $13.5 million, or 8.0% of total revenues, for the first half of fiscal 2004 compared to $14.1 million, or 8.5% of total revenues, for the first half of 2003. Factors contributing to the changes for the first half of 2004 included approximately $1.4 million of lower costs due to the reduction in work force, a $0.2 million decrease in bad debt expense recorded in the first quarter of fiscal 2003 and bonuses of $0.7 million granted to certain executive officers in the first quarter of 2003 which were not granted in the first quarter of 2004 offset, in part, by $0.7 million recorded in the first quarter of fiscal 2004 of severance and other costs related to the reduction in work force and $0.7 million of costs related to new executives. In addition, general and administrative costs in the second quarter of 2003 included a $0.3 million gain on the sale of an other concept location. The annual effect of our reduction in work force on our administrative and general costs is estimated at $3.1 million. Page 29 SBARRO, INC. AND SUBSIDIARIES General administrative expenses were $5.3 million in each second quarter, or 7.3% and 7.4% of total revenues, for the second quarter of fiscal 2004 and 2003, respectively. For the second quarter of 2004, there were lower costs due to the reduction in work force of approximately $0.7 million offset by costs of approximately $0.3 million for new executives. General and administrative costs in the second quarter of 2003 included a $0.3 million gain on the sale of an other concept location. Interest expense for the first half of fiscal 2004 and 2003 was $16.6 million and $16.8 million, respectively, and $7.1 million and $7.2 million for the second quarter of 2004 and 2003, respectively. Interest costs were incurred for the 11%, $255 million senior notes issued to finance our going private transaction in 1999 and the 8.4%, $16 million mortgage loan on our corporate headquarters in 2001. In addition, interest expense includes non-cash charges for the accretion of the original issue discount on our senior notes and the amortization of deferred financing costs on the senior notes and the mortgage loan and, for 2003, the credit agreement that was terminated in the fourth quarter of fiscal 2003. Equity in the net income of unconsolidated affiliates represents our proportionate share of earnings and losses in those other concepts in which we have a 50% or less ownership interest. The $0.2 million and $0.1 million increase in the first half and second quarter of 2004, respectively, in our share of the equity in the net income of unconsolidated affiliates was primarily as a result of an improvement in the performance of our steakhouse joint venture. There currently are two steakhouses under construction which are expected to be completed by the end of fiscal 2004 or early in fiscal 2005. We do not have any further expansion plans for our unconsolidated joint ventures. We have elected to be taxed under the provisions of Subchapter S of the Internal Revenue Code and, where applicable and permitted, under similar state and local income tax provisions beginning January 3, 2000. Under the provisions of Subchapter S, substantially all taxes on our income are paid by our shareholders rather than us. Our tax expense was $0.4 million and approximately $0.6 million for the first halves and $0.1 million and $0.3 million for the second quarters of 2004 and 2003, respectively. The expense was for taxes owed by us (rather than our shareholders) to jurisdictions that do not recognize S corporation status or that tax entities based on factors other than income and for taxes withheld at the source of payment on foreign franchise income related payments. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- CASH REQUIREMENTS Our liquidity requirements relate to debt service, capital expenditures, working capital, investments in other ventures, distributions to shareholders when permitted under the indenture for the senior notes, to repay any borrowings we may make under our line of credit agreement and general corporate purposes. We incur annual cash interest expense of approximately $29.5 million under the senior notes and mortgage loan and may incur additional interest expense for borrowings under our line of credit. We are not required to make principal payments, absent the Page 30 SBARRO, INC. AND SUBSIDIARIES occurrence of certain events, on our senior notes until they mature in September 2009. We believe that aggregate restaurant capital expenditures and our investments in joint ventures during fiscal 2004 will approximate the fiscal 2003 level of $8.5 million. Our $3.0 million line of credit which expires in May 2005 is uncommitted. Therefore, our lender could refuse to lend to us at any time. There were no unpaid capital expenditure commitments at July 11, 2004. We expect our primary source of liquidity to meet these needs will be cash flow from operations. We do not presently expect to borrow under our line of credit in fiscal 2004 except for required letters of credit. CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS Our contractual obligations and off balance sheets arrangements with respect to Sbarro owned and franchised restaurants as well as those for our other concept arrangements (both those in which we have a majority or minority interest) do not materially differ from the information disclosed in Part II, Item 7 of our Annual Report on Form 10-K for the 2003 fiscal year. SOURCES AND USES OF CASH The following table summarizes our cash and cash equivalents and working capital as at the end of the second quarter of 2004 and 2003 and the uses of our cash flows during the first half of each of the respective fiscal years:
As at and for the Six Months Ended ---------------------------------- July 11, 2004 July 13, 2003 ------------- ------------- (in millions) ------------- Liquidity at the end of periods ------------------------------- Cash and cash equivalents $ 39.3 $42.5 Working capital 23.2 15.6 Net cash flows for the period ----------------------------- Used in operating activities (12.7) (6.7) Used in investing activities (4.2) (4.7) Used in financing activities (0.3) (1.2) Net decrease in cash (17.2) (12.6)
We have historically not required significant working capital to fund our existing operations and have financed our capital expenditures and investments in joint ventures through cash generated from operations. Net cash used in operating activities was $12.7 million for the first half of 2004 compared to $6.7 million used during the first half of 2003. The $5.9 million increase was primarily due to the effect of the decrease in the loss from operations, as adjusted for non-cash items, in the first half of 2004 compared to the same calculation for the first half of 2003 of approximately $3.3 million, income tax refunds received of approximately $0.3 million, contractual payments of $0.2 Page 31 SBARRO, INC. AND SUBSIDIARIES million related to prior year sales of other concept locations and a $2.4 million increase in the use of cash as a result of the timing of payments in fiscal 2004 for our insurance policy renewal as the 2003 policy renewals were financed, offset by an increase of approximately $1.2 million in inventory value due to increases in product costs, primarily cheese, a reduction in franchise related collections during fiscal 2004 of approximately $1.2 million and a decrease of approximately $4.7 million in accounts payable and accrued expenses between the comparable 2004 and 2003 periods due to the change in the level of sales just prior to the beginning of each of those fiscal years. Net cash used in investing activities has historically been primarily for capital expenditures. Net cash used in investing activities decreased from $4.7 million for the first half of 2003 to $4.2 million for the first half of 2004 primarily due to $0.6 million that was expended in the first half of fiscal 2003 relating to an upgrade of our computer system. Net cash used in financing activities was $0.3 million in the first half of fiscal 2004 compared to $1.2 million for the first half of fiscal 2003. Cash used in financing activities in both years resulted primarily from tax distributions to our shareholders. In March 2000, we elected to be taxed under the provisions of Subchapter S of the Internal Revenue Code and, where applicable and permitted, under similar state and local income tax provisions beginning January 3, 2000. Under the provisions of Subchapter S, substantially all taxes on our income are paid by our shareholders. The indenture for the senior notes permits us to make distributions to shareholders under a formula that is designed to approximate the income taxes, including estimated taxes, that would be payable by our shareholders if their only income were their pro-rata share of our taxable income and such income were taxed at the highest applicable federal and New York State marginal income tax rates. There are differences in the book and tax treatments of the provision for asset impairment, tax credits and in book and tax depreciation. The tax distributions in the first quarter of both fiscal years were made with respect to our taxable income for fiscal 2002. The $0.7 million distribution made in the first quarter of 2004 was declared in November 2003. We do not expect to make tax distributions in 2004 related to the 2003 results of operation. FINANCING As part of the transaction in which we became a privately-held company in 1999, we sold $255 million of 11% senior notes (at a price of 98.514% of par to yield 11.25% per annum), the net proceeds of which, together with substantially all of our then existing cash, was used to finance the transaction. At that time, we also entered into a $30 million credit agreement that we terminated in the fourth quarter of 2003. In March 2004, we obtained an uncommitted line of credit, which expires in May 2005, to replace our former revolving credit facility. We currently have the ability, subject to bank approval, to borrow up to $3 million, including outstanding letters of credit. We have $1.7 million of outstanding letters of credit and $1.3 million of undrawn availability. The new line of credit contains no financial covenants or unused line fees. Interest applicable to the loans under the new line of credit is at the bank's prime rate at the time of any borrowings. Under our senior notes indenture, there are various covenants that limit our ability to borrow funds to make "restricted payments" including, among other things, dividend payments (other Page 32 SBARRO, INC. AND SUBSIDIARIES than as distributions pursuant to the tax payment agreement), and to make investments in, among other things, unrestricted subsidiaries. Among other covenants, the indenture requires that, in order for us to borrow, our consolidated interest ratio coverage (as defined in the Indenture), after giving pro forma effect to the interest on the new borrowing, for the four most recently ended fiscal quarters must be at least 2.5 to 1. As of July 11, 2004, that ratio was 1.3 to 1. As a result, we are not presently able to borrow funds except for specifically permitted indebtedness, including up to $75.0 million of revolving credit loans. In order to make restricted payments, that ratio must be at least 2.0 to 1, after giving pro forma effect to the restricted payment and, in any event, is limited in dollar amount pursuant to a formula contained in the indenture. We refer to the amount that is available for us to make dividends and other restricted payments as the "restricted payment availability." We cannot make restricted payments (other than distributions pursuant to the tax payment agreement) until we increase the restricted payment availability by approximately $20.5 million, and then only to the extent of any excess over that amount. In March 2000, one of our subsidiaries obtained a $16 million, 8.4% loan due in 2010, secured by a mortgage on our corporate headquarters building. The loan is payable in monthly installments of principal and interest of $0.1 million. The outstanding principal balance of the loan as of July 11, 2004 was $15.4 million. The mortgage agreement contains various covenants, including a requirement that the subsidiary maintain a minimum ratio of EBITDA to annual debt service of at least 1.2 to 1.0. We were in compliance with all covenants in the indenture for the senior notes and our mortgage as of July 11, 2004. CRITICAL ACCOUNTING POLICIES AND JUDGMENTS ------------------------------------------ Accounting policies are an integral part of the preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America. Understanding these policies, therefore, is a key factor in understanding our reported results of operations and financial position. Accounting policies often require us to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in the financial statements. Due to their nature, estimates involve judgments based upon available information. Therefore, actual results or amounts could differ from estimates and the difference could have a material impact on our consolidated financial statements. During the first half of fiscal 2004, there were no material changes in the accounting policies, the application of which may have the most significant effect on our reported results of operations and financial position and that require judgments estimates and assumptions by management that can affect their application from the matters discussed under the heading "Critical Accounting Policies and Judgments" in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 28, 2003. Page 33 SBARRO, INC. AND SUBSIDIARIES CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- During the first half of fiscal 2004 there were no changes in the matters discussed under the heading "Certain Relationships and Related Transactions" in Part II, Item 13 of our Annual Report on Form 10-K for the fiscal year ended December 28, 2003. FORWARD LOOKING STATEMENTS -------------------------- This report contains certain forward-looking statements about our financial condition, results of operations, future prospects and business. These statements appear in a number of places in the report and include statements regarding our intent, belief, expectation, strategies or projections at this time. These statements generally contain words such as "may," "should," "seeks," "believes," "in our opinion," "expects," "intends," "plans," "estimates," "projects," "strategy" and similar expressions or the negative of those words. Forward-looking statements are subject to a number of known and unknown risks and uncertainties that could cause actual results to differ materially from those projected, expressed or implied in the forward-looking statements. These risks and uncertainties, many of which are not within our control, include but are not limited to: o general economic, weather and business conditions; o the availability of suitable restaurant sites in appropriate regional shopping malls and other locations on reasonable rental terms; o changes in consumer tastes; o changes in population, energy prices and traffic patterns, including the effect that military action and terrorism or other events may have on the willingness of consumers to frequent shopping malls, airports or downtown areas which are the predominant areas in which our restaurants are located; o our ability to continue to attract franchisees; o the success of our present, and any future, joint ventures and other expansion opportunities; o the availability of food (particularly cheese and tomatoes), beverage and paper products at current prices; o our ability to pass along cost increases to our customers; o no material increase occurring in the Federal minimum wage; o the continuity of services of members of our senior management team; o our ability to attract and retain competent restaurant and executive managerial personnel; o competition; o the level of, and our ability to comply with, government regulations; o our ability to generate sufficient cash flow to make interest payments and principal under our senior notes and mortgage loan; o our ability to comply with covenants contained in the indenture under which the senior notes are issued, and the effects which the restrictions imposed by those covenants may have on our ability to operate our business; and o our ability to repurchase senior notes to the extent required in the event we make certain asset sales or experience a change of control. Page 34 SBARRO, INC. AND SUBSIDIARIES You are cautioned not to place undue reliance on these statements, which speak only as of the date of the report. We do not undertake any responsibility to release publicly any revisions to these forward-looking statements to take into account events or circumstances that occur after the date of this report. Additionally, we do not undertake any responsibility to update you on the occurrence of any unanticipated events which may cause actual results to differ from those expressed or implied by the forward-looking statements contained in this report. Page 35 SBARRO, INC. AND SUBSIDIARIES ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES OF MARKET RISK We have historically invested our cash on hand in short term, fixed rate, highly rated and highly liquid instruments which are reinvested when they mature throughout the year. The indenture under which our senior notes are issued limits us to similar investments. Although our existing investments are not considered at risk with respect to changes in interest rates or markets for these instruments, our rate of return on short-term investments could be affected at the time of reinvestment as a result of intervening events. Future borrowings under our uncommitted line of credit (none are currently outstanding) will be at rates that float with the market and, therefore, will be subject to fluctuations in interest rates. We are not a party to, and do not expect to enter into any interest rate swaps or other instruments to hedge interest rates. We have not, and do not expect to, purchase future, forward, option or other instruments to hedge against fluctuations in the prices of the commodities we purchase. As a result, our future commodities purchases are subject to changes in the prices of such commodities. All of our transactions with foreign franchisees have been denominated in, and all payments have been made in, United States dollars, reducing the risks attendant to changes in the values of foreign currencies. As a result, we have not purchased future contracts, options or other instruments to hedge against changes in values of foreign currencies. ITEM 4. CONTROLS AND PROCEDURES Disclosure Controls and Procedures: Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of l934, as amended (the "Exchange Act"), as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period, our disclosure controls and procedures are effective. Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that it will detect or uncover failures within Sbarro to disclose material information otherwise required to be set forth in our periodic reports. Internal Control Over Financial Reporting: There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the twenty eight weeks ended July 11, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Page 36 SBARRO, INC. AND SUBSIDIARIES PART II. OTHER INFORMATION -------------------------- Item 1. Legal proceedings None of the proceedings discussed in Item 3 of our Annual Report on Form 10-K for our 2003 fiscal year have been terminated and there have not been any material developments in those proceedings during the second fiscal quarter of fiscal 2004. Item 6. Exhibits and Reports on Form 8-K. a) Exhibits: 31.01 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.02 Certification of Vice President, Chief Financial Officer and Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.01 Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.02 Certification of Vice President, Chief Financial Officer and Principal Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: We filed no reports on Form 8-K during the quarter covered by this report. Page 37 SBARRO, INC. AND SUBSIDIARIES SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. SBARRO, INC. -------------------------------------------- Registrant Date: August 17, 2004 By: /s/ MICHAEL O'DONNELL --------------------- ---------------------------------------- Michael O'Donnell President and Chief Executive Officer Date: August 17, 2004 By: /s/ ANTHONY J. PUGLISI --------------------- ---------------------------------------- Anthony J. Puglisi Vice President; Chief Financial Officer and Principal Accounting Officer Page 38 EXHIBIT INDEX ------------- EXHIBIT NUMBER DESCRIPTION -------------- ----------- 31.01 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.02 Certification of Vice President, Chief Financial Officer and Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.01 Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.02 Certification of Vice President, Chief Financial Officer and Principal Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.