10-K 1 f10k-01022005.txt JANUARY 2, 2005 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K |X| Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended JANUARY 2, 2005. |_| Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ________ to ________ 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 incorporation or organization) Identification No.) 401 BROADHOLLOW ROAD, MELVILLE, NEW YORK 11747 - 4714 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (631) 715-4100 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days. *Yes No ------- ------- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ X ]. 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 registrant's common stock is not publicly-held or publicly traded. The number of shares of Common Stock of the registrant outstanding as of March 31, 2005 was 7,064,328. DOCUMENTS INCORPORATED BY REFERENCE None -------------------------------------------------------------------------------- *This Form 10-K is voluntarily submitted pursuant to a requirement contained in the indenture governing Sbarro, Inc.'s Senior Notes due 2009. SBARRO, INC. ------------ UNLESS THE CONTEXT OTHERWISE REQUIRES, ALL REFERENCES TO "WE," "US," "OUR," "SBARRO" OR THE "COMPANY" INCLUDE SBARRO, INC. AND OUR SUBSIDIARIES. 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, inflation, national security, 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 and traffic patterns, including the effects that military action and terrorism or other events may have on the willingness of consumers to frequent 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 increases in the Federal minimum wage; o the continuity of service 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 line of credit; 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 our senior notes to the extent required in the event we make certain asset sales or experience a change of control. -2- You are cautioned not to place undue reliance on forward looking 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. PART I ------ ITEM 1. BUSINESS ------- -------- Sbarro, Inc., a New York corporation, was organized in 1977 and is the successor to a number of family food and restaurant businesses developed and operated by the Sbarro family. Today, we are a leading owner, operator and franchisor of quick-service restaurants, serving a wide variety of Italian specialty foods with 927 company-owned and franchised restaurants worldwide at January 2, 2005. In addition, since 1995, we have created, through subsidiaries and joint ventures, other restaurant concepts for the purpose of developing growth opportunities in addition to the Sbarro restaurants. We presently operate 24 other concept restaurants through owned subsidiaries and joint ventures. GOING PRIVATE TRANSACTION ------------------------- On September 28, 1999, members of the Sbarro family (who prior thereto owned approximately 34.4% of our common stock) became the holders of 100% of our issued and outstanding common stock as a result of a merger in which a company owned by the members of the Sbarro family merged with and into us. The cost of the merger, including fees and expenses, was funded through the use of substantially all of our cash then on hand and the placement of $255 million of 11% senior notes due September 15, 2009 sold at a price of 98.514% of par to yield 11.25% per annum. In April 2000, we exchanged these senior notes for new senior notes having the same terms, except that the new senior notes were registered under the Securities Act of 1933. Throughout this report we are referring to the new senior notes as the "Senior Notes." The old senior notes and the new senior notes were issued under an indenture dated September 28, 1999, which, throughout this report, we are referring to as the "Indenture." Our payment obligations under the senior notes are jointly, severally, unconditionally and irrevocably guaranteed by all of our current restricted subsidiaries (as defined in the indenture) and are to be similarly guaranteed by our future restricted subsidiaries. -3- GENERAL ------- We are a leading owner, operator and franchisor of quick service restaurants, serving a wide variety of Italian specialty foods. Under the "Sbarro", "Sbarro The Italian Eatery", "Cafe Sbarro", "Umberto's", "Tony and Brunos" and "La Cuccina" names, we developed one of the first quick-service concepts that extended beyond offering one primary specialty item, such as pizza or hamburgers. Our diverse menu offering includes pizza, pasta and other hot and cold Italian entrees, salads, sandwiches, cheesecake and other desserts and beverages. All of our entrees are prepared fresh daily in each restaurant using special recipes developed by us. We focus on serving our customers generous portions of high quality Italian food at attractive prices. We believe that the Sbarro concept is unlike other quick-service Italian restaurants due to its diverse menu selection and its fast, cafeteria-style service. Since our inception in 1959, we have focused on high customer traffic venues due to the large number of captive customers who base their eating decision primarily on impulse and convenience. We therefore do not have to incur the significant advertising and promotional expenditures that certain of our competitors incur to attract customers to their destination restaurants. These factors, combined with adherence to strict cost controls, provide us with reasonable operating margin percentages. Sbarro restaurants are primarily located in shopping malls, downtown locations and other high customer traffic venues, including toll roads, airports, sports arenas, hospitals, convention centers, university campuses and casinos. We believe that there may be opportunities to open similar Sbarro units in these and other venues. As of January 2, 2005, we had 927 Sbarro quick service restaurants, consisting of 511 company-owned restaurants and 416 franchised restaurants located in 46 States, the District of Columbia, the Commonwealth of Puerto Rico, certain United States territories and 29 countries throughout the world. In addition, since 1995, we have created and operated other casual and fine dining concepts for the purpose of developing growth opportunities in addition to our Sbarro restaurants. With our joint venture partners or in wholly owned subsidiaries, we currently operate 24 casual and fine dining restaurants featuring varying cuisines under other restaurant concepts, including three opened and one closed in the first quarter of 2005. -4- RESTAURANT EXPANSION -------------------- The following table summarizes the number of Sbarro owned, franchised and other concept restaurants in operation during each of the years from 2000 through 2004:
2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- Company owned Sbarro restaurants (1): Open at beginning of period 533 563 607 641 643 Opened during the period 2 4 13 9 13 (Sold to) acquired from franchisees during period (3) (12) (6) - 1 Closed during period (21) (22) (51) (43) (16) ---- ---- ---- ---- ---- Open at end of period 511 533 563 607 641 Franchised Sbarro restaurants: Open at beginning of period 364 349 322 303 286 Opened during the period 63 41 43 42 36 Acquired from (sold to) Sbarro during period 3 12 6 - (1) Closed or terminated during period (14) (38) (22) (23) (18) ---- ---- ---- ---- ---- Open at end of period 416 364 349 322 303 Other concepts (1): Open at beginning of period 27 27 31 27 25 Opened during period 0 3 2 4 2 Closed during period (5) (3) (6) 0 0 ---- ---- ---- ---- ---- Open at end of period 22 27 27 31 27 All restaurants (1): Open at beginning of period 924 939 960 971 954 Opened during the period 65 48 58 55 51 Closed or terminated during period (40) (63) (79) (66) (34) ---- ---- ---- ---- ---- Open at end of period of 949 924 939 960 971
(1) The table above reflects a reclassification of our Umberto mall restaurants from, other concepts to Company owned Sbarro restaurants for each of the years presented. -5- QUICK SERVICE RESTAURANTS ------------------------- Our Quick Service Restaurants ("QSR"), which operate under the names "Sbarro", "Sbarro The Italian Eatery," "Cafe Sbarro", "Umberto's", "Tony and Bruno's" and "La Cuccina", are family oriented restaurants offering cafeteria and buffet style quick service designed to minimize customer waiting time and facilitate table turnover. The decor of a QSR restaurant incorporates a contemporary motif that blends with the characteristics of the surrounding area. As of January 2, 2005, there were 96 company owned "in-line" QSR restaurants and 415 company owned "food court" QSR restaurants. In addition, franchisees operated 416 QSR restaurants. "In-line" restaurants, which are self-contained restaurants, usually occupy between 1,500 and 3,000 square feet, and seat approximately 60 to 120 people and employ 10 to 40 persons, including part-time personnel. "Food court" restaurants are primarily located in areas of shopping malls designated exclusively for restaurant use and share a common dining area provided by the mall. These restaurants generally occupy between 500 and 1,000 square feet, contain only kitchen and service areas, have a more limited menu and employ 6 to 30 persons, including part-time personnel. QSR restaurants are generally open seven days a week serving lunch, dinner and, in a limited number of locations, breakfast, with hours conforming to those of the major department stores or other large retailers in the mall or trade area in which they are located. Typically, mall restaurants are open to serve customers 10 to 12 hours a day, except on Sunday, when mall hours may be more limited. For company owned QSR restaurants open a full year, average annual sales in 2004 were approximately $840,000 for an "in-line" restaurant and $562,000 for a "food court" restaurant. Our business is subject to seasonal fluctuations, and the effects of weather, economic conditions, inflation, national security and business conditions. Sales have been highest in our fourth quarter due primarily to increased volume in shopping malls during the holiday shopping season but fluctuate due to the length of the holiday shopping period between Thanksgiving and New Year's Day, the number of weeks in our fourth quarter and weather conditions. Sbarro restaurants feature a menu of popular Italian food, including pizza with a variety of toppings, a selection of pasta dishes and other hot and cold Italian entrees, salads, sandwiches, cheesecake and other desserts. A limited number of restaurants serve breakfast. In addition to soft drinks, a limited number of the restaurants serve beer and wine. All of our entrees are prepared fresh daily in each restaurant according to special recipes developed by us. We place emphasis on serving generous portions of quality Italian food at attractive prices. Entree selections, excluding pizza, generally range in price from $2.79 to $7.99. We believe that pizza, which is sold predominantly by the slice, accounts for approximately 50% of QSR restaurant sales. Substantially all of the food ingredients, beverages and related restaurant supplies used by our QSR restaurants are purchased from a national independent wholesale food distributor which is required to adhere to established product specifications for all food products sold to our restaurants. Breads, pastries, produce, fresh dairy and certain meat products are purchased locally for each restaurant. Soft drink mixes are purchased from major beverage producers under national contracts and distributed by our national independent distributor. Our current contractual arrangement, which expires in January 2008, requires us to purchase 95% of all of our food ingredients that are not purchased locally and related restaurant supplies through the distributor. The majority of the products used in our restaurants are proprietary and we are involved in negotiating their cost to the -6- wholesaler. We believe that there are other distributors who would be able to service our needs and that satisfactory alternative sources of supply are generally available for all items regularly used in our QSR restaurants. RESTAURANT MANAGEMENT --------------------- Our QSR restaurants are managed by one general manager and one or two co-managers or assistant managers, depending upon the size of the location. Managers are required to participate in Sbarro training sessions in restaurant management and operations prior to the assumption of their duties. In addition, each manager is required to comply with an extensive operations manual containing procedures for assuring uniformity of operations and consistent high quality of products. We have a restaurant management bonus program that provides the management teams of Company owned QSR restaurants with the opportunity to receive cash bonuses based on certain performance-related criteria of their location. We employ 31 Directors of Operations, each of whom is typically responsible for the operations of 13 to 18 company owned QSR restaurants. Directors of Operations recruit and supervise the managerial staff of all company owned QSR restaurants and report to one of the five Vice Presidents of Operations. The Vice Presidents of Operations coordinate the activities of the Directors of Operations and report to our President and Chief Executive Officer. FRANCHISE DEVELOPMENT --------------------- Growth in franchise operations occurs through the opening of new QSR restaurants by new and existing franchisees. We rely principally upon our reputation, the strength of our existing restaurants, and participation in national franchise conventions to attract new franchisees. As of January 2, 2005, we had 416 franchised Sbarro restaurants operated by 106 franchisees in 38 states of the United States as well as its territories and in 29 countries throughout the world. We are presently considering additional worldwide franchise opportunities. In certain instances, we have established franchise locations under territorial agreements in which we have granted, for specified time periods, exclusive rights to enter into franchise agreements for restaurant units in certain geographic areas (primarily foreign countries). In order to obtain a franchise, we generally require payment of an initial fee and continuing royalties at rates of 3.5% to 10% of gross revenues. We require the franchise agreements to end at the same time as the underlying lease, generally ten years, including a renewal period of the underlying lease, if applicable. Since 1990, the renewal option has also been subject to conditions, including a remodel or image enhancement requirement. Franchise agreements granted under territorial agreements and those for non-traditional sites are at negotiated fees, royalty rates and terms and conditions other than those contained in our basic franchise agreement. The franchise and territorial agreements provide us with the right to terminate a franchisee for a variety of reasons, including insolvency or bankruptcy, failure to operate its restaurant according to Sbarro standards, understatement of gross receipts, failure to pay fees, or material misrepresentation on a franchise application. We presently employ 12 management level employees who are responsible for overseeing the operations of franchise units and for developing new units. -7- OTHER CONCEPTS -------------- Since 1995, we have developed and established new restaurant concepts to provide growth opportunities that leverage our restaurant management and financial expertise. These concepts are operated either by us alone or through joint ventures with restauranteurs experienced in the particular food area. We participate with our partners in overseeing the operations of each venture. Our joint ventures and other wholly-owned concepts presently operate 24 restaurants. As of January 2, 2005, we are including our Umberto mall restaurants that had previously been included in our "Other concepts" with our Company owned QSR restaurants. The following is a summary of our other concepts: o In early 2005, we opened a casual dining restaurant serving Italian food under the name "Carmela's of Brooklyn" in Orlando, Florida The restaurant provides both take out and table service, and generally caters to families. In connection with this concept we entered into a Joint Venture Development Agreement for the Orlando market. The joint venture partner will be required to contribute one half of the estimated development cost and will share in one half of the profits, as defined, of each location in which it decides to participate. We plan to open five additional restaurants in 2005. o We operate eight casual dining restaurants serving Italian food principally under the name "Mama Sbarro" in New York. The restaurants provide both take-out and table service, and generally caters to families. We did not open any Mama Sbarro locations in 2004 nor do we plan to open any in 2005. o We have a 40% interest in a joint venture that presently operates ten casual dining restaurants, including one opened in January 2005, with a Rocky Mountain steakhouse motif under the name "Boulder Creek Steaks & Saloon" in New York. This joint venture also operates three fine dining steak restaurants, two of which are operated under the name "Rothmann's Steak House" and one which is operated under the name "Burton & Doyle." During 2004, a Boulder Creek location was closed and reopened in January 2005 as a mid-scale steakhouse under the name "Sagamore." We are planning to open one fine dining restaurant in 2005. o In January 2005, we sold, to a related party, our 70% interest in a joint venture that, operated one moderately priced, table service restaurant featuring an Italian Mediterranean menu under the name "Salute" in New York City. (See Item 13 "Certain Relationships and Related Transactions.") o We have a 50% interest in a joint venture which operates two quick service Mexican style restaurants in strip centers under the name "Baja Grill." All of our other concept locations presently operate through unrestricted subsidiaries which do not guarantee our senior notes. As such, we have certain restrictions as to the financing we can provide to these new concepts and these entities are not subject to the restrictions contained in the indenture under which our senior notes are issued. Ventures which are less than 50% owned and those owned at 50% for which we do not have operating control and where we are not considered the primary beneficiary are accounted for under the equity method of accounting. -8- As of January 2, 2005, we had an aggregate investment, net of write-downs, in these ventures of approximately $4.6 million. The amount of our investment does not include our share of guarantees of indebtedness and reimbursement obligations with respect to letters of credit in the aggregate amount of approximately $7.4 million and guarantees of certain real property lease obligations of these subsidiaries and other concepts in the approximate amount of $1.8 million. All concepts which are greater than 50% owned or where we are considered the primary beneficiary are consolidated in our financial statements. EMPLOYEES --------- As of January 2, 2005, we employed approximately 6,500 persons, excluding employees of our other concepts, of whom approximately 3,970 were full-time field and restaurant personnel, approximately 2,400 were part-time restaurant personnel and 130 were corporate administrative personnel. None of our employees are covered by collective bargaining agreements. We believe our employee relations are satisfactory. In the first quarter of 2004, we implemented a reduction in work force that reduced our corporate administrative head count by approximately 35 persons and recorded severance and other related costs of approximately $0.7 million. COMPETITION ----------- The restaurant business is highly competitive. Many of our direct competitors operate within the pizza restaurant segment. We compete in each market in which we operate with locally-owned restaurants, as well as with national and regional restaurant chains. We believe we compete on the basis of menu selection, price, service, location and food quality. Factors that affect our business operations include changes in consumer tastes, inflation, national, regional and local economic conditions, population, traffic patterns, changes in discretionary spending priorities, demographic trends, national security, military action, terrorism, consumer confidence in food wholesomeness, handling and safety, weather conditions, the type, number and location of competing restaurants and other factors. There is also active competition for management personnel and attractive commercial shopping mall, center city and other locations suitable for restaurants. Increased food, beverage, labor, occupancy and other costs could also adversely affect us. Although we believe we are well positioned to compete in the quick-service Italian specialty food business because of our leading market position, focus, expertise and strong national brand name recognition, increased competition from existing or new companies and loss of market share, could have an adverse effect on our operations. TRADEMARKS ---------- Our Sbarro restaurants operate principally under the "Sbarro," "Sbarro The Italian Eatery", "Cafe Sbarro", "Umberto's", "Tony and Bruno's" and "La Cuccina" trademarks. Our other concept locations operate under separate trademarks, including "Mama Sbarro" and "Boulder Creek." In addition, we have trademarked the font and style of "Carmela's of Brooklyn." The trademarks are registered with the United States Patent and Trademark Office with no expiration date but must be renewed every ten years. Such registered service marks may continually be renewed for 10-year periods. We have also registered or filed applications to register "Sbarro" and "Sbarro The Italian Eatery" in several other countries. We believe that these marks continue to be materially important to our business. The joint ventures to which we are a party have also applied for United States trademarks covering trade names used by them. -9- GOVERNMENTAL REGULATION ----------------------- We are subject to various federal, state and local laws affecting our businesses, as are our franchisees. Each of our restaurants and those owned by our franchisees and joint ventures are subject to a variety of licensing and governmental regulatory provisions relating to wholesomeness of food, sanitation, building, health, safety and, in certain cases, licensing of the sale of alcoholic beverages. Difficulties in obtaining, or the failure to obtain, required licenses or approvals can delay or prevent the opening of a new restaurant in any particular area. Our operations and those of our franchisees and joint ventures are also subject to federal laws, such as minimum wage laws, the Fair Labor Standards Act and the Immigration Reform and Control Act of 1986. They are also subject to state laws governing such matters as wages, working conditions, employment of minors, citizenship requirements and overtime. Some states have set minimum wage requirements higher than the federal level. We are also subject to Federal Trade Commission ("FTC") regulations and various state laws regulating the offer and sale of franchises. The FTC and various state laws require us to furnish to prospective franchisees a franchise offering circular containing prescribed information. We are currently registered to offer and sell franchises, or are exempt from registering, in all states in which we operate franchised restaurants that have registration requirements. The states in which we are registered, and a number of states in which we may franchise, require registration of a franchise offering circular or a filing with state authorities. Substantive state laws that regulate the franchisor-franchisee relationship presently exist in a substantial number of states, and bills have been introduced in Congress from time to time which provide for federal regulation of the franchisor-franchisee relationship in certain respects. The state laws often limit, among other things, the duration and scope of non-competition provisions and the ability of a franchisor to terminate or refuse to renew a franchise. Although alcoholic beverage sales are not emphasized in our Sbarro QSR restaurants, our other concepts serve alcoholic beverages and some of our larger restaurants serve beer and wine. Sales of beer and wine have historically contributed less than 1% of total revenues of QSR restaurants. We believe that we are in compliance in all material respects with the laws to which we are subject. AVAILABLE INFORMATION: Although we are not required to file reports with the Securities and Exchange Commission ("SEC") as a result of our going private transaction, we voluntarily file with the SEC quarterly reports on Form 10-Q, annual reports on Form 10-K and, if applicable, current reports on Form 8-K, and amendments to these reports. The public may read and copy any materials that we file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public can obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site, with an address of http://www.sec.gov that contains reports, proxy and information statements and other information regarding our electronic filings with the SEC. -10- The address of our Internet site is http://www.sbarro.com. Our Internet site does not include reports we file with the SEC because our only traded security is our senior notes which are not actively traded. However, we will provide to the public, as soon as reasonably practical after we electronically file them with the SEC, free of charge, a reasonable number of copies of our periodic reports filed with the SEC, upon written request to our Chief Financial Officer at our corporate headquarters, 401 Broadhollow Road, Melville, New York 11747-4714. ITEM 2. PROPERTIES ------- ---------- All Sbarro restaurants are typically leased under ten-year leases that often do not include an option to renew the lease. We have historically generally been able to renew or extend leases on existing sites. As of January 2, 2005, we leased 532 restaurants, of which 29 were subleased to franchisees under terms which cover all of our obligations under the leases. The remaining franchisees directly lease their restaurant spaces. Most of our restaurant leases provide for the payment of base rents plus real estate taxes, utilities, insurance, common area charges and certain other expenses. Some leases provide, either exclusively or in combination with base rent, for contingent rents generally ranging from 8% to 10% of net restaurant sales, usually in excess of stipulated amounts. Leases to which we were a party at January 2, 2005 have initial terms expiring as follows (excludes unconsolidated joint ventures):
YEARS INITIAL LEASE NUMBER OF SBARRO- NUMBER OF FRANCHISED TERMS EXPIRE OWNED RESTAURANTS RESTAURANTS ------------ ----------------- ----------- 2005........................................ 34 (1) 4 2006........................................ 41 4 2007 ....................................... 68 6 2008........................................ 63 2 2009........................................ 70 3 Thereafter.................................. 230 10
(1) Includes 13 restaurants under month-to-month arrangements and 16 restaurants as to which we pay only contingent rent based on the level of net restaurant sales, the leases for which are generally for a one year period. We own a four-story office building in Melville, New York having approximately 100,000 square feet and a cafeteria style restaurant operated by us. Approximately 73% of the rentable square feet is currently under lease to unaffiliated third parties. The remaining 27%, consisting primarily of one floor of the building, is occupied by our Corporate and Principal Executive offices. We occupied a two-story 20,000 square foot office building for administrative support functions located in Commack, New York. We had leased the building since May 1986 until April 2004 from a partnership owned by some of our shareholders. Our obligation for the remainder of the lease term was terminated in April 2004 upon the sale of the building. In addition, our other concepts own one restaurant and lease 23 restaurants. -11- ITEM 3. LEGAL PROCEEDINGS ------- ----------------- In December 1999, fourteen current and former general managers of Sbarro restaurants in California amended a complaint against us filed 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 attorneys' fees, each in unspecified amounts. Plaintiffs filed a motion to certify the lawsuit as a class action, but the motion was denied by the court. The court issued a ruling in December 2003 which was unfavorable to us but did not set the amount of damages. We are appealing the ruling due to errors that we believe were made by the trial judge. In September 2000, eight other current and former general managers of Sbarro restaurants in California filed a complaint against us 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 are seeking actual damages, punitive damages and costs of the lawsuit, including reasonable attorneys' 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. In March 2002, four former general managers of Sbarro restaurants in California filed a complaint against us in the Superior Court of California for Los Angeles County. The complaint alleged that the plaintiffs were required to perform labor services without proper premium overtime compensation from at least May 1999. The plaintiffs sought actual damages, punitive damages and attorneys' fees and costs, each in unspecified amounts. The case was settled March 22, 2005 for $48,000, with our insurance company paying $30,000 and us paying $18,000. In August 2002, a subcontractor and the general contractor, pursuant to a construction contract entered into to build the joint venture location that was closed during 2002 and also the subject of the lawsuit discussed below, filed a complaint against the limited liability joint venture company alleging that they were owed for unpaid billings. We were a defendant in the suit by reason of the fact that we guaranteed the bonds under which mechanics liens against the plaintiffs were bonded. In late 2004, we settled the lawsuit for $500,000. The settlement amount had been paid and included in our financial statements. In May 2002, the landlord of the joint venture described above filed a complaint against Sbarro in the Supreme Court of the 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 Company. We believed that our guarantee was limited in amount while the landlord alleged that the guarantee covered all amounts that would become due during the remaining lease term. The court issued a ruling in November 2003 which limited our liability, which we estimated at $500,000. The landlord appealed this decision. Given the uncertainty of the results of an appeal and liability we would have by reason of a reversal, we agreed to settle the matter for $800,000. Settlement agreements are currently being drafted. In November 2004, a contractor, pursuant to a construction contract entered into to build a QSR location, instituted an action for unpaid amounts under the construction contract. We have -12- disputed certain change orders under the contract and seek to invoke the penalty clause under the contract. The action is pending in the Broward County Circuit Court, State of Florida. We believe that our ultimate liability will not exceed $50,000. In May 2004, a suit was filed by the landlord of one of our QSR locations as a result of premature termination of the lease on that location by one of our subsidiaries. The landlord has obtained a consent judgment against the subsidiary for approximately $75,000. The landlord now seeks to enforce the judgment against the subsidiary. While we do not believe the judgment can be enforced against us, we believe that our ultimate liability will not exceed $75,000. In March 2005, we settled a case relating to payments due to a contractor for construction done on one of our other concept restaurants. In addition to the above complaints, from time to time, we are a party to claims and legal proceedings in the ordinary course of business. In our opinion, the results of such claims and legal proceedings are not expected to have a material adverse effect on our consolidated financial position or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------- --------------------------------------------------- Not applicable. -13- PART II ------- ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY ------- ------------------------------------- AND RELATED SHAREHOLDER MATTERS ------------------------------- As a result of the going private transaction in September 1999, our common stock is not publicly-held nor publicly traded. We currently have six shareholders of record. (See Item 12 "Security Ownership of Certain Beneficial Owners and Management.") No dividends were declared in 2004. During 2003, we declared dividends of $1,782,283 to our shareholders for tax distributions related to 2002 taxable earnings of which $1.1 million was paid in 2003 and $0.7 million was paid in March 2004. Tax distributions are determined under a formula contained in a tax payment agreement with our shareholders designed to enable them to pay income taxes imposed upon them, as a result of our election to be taxed under the provisions of Subchapter S of the Internal Revenue Code, on their pro-rata share of our taxable income (See Item 13, "Certain Relationships and Related Transactions - Tax Payment Agreement".) The indenture permits redemption of the senior notes at our option at varying redemption prices and requires us to offer to purchase senior notes in the event of a Change of Control and in connection with certain Asset Sales (each as defined). The indenture contains various covenants, including, but not limited to, restrictions on the payment of dividends, stock repurchases, certain investments and other restricted payments, the incurrence of indebtedness and liens on our assets, affiliate transactions, asset sales and mergers by us and the guaranteeing subsidiaries. We were in compliance with the various covenants contained in the indenture as of January 2, 2005; however, we are not presently permitted under the indenture to pay dividends (other than distributions pursuant to the tax payment agreement) make stock repurchases or, with certain exceptions, incur indebtedness. -14- ITEM 6. SELECTED FINANCIAL DATA ------- ----------------------- The following Selected Financial Data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7 of this report and our consolidated financial statements and the related notes included in Item 8 of this report. Our 2004, 2003 and 2002 consolidated financial statements have been audited and reported on by BDO Seidman, LLP, an independent registered public accounting firm, and our consolidated financial statements for years 2001 and 2000 were audited and reported on by Arthur Andersen LLP, independent public accountants.
FISCAL YEAR (1) --------------- (DOLLARS IN THOUSANDS) 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- SYSTEM-WIDE SALES (UNAUDITED)(2) $584,723 $536,216 $550,279 $570,609 $569,260 ======== ======== ======== ======== ======== INCOME STATEMENT DATA: Revenues: Restaurant sales (1) $331,313 $314,708 $345,206 $372,673 $382,365 Franchise related income 12,093 10,868 10,070 10,286 11,231 Real estate and other 5,488 6,748 5,104 5,756 5,812 -- -------- -------- -------- -------- -------- Total revenues 348,894 332,324 360,380 388,715 399,408 -- -------- -------- -------- -------- -------- Costs and expenses: Costs of food and paper products 72,073 67,446 67,593 74,614 74,405 Payroll and other employee benefits.. 90,857 89,614 96,288 103,828 101,553 Other operating costs 114,571 110,453 114,892 116,581 114,122 Depreciation and amortization (3) 16,400 19,712 20,683 30,375 29,039 General and administrative 28,576 25,451 23,960 29,472 30,882 Asset impairment, restaurant closings and loss on sale of other concept restaurant (4) 2,202 6,073 9,196 18,224 - -- -------- -------- -------- -------- -------- Total costs and expenses 324,679 318,749 332,612 373,094 350,001 -- -------- -------- -------- -------- -------- Operating income 24,215 13,575 27,768 15,621 49,407 -- -------- -------- -------- -------- -------- Other (expense) income: Interest expense (30,694) (31,039) (30,959) (30,950) (30,243) Interest income 654 694 528 756 949 Equity in net income of unconsolidated affiliates 855 425 668 310 303 Other income (5) 1,181 - 7,162 - - -- -------- -------- -------- -------- -------- Net other expense (28,004) (29,920) (22,601) (29,884) (28,991) -- -------- -------- -------- -------- -------- (Loss) income before minority interest (credit) (3,789) (16,345) 5,167 (14,263) 20,416 Minority interest - (41) (52) (1) (46) -- -------- -------- -------- -------- -------- (Loss) income before income taxes (credit) (3,789) (16,386) 5,115 (14,264) 20,370 Income taxes (credit) (6) 534 844 334 325 (5,075) -- -------- -------- -------- -------- -------- Net (loss) income $(4,323) $(17,230) $4,781 $(14,589) $25,445 ========= ========= ======== ========= =======
-15-
FISCAL YEAR (1) --------------- (DOLLARS IN THOUSANDS) 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- OTHER FINANCIAL AND RESTAURANT DATA: Net cash provided by operating activities (7) $15,816 $11,034 $32,453 $34,812 $48,329 Net cash used in investing activities (7) $(8,906) $(8,521) $(10,988) $(22,453) $(31,158) Net cash used in financing activities (7) $(340) $(1,254) $ (3,267) $(17,726) $ (8,606) EBITDA (8) $42,651 $33,671 $56,229 $46,305 $78,703 Capital expenditures $8,906 $8,521 $10,988 $22,528 $31,193 Number of restaurants at end of period: Company-owned 511 533 563 607 641 Franchised 416 364 349 322 303 Other concepts 22 27 27 31 27 --------- --------- -------- --------- ---------- Total number of restaurants 949 924 939 960 971 === === === === === BALANCE SHEET DATA (AT END OF PERIOD): Total assets $384,613 $386,830 $404,291 $404,228 $428,020 Working capital $32,554 $28,352 $27,095 $4,614 $10,293 Total long-term obligations $268,349 $268,152 $267,941 $267,718 $267,478 Shareholders' equity (as restated) (9) $65,334 $69,657 $88,669 $87,013 $113,597
(1) Our fiscal year ends on the Sunday nearest December 31. Our 2004 year, which ended January 2, 2005, contained 53 weeks. All other years presented contained 52 weeks. The 53rd week of operations produced revenues of approximately $9 million and approximate income before taxes of $2.5 million. (2) System-wide sales are the total of sales at QSR Company-owned and consolidated other concept restaurants and the sales of our franchisees as reported to us. We believe system-wide sales information is an industry-wide statistic used by analysts and investors to compare restaurant companies that operate franchise units and/or operate multiple concept restaurants, as well as company-owned restaurant units. We use this statistic to assist in our analysis of per location sales and per location sales information by type of location and to compare sales at franchise restaurants to sales at Company-owned restaurants to judge, among other things, the relative operating success of the franchisee. The following table reconciles our system-wide sales to our restaurant sales which we believe is the most direct comparable United States generally accepted accounting principles ("GAAP") financial measure to system-wide sales for each of the years presented (in thousands):
2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- Restaurant sales $331,313 $314,708 $345,206 $372,673 $382,365 Franchise unit sales 253,410 221,508 205,073 197,936 186,895 ------- ------- ------- ------- ------- System-wide sales $584,723 $536,216 $550,279 $570,609 $569,260
-16- (3) Includes amortization of the excess purchase price over the book value of assets acquired as a result of our going private transaction on September 28, 1999 of $5.4 million and $5.0 million in 2001 and 2000, respectively. In 2000, we finalized our allocation of the purchase price from the going private transaction based on an evaluation of our net assets at September 28, 1999, resulting in lower annual amortization expense than originally estimated. In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," which became effective for us with the beginning of 2002. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are reviewed annually for impairment (or more frequently if impairment indicators arise). Accordingly, we incurred no amortization of goodwill or of intangible assets with indefinite lives for years after 2001. Separable intangible assets that are not deemed to have indefinite lives continue to be amortized over their useful lives. Our goodwill and intangible assets with indefinite lives, which aggregated $205.1 million, net of accumulated amortization, at January 2, 2005, are tested annually for impairment. Our testing for impairment concluded that there was no impairment of our goodwill or intangible assets for any periods presented. (4) Asset impairment, restaurant closings and loss on sale of other concept restaurant consists of the following (in millions):
2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- Impairment of assets $1.1 $4.1 $0.4 $5.5 - Restaurant closings/remodels 0.8 2.0 8.8 12.7 - Loss on sale of other concept restaurant 0.3 - - - - ---- ---- ---- ----- ---- Total $2.2 $6.1 $9.2 $18.2 - ==== ==== ==== ===== ====
(5) Other income in 2004 represents the difference between the amounts allegedly owed to a former distributor and the negotiated settlement with the Bankruptcy Trustee. Other income in 2002 represents the portion of the settlement of our insurance claim, net of related expenses attributable to the reimbursement of lost income under our business interruption insurance arising out of the events of September 11, 2001. (6) A credit of $5.6 million was recorded in 2000 to write-off deferred income taxes as a result of electing 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 laws beginning in 2000. (7) For a more detailed presentation of our cash flow data, see our audited consolidated financial statements and related notes included in Item 8 of this report. In 2000, net cash provided by -17- operating activities before a change in deferred taxes caused by the conversion to Subchapter S status and a change in accrued interest payable was $53.3 million. (8) EBITDA represents earnings (losses) before interest income, interest expense, taxes, depreciation and amortization and includes the effect of the insurance recovery described in note 4 above. 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 "GAAP" or as a 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 to determine whether or not to continue operating restaurant units since it provides us with a measurement of whether we are receiving an adequate cash return on our 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 income (loss) for each of the periods which we believe is the most direct comparable GAAP financial measure to EBITDA, presented (in thousands):
2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- EBITDA $42,651 $33,671 $56,229 $46,305 $78,703 Interest expense (30,694) (31,039) (30,959) (30,950) (30,243) Interest income 654 694 528 756 949 Income (taxes) credit (534) (844) (334) (325) 5,075 Depreciation and amortization (16,400) (19,712) (20,683) (30,375) (29,039) -------- -------- -------- -------- -------- Net (loss) income $(4,323) $(17,230) $ 4,781 ($14,589) $25,445 ========== =========== ======= ========= =======
(9) In 2004, the Company noted an error in the minority interest account and accrued expenses and recorded $569,000 to correct this error, which related to the recording of income and minority interest of a consolidated subsidiary in years prior to December 31, 2000. The correction was adjusted to opening retained earnings. The error resulted from the misinterpretation of certain Partnership Agreements concerning the sharing of the losses of two of the locations within this consolidated subsidiary. -18- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS ------- ----------------------------------------------------------------------- OF OPERATIONS ------------- The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements, the notes thereto and other data and information appearing elsewhere in this report. RESULTS OF OPERATIONS EXECUTIVE OVERVIEW We are a leading owner, operator and franchisor of Quick Service Restaurants ("QSR") restaurants, serving a wide variety of Italian specialty foods with 927 locations as of January 2, 2005. We also operate, in certain cases with joint venture partners, a number of other restaurant concepts with 22 locations as of January 2, 2005. In 2005, we sold one other concept restaurant and we opened three in early 2005. While we have been faced with numerous pressures that have affected our business, including the events of September 11, 2001, the general economic downturn in recent years in the United States, and the March 2003 military action in Iraq, we saw increased sales in all areas of our business as we moved through 2004 and into 2005. Mall traffic has increased as retailers, particularly high end mall based retailers, are serving more customers. In addition, during 2004, we re-energized our quick-service restaurant operations while continuing to provide a quality product coupled with quality service. We believe our strategy resulted in the significant improvement of our operating results, including higher sales and earnings. The increase in mall traffic, combined with selective price increases, improvements in operational controls and upgraded store management at all levels produced increased sales in 2004. While we have closed approximately 130 company owned QSR locations since 2001, net of those opened, substantially all those QSR restaurants which remain are generating increased levels of sales. As a result, earnings which had been declining in prior years, improved significantly in 2004 over those reported in 2003. Our Franchise Group has also seen improvements in revenues as economic conditions have improved world wide. Approximately 113 new franchised locations, net of those closed, have opened since 2001. We developed a new concept, Carmela's of Brooklyn, which opened its first restaurant in early 2005. Carmela's of Brooklyn is expected to operate outside of our traditional mall, hospitality and airport venues. We believe that the continuing development of this and other concepts, along with a combination of our re-energized QSR restaurants and continued growth in our franchise based business, should lead to continued improvements in both revenue and profit. Since September 2003, we have restructured our corporate staff. In September 2003, Michael O'Donnell was hired as our President and Chief Executive Officer, while Mario Sbarro remained as Chairman of the Board of Directors. In January 2004, Peter Beaudrault joined us as our Corporate Vice President and President of our Quick Service Division, and Anthony J. Missano, formerly President of our Quick Service Division, became our President of Business Development, with responsibilities for real estate, construction, purchasing and other business development matters. In February 2004, Anthony J. Puglisi was hired as our Chief Financial Officer, a position that had remained vacant since June 2002. In March 2005, Michael O'Donnell resigned his position as -19- President and Chief Executive Officer and Peter Beaudrault was appointed President and Chief Executive Officer. Mr. O'Donnell remains a member of our Board of Directors. SEASONALITY Our business is subject to seasonal fluctuations, and the effects of weather, national security, economic and business conditions. Earnings have been highest in our fourth quarter due primarily to increased volume in shopping malls during the holiday shopping season. 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. GOODWILL AND OTHER INTANGIBLE ASSETS Due to the seasonality of our business, until we determine the results of operations for our fourth quarter, we are not able to perform the annual test 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," and fully evaluate the impairment of long-lived assets as required by SFAS No. 144, "Accounting for the Impairment and Disposal of Long-Lived Assets." Any required adjustments are recorded at that time unless impairment factors are present earlier. Our annual test for impairment charges of our goodwill and intangible assets with indefinite lives at the end of 2004 and 2003 concluded that there were no impairment changes related to these assets. However, during 2004 and 2003, we recorded impairment of our long-lived assets of $1.1 million and $4.1 million, respectively, as a result of our periodic evaluation of impairment indicators of the property and equipment that is part of our long lived assets. ACCOUNTING PERIOD Our fiscal year ends on the Sunday nearest to December 31. Our 2004 year contained 53 weeks. All other reported years contain 52 weeks. As a result, our 2004 year benefited from one additional week of operations over the other years which generated approximate revenues of $9 million and approximate income before taxes of $2.5 million. PRIMARY FACTORS CONSIDERED BY MANAGEMENT IN EVALUATING OPERATING PERFORMANCE Our evaluation of operating performance of Sbarro focuses on a number of factors, all of which play a material role: o comparable Sbarro owned QSR location sales; o franchise location sales and their relationship to our franchise revenues; o decisions to continue to operate or close Sbarro owned QSR locations; o percentage relationship of the cost of food and paper products and payroll and other benefit costs to our restaurant sales; o level of other operating expenses and their relationship to restaurant sales; o relationship of general and administrative costs to revenues; o provision for asset impairment and restaurant closings; and o EBITDA. The following statistical information highlights the primary factors covered by our management in evaluating our operating performance: -20- RELEVANT FINANCIAL INFORMATION
Fiscal Year ----------- 2004 2003 2002 ---- ---- ---- (in millions) Comparable QSR owned sales (1) $309 $288 $298 Comparable QSR owned sales - percentage change vs. prior year (1) 8.2% -3.4% -1.3% Franchise location sales $253 $222 $205 Franchise revenues $ 12 $11 $10 Cost of food and paper products as a percentage of restaurant sales 21.8% 21.4% 19.6% Payroll and other benefits as a percentage of restaurant sales 27.4% 28.5% 27.9% Other operating expenses as a percentage of restaurant sales 34.6% 35.1% 33.3% General and administrative costs as a percentage of revenues 8.2% 7.7% 6.6% Provision for asset impairment and restaurant closings, loss on sale of other concept restaurants $2.2 $6.1 $9.2 EBITDA (2) $43 $34 $56
(1) Comparable QSR owned sales dollars and annual percentage changes are based on locations that were in operation on a continuing basis within each year presented. Comparable QSR sales in 2004 include the 53rd week of approximately $8.5 million in sales. The 53rd week in 2004 accounts for approximately 3% of the 8.2% comparable increase. (2) See "Selected Financial Data" for information concerning this "Non-GAAP" financial measure and a reconciliation of EBITDA to our net income (loss), which we believe is the most direct comparable financial measure to EBITDA. IMPACT OF INFLATION AND OTHER FACTORS Food, labor, rent, construction and equipment costs are the items most affected by inflation in the restaurant business. Although for the past several years, inflation has not been a significant factor, there can be no assurance that this trend will continue. In addition, food and paper product costs may be temporarily or permanently affected by weather, economic and other factors beyond our control that may reduce the availability and increase the cost of these items. Historically, the price of cheese has fluctuated more than any of our other food ingredients and related restaurant supplies. -21- FISCAL 2004 COMPARED TO FISCAL 2003 Sales by QSR restaurants and consolidated other concept restaurants increased 5.3% to $331.3 million for 2004 from $314.7 million for 2003. The increase in sales for 2004 reflects $16.6 million (5.5%) of higher sales of QSR restaurants. The sales of consolidated other concept units were essentially flat in 2004 as compared to 2003. Increases in comparable location sales of $24 million (8.2%) (includes approximately $8.5 million of QSR revenue, or a 3.0% increase relating to the 53rd week) in 2004 from 2003 was the primary reason for the improvement in QSR restaurant sales. Comparable restaurant sales represent sales at locations that were open during the entire current and prior years. We believe that improved economic conditions in the United States, increased mall traffic, improvement in operational controls and upgraded field and store management combined with selective price increases accounted for the improvements. Franchise related income increased 11.3% to $12.1 million in 2004 from $10.9 million in 2003. The increase was attributed to additional locations opened during the year (net of closed locations) and an increase in comparable sales of 6% for foreign locations and 2% for domestic locations. Real estate and other decreased to $5.5 million in 2004 as compared to $6.8 million in 2003. The decrease was primarily due to $.7 million of rebates recorded in 2003 resulting from a change in estimate. Cost of food and paper products as a percentage of restaurant sales increased by .4% to 21.8% for 2004 from 21.4% for 2003. The cost of sales percentage in 2004 was negatively impacted by the increase in cheese prices throughout most of the year. Cheese prices in 2004 increased substantially over cheese prices in 2003 and were approximately $0.34 per pound higher for a total increase of approximately $2.9 million or 0.9% of restaurant sales. Improved operational controls combined with selective price increases of our products offset the effect of the increased cheese prices on our cost of sales as a percentage of restaurant sales. Payroll and other employee benefits increased $1.2 million but, as a percentage of restaurant sales, decreased to 27.4% in 2004 from 28.5% of restaurant sales in 2003. The dollar increase was primarily due to payroll and other employee benefits relating to the 53rd week in 2004 of approximately $2.0 million offset by better management of staff levels and less restaurants in operation than in 2003. The decrease as a percentage of restaurant sales was primarily a result of improved sales resulting from increased mall traffic and selective price increases. Other operating costs increased by $4.1 million but decreased to 34.6% of restaurant sales in 2004 from 35.1% in 2003. The increase was primarily related to an increase in restaurant management bonuses of $2.2 million resulting from improved profits and an increase in occupancy and other costs due to the 53rd week in 2004 of approximately $1.6 million. Depreciation and amortization expense decreased by $3.3 million to $16.4 million for 2004 from $19.7 million for 2003. The reduction was due to fewer restaurants in operation in 2004, as well as the reduction in depreciation resulting from the asset impairment charges taken in 2003 and disposal of assets in 2004. General and administrative expenses were $28.6 million for 2004, compared to $25.5 million for 2003. The principal factors contributing to the increase were increased bonuses of $1.5 million, additional litigation reserves of $1.2 million and costs associated with additions and changes to -22- senior management of $1.2 million. These increases were offset by a reduction in work force that reduced our 2004 costs by approximately $2.5 million. In connection with this reduction in work force in early 2004, we recorded severance and other related costs of approximately $1.2 million in 2004. During 2004 and 2003, we recorded a provision for asset impairment, restaurant closing and remodel charges and loss on sale of other concept restaurant of $2.2 million and $6.1 million, respectively. In 2004, $1.1 million related to the impairment of assets as compared to $4.1 million in 2003. Restaurant closings and remodels accounted for $0.8 million and $2.0 million in 2004 and 2003, respectively. In 2004, there was a charge of $0.3 million to record the loss on sale of another concept restaurant. The charge for asset impairment resulted from our evaluation of impairment indicators which determined that the carrying amount of certain store assets may not be recoverable from the estimated undiscounted future cash flows resulting from the use of those assets. Interest expense of approximately $31 million for both 2004 and 2003 relates to the 11%, $255 million senior notes we issued to finance our going private transaction ($28.1 million in both 2004 and 2003), the 8.4%, $16 million mortgage loan on our corporate headquarters ($1.3 million in both periods). In addition, $1.5 million in both 2004 and 2003 represents non-cash charges primarily 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. Interest income was approximately $0.7 million in both 2004 and 2003. Equity in the net income of unconsolidated affiliates represents our proportionate share of earnings and losses in those other concept restaurants in which we have a 50% or less ownership interest. Our equity in the overall profits of those concepts increased by $0.4 million in 2004 from 2003 as a result of improvements in our steakhouse joint venture. In 2003, we replaced our then national independent wholesale distributor which had declared bankruptcy. In December 2004, we entered into a settlement agreement with the bankruptcy trustee to settle $2.1 million allegedly due from us for $0.9 million. The difference between the alleged amount due (which we had fully reserved for) and the settlement agreement of approximately $1.2 million is reported in other income. 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 $0.5 million and $0.8 million for 2004 and 2003, respectively. The expense was for taxes owed by us 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. -23- FISCAL 2003 COMPARED TO FISCAL 2002 Sales by QSR restaurants and consolidated other concept restaurants decreased 8.8% to $314.7 million for 2003 from $345.2 million in 2002. The decrease in sales for 2003 reflected $22.3 million (6.9%) of lower sales of Sbarro QSR restaurants and $8.2 million (35.6%) of lower sales of consolidated other concept units. Declines in comparable location sales of $10.1 million (3.4% to $287.3 million) in 2003 from 2002 was the primary reason for the decline in QSR restaurant sales. We believe that these declines were attributable to a reduction in shopping mall traffic related to the general economic downturn in the United States and, additionally with respect to the first quarter of 2003, the effects of the threatened and then actual military action in Iraq. Comparable restaurant sales are made up of sales at locations that were open during the entire current and prior years. During 2003, we closed 30 more units than we opened, causing the remaining $12.3 million net reduction in QSR restaurant sales. The units closed were generally low volume units that did not have a material impact on our results of operations. Of the decline in consolidated other concept unit sales, approximately $0.7 million resulted from a 4.7% decrease in comparable unit sales to $14.7 million. We believe that the decline was attributable to the same factors that affected QSR restaurant sales. In addition, during 2003 two consolidated other concept units were closed, resulting in a net sales reduction of $7.5 million for 2003. These units were either unprofitable or marginally profitable and were part of ventures that we determined to discontinue. Franchise related revenues rose by $0.8 million, or 7.9%, in 2003 over 2002. Excluding approximately $0.6 million of revenues in 2003 related to area development agreements for the United Arab Emirates and Korea that expired, franchise related income increased 2.0% to $10.3 million in 2003 from $10.1 million in 2002. Initial royalties from locations opened during 2003 and ongoing royalties earned from locations opened in 2003 and during 2002 were offset, in part, by a 2.7% reduction in comparable unit sales in 2003 from 2002 levels. Approximately $0.7 million of the increase in real estate and other revenues to $6.8 million in 2003 from $5.1 million in 2002 was for rebates recorded in 2003 resulting from a change in estimate. Increased usage of certain other products that were subject to rebates accounted for the remainder of the 2003 increase from 2002 levels. Cost of food and paper products as a percentage of restaurant sales increased to 21.4% for 2003 from 19.6% in 2002. The cost of sales percentage in 2003 was negatively impacted by the decrease in comparable unit sales. In addition, without changing the effect on the final product, we modified our pizza and pasta sauce recipes to utilize ready made sauce instead of crushed tomatoes as the base raw material to facilitate the consistency in product in each restaurant unit and reduce labor needed to prepare our products. We estimate that this added approximately 3/4 of 1 percentage point to our cost of food. The increase in cheese prices that began at the end of the second quarter resulted in significantly higher cheese costs in the third and fourth quarters of 2003 compared to the similar periods in 2002 causing a 7/10 of 1% increase in cost of sales for 2003. In early 2003, we replaced our then national independent wholesale distributor, which had declared bankruptcy, with another national independent wholesale distributor. -24- Payroll and other employee benefits decreased by $6.7 million but, as a percentage of restaurant sales, increased to 28.5% in 2003 from 27.9% of restaurant sales in 2002. The dollar decrease was primarily due to fewer units in operation while the percentage of sales increase was due to the reduction in comparable unit sales and resulting operating inefficiencies. Other operating expenses decreased by $4.4 million but increased to 35.1% of restaurant sales in 2003 from 33.3% in 2002. The lower dollar level of other operating expenses resulted primarily from the fewer number of units in operation. The increase as a percentage of restaurant sales was primarily due to increases in rent and other occupancy related expenses resulting from the renewal of existing leases at the end of their terms at higher rental rates, compounded by the reduction in comparable unit sales and increases in our repair and maintenance costs due to the number of years that the majority of our locations have been operating and the effects of the long-term utilization on their equipment. Depreciation and amortization expense decreased by $1.0 million to $19.7 million for 2003 from $20.7 million in 2002. The reduction was primarily due to fewer restaurants in operation in 2003. General and administrative expenses were $25.5 million for 2003, compared to $24.0 million in 2002. The principal factors contributing to the increase in 2003 were $0.2 million of legal fees incurred in connection with a lawsuit, a $0.2 million allowance for doubtful accounts receivable recorded with respect to our franchisee in Spain that declared bankruptcy, a $0.2 million allowance against the collectibility of amounts owed by our Israeli franchisee, bonuses of $0.7 million that were granted to certain executive officers, $0.5 million of costs and expenses related to the hiring and employment of our then President and Chief Executive Officer and higher QSR field management travel and related costs, offset by a reversal of approximately $0.3 million of excess estimates for the ultimate cost of two lawsuits related to one of our former joint venture locations. During 2003, we recorded a provision for asset impairment, restaurant closing and loss on sale of other concept restaurant of $6.1 million. Of the provision, $2.0 million was for costs relating to restaurant closings and $4.1 million was for the impairment of property and equipment. The charge for asset impairment resulted from our evaluation of impairment indicators which determined that the carrying amount of certain store assets may not be recoverable from the estimated undiscounted future cash flows resulting from the use of those assets. Interest expense of $31 million for both 2003 and 2002 related primarily to the 11%, $255 million senior notes we issued to finance our going private transaction ($28.1 million in both 2003 and 2002), the 8.4%, $16 million mortgage loan on our corporate headquarters in 2001 ($1.3 million in both periods). In addition, $1.5 million in both 2003 and 2002 represented 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. Interest income was approximately $0.7 million in 2003 and $0.5 million in 2002. Higher average cash available for investment in 2003 compared to 2002 was partially offset by lower prevailing interest rates in effect. 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. Our equity in the overall profits of those concepts declined by $0.2 million in 2003 from 2002 resulting from our proportionate share ($0.5 million) of the losses from the sale of a clam bar joint venture -25- location and one of the locations of our steakhouse joint venture. These losses offset our equity in the operating net income of unconsolidated affiliates of approximately $0.9 million in 2003 compared to $0.7 million in 2002. 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 $0.8 million and $0.3 million for 2003 and 2002, respectively. The expense was for taxes owed by us 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 and to repay any borrowings we may make under our line of credit and general corporate purposes. We incur annual cash interest expense of approximately $29 million under the senior notes and our 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 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 the next twelve months will be approximately $14 million. We expect our primary sources of liquidity to meet current requirements will be cash flow from operations. 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. We do not presently expect to borrow under our line of credit except for required letters of credit. The maximum amount available of our line of credit, after given effect to outstanding letters of credit, was $1.2 million at January 2, 2005. The Company is in discussions with several banks to extend or replace the credit line. -26- CONTRACTUAL OBLIGATIONS ----------------------- Our contractual obligations with respect to both our and the other concepts (both those in which we have a majority or minority interest) were as follows as of January 2, 2005:
PAYMENTS DUE BY PERIOD ---------------------- LESS THAN MORE THAN 5 --------- ----------- TOTAL 1 YEAR 1 - 3 YEARS 4 - 5 YEARS YEARS ----- ------ ----------- ----------- ----- (IN MILLIONS) Long-Term Debt Obligations: Senior notes (1) $255.0 $ - $ - $255.0 $ - Mortgage loan (2) 15.3 0.2 0.4 0.5 14.2 Credit line (3) - - - - - Estimated interest expense 162.0 29.3 87.9 30.5 14.3 on long-term debt Letters of credit (4) 1.8 1.8 - - - Guaranteed indebtedness (5) 7.4 1.6 3.0 1.7 1.1 Capital lease obligations - - - - - Operating leases (6) 290.6 51.4 93.8 69.8 75.6 Purchase obligations (7) 0.4 0.4 - - - ------- ------ ------ ------- ------- Total $732.5 $84.7 $185.1 $357.5 $105.2 ====== ====== ====== ======= =======
(1) There are no principal repayment obligations under the senior notes until September 2009, when the entire principal balance becomes payable. (2) Payable in monthly installments of principal and interest of $0.1 million. Table includes only the principal portion of the installment payments. (3) Our line of credit enables us to borrow, subject to bank approval, up to $3.0 million, less outstanding letters of credit through May 2005. There are currently no amounts outstanding under the new line of credit. The $1.8 million of letters of credit reflected in the table above reduces our availability under the line of credit to $1.2 million. (4) Represents our maximum reimbursement obligations to the issuer of the letters of credit in the event the letters of credit is drawn upon. The letters of credit generally are issued instead of cash security deposits under operating leases or to guarantee construction costs for Sbarro or other concept locations. Of the outstanding standby letters of credit, approximately $0.1 million are for locations that have been subleased to the buyers of two of our other concept locations. All the standby letters of credit supporting leases are annually renewable through the expiration of the related lease terms. If not renewed, the beneficiary may draw upon the letters of credit as long as the underlying obligation remains outstanding. (5) Represents our maximum reimbursement obligations relating to guarantees of our nonconsolidated subsidiaries' debt and letter of credit obligations. Although we do not expect to have to pay these obligations, the amount disclosed represents the full exposure. (6) Represents base rent under operating leases including those which we either sublease to, or guarantee the obligations of, franchisees or certain of our other concepts. Excludes real estate taxes, utilities, insurance, common area charges and other expenses that are not fixed and contingent rent obligations which vary with the level of net restaurant sales. Also excludes leases that are under month-to-month tenancies. -27- (7) Represents commitments for capital expenditures, including for the construction of restaurants for which we are contractually committed. Excludes potential purchases under our contractual arrangement with our national independent wholesale distributor that commenced in February 2003 and that requires us, for the next four years, subject to various causes for termination, to purchase 95% of most all our food ingredients and related restaurant supplies from them. The agreement does not, however, require us to purchase any specific fixed or minimum quantities. Among the factors that will affect the dollar amount of purchases we make under the agreement are: o number of Sbarro locations open during the term of the contract; o level of sales made at Sbarro locations; o market price of mozzarella cheese and other commodity items; o price of diesel fuel; and o mix of products sold by Sbarro locations. Historically, we have not purchased or entered into interest rate swaps of future, forward, option or other instruments designed to hedge against changes in interest rates, the price of commodities we purchase or the value of foreign currencies. SOURCES AND USES OF CASH The following table summarizes our cash and cash equivalents and working capital as at the end of our two latest years and the sources and uses of our cash flows during those two years: Year Ended 2004 2003 ---- ---- (in millions) Liquidity at year end --------------------- Cash and cash equivalents $63.0 $56.4 Working capital $32.6 $28.4 Net cash flows for each year ---------------------------- Provided by operating activities $15.8 $11.0 Used in investing activities $(8.9) $(8.5) Used in financing activities $(0.3) $(1.2) ------ ------ Net increase in cash $6.6 $1.3 ==== ==== We have not historically 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 provided by operating activities was $15.8 million in 2004 compared to $11.0 million in 2003 year. This $4.8 million increase was primarily due to the improvements in operating income of $10.6 million offset by a non cash decrease as compared to 2003 primarily of depreciation and amortization of $3.3 million and asset impairment, restaurant closings and loss on sale of other concept restaurants of $3.9 million. Net cash used in investing activities has historically been primarily for capital expenditures. Net cash used in investing activities increased to $8.9 million in 2004 from $8.5 million in 2003. -28- Capital expenditures were utilized for QSR restaurant openings and renovation activity and for expenditures for consolidated other concept locations. Net cash used in financing activities was $0.3 million in 2004 compared to $1.2 million in 2003. Cash used in financing activities in 2004 resulted primarily from a tax distribution to shareholders offset by a reduction in loans receivable from officers. 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. FINANCING In March 2004, we obtained a line of credit under which we currently have the ability, subject to bank approval, to borrow up to $3 million, less outstanding letters of credit. At January 2, 2005, there were $1.8 million of letters of credit outstanding and, we had $1.2 million of undrawn availability, subject to bank approval, under the line of credit. The line of credit contains no financial covenants or unused line fees. Interest applicable to the loans under the line of credit is at the bank's prime rate at the time of any borrowings. The line expires in May 2005. The Company is in discussions with several banks to extend or replace the line of credit. As part of the going private transaction, 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. The indenture under which our senior notes are issued does not require us to make, except under certain circumstances, principal payments until September 2009, when the outstanding principal balance is due. The indenture contains various covenants that limit our ability to borrow funds in addition to lending arrangements that existed at the date of the going private transaction 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 (except under specifically permitted arrangements) our consolidated interest ratio coverage (as defined in the Indenture), after giving pro forma effect to the interest on the new borrowings, for the four most recently ended quarters must be at least 2.5 to 1. As of January 2, 2005, that ratio was 1.36 to 1. As a result, we are not presently able to borrow funds except for the specifically permitted indebtedness, such as 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 $18 million, and then only to the extent of any excess over that amount. In March 2000, one of our restricted 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 as of -29- January 2, 2005 was $15.3 million. The mortgage agreement contains various covenants, including a requirement that the subsidiary maintain a minimum ratio of EBITDA to annual and quarterly debt service of at least 1.2 to 1.0. As of January 2, 2005, we were in compliance with all covenants in the indenture for the senior notes and our mortgage. Our subsidiary is in compliance with the covenants for its mortgage. OFF-BALANCE SHEET ARRANGEMENTS We and our unconsolidated subsidiaries have contractual obligations that contingently require payments under a line of credit, standby letters of credit and a mortgage loan of our steakhouse joint venture and a bank loan of our quick service Mexican-style restaurant joint venture. In addition, we have a contractual obligation for the remainder of the original term of the operating lease for the clam bar location which was sold by the joint venture to which we are a party. We are a party to various financial guarantees to a bank for two of our other concepts. We are jointly liable, along with our joint venture partner, for a loan owed by one of the other concepts. Our liabilities under the line of credit, mortgage loan and $0.1 million of letters of credit to the second concept are limited to our minority ownership percentage. The remaining letter of credit for the second concept of $0.6 million is jointly and severally guaranteed by each of the partners in the joint venture. To varying degrees, these guarantees involve elements of performance and credit risk. The possibility of our having to honor our contingencies is largely dependent upon future operations of the other concepts. We record a liability if events occur that make payment under the guarantees probable. Under FIN No. 45, we are required to record a liability for the fair value of any obligation undertaken or modified after December 31, 2002. No such obligation was undertaken or modified in 2004 or 2003. The details of our guarantees as of January 2, 2005 and their terms are as follows: TYPE OF GUARANTEED OBLIGATION AMOUNT (1) TERM ----------------------------- ---------- ---- Line of credit $5.0 million December 2010 Loan 1.4 million November 2007 Letters of credit 0.7 million December 2010 Mortgage loan 0.3 million August 2019 --------- (1) Represents our current maximum exposure under existing borrowings and letters of credit. Our exposure under the line of credit could increase to $6.3 million if the full amount of the line of credit is utilized. In 2003, the loan expiration date for all new term loans was extended from December 31, 2008 to December 31, 2010. Our steakhouse joint venture entered into construction contracts aggregating approximately $4.3 million for three restaurants, of which two opened in early 2005. Through March 1, 2005, payments of approximately $2.8 million have been made against these contracts. The construction of the restaurants is guaranteed by us under the terms of the leases for the locations. In addition, we also guarantee the rent through the first year of operations of one restaurant location and the rent until another restaurant opens. -30- Our obligation under the bank loan to our quick service Mexican-style restaurant joint venture is joint and several with our partner's guarantee and is therefore up to 100% of the outstanding amount of the loan. Our guarantee was established at the inception of the borrowing by the venture to facilitate its borrowings and is required to be in place until the loan is repaid. As of January 2, 2005, the amount subject to our loan guarantee for this joint venture was $1.4 million. In August 2003, we closed, sold the assets and transferred the lease, subject to our remaining $0.15 million guarantee for the remainder of the original lease term, of the clam bar location. Our guarantee of the lease became operable upon the buyer's default and will continue until the premises are released. In certain instances, we guarantee the leases for franchisees. We currently guarantee 29 leases for franchisees. Ten of these leases were guaranteed after the adoption of FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." The Company has recorded a liability of $0.1 million which represents the fair value of these guarantees as of January 2, 2005. RELATED PARTY TRANSACTIONS We were the sole tenant of an administrative office building which we leased from a partnership owned by Sbarro Enterprises, L.P., the limited partners of which are Mario Sbarro, our Chairman and a director, Joseph Sbarro, our Senior Vice President, Secretary and a director, Anthony Sbarro, our Vice Chairman, Treasurer and a director, and Carmela Sbarro, Vice President and a director. The annual rent paid was $100,000, $300,000 and $300,000 for 2004, 2003 and 2002, respectively. We were advised by a real estate broker that the rent to be paid by us was comparable to the rent that would have been charged by an unaffiliated third party. The lease was terminated upon the sale of the building by the partnership in April 2004. On April 5, 2001, we loaned $3.2 million to certain of our shareholders, including: Mario Sbarro, $1.1 million, Joseph Sbarro, $1.2 million and Anthony Sbarro, $0.9 million. The due dates of the related notes have been extended to April 6, 2007. The notes bear interest at the rate of 4.63% per annum, payable annually. As of January 2, 2005, the balance of these loans was $2.9 million. On December 28, 2001, we loaned $2.8 million to our shareholders, including: Mario Sbarro, $0.6 million, Joseph Sbarro, $0.7 million, Anthony Sbarro, $0.5 million, and the Trust of Carmela Sbarro, $1.0 million. The due dates of the related notes have been extended to December 28, 2007. The notes bear interest at the rate of 2.48% per annum, payable annually. As of January 2, 2005, the balance of these loans was $2.6 million. In March 2004, we loaned $40,000 to Gennaro A. Sbarro, then our Corporate Vice President and President of our Franchising and Licensing Division. The note was repaid in February 2005 including interest at 2.69% per annum. In connection with his resignation in 2004, we entered into a severance agreement providing for a lump sum payment of approximately $453,000. In June 2003, Anna Missano, the daughter of Joseph Sbarro, issued to us a note for approximately $90,000 for royalties due us for 2001 and 2000. The note is repayable at approximately $10,000 per year, including interest at 2.96% per annum, with a balloon payment due on June 30, 2010. The principal balance of the notes at January 2, 2005 was approximately $79,000. -31- The interest rates charged on the foregoing related party loans included above approximate the Applicable Federal Rate (AFR) published by the Internal Revenue Service at the time of the loan. We recorded interest income from related parties was approximately $211,000, $223,000 and $221,000 in 2004, 2003 and 2002, respectively. Bernard Zimmerman & Company, Inc., of which Bernard Zimmerman, a director of Sbarro, is President and a majority shareholder, renders financial and consulting assistance to us, for which it received fees of approximately $26,000 for services rendered during 2004 and $0.3 million in both 2003 and 2002. Harold Kestenbaum, a member of our Board of Directors, assisted one of our other concepts in the preparation of its initial Uniform Franchise Offering Circular in 2002 for which the fee was $20,000. We and our other concepts have purchased printing services from a corporation owned by a son-in-law of Mario Sbarro, for which we and our other concepts paid, in the aggregate, $480,000, $340,000 and $422,000 in 2004, 2003 and 2002, respectively. Companies owned by a son of Anthony Sbarro are parties to franchise agreements with us containing terms similar to those in agreements entered into by us with unrelated franchises. Royalties under these agreements in 2004, 2003 and 2002 were approximately $89,000, $90,000 and $92,000, respectively. As of July 2002, we sold the assets of a restaurant to a corporation owned by the brother-in-law of our Chairman of the Board for $88,900. The sales price resulted in a loss of approximately $64,000 that was included in the provision for restaurant closings. That corporation also entered into a franchise agreement with us. We received promissory notes for each of the purchase price and initial franchise fee that were payable over seven years and bore interest on the unpaid principal balances at 7% per annum. In addition in 2002, we subleased this location to that franchisee. Payments under the sublease were being made directly to the landlord by the franchisee. Interest payments received relating to the promissory notes was approximately $4,000 in 2003. No interest payments were received in 2004. Royalties paid under this arrangement were approximately $1,800 in 2004, $3,300 in 2003 and $6,800 in 2002. In March 2005, we re-purchased the assets of the restaurant from the corporation for $88,900. The remaining unpaid principal balance of the promissory notes were offset against the purchase price of the assets. The remaining balance under the promissory notes of approximately $22,000, and accrued but unpaid royalties of approximately $31,000 had been fully reserved in 2004. In 2002, a company in which Gennaro J. Sbarro, then our Corporate Vice President and President of our Casual and Fine Dining Division and the son of Joseph Sbarro has a 50% interest (the other 50% is owned by an unaffiliated third party) entered into a sublease for $50,000 greater than rent or other charges due under the lease. Rent and other charges due under the lease are paid directly to the landlord. Payment under the sublease are due to us. Rent of approximately $23,000 was included in the 2004 results of operations. To reimburse Sbarro for equipment costs, the Company owned by Mr. Sbarro, issued a non-interest bearing note in our favor for approximately $55,000, that is repayable in eighteen equal monthly installments of approximately $3,000 which commenced in November 2002. The principal balance on the note as of January 2, 2005 was approximately $16,000. As of October 31, 2003, Mr. Sbarro resigned from his positions with us and a corporation owned by Mr. Sbarro entered into an eighteen month agreement with us to provide -32- consulting services to our quick service and casual dining division for approximately $23,000 per month and the reimbursement for customary and usual expenses that may be incurred by that corporation in the performance of its services. In October 2003, we sold the assets of three underperforming Sbarro-owned restaurants that we proposed to close to entities owned separately by each of three other of Anthony Sbarro's sons, each of which entered into a franchise agreement with us. Two of the locations, which had no remaining book value, were transferred for no consideration while the third was sold for $0.3 million that was paid in full, and resulted in a gain to Sbarro of approximately $0.1 million. In connection with the sale of the locations, the employment of these individuals with Sbarro was terminated and we included a charge for their total severance pay of approximately $60,000 in our results of operations for 2003. The franchise agreements provide for the payment of 5% of the location's sales as a continuing franchise fee but did not provide for any initial franchise fee. We have waived continuing franchise fees through 2006. In addition, we subleased two of the locations to two of the franchisees. Payments under the subleases are being made directly to the landlord by the franchisees and they are not in default. In January 2004, one of Mario Sbarro's daughters, resigned from her position as Manager of Administration - Construction. A corporation owned by her entered into a one year agreement to provide consulting services related to construction matters to us for a series of monthly payments totaling $100,000. In addition, that corporation provided consulting services related to construction matters for our steakhouse joint venture of $18,900 in 2004. In February 2005, a joint venture in which we have a 70% interest, sold the assets of one of our other joint venture restaurants to a company owned by Gennaro A. Sbarro our then Corporate Vice President and President of our Franchising and Licensing Division and the son of Mario Sbarro, for approximately $900,000 (which approximated fair value) resulting in a loss of approximately $284,000. The Company received $300,000 in cash and promissory notes of $600,000. The promissory notes are payable monthly in 72 equal monthly installments in the amount of $8,333 including interest at 5% per annum with a balloon payment of $111,375 at maturity. The joint venture also sold the inventory of the restaurant for approximately $67,000, with $50,000 paid at closing and the remainder of $17,000 payable in four equal monthly installments from March 2005 to June 2005. The company owned by Mr. Sbarro entered into a sublease, which we guarantee and a Security Agreement to secure the obligations under the promissory notes. The sublease and Security Agreement are intended to enable Sbarro to recapture the business in the event of an uncured default. Compensation of related parties includes salary, taxable benefits and accrued bonus. Salaries for 2004 include one additional week of salary due to our 53 week year in 2004. Compensation is as follows: o Mario Sbarro was our Chairman of the Board in 2004 and Chairman of the Board, President and Chief Executive Officer in 2003 and 2002. His compensation was approximately $884,000 in 2004, $700,000 in 2003 and $920,000 in 2002. o Anthony Sbarro was our Vice Chairman of the Board and Treasurer in 2004, 2003 and 2002. His compensation was approximately $582,000 in 2004, $400,000 in 2003 and $545,000 in 2002. -33- o Joseph Sbarro was our Senior Executive Vice President and Secretary in 2004, 2003 and 2002. His compensation was approximately $585,000 in 2004, $400,000 in 2003 and $575,000 in 2002. In addition to the compensation of Mario, Anthony, and Joseph Sbarro: o Carmela Sbarro, the mother of Mario, Anthony and Joseph Sbarro, who was a co-founder of Sbarro and serves as Vice President and a director, received $100,000 from us for services rendered in 2004, 2003 and 2002. o Other members of the immediate families of Mario, Anthony, Joseph and Carmela Sbarro who are our employees were paid an aggregate of approximately $860,000, $1,344,000 and $1,565,000 during 2004, 2003 and 2002, respectively. The company has a 40% equity interest in Boulder Creek Steakhouse and provided administrative services for $165,000, $172,000 and $148,000 in 2004, 2003 and 2002, respectively. RECENT ACCOUNTING PRONOUNCEMENTS SFAS 153: In December 2004, the Financial Accounting Standards Board ("FASB"), issued Statement of Financial Accounting Standards ("SFAS") SFAS No. 153, "Exchanges of Non Monetary Assets", which addresses the measurement of exchanges of nonmonetary assets and eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005, with earlier application permitted. We do not anticipate that SFAS No. 153 will have a material impact on our financial position or results of operations. SFAS 123R: In December 2004, the FASB issued a revision of SFAS No. 123, "Statement of Financial Accounting Standards No. 123 (revised 2004)", which requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. This Statement is effective as of the beginning of the first annual reporting period that begins after June 15, 2005. We do not anticipate SFAS No. 123R will have a material impact on our financial position or results of operations. 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 our 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. Accounting policies whose -34- application 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 and our results of operations and financial position, are: o SFAS No. 5, "Accounting for Contingencies." Pursuant to SFAS No. 5, in the past we have made, and we intend in the future to make, decisions regarding the accounting for legal matters based on the status of the matter and our best estimate of the outcome (we expense defense costs as incurred). This requires management to make judgments regarding the probability and estimated amount of possible future contingent liabilities, especially, in our case, legal matters. However, especially if a matter goes to a jury trial, our estimate could be off since our estimates are based, in large part, on our experience in settling matters. In our judgment, we believe that the estimate of approximately $3.2 million for outstanding legal actions. o SFAS No. 142, "Goodwill and Other Intangible Assets," requires us to test annually and periodically assess whether there has been an impairment of goodwill and indefinite lived intangible assets acquired prior to July 1, 2001 ($205.1 million, net of accumulated amortization, at December 28, 2003 and January 2, 2005). As discussed under "Results of Operations" above, the independent firm we engaged to assist us in the determination of impairment, used the discounted cash flow method and the guideline company valuation methods in determining the fair value of our goodwill and the discounted cash flow and market approach methods in determining the fair value of our trademark and concluded that there was no impairment in the carrying value of these assets as of January 2, 2005. However, future estimates could change and cause us to take an impairment charge with respect to those assets. Further, after taking such a charge, should future estimates determine that the fair value has risen, SFAS No. 142 does not allow us to increase the then current value. o SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 requires judgments regarding future operating or disposition plans for marginally performing assets. The application of this policy has affected the amount and timing of charges to operating results that have been significant in recent years ($1.1 million, $4.1 million and $0.4 million in 2004, 2003 and 2002, respectively). We evaluate our long-lived assets for impairment at the individual restaurant level on an annual basis, or whenever events and circumstances indicate that the carrying amount of a restaurant may not be recoverable, including our business judgment of when to close underperforming units. These impairment evaluations require an estimation of cash flows over the remaining life of the related restaurant lease, which is generally up to 10 years. Our estimates are based on cash flows from recent operations of the restaurants and, unless specific circumstances about the location warrant, do not include unsupportable sales growth and margin improvement assumptions. Should the carrying amount not be deemed to be recoverable, we write the assets down to their fair value. After the impairment has been identified and the related asset written down, in accordance with SFAS No. 144, the effect cannot be reversed. As a result, the result of evaluation is not subject to future review and change. o SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses accounting for restructuring and similar costs, supersedes previous accounting guidance, principally EITF No. 94-3. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 changes the expense recognition for certain costs we incur while closing restaurants or undertaking other exit or disposal activities. However, the timing difference is not typically of significant length. -35- o FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," elaborates on the disclosures to be made by a guarantor in its financial statements concerning its obligations under certain guarantees that it has issued. It also clarifies (for guarantees issued or modified after January 1, 2003), that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligations undertaken in issuing the guarantee. We have guarantees that would require recognition upon issuance or modification under the provisions of FIN No. 45. The nature of our business will likely result in the issuance of certain guarantees in the future and, as such, we will be required to evaluate the fair value of the obligation at the inception of such guarantee. We recognized a liability under FIN No. 45 of approximately $120,000 in 2004 and $38,000 in 2003. The amount we may be required to recognize in future years may be higher than this amount depending on the number and magnitude of guarantees we issue. o FIN No. 46,"Consolidation of Variable Interest Entities," was effective immediately upon its issuance during fiscal 2003 for all enterprises with interests in variable interest entities created after January 31, 2003. In December 2003, FASB issued FIN No. 46 (R) which changed the effective dates for the recording of interests in variable interest entities created before February 1, 2003 beginning with the first interim reporting period ending 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, or 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. We have also reviewed our joint ventures, equity investments and corporate relationships for possible coverage under FIN No. 46. The application of FIN No. 46 did not have a material effect on our disclosures and our financial position or operating results. 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. o SFAS 13, "Accounting for Leases" establishes standards of financial accounting for leases. Certain of the Company's operating leases contain predetermined fixed escalations of the minimum rentals during the original term of the lease. For these leases, the Company recognizes the related rental expense on a straight-line basis over the life of the lease and records the difference between the amounts charged to operations and amounts paid as deferred rent. Any lease incentives received by the Company are deferred over the same period as the lease and amortized over a straight-line basis over the life of the lease as a reduction of rent expense. We calculate deferred rent based on the lease term from when we obtain access or control over the leased property. Rent expense accrued during the construction period is capitalized as part of the cost of leasehold improvements. The length of time from when we take possession of property for our QSR restaurants and when our restaurant opens is normally minimal (1-2 months) as compared to our normal lease terms of ten years. -36- ITEM 7-A. 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 credit facility (none are currently outstanding) will be at rates that float with the market and, therefore, will be subject to fluctuations in interest rates. Our $255 million senior notes bear a fixed interest rate of 11%. 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 purchased, 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 in the changes of 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. -37- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------- ------------------------------------------- Report of Independent Registered Public Accounting Firm 39 Consolidated Balance Sheets as of January 2, 2005 and December 28, 2003 40 Consolidated Statements of Operations for the years 42 ended January 2, 2005, December 28, 2003 and December 29, 2002 Consolidated Statements of Shareholders' Equity (as restated) for the 43 years ended January 2, 2005, December 28, 2003 and December 29, 2002 Consolidated Statements of Cash Flows for the years 44 ended January 2, 2005, December 28, 2003 and December 29, 2002 Notes to Consolidated Financial Statements 46 -38- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ------------------------------------------------------- Board of Directors and Shareholders Sbarro, Inc. Melville, New York We have audited the accompanying consolidated balance sheets of Sbarro, Inc. and subsidiaries as of January 2, 2005 and December 28, 2003, and the related consolidated statements of operations, shareholders' equity and cash flows for the years ended January 2, 2005, December 28, 2003 and December 29, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sbarro, Inc. and subsidiaries at January 2, 2005 and December 28, 2003 and the results of their operations and their cash flows for the years ended January 2, 2005, December 28, 2003 and December 29, 2002 in conformity with accounting principles generally accepted in the United States. As explained in Note 1 to the consolidated financial statements, the Company has restated its financial statements to reflect a correction of an error related to the calculation of minority interest in prior years. The impact of this adjustment is to minority interest, accrued expenses and retained earnings as of the beginning of the year ended December 29, 2002. /s/ BDO Seidman, LLP Melville, New York March 7, 2005 -39- SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS
JANUARY 2, 2005 DECEMBER 28, 2003 --------------- ----------------- (IN THOUSANDS) Current assets: Cash and cash equivalents $63,000 $56,430 Receivables, net of allowance for doubtful accounts of $431 in 2004 and $488 in 2003: Franchise 1,846 1,700 Other 1,680 1,171 -------- -------- 3,526 2,871 Inventories 2,809 2,707 Prepaid expenses 3,877 3,844 Current portion of loans receivable from officers 46 2,810 ----------- -------- Total current assets 73,258 68,662 Property and equipment, net 88,465 96,604 Trademarks 195,916 195,916 Goodwill 9,204 9,204 Deferred financing costs, net 4,521 5,482 Loans receivable from officers, less current portion 5,602 3,347 Other assets 7,647 7,615 ---------- ----------- $384,613 $386,830 ======== ========
See notes to consolidated financial statements. -40- SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) LIABILITIES AND SHAREHOLDERS' EQUITY
JANUARY 2, 2005 DECEMBER 28, 2003 --------------- ----------------- (IN THOUSANDS EXCEPT SHARE DATA) Current liabilities: Accounts payable $11,593 $13,734 Accrued expenses 20,748 18,227 Accrued interest payable 8,181 8,181 Current portion of mortgage payable 182 168 ----------- ---------- Total current liabilities 40,704 40,310 --------- -------- Deferred rent 10,226 8,711 ----------- --------- Long-term debt, net of original issue discount 268,349 268,152 ---------- ------- Commitments and 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 at January 2, 2005 and December 28, 2003 71 71 Additional paid-in capital 10 10 Retained earnings 65,253 69,576 --------- -------- 65,334 69,657 --------- -------- $384,613 $386,830 ======== --------
See notes to consolidated financial statements. -41- SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE FISCAL YEARS ENDED -------------------------------------------------------- JAN. 2, 2005 DEC. 28, 2003 DEC. 29, 2002 ------------ ------------- ------------- (IN THOUSANDS) Revenues: Restaurant sales $331,313 $314,708 $345,206 Franchise related income 12,093 10,868 10,070 Real estate and other 5,488 6,748 5,104 -------- -------- -------- Total revenues 348,894 332,324 360,380 -------- -------- -------- Costs and expenses: Cost of food and paper products 72,073 67,446 67,593 Payroll and other employee benefits 90,857 89,614 96,288 Other operating costs 114,571 110,453 114,892 Depreciation and amortization 16,400 19,712 20,683 General and administrative 28,576 25,451 23,960 Asset impairment, restaurant closings and loss on sale of other concept restaurant 2,202 6,073 9,196 -------- -------- -------- Total cost and expenses 324,679 318,749 332,612 -------- -------- -------- Operating income 24,215 13,575 27,768 -------- -------- -------- Other (expense) income: Interest expense (30,694) (31,039) (30,959) Interest income 654 694 528 Equity in net income of unconsolidated affiliates 855 425 668 Other income 1,181 - 7,162 -------- -------- -------- Net other expense (28,004) (29,920) (22,601) -------- -------- -------- (Loss) income before minority interest (3,789) (16,345) 5,167 -------- -------- -------- Minority Interest - (41) (52) -------- -------- -------- (Loss) income before income taxes (credit) (3,789) (16,386) 5,115 Income taxes 534 844 334 -------- -------- -------- Net (loss) income $(4,323) $(17,230) $4,781 ======== ========= ======
See notes to consolidated financial statements. -42- SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (AS RESTATED)
COMMON STOCK ------------ NUMBER OF ADDITIONAL RETAINED SHARES AMOUNT PAID-IN CAPITAL EARNINGS TOTAL ------- ------ --------------- -------- ----- (IN THOUSANDS, EXCEPT SHARE DATA) Balance at December 30, 2001, 7,064,328 $71 $10 $86,363 $86,444 as previously reported Correction of error in recording prior years income of a consolidated subsidiary 569 569 --------- --- --- ------- ------- Balance at December 30, 2001, as restated 7,064,328 71 10 86,932 87,013 Net income 4,781 4,781 Distributions to shareholders (3,125) (3,125) --------- --- --- ------- ------- Balance at December 29, 2002 7,064,328 71 10 88,588 88,669 Net loss (17,230) (17,230) Distributions to shareholders (1,782) (1,782) --------- --- --- ------- ------- Balance at December 28, 2003 7,064,328 71 10 69,576 69,657 Net loss (4,323) (4,323) --------- --- --- ------- ------- Balance at January 2, 2005 7,064,328 $71 $10 $65,253 $65,334 ========= === === ======= =======
See notes to consolidated financial statements. -43- SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE FISCAL YEARS ENDED ---------------------------------------------------------- JANUARY 2, DECEMBER 28, DECEMBER 29, 2005 2003 2002 ---- ---- ---- (IN THOUSANDS) OPERATING ACTIVITIES: Net (loss) income $(4,323) $(17,230) $4,781 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation and amortization 16,400 19,712 20,683 Amortization of deferred financing cost 962 1,148 1,074 Amortization of bond discount 379 379 379 Allowance for doubtful accounts receivable 222 435 350 Increase in deferred rent, net 273 242 212 Asset impairment, restaurant closings and loss on sale of other concept restaurant 2,202 6,073 9,196 Minority interest - 41 52 Equity in net income of unconsolidated affiliates (855) (425) (668) Other 155 44 (76) Changes in operating assets and liabilities: Decrease (increase) in receivables (877) 191 1,308 Decrease (increase) in inventories (102) 578 252 Increase in prepaid expenses (33) (253) (1,121) Decrease (increase) in other assets 458 (366) (429) Increase (decrease) in accounts payable and accrued expenses 955 465 (3,540) ------ ------- --------- Net cash provided by operating activities 15,816 11,034 32,453 ------ ------- ---------
(continued) -44- SBARRO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
FOR THE FISCAL YEARS ENDED JANUARY 2, DECEMBER 28, DECEMBER 29, ---------- ------------ ------------ 2005 2003 2002 ---- ---- ---- (IN THOUSANDS) INVESTING ACTIVITIES: Purchases of property and equipment (8,906) (8,521) (10,988) ------- ------- -------- Net cash used in investing activities (8,906) (8,521) (10,988) ------- ------- -------- FINANCING ACTIVITIES: Mortgage principal repayments (167) (154) (142) Tax distributions (682) (1,100) (3,125) Reduction in loans receivable from officers 509 - - ------- ------- -------- Net cash used in financing activities (340) (1,254) (3,267) ------- ------- -------- Increase in cash and cash equivalents 6,570 1,259 18,198 Cash and cash equivalents at beginning of year 56,430 55,171 36,973 ------- ------- -------- Cash and cash equivalents at end of year $63,000 $56,430 $55,171 ======= ======= ======= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid for: Income taxes $417 $388 $796 ==== ==== ==== Interest $29,352 $29,400 $29,498 ======= ======= =======
See notes to consolidated financial statements. -45- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: BASIS OF FINANCIAL STATEMENT PRESENTATION: The consolidated financial statements include the accounts of Sbarro, Inc., its wholly owned subsidiaries and the accounts of its majority-owned joint ventures (together, "we," "our," "us," or "Sbarro"). All significant intercompany accounts and transactions have been eliminated. Minority interest includes the interests held by our partners in certain of our majority-owned joint ventures. ESTIMATES: The preparation of our financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that may affect the amounts reported in the financial statements and accompanying notes. Our actual results could differ from those estimates. CASH EQUIVALENTS: Cash equivalents represent funds invested overnight and highly liquid money market accounts with a maturity of three months or less at the time of purchase. Cash equivalents at the end of 2004 and 2003 were $51 million and $34 million, respectively. The Company has restricted cash of $21,000 which is included in cash in 2004 and 2003. INVENTORIES: Inventories, consisting primarily of food, beverages and paper supplies, are stated at lower of cost or market, which is determined by the first-in, first-out method. PROPERTY AND EQUIPMENT: Property and equipment is stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives for furniture, fixtures and equipment - three to ten years and leasehold improvements - the lesser of the useful lives of the assets or lease terms. Rent incurred during the construction period is capitalized. INTANGIBLE ASSETS: Intangible assets consist of our trademarks, goodwill and deferred financing costs. Trademark values, as well as goodwill, were determined based on a fair value allocation of the purchase price from our going private transaction (see Note 2). -46- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Deferred financing costs were incurred as a result of the going private transaction (see Notes 2 and 6) and the mortgage on the corporate headquarters building (see Note 9.) The costs are being amortized as additional interest expense over the respective remaining lives of the related debt instruments, which range from 1 1/2 years to 6 years. TRADEMARKS AND GOODWILL: There were no changes in the carrying amount of the trademarks or goodwill for the years ended January 2, 2005 and December 28, 2003. We test for impairment annually or earlier if impairment indicators exist. We follow a two-step process for impairment testing of goodwill. The first step of this test, used to identify impairment, compares the fair value of a reporting unit, including goodwill, with its carrying amount. The second step (if necessary) measures the amount of the impairment. We have determined that Sbarro as a whole is the reporting unit for purposes of evaluating goodwill for impairment. Our annual impairment test indicated that the fair value of the reporting unit exceeded the reporting unit's carrying amount. Accordingly, the second step of the goodwill impairment test was not necessary. We performed a separate impairment test on our trademarks based on the discounted cash flows method and market approach method. The fair value of the trademarks exceeded the carrying value. LONG-LIVED ASSETS: Long-lived assets are evaluated for impairment when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable through the estimated undiscounted future cash flows resulting from the use of these assets. When any such impairment exists, the related assets will be written down to their fair value. EXIT OR DISPOSAL ACTIVITIES: The liability for costs associated with an exit or disposal activity is recognized when a liability is incurred in accordance with FAS 146 "Accounting for Costs Associated with Exit or Disposal Activities" and is measured at fair value. GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES: At the inception of a guarantee for the indebtedness of others, a liability for the fair value of the obligation undertaken is recorded for all these guarantees entered into or modified after January 1, 2003. As described in Note 10, there are certain arrangements that were entered into during 2003 and 2004 with respect to guarantees for franchised locations and restaurants sold to related parties. The fair value of these guarantees of $120,000 has been recorded. While the nature of our business will likely result in the issuance of certain guarantees in the future, we do not anticipate that they will have a material impact on our financial position or operating results. -47- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) VARIABLE INTEREST ENTITIES: 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 interests in variable interest entities created after January 31, 2003. In December 2003, FASB issued FIN No. 46 (R) which changed the effective dates for the recording of interests in variable interest entities created before February 1, 2003 beginning with the first interim reporting period ending 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, or 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. We have reviewed our joint ventures, equity investments and corporate relationships for possible coverage under FIN No. 46. The application of FIN No. 46 did not have a material effect on our disclosures and our financial position or operating results. 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. ACCOUNTING FOR VENDOR REBATES: We account for vendor rebates related to the usage of the products for which rebates are received in company owned Sbarro locations as a reduction of the cost of food and paper products. The rebates are recognized as earned based on our usage, which approximates purchases, of the related products. We also receive consideration from manufacturers for the usage, which approximates purchases, of the same raw materials by our franchisees. Those rebate amounts are included in "real estate and other" in our statements of operations. EQUITY INVESTMENTS: We account for our investments in 50% or less owned joint ventures and for 50% owned joint ventures for which we do not have operating control and are not the primary beneficiary, under the equity method of accounting. The equity in the net income (loss) of these unconsolidated affiliates are included in "equity in net income of unconsolidated affiliates" in our statements of operations and the related assets are included in "other assets" in the accompanying balance sheets. -48- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) CONCENTRATION OF CREDIT RISK: Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and accounts receivable. The Company maintains its cash in commercial banks insured by the FDIC. At times, such cash in banks exceeds the FDIC insurance limit. Concentration of credit risk with respect to accounts receivable is generally limited to franchise fees and royalties. Prior to the Company entering into an agreement with a new franchise, an evaluation of the financial position and credit worthiness is completed. The Company has established an allowance for doubtful accounts based upon factors surrounding the credit risk of certain franchises and other information. FRANCHISE RELATED INCOME AND ALLOWANCE FOR DOUBTFUL ACCOUNTS: Initial franchise fees are recorded as income as restaurants are opened by the franchisee and we have performed substantially all required services. Development fees are recognized over the number of restaurant openings covered under each development agreement, with any remaining balance recognized at the end of the term of the agreement. Royalty and other fees from franchisees are accrued as earned. We monitor the financial condition of our franchisees and record provisions for estimated losses on receivables when we believe that our franchisees are unable to make their required payments. While we use the best information available in making our determination, the ultimate recovery of recorded receivables is also dependent upon future economic events and other conditions that may be beyond our control. Included in general and administrative expenses are provisions for uncollectible franchise receivables of $0.2 million, $0.4 million, and $0.3 million in 2004, 2003 and 2002, respectively. LEASES: Certain of the Company's operating leases contain predetermined fixed escalations of the minimum rentals during the original term of the lease. For these leases, the Company recognizes the related rental expense on a straight-line basis over the life of the lease and records the difference between the amounts charged to operations and amounts paid as deferred rent. Any lease incentives received by the Company are deferred over the same period as the lease and amortized over a straight-line basis over the life of the lease as a reduction of rent expense. We calculate deferred rent based on the lease term from when we obtain access or control over the leased property. Rent expense accrued during the construction period is capitalized as part of the cost of leasehold improvements. Due to recent interpretive guidance related to lease accounting, the Company reviewed their accounting policies for leases. As of January 2, 2005, we classified $1.3 million in net leasehold improvements to account for the capitalized rent during the build-out period which had been previously classified as deferred rent. -49- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) INCOME TAXES: We are taxed under the provisions of Subchapter S of the Internal Revenue Code of 1986, and, where applicable and permitted, under similar state and local income tax provisions. Therefore, we do not pay federal or, with certain limited exceptions, state and local income taxes for periods for which we are treated as an S corporation. Rather, our shareholders include their pro-rata share of our taxable income on their individual income tax returns and thus are required to pay taxes on their respective share of our taxable income, whether or not it is distributed to them. We file a consolidated federal income tax return for informational purposes. Deferred taxes are not material. ACCOUNTING PERIOD: Our fiscal year ends on the Sunday nearest to December 31. Our 2004 fiscal year ended January 2, 2005 and contained 53 weeks. All other reported fiscal years contained 52 weeks. FAIR VALUE OF FINANCIAL INSTRUMENTS: The carrying amounts of cash, receivables and accounts payable approximate fair value because of the short-term nature of these items. Based on the current quoted market price, the estimated fair value of our senior notes at January 2, 2005 approximated the face value of $255 million. The carrying amount of the mortgage loan approximates fair value because the interest rate this instrument bears is reasonably equivalent to the current rates offered for debt of a similar nature and maturity. DEFINED CONTRIBUTION PLAN: We have a 401(k) Plan ("Plan") for all qualified employees. The Plan provides for a 25% matching employer contribution of up to 4% of the employees' deferred savings (maximum contribution of 1% of an employee's salary). The employer contributions vest over five years. The employee's deferred savings cannot exceed 15% of an individual participant's compensation in any calendar year. Our contribution to the Plan was $90,000, $105,000, and $36,000 in 2004, 2003 and 2002, respectively. The contribution was lower in 2002 as our matching contribution was suspended for the first half of the year. NEW ACCOUNTING PRONOUNCEMENTS: SFAS 153: In December 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 153, "Exchanges of Non Monetary Assets", which addresses the measurement of exchanges of nonmonetary assets and eliminates the exception from fair value measurement for nonmonetary -50- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) exchanges of similar productive assets and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005, with earlier application permitted. We do not anticipate that SFAS No. 153 will have a material impact on our financial position or results of operations. SFAS 123R: In December 2004, the FASB issued a revision of SFAS No. 123, SFAS No. 123R "Statement of Financial Accounting Standards No. 123 (revised 2004)", which requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. This Statement is effective as of the beginning of the first annual reporting period that begins after June 15, 2005. We do not anticipate that SFAS No. 123R will have a material impact on our financial position or results of operations. RECLASSIFICATIONS: Certain items in the financial statements presented have been reclassified to conform to the 2004 presentation. RESTATEMENT: In 2004, the Company noted an error in the minority interest account and accrued expenses and recorded $569,000 to correct this error, which related to the recording of income and minority interest of a consolidated subsidiary in years prior to December 31, 2001. The correction was adjusted to opening retained earnings. The error resulted from the misinterpretation of certain partnership agreements concerning the sharing of the losses of two of the locations within this consolidated subsidiary. 2. GOING PRIVATE TRANSACTION: On September 28, 1999, members of the Sbarro family (who prior thereto owned approximately 34.4% of our common stock) became the holders of 100% of our issued and outstanding common stock as a result of a "going private" merger. (Note 9) During the second quarter of 2001, the funds remaining for untendered shares that had been held by a third party paying agent were returned to us. We will hold such funds until the related shares are tendered or escheated to the appropriate jurisdiction. At January 2, 2005, there was $21,000 being held by us for such untendered shares included in cash and cash equivalents. -51- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In accordance with EITF Issue No. 88-16, "Basis in Leveraged Buyout Transactions," the acquisition of all the outstanding shares of common stock not owned by the Sbarro family and all outstanding stock options was accounted for under the purchase method of accounting. As a result, the remaining shares of common stock owned by the Sbarro family are presented in shareholders' equity at their original basis in the accompanying consolidated balance sheet. During 2000, we finalized an allocation of the purchase price from the going private transaction based on an evaluation of Sbarro at September 29, 1999 which increased property and equipment and intangible assets by $7 million and $216 million, respectively. In accordance with SFAS No. 142, we have not, since 2001, amortized any of the intangible assets with indefinite lives. 3. DESCRIPTION OF BUSINESS: We and our franchisees develop and operate family oriented cafeteria-style Italian restaurants principally under the "Sbarro" and "Sbarro The Italian Eatery" names. The restaurants are located throughout the world, principally in shopping malls and other high traffic locations. Since 1995, we have developed and established other restaurant concepts in seeking to provide growth opportunities that leverage our restaurant management and financial expertise. We operate all of these restaurants as one segment. The following sets forth the number of Sbarro restaurants in operation as of: JANUARY 2, DECEMBER 28, DECEMBER 29, 2005 2003 2002 ---- ---- ---- Sbarro owned 511 533 563 Franchised 416 364 349 Other concepts 22 27 27 --- --- --- All restaurants 949 924 939 === === === 4. OTHER INCOME: BANKRUPTCY SETTLEMENT: In 2003 we replaced our then national independent wholesale distributor which had declared bankruptcy. The trustee in bankruptcy alleged that we were indebted to that distributor in the amount of approximately $2.1 million which had been fully reserved. In December 2004, we entered into a settlement agreement with the bankruptcy trustee to settle the alleged amount due for $0.9 million. The difference between the alleged amount due and the settlement agreement of approximately $1.2 million has been reported in other income. -52- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) EFFECT OF EVENTS OF SEPTEMBER 11, 2001: As a result of the events of September 11, 2001, a Sbarro-owned location, as well as a franchise location, that had operated in the World Trade Center in New York City were destroyed. Due to the continuing effect of the events of September 11 compounded by the effect of the economic slowdown in the United States, airport locations and a number of downtown locations continued to experience a period of reduced sales through 2003. In September 2002, we reached an agreement to settle, for $9.65 million, our claim with our insurance company for the reimbursement of the depreciated cost of the assets destroyed at the Sbarro-owned location, as well as for lost income under our business interruption insurance coverage. The proceeds of the settlement were received in September 2002. Approximately $7.2 million, net of related expenses, of the settlement relates to reimbursement of lost income under our business interruption insurance coverage and is included in our results of operations for 2002. 5. PROPERTY AND EQUIPMENT, NET: JANUARY 2, DECEMBER 28, 2005 (A) 2003 (B) ---- ---- (IN THOUSANDS) Land $3,781 $3,781 Leasehold improvements 146,362 141,538 Furniture, fixtures and equipment 64,096 65,594 ------ ------ 214,239 210,913 Less accumulated depreciation and amortization (c) 125,774 114,309 ------- ------- $88,465 $96,604 ======= ======= (a) During 2004, we recorded a charge of $1.1 million, relating to impairment losses on property and equipment. In addition, we recorded a provision for restaurant closings and remodels of approximately $0.8 million. (b) During 2003, we recorded a charge of $4.1 million, of which $0.4 million was for our other concepts, relating to impairment losses on property and equipment. In addition, we recorded a provision for restaurant closings and remodels of approximately $2.0 million. (c) Depreciation and amortization of property and equipment was $16.4 million, $19.7 million and $20.7 million in 2004, 2003 and 2002, respectively. -53- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. DEFERRED FINANCING COSTS (IN THOUSANDS):
JANUARY 2, DECEMBER 28, 2005 2003 ---- ---- Deferred financing costs $ 9,573 $ 9,573 Less accumulated amortization (5,052) (4,091) -------- ------- $ 4,521 $ 5,482 ======== =======
Amortization expense of the deferred financing costs was (included in interest expense) $962, $1,148, and $1,074 for 2004, 2003 and 2002 respectively. Amortization of deferred financing costs for the next five years will be as follows: 2005 $ 962 2006 962 2007 962 2008 962 2009 673 -------- $ 4,521 7. ACCRUED EXPENSES (IN THOUSANDS):
JANUARY 2, DECEMBER 28, 2005 2003 ---- ---- Compensation $4,886 $5,112 Payroll, sales and other taxes 3,730 4,176 Rent and related cost 2,971 1,725 Litigation and legal costs 2,552 1,806 Rebates and other advances 2,270 2,731 Other 4,339 2,677 ------- ------- $20,748 $18,227 ======= =======
-54- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. INCOME TAXES: In connection with the going private transaction and the related financing, we entered into a tax payment agreement with our shareholders. The tax payment agreement permits us to make periodic tax distributions to our shareholders in amounts determined under a formula 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 that income was taxed at the highest applicable federal and New York State marginal income tax rates. We may only make the tax distributions with respect to periods in which we are treated as an S corporation for income tax purposes. We made no distribution to our shareholders in accordance with the tax payment agreement with respect to our 2004 and 2003 results of operations. However, we made distributions to our shareholders, in accordance with the tax payment agreement, of $1.8 million with respect to our 2002 results of operations and $3.1 million with respect to 2001 results of operations. The provision for income taxes is comprised of taxes payable directly by us 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 is as follows:
JANUARY 2, DECEMBER 28, DECEMBER 29, 2005 2003 2002 ---- ---- ---- (IN THOUSANDS) Current state and local: $(133) $500 $17 Foreign: 667 344 317 ---- ---- ---- $534 $844 $334 ==== ==== ====
9. LONG-TERM DEBT: INDENTURE: The going private transaction (Note 2) was partially funded by the placement of $255 million of 11% senior notes due September 15, 2009. Interest on the senior notes is payable semi-annually on March 15 and September 15 of each year. Our payment obligations under the senior notes are jointly, severally, unconditionally and irrevocably guaranteed by all of Sbarro's current Restricted Subsidiaries (as defined in the indenture) and is to be similarly guaranteed by our future Restricted Subsidiaries. The senior notes and the subsidiary guarantees are senior unsecured obligations of Sbarro and the guaranteeing subsidiaries, respectively, ranking equally in right of payment to all of our and their respective present and future senior debt, including amounts outstanding under the bank line of credit agreement discussed below. The indenture permits redemption of the senior notes at our -55- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) option at varying redemption prices and requires us to offer to purchase senior notes in the event of a Change of Control and in connection with certain Asset Sales (each as defined). The indenture contains various covenants, including, but not limited to, restrictions on the payment of dividends, stock repurchases, certain investments and other restricted payments, the incurrence of indebtedness and liens on our assets, affiliate transactions, asset sales and mergers by us and the guaranteeing subsidiaries. We were in compliance with the various covenants contained in the indenture as of January 2, 2005; however, we are not presently permitted under the indenture to pay dividends, make stock repurchases or, with certain exceptions, incur indebtedness. We are in compliance with all covenants in the indenture for the senior notes and our mortgage as of January 2, 2005. The senior notes were issued, at an aggregate discount of approximately $3.8 million, which is being accreted to the senior notes on a straight-line basis over the original ten year life of the senior notes. Accretion of the discount was $0.4 million in each of 2004, 2003, and 2002. LINE OF CREDIT: In March 2004, we entered into a line of credit arrangement that enables us to borrow, subject to bank approval, $3 million through May 2005, subject to reduction for standby letters of credit issued by the bank ($1.8 million at January 2, 2005). Interest applicable to loans under the line of credit is to be at the bank's prime rate at the time of any borrowings. There are no unused line fees to be paid or covenants to be met under the line of credit. Each of our current guaranteeing subsidiaries (the same entities as the Restricted Subsidiaries under the Indenture) have agreed to unconditionally and irrevocably guarantee our obligations under the new line of credit on a joint and several basis. No amounts have been borrowed under this agreement. The Company is in discussion with several banks to extend or replace the credit line. During 2003, we terminated a previous bank credit agreement which provided us with an unsecured senior revolving credit facility that enabled us to borrow, on a revolving basis until September 2004, up to $30 million, including a $10 million sub limit for standby letters of credit. No amounts had been borrowed under the credit agreement. The outstanding letters of credit under this facility were transferred to our new line of credit facility. MORTGAGE: In March 2000, one of our Restricted 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 as of January 2, 2005 was $15.3 million. The mortgage agreement contains various covenants, including a requirement that the subsidiary maintain a minimum ratio of EBITDA to annual and quarterly debt service of at least 1.2 to 1.0. The subsidiary was in compliance with the various covenants contained in the mortgage agreement as of January 2, 2005. -56- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) MATURITIES OF LONG-TERM DEBT: Scheduled maturities of long-term debt are as follows (in thousands): 2005 $182 2006 197 2007 215 2008 235 2009 255,255 Thereafter 14,240 ------ 270,324 ------- Current maturities (182) Unaccreted original issue discount (1,793) -------- $268,349 ======== 10. COMMITMENTS AND CONTINGENCIES: EMPLOYMENT AGREEMENT: On September 8, 2003, we entered into an employment agreement with Michael O'Donnell, our then President and Chief Executive Officer, for a term ending on December 31, 2006, subject to earlier termination by us or Mr. O'Donnell following specified notice. Mr. O'Donnell resigned his employment effective March 2005. The agreement provided, among other things, for an annual salary of $450,000 and an annual performance bonus beginning in 2004 to be based upon the achievement of increases in EBITDA, as defined, and other objectives to be set forth in business plans and budgets approved from time to time by our Board of Directors. The Company paid Mr. O'Donnell a bonus for the year ended January 2, 2005 of approximately $142,000. No further payments are due under this agreement as a result of Mr. O'Donnell's resignation. SPECIAL EVENT BONUS: We entered into special event bonus agreements on December 10, 2004 with Carmela Merendino, our Vice President-Administration, and Anthony Missano, President of our Business Development Division, which provide for them to receive a bonus in the event of a public offering of our common stock, a change in control of Sbarro, including by merger, sale of stock or sale of assets, or a liquidation or dissolution of Sbarro. The special event bonus will be based on the per share proceeds (as defined in the agreements) received by our shareholders if a special event occurs in excess of a certain threshold amount. A similar agreement was entered into with a member of the law firm we retain as general counsel. This agreement is in addition to the payment of services at fair value. -57- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As part of their "at will" employment letter agreements entered into by us with Peter Beaudrault, our new President and Chief Executive Officer, and Anthony J. Puglisi, our Vice President and Chief Financial Officer they received similar special bonus arrangements. When the special events referenced in the agreements become probable a fair value model will be used to determine the value of such award. LEASES: All of our restaurants are in leased facilities. Most of our restaurant leases provide for the payment of base rents plus real estate taxes, utilities, insurance, common area charges and certain other expenses, as well as contingent rents generally ranging from 8% to 10% of net restaurant sales in excess of stipulated amounts. Rental expense under operating leases was as follows:
2004 2003 2002 ---- ---- ---- (IN THOUSANDS) Minimum rentals $52,100 $51,089 $51,975 Common area charges 14,748 14,702 15,246 Contingent rentals 4,321 4,112 3,760 ------- ------- ------- $71,169 $69,903 $70,981 ======= ======= =======
Future minimum rental and other payments required under non-cancelable operating leases for our Sbarro restaurants and our other concept locations are as follows (in thousands): FISCAL YEARS ENDING: -------------------- 2005 $71,557 2006 69,021 2007 65,234 2008 59,474 2009 52,014 Thereafter 137,267 ------- $454,567 ======== We are the principal lessee under certain operating leases for four other concept locations that have been sold and sublet to unaffiliated third parties for which we are contingently responsible. Future minimum rental payments required under these non-cancelable operating leases as of January 2, 2005 are as follows (in thousands): -58- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) FISCAL YEARS ENDING: -------------------- 2005 $321 2006 329 2007 330 2008 277 2009 279 Thereafter 2,796 ----- $4,332 ====== We are the principal lessee under operating leases for certain franchised restaurants which are subleased to franchisees. Franchisees pay rent and related expenses directly to the landlord. Future minimum rental payments required under these non-cancelable operating leases for franchised restaurants that were open as of January 2, 2005 are as follows (in thousands): FISCAL YEARS ENDING: -------------------- 2005 $1,785 2006 1,730 2007 1,300 2008 805 2009 661 Thereafter 1,128 ----- $7,409 ====== We are the principal lessee under operating leases for three franchised restaurants that were sold and franchised to related parties (see Note 11) and are subleased by us to the franchisees. The franchisees pay rent and related expenses directly to the landlord. In 2005, we repurchased one restaurant. Future minimum rental payments required under these non-cancelable operating leases are as follows (in thousands): FISCAL YEARS ENDING: -------------------- 2005 $288 2006 181 2007 156 2008 157 2009 158 Thereafter 486 --- $1,426 ====== Future minimum rental payments required under non-cancelable operating leases for restaurants that had not as yet opened as of January 2, 2005 are as follows (in thousands): -59- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) FISCAL YEARS ENDING: -------------------- 2005 $17 2006 97 2007 248 2008 280 2009 310 Thereafter 2,613 ----- $3,565 ====== In accordance with FIN No. 45, we have recorded a liability of approximately $120,000 in 2004 and $38,000 in 2003 which represents the fair value of the guarantees related to our guarantee of certain leases. CONSTRUCTION CONTRACTS AND OTHER: As of January 2, 2005, we are a party to a contract of approximately $390,000 with respect to the new construction of a restaurant. Payments of approximately $215,000 were made on that contract in 2004. Our joint venture entered into construction contracts aggregating approximately $4,326,000 for three restaurants of which two opened in early 2005. Through March 1, 2005, payments of approximately $2,816,000 have been made against these contracts. The construction of the restaurants is guaranteed by the Company under the terms of the leases for the locations. In addition, we also guarantee the rent through the first year of operations of one restaurant location and the rent until another restaurant opens. PRODUCT PURCHASE DISTRIBUTION ARRANGEMENT: We have a contractual arrangement with a national independent wholesale distributor that commenced in February 2003 and that requires us, until January 2008, subject to early termination for certain specified causes to purchase 95% of most of our food ingredients and related restaurant supplies from it. The agreement does not, however, require us to purchase any specific fixed quantities. Among the factors that will affect the dollar amount of purchases we make under the contract are: o Number of Sbarro locations open during the term of the contract; o Level of sales made at Sbarro locations; o Market price of mozzarella cheese and other commodity items; o Price of diesel fuel; and o Mix of products sold by Sbarro locations. -60- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) LETTERS OF CREDIT: As of January 2, 2005, there are $1.8 million of bank letters of credit issued under our line of credit to support potential obligations. The letters of credit have been issued instead of cash security deposits under operating leases. Of the outstanding standby letters of credit, approximately $0.1 million are for locations that have been subleased to the buyers of two of our other concept locations. GUARANTEE ARRANGEMENTS PERTAINING TO THE OTHER CONCEPTS: We are a party to various financial guarantees to a bank for two of our other concepts. We are jointly liable, along with our joint venture partner, for a loan owed by one of the other concepts. Our liabilities under the line of credit, mortgage loan and $0.1 million of letters of credit to the second concept are limited to our minority ownership percentage. The remaining letter of credit for the second concept of $0.6 million is jointly and severally guaranteed by each of the partners in the concept. To varying degrees, these guarantees involve elements of performance and credit risk. The possibility of our having to honor our contingencies is largely dependent upon future operations of the other concepts. We record a liability if events occurred that make payment under the guarantees probable. Under FIN No. 45, we are required to record a liability for the fair value of any obligation undertaken or modified after December 31, 2002. No such obligation was undertaken or modified in 2004 or 2003. The details of our guarantees as of January 2, 2005 and their terms are as follows: TYPE OF GUARANTEED OBLIGATION AMOUNT (1) TERM ----------------------------- ---------- ---- Line of Credit $5.0 million December 2010 Loan 1.4 million November 2007 Letters of credit 0.7 million December 2010 Mortgage Loan 0.3 million August 2019 (1) Represents our current maximum exposure under existing borrowings and letters of credit. Our exposure under the line of credit could increase to $6.3 million if the full amount of the line of credit is utilized. In 2003, the loan expiration date for all new term loans was extended from December 31, 2008 to December 31, 2010. -61- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) LITIGATION: There is approximately $3.2 million included in the Company's financial statements as a reserve for contingent liabilities related to litigation. In December 1999, fourteen current and former general managers of Sbarro restaurants in California amended a complaint against us filed 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 attorneys' fees, each in unspecified amounts. Plaintiffs filed a motion to certify the lawsuit as a class action, but the motion was denied by the court. The court issued a ruling in December 2003 which was unfavorable to us but did not set the amount of damages. We are appealing the ruling due to errors that we believe were made by the trial judge. In September 2000, eight other current and former general managers of Sbarro restaurants in California filed a complaint against us 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 are seeking actual damages, punitive damages and costs of the lawsuit, including reasonable attorneys' 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. In March 2002, four former general managers of Sbarro restaurants in California filed a complaint against us in the Superior Court of California for Los Angeles County. The complaint alleged that the plaintiffs were required to perform labor services without proper premium overtime compensation from at least May 1999. The plaintiffs sought actual damages, punitive damages and attorneys' fees and costs, each in unspecified amounts. The case was settled March 22, 2005 for $48,000, with our insurance company paying $30,000 and us paying $18,000. In August 2002, a subcontractor and the general contractor, pursuant to a construction contract entered into to build the joint venture location that was closed during 2002 and also the subject of the lawsuit discussed below, filed a complaint against the limited liability joint venture company alleging that they were owed for unpaid billings. We were a defendant in the suit by reason of the fact that we guaranteed the bonds under which mechanics liens against the plaintiffs were bonded. In late 2004, we settled the lawsuit for $500,000. The settlement amount had been paid and included in our financial statements. In May 2002, the landlord of the joint venture described above filed a complaint against Sbarro in the Supreme Court of the New York for Westchester County alleging that we were obligated to it, -62- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 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 Company. We believed that our guarantee was limited in amount while the landlord alleged that the guarantee covered all amounts that would become due during the remaining lease term. The court issued a ruling in November 2003 which limited our liability, which we estimated at $500,000 and we have included this amount in our financial statements in 2003. The landlord appealed this decision. Given the uncertainty of the results of an appeal and liability we would have by reason of a reversal, we agreed to settle the matter for $800,000 and have increased the estimated reserve in 2004. Settlement agreements are currently being drafted. In November 2004, a contractor, pursuant to a construction contract entered into to build a QSR location, instituted an action for unpaid amounts under the construction contract. We have disputed certain change orders under the contract and seek to invoke the penalty clause under the contract. The action is pending in the Broward County Circuit Court, State of Florida. We believe that our ultimate liability will not exceed $50,000. Provisions have been made in the 2004 financial statements for this amount. In May 2004, a suit was filed by the landlord of one of our QSR locations as a result of our premature termination of the lease on that location by one of our subsidiaries The landlord has obtained a consent judgment against the subsidiary for approximately $75,000. The landlord now seeks to enforce the judgment against the subsidiary. While we do not believe the judgment can be enforced against us, we believe that its ultimate liability will not exceed $75,000. Provisions have been made in the 2004 financial statements for this amount. In March 2005, we settled a case relating to payments due to a contractor for construction done on one of our other concept restaurants. The matter was settled for $90,000 and has been recorded in the 2004 financial statements. In addition to the above complaints, from time to time, we are a party to claims and legal proceedings in the ordinary course of business. In our opinion, the results of such claims and legal proceedings are not expected to have a material adverse effect on our consolidated financial position or results of operations. 11. TRANSACTIONS WITH RELATED PARTIES: We were the sole tenant of an administrative office building which we leased from a partnership owned by Sbarro Enterprises, L.P., the limited partners of which are Mario Sbarro, our Chairman and a director, Joseph Sbarro, our Senior Vice President, Secretary and a director, Anthony Sbarro, our Vice Chairman, Treasurer and a director, and Carmela Sbarro, Vice President and a director. The annual rent paid was $100,000, $300,000 and $300,000 for 2004, 2003 and 2002, respectively. We were advised by a real estate broker that the rent to be paid by us was comparable to the rent that would have been charged by an unaffiliated third party. The lease was terminated upon the sale of the building by the partnership in April 2004. -63- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) On April 5, 2001, we loaned $3.2 million to certain of our shareholders, including: Mario Sbarro, $1.1 million, Joseph Sbarro, $1.2 million and Anthony Sbarro, $0.9 million. The due dates of the related notes have been extended to April 6, 2007. The notes bear interest at the rate of 4.63% per annum, payable annually. As of January 2, 2005, the balance of these loans was $2.9 million. On December 28, 2001, we loaned $2.8 million to our shareholders, including: Mario Sbarro, $0.6 million, Joseph Sbarro, $0.7 million, Anthony Sbarro, $0.5 million, and the Trust of Carmela Sbarro, $1.0 million. The due dates of the related notes have been extended to December 28, 2007. The notes bear interest at the rate of 2.48% per annum payable annually. As of January 2, 2005, the balance of these loans was $2.6 million. In March 2004, we loaned $40,000 to Gennaro A. Sbarro, then our Corporate Vice President and President of our Franchising and Licensing Division. The note was repaid in February 2005 including interest at 2.69% per annum. In connection with his resignation in 2004 we entered into a severance agreement providing for a lump sum payment of approximately $453,000. In June 2003, Anna Missano, the daughter of Joseph Sbarro, issued to us a note for approximately $90,000 for royalties due us for 2001 and 2000. The note is repayable at approximately $10,000 per year, including interest at 2.96% per annum, with a balloon payment due on June 30, 2010. The principal balance of the notes at January 2, 2005 was approximately $79,000. The interest rates charged on the foregoing related party loans included above approximate the Applicable Federal Rate (AFR) published by the Internal Revenue Service at the time of the loan. We recorded interest income from related parties was approximately $211,000, $223,000 and $221,000 in 2004, 2003 and 2002, respectively. Bernard Zimmerman & Company, Inc., of which Bernard Zimmerman, a director of Sbarro, is President and a majority shareholder, renders financial and consulting assistance to us, for which it received fees of approximately $26,000 for services rendered during 2004 and $0.3 million in both 2003 and 2002. Harold Kestenbaum, a member of our Board of Directors, assisted one of our other concepts in the preparation of its initial Uniform Franchise Offering Circular in 2002 for which the fee was $20,000. We and our other concepts have purchased printing services from a corporation owned by a son-in-law of Mario Sbarro, for which we and our other concepts paid, in the aggregate, $480,000, $340,000 and $422,000 in 2004, 2003 and 2002, respectively. Companies owned by a son of Anthony Sbarro are parties to franchise agreements with us containing terms similar to those in agreements entered into by us with unrelated franchises. Royalties under these agreements in 2004, 2003 and 2002 were approximately $89,000, $90,000 and $92,000, respectively. -64- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of July 2002, we sold the assets of a restaurant to a corporation owned by the brother-in-law of our Chairman of the Board for $88,900. The sales price resulted in a loss of approximately $64,000 that was included in the provision for restaurant closings. That corporation also entered into a franchise agreement with us. We received promissory notes for each of the purchase price and initial franchise fee that were payable over seven years and bore interest on the unpaid principal balances at 7% per annum. In addition in 2002, we subleased this location to that franchisee. Payments under the sublease were being made directly to the landlord by the franchisee. Interest payments received relating to the promissory notes was approximately $4,000 in 2003. No interest payments were received in 2004. Royalties paid under this arrangement were approximately $1,800 in 2004, $3,300 in 2003 and $6,800 in 2002. In March 2005, we re-purchased the assets of the restaurant from the corporation for $88,900. The remaining unpaid principal balance of the promissory notes were offset against the purchase price of the assets. The remaining balance under the promissory notes of approximately $22,000, and accrued but unpaid royalties of approximately $31,000 had been fully reserved in 2004. In 2002, a company in which Gennaro J. Sbarro, then our Corporate Vice President and President of our Casual and Fine Dining Division and the son of Joseph Sbarro, has a 50% interest (the other 50% is owned by an unaffiliated third party) entered into a sublease for $50,000 greater than rent or other charges due under the lease. Rent and other charges due under the lease are paid directly to the landlord. Payment under the sublease are due to us. Rent of approximately $23,000 was included in the 2004 results of operations. To reimburse Sbarro for equipment costs, the Company owned by Mr. Sbarro, issued a non-interest bearing note in our favor for approximately $55,000, that is repayable in eighteen equal monthly installments of approximately $3,000 which commenced in November 2002. The principal balance on the note as of January 2, 2005 was approximately $16,000. As of October 31, 2003, Mr. Sbarro resigned from his positions with us and a corporation owned by Mr. Sbarro entered into an eighteen month agreement with us to provide consulting services to our quick service and casual dining division for approximately $23,000 per month and the reimbursement for customary and usual expenses that may be incurred by that corporation in the performance of its services. In October 2003, we sold the assets of three underperforming Sbarro-owned restaurants that we proposed to close to entities owned separately by each of three other of Anthony Sbarro's sons, each of which entered into a franchise agreement with us. Two of the locations, which had no remaining book value, were transferred for no consideration while the third was sold for $0.3 million that was paid in full, and resulted in a gain to Sbarro of approximately $0.1 million. In connection with the sale of the locations, the employment of these individuals with Sbarro was terminated and we included a charge for their total severance pay of approximately $60,000 in our results of operations for 2003. The franchise agreements provide for the payment of 5% of the location's sales as a continuing franchise fee but did not provide for any initial franchise fee. We have waived continuing franchise fees through 2006. In addition, we subleased two of the -65- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) locations to two of the franchisees. Payments under the subleases are being made directly to the landlord by the franchisees and they are not in default. In January 2004, one of Mario Sbarro's daughters, resigned from her position as Manager of Administration - Construction. A corporation owned by her entered into a one year agreement to provide consulting services related to construction matters to us for a series of monthly payments totaling $100,000. In addition, that corporation provided consulting services related to construction matters for our steakhouse joint venture of $18,900 in 2004. In February 2005, a joint venture in which we have a 70% interest, sold the assets of one of our other joint venture restaurants, to a company owned by Gennaro A. Sbarro our then Corporate Vice President and President of our Franchising and Licensing Division and the son of Mario Sbarro for approximately $900,000 (which approximated fair value) resulting in a loss of approximately $284,000. The Company received $300,000 in cash and promissory notes of $600,000. The promissory notes are payable monthly in 72 equal monthly installments in the amount of $8,333 including interest at 5% per annum with a balloon payment of $111,375 at maturity. The joint venture also sold the inventory of the restaurant for approximately $67,000 with $50,000 paid at closing and the remainder of $17,000 payable in four equal monthly installments from March 2005 to June 2005. The company owned by Mr. Sbarro entered into a sublease, which we guarantee and a Security Agreement to secure the obligations under the promissory notes. The sublease and Security Agreement are intended to enable Sbarro to recapture the business in the event of an uncured default. Compensation of related parties includes salary, taxable benefits and accrued bonus. Salaries for 2004 include one additional week of salary due to our 53 week year in 2004. Compensation is as follows: o Mario Sbarro was our Chairman of the Board in 2004 and Chairman of the Board, President and Chief Executive Officer in 2003 and 2002. His compensation was approximately $884,000 in 2004, $700,000 in 2003 and $920,000 in 2002. o Anthony Sbarro was our Vice Chairman of the Board and Treasurer in 2004, 2003 and 2002. His compensation was approximately $582,000 in 2004, $400,000 in 2003 and $545,000 in 2002. o Joseph Sbarro was our Senior Executive Vice President and Secretary in 2004, 2003 and 2002. His compensation was approximately $585,000 in 2004, $400,000 in 2003 and $575,000 in 2002. -66- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In addition to the compensation of Mario, Anthony, and Joseph Sbarro: o Carmela Sbarro, the mother of Mario, Anthony and Joseph Sbarro, who was a co-founder of Sbarro and serves as Vice President and a director, received $100,000 from us for services rendered in 2004, 2003 and 2002. o Other members of the immediate families of Mario, Anthony, Joseph and Carmela Sbarro who are our employees were paid an aggregate of approximately $860,000, $1,344,000 and $1,565,000 during 2004, 2003 and 2002, respectively. The company has a 40% equity interest in Boulder Creek Steakhouse and provided administrative services for $165,000, $172,000 and $148,000 in 2004, 2003 and 2002, respectively. 12. PROVISION FOR ASSET IMPAIRMENT, RESTAURANT CLOSINGS, AND LOSS ON SALE OF OTHER CONCEPT RESTAURANT (IN THOUSANDS): The provision for asset impairment, restaurant closings/remodels, and loss on sale of other concept restaurant consists of the following:
2004 2003 2002 ---- ---- ---- Impairment of assets $1,103 $4,100 $400 Restaurant closings/remodels 815 2,000 8,800 Loss on sale of other concept restaurant 284 - - ------ ------ ------ $2,202 $6,100 $9,200 ====== ====== ======
13. DIVIDENDS: We declared distributions to our shareholders pursuant to the tax payment agreement described in Note 8 as follows: o $1.8 million with respect to our taxable income for 2002, of which $1.1 million was paid in 2003 and $0.7 million was paid in March 2004; o $3.1 million with respect to our taxable income for 2001 was paid in 2002. -67- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. QUARTERLY FINANCIAL INFORMATION (UNAUDITED):
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- ------- ------- ------- (IN THOUSANDS) 2004 Revenues $96,211 $72,717 $78,306 $101,660 Gross profit (a) 70,837 52,747 57,988 77,668 Net (loss) income (d) (6,161) (4,556) (1,029) 7,423 2003 Revenues (b) $93,115 $72,043 $75,778 $91,388 Gross profit (a) (b) 69,205 54,002 56,408 67,647 Net (loss) income (b) (c) (10,490) (5,212) (7,954) 6,426
(a) Gross profit represents the difference between restaurant sales and the cost of food and paper products. (b) Revenues and net income for the fourth quarter of 2003 include approximately $0.7 million and $0.4 million of vendor rebates that should have been recorded during 2002 and in the first two quarters of 2003, respectively. During 2003, we received new information regarding those rebates and, as a result, were able to apply better judgment in their recording. (c) We recorded a provision for asset impairment of $3.0 million and $1.1 million in the third and fourth quarters of 2003, respectively. (d) In the fourth quarter of 2004, we recorded a provision for asset impairment of $1.1 million, litigation expense of $1.2 million and reversed an accrual for a rebate receivable of $0.3 million. In addition, we reduced our tax liability reserve by approximately $0.4 million to reflect our current estimated tax exposure and reported income of approximately $1.2 million for a settlement agreement with the bankruptcy trustee of our former distributor. -68- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 15. EQUITY INVESTMENT IN BOULDER CREEK STEAKHOUSE: The company has a 40% equity interest in Boulder Creek Steakhouse. The combined condensed financial statements below include the accounts of Boulder Creek Holding LLC ("Holding"), Boulder Creek Venture LLC ("Venture") and Boulder Creek Properties LLC ("Properties") and their wholly owned subsidiaries (collectively "Boulder Creek"). Properties holds the trademark used by Holding and Venture. All material intercompany accounts and transactions have been eliminated in combination. The members of Holding, Venture and Properties are Scotto LLC ("Scotto") (40%), Sbarro Boulder LLC ("Sbarro Boulder") (40%) and Fee Fee LLC ("Fee Fee") (20%) (the "member LLCs"). Sbarro Boulder is 100% owned by Sbarro, Inc. INCOME STATEMENT DATA (IN THOUSANDS):
2004 2003 2002 ---- ---- ---- Net sales $49,697 $50,141 $39,889 Costs and expenses 47,149 46,960 37,344 Interest expense, net 477 531 611 Loss from discontinued operations 47 901 157 ------ ------ ------ Net income $2,024 $1,749 $1,777 ====== ====== ======
BALANCE SHEET DATA (IN THOUSANDS):
2004 2003 ---- ---- Total assets $30,031 $27,290 Total liabilities $21,628 $20,147 Members' equity $ 8,403 $7,143
-69- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 16. 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 on a joint and several basis. The following condensed consolidating financial information presents: (1) Condensed consolidating balance sheets as of January 2, 2005 and December 28, 2003 and related statements of operations and cash flows for the fiscal years ended January 2, 2005, December 28, 2003 and December 29, 2002 of (a) Sbarro, Inc., the parent, (b) the guarantor subsidiaries as a group, (c) the nonguarantor 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 nonguarantor subsidiaries. The principal elimination entries eliminate intercompany balances and transactions. Investments in subsidiaries are accounted for by the parent on the cost method. -70- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF JANUARY 2, 2005 (IN THOUSANDS) ASSETS
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Current assets: Cash and cash equivalents $57,150 $4,680 $1,170 $ - $63,000 Restricted cash for untendered shares Receivables less allowance for doubtful accounts of $431: Franchise 1,846 - - - 1,846 Other 53 1,053 574 - 1,680 -------- -------- ------ --------- -------- 1,899 1,053 574 - 3,526 Inventories 1,204 1,465 140 - 2,809 Prepaid expenses 4,020 (199) 56 - 3,877 Current portion of loans receivable from officers 46 - - - 46 -------- -------- ------ --------- -------- Total current assets 64,319 6,999 1,940 - 73,258 Intercompany receivables 406 439,364 (1,875) (437,895) - Investment in subsidiaries 67,570 1,944 - (69,514) - Property and equipment, net 33,307 50,799 4,359 - 88,465 Intangible assets: Trademarks, net 195,916 - - - 195,916 Goodwill 9,204 - - - 9,204 Deferred financing costs, net 4,326 195 - - 4,521 Loans receivable from officers less 5,602 - - - 5,602 current portion Other assets 5,906 1,720 21 - 7,647 -------- -------- ------ --------- -------- $386,556 $501,021 $4,445 $(507,409) $384,613 ======== ======== ====== ========== ========
-71- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF JANUARY 2, 2005 (IN THOUSANDS) LIABILITIES AND SHAREHOLDERS' EQUITY
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Current liabilities: Accounts payable $10,877 $190 $526 $ - $11,593 Accrued expenses 16,802 2,474 1,472 - 20,748 Accrued interest payable 8,181 - - - 8,181 Current portion of mortgage payable - 182 - - 182 -------- -------- ------ --------- -------- Total current liabilities 35,860 2,846 1,998 - 40,704 -------- -------- ------ --------- -------- Intercompany payables 437,895 - - (437,895) - -------- -------- ------ --------- -------- Deferred rent 9,811 - 415 - 10,226 -------- -------- ------ --------- -------- Long-term debt, net of original issue discount 253,207 15,142 - - 268,349 -------- -------- ------ --------- -------- 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 (65,479) 133,671 3,018 (71,200) 10 Retained earnings (deficit) (284,809) 349,362 (986) 1,686 65,253 -------- -------- ------ --------- -------- (350,217) 483,033 2,032 (69,514) 65,334 -------- -------- ------ --------- -------- $386,556 $501,021 $4,445 $(507,409) $384,613 ======== ======== ====== ========== ========
-72- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF DECEMBER 28, 2003 (IN THOUSANDS) ASSETS
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Current assets: Cash and cash equivalents $49,536 $5,595 $1,299 $ - $56,430 Receivables net of allowance for doubtful accounts of $488: Franchise 1,700 - - - 1,700 Other (191) 966 396 - 1,171 -------- -------- ------ --------- -------- 1,509 966 396 - 2,871 Inventories 1,177 1,387 143 - 2,707 Prepaid expenses 4,018 (227) 53 - 3,844 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 9,204 - - - 9,204 Deferred financing costs net 5,369 233 - (120) 5,482 Loans receivable from officers, less current portion 3,347 - - - 3,347 Other assets 7,476 1,822 (653) (1,030) 7,615 -------- -------- ------ --------- -------- $388,717 $382,719 $5,947 $(390,553) $386,830 ======== ======== ====== ========== ========
-73- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING BALANCE SHEET AS OF DECEMBER 28, 2003 (IN THOUSANDS) LIABILITIES AND SHAREHOLDERS' EQUITY
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Current liabilities: Accounts payable $11,859 $129 $419 $1,327 $13,734 Accrued expenses 14,974 1,447 1,806 - 18,227 Accrued interest payable 8,181 - - - 8,181 Current portion of mortgage payable - 168 - - 168 -------- -------- ------ --------- -------- Total current liabilities 35,014 1,744 2,225 1,327 40,310 -------- -------- ------ --------- -------- Intercompany payables 317,236 2,958 3,740 (323,934) - -------- -------- ------ --------- -------- Deferred rent 8,009 - 702 - 8,711 -------- -------- ------ --------- -------- Long-term debt, net of original issue discount 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) (224,450) 297,223 (3,197) - 69,576 -------- -------- ------ --------- -------- (224,369) 362,692 (720) (67,946) 69,657 -------- -------- ------ --------- -------- $388,717 $382,719 $5,947 $(390,553) $386,830 ======== ======== ====== =========== ========
-74- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE FISCAL YEAR ENDED JANUARY 2, 2005 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Revenues: Restaurant sales $143,649 $172,361 $15,303 $ - $ 331,313 Franchise related income 12,093 - - - 12,093 Real estate and other 1,838 3,547 103 - 5,488 Intercompany charges 11,747 - - (11,747) - ------- ------- ------ --------- ---------- Total revenues 169,327 175,908 15,406 (11,747) 348,894 ------- ------- ------ --------- ---------- Costs and expenses: Restaurant operating expenses: Cost of food and paper products 28,948 39,001 4,124 - 72,073 Payroll and other employee benefits 38,641 47,212 5,004 - 90,857 Other operating costs 51,444 58,925 4,202 - 114,571 Depreciation and amortization 7,145 8,347 908 - 16,400 General and administrative 17,143 11,254 179 - 28,576 Asset impairment, restaurant closings & loss on sale of 2,202 - - - 2,202 other concept restaurant Intercompany charges - 11,747 - (11,747) - ------- ------- ------ --------- ---------- Total costs and expenses 145,523 176,486 14,417 (11,747) 324,679 ======== ======== ====== ========== ========== Operating income (loss) 23,804 (578) 989 - 24,215 ------- ------- ------ --------- ---------- Other (expense) income: Interest expense (29,361) (1,333) - - (30,694) Interest income 654 - - - 654 Equity in net income of unconsolidated affiliates 855 - - - 855 Other income 1,181 - - - 1,181 ------- ------- ------ --------- ---------- Net other expense (26,671) (1,333) - - (28,004) ------- ------- ------ --------- ---------- (Loss) income before taxes (2,867) (1,911) 989 - (3,789) Income taxes 500 - 34 - 534 ------- ------- ------ --------- ---------- Net (loss) income $(3,367) $(1,911) $955 $ - $(4,323) ======== ======== ====== ========== ===========
-75- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE FISCAL YEAR ENDED DECEMBER 28, 2003 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Revenues: Restaurant sales $135,295 $164,535 $14,878 $ - $314,708 Franchise related income 10,868 - - - 10,868 Real estate and other 4,077 2,586 85 - 6,748 Intercompany charges 10,728 - - (10,728) - --------- -------- ------- ---------- --------- Total revenues 160,968 167,121 14,963 (10,728) 332,324 --------- -------- ------- ---------- --------- Costs and expenses: Restaurant operating expenses: Cost of food and paper products 27,402 36,116 3,928 - 67,446 Payroll and other employee benefits 36,474 48,155 4,985 - 89,614 Other operating costs 49,196 57,282 3,975 - 110,453 Depreciation and amortization 8,801 9,899 1,012 - 19,712 General and administrative 15,212 10,418 (179) - 25,451 Asset impairment, restaurant closings and loss on sale of other concept restaurant 5,647 - 426 - 6,073 Intercompany charges - 10,728 - (10,728) - --------- -------- ------- ---------- --------- Total costs and expenses 142,732 172,598 14,147 (10,728) 318,749 --------- -------- ------- ---------- --------- Operating income (loss) 18,236 (5,477) 816 - 13,575 --------- -------- ------- ---------- --------- Other (expense) income: Interest expense (29,693) (1,346) - - (31,039) Interest income 694 - - - 694 Equity in net income of unconsolidated affiliates 425 - - - 425 --------- -------- ------- ---------- --------- Net other (expense) (28,574) (1,346) - - (29,920) --------- -------- ------- ---------- --------- (Loss) income before minority interest (credit) (10,338) (6,823) 816 - (16,345) Minority interest - - (41) - (41) --------- -------- ------- ---------- --------- Loss before income taxes (credit) (10,338) (6,823) 775 - (16,386) Income taxes (credit) 536 348 (40) - 844 --------- -------- ------- ---------- --------- Net (loss) income $(10,874) $(7,171) $815 $ - $(17,230) ========= ======== ======= ========== =========
-76- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF OPERATIONS FOR THE FISCAL YEAR ENDED DECEMBER 29, 2002 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Revenues: Restaurant sales $144,394 $177,728 $23,084 $ - $345,206 Franchise related income 10,070 - - - 10,070 Real estate and other 1,605 3,499 - - 5,104 Intercompany charges - 15,275 - (15,275) - --------- -------- -------- ---------- -------- Total revenues 156,069 196,502 23,084 (15,275) 360,380 --------- -------- -------- ---------- -------- Costs and expenses: Restaurant operating expenses: Cost of food and paper products 26,596 34,592 6,405 - 67,593 Payroll and other employee benefits 37,996 50,005 8,287 - 96,288 Other operating costs 48,242 59,207 7,443 - 114,892 Depreciation and amortization 9,133 10,290 1,260 - 20,683 General and administrative 11,203 12,286 471 - 23,960 Provision for asset impairment, restaurant closings and loss on sale of other concept restaurant 12,850 - (3,654) - 9,196 Intercompany charges 15,275 - - (15,275) - --------- --------- --------- ------------ -------- Total costs and expenses 161,295 166,380 20,212 (15,275) 332,612 --------- --------- --------- ------------ -------- Operating (loss) income (5,226) 30,122 2,872 - 27,768 --------- --------- --------- ------------ -------- Other (expense) income: Interest expense (29,600) (1,359) - - (30,959) Interest income 528 - - - 528 Equity in net income of unconsolidated affiliates 668 - - - 668 Insurance recovery, net 7,162 - - - 7,162 --------- --------- --------- ------------ -------- Net other expense (21,242) (1,359) - - (22,601) --------- --------- --------- ------------ -------- (Loss) income before minority interest (credit) (26,468) 28,763 2,872 - 5,167 Minority interest - - (52) - (52) --------- --------- --------- ------------ -------- (Loss) income before income tax (credit) (26,468) 28,763 2,820 - 5,115 Income taxes (credit) (1,629) 1,773 190 - 334 --------- --------- --------- ------------ -------- Net (loss) income $(24,839) $26,990 $2,630 $ - $4,781 ========= ========= ========= ============= ========
-77- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE FISCAL YEAR ENDED JANUARY 2, 2005 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED Operating activities: PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL --------------------- ------ ------------ ------------ ------------ ----- Net (loss) income $(3,367) $(1,911) $955 $ - $(4,323) Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 7,145 8,347 908 - 16,400 Amortization of deferred financing costs 962 - - - 962 Amortization of bond discount 379 - - - 379 Allowance for doubtful accounts receivable 222 - - - 222 Asset impairment, restaurant closings and loss on sale of other concept restaurant 2,202 - - - 2,202 Increase (decrease) in deferred rent, net 502 - (229) - 273 Equity in net income of unconsolidated affiliates (855) - - - (855) Other 155 - - - 155 Changes in operating assets and liabilities: Increase in receivables (612) (87) (178) - (877) Decrease (increase) in inventories (27) (78) 3 - (102) Increase in prepaid expenses (2) (28) (3) - (33) Decrease (increase) in other assets 2,117 103 (732) (1,030) 458 Increase (decrease) in accounts payable and accrued expenses (936) 1,088 (227) 1,030 955 ------- ------- ----- ------- ------- Net cash provided by operating activities 7,885 7,434 497 - 15,816 ------- ------- ----- ------- ------- Investing activities: Purchases of property and equipment (6,103) (2,144) (659) - (8,906) ------- ------- ----- ------- ------- Net cash used in investing activities (6,103) (2,144) (659) - (8,906) ------- ------- ----- ------- -------
-78- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS (CONTINUED) FOR THE FISCAL YEAR ENDED JANUARY 2, 2005 (IN THOUSANDS) GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Financing activities: Mortgage principal repayments - (167) - - (167) Tax distributions (682) - - - (682) Reduction in loans receivable from officers 509 - - - 509 - - Intercompany balances 6,005 (6,039) 34 - - ------ ------ ---------- ---------- -------- Net cash (used in) provided by financing activities 5,832 (6,206) 34 - (340) ------ ------ ---------- ---------- -------- Increase (decrease) in cash and cash equivalents 7,614 (916) (128) - 6,570 Cash and cash equivalents at beginning of year 49,536 5,596 1,298 - 56,430 ------ ------ ---------- ---------- -------- Cash and cash equivalents at end of year $57,150 $4,680 $1,170 - $63,000 ======= ====== ====== ========= ======= Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $417 $ - $ - $ - $417 ------ ------ ---------- ---------- -------- Cash paid during the period for interest 28,058 $1,294 $ - $ - $29,352 ====== ====== ========== ========== =======
-79- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE FISCAL YEAR ENDED DECEMBER 28, 2003 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED Operating activities: PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL --------------------- ------ ------------ ------------ ------------ ----- Net (loss) income $(10,874) $(7,171) $815 $ - $(17,230) Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 8,674 10,029 1,009 - 19,712 Amortization of deferred financing 1,148 - - - 1,148 Amortization of bond discount 379 - - - 379 Allowance for doubtful accounts receivable 435 - - - 435 Asset impairment, restaurant closings and loss on sale of other concept restaurant 4,199 1,452 422 - 6,073 Minority interest 41 - 41 Increase in deferred rent, net 200 - 42 - 242 Equity in net income of unconsolidated affiliates (425) - - - (425) Other 44 - - - 44 Changes in operating assets and liabilities: Decrease in receivables 15 121 55 - 191 Decrease in inventories 239 339 - - 578 Increase in prepaid expenses (185) (41) (27) - (253) Decrease (increase) in other assets 816 (49) 194 $(1,327) (366) Increase (decrease) in accounts payable and accrued expenses 849 (1,108) (603) 1,327 465 ----- ----- ----- ---------- ------ Net cash provided by operating activities 5,514 3,572 1,948 - 11,034 ----- ----- ----- ---------- ------ Investing activities: Purchases of property and equipment (5,849) (2,485) (187) - (8,521) ------- ------- ----- ---------- ------- Net cash used in investing activities (5,849) (2,485) (187) - (8,521) ------- ------- ----- ---------- -------
-80- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS (CONTINUED) FOR THE FISCAL YEAR ENDED DECEMBER 28, 2003 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Financing activities: --------------------- Mortgage principal repayments - (154) - - (154) Tax distributions (1,100) - - - (1,100) Intercompany balances 3,314 (1,876) (1,438) - - ------ ------- ------- ----------- ------ Net cash (used in) provided by financing activities 2,214 (2,030) (1,438) - (1,254) ------ ------- ------- ----------- ------ Increase (decrease) in cash and cash equivalents 1,879 (943) 323 - 1,259 Cash and cash equivalents at beginning of year 47,657 6,539 975 - 55,171 ------ ------- ------- ----------- ------ Cash and cash equivalents at end of year $49,536 $5,596 $1,298 - $56,430 ======= ====== ====== =========== ======= Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $290 $85 $13 $ - $388 ======= ====== ====== =========== ======= Cash paid during the period for interest $28,192 $1,208 $ - $ - $29,400 ======= ====== ====== =========== =======
-81- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE FISCAL YEAR ENDED DECEMBER 29, 2002 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED Operating activities: PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL --------------------- ------ ------------ ------------ ------------ ----- Net (loss) income $(24,839) $26,990 $2,630 $ - $4,781 Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 11,097 8,325 1,261 - 20,683 Allowance for doubtful accounts receivable 350 - - - 350 Amortization of deferred financing 1,074 - - - 1,074 Amortization of bond discount 379 - - - 379 Increase (decrease) in deferred rent, net 421 (135) (74) - 212 Asset impairment, restaurant closings and loss on sale of other concept restaurant 4,727 - 4,469 - 9,196 Equity in net income of unconsolidated affiliates (668) - - - (668) Minority interest 52 - 52 Other (76) - - - (76) Changes in operating assets and liabilities: Decrease (increase) in receivables 1,755 (475) 28 - 1,308 (Increase) decrease in inventories (4) 46 210 - 252 (Increase) decrease in prepaid expenses (763) (187) (171) - (1,121) (Increase) decrease in other assets (438) 282 (273) - (429) (Decrease) increase in accounts payable and accrued expenses (3,361) 1,827 (1,886) (120) (3,540) ---------- --------- ----------- ----------- ---------- Net cash (used in) provided by operating activities (10,346) 36,673 6,246 (120) 32,453 ---------- --------- ----------- ----------- ---------- Investing activities: Purchases of property and equipment (8,357) (2,398) (233) - (10,988) ---------- --------- ----------- ----------- ---------- Net cash used in investing activities (8,357) (2,398) (233) - (10,988) ---------- --------- ----------- ----------- ----------
-82- SBARRO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATING STATEMENT OF CASH FLOWS (CONTINUED) FOR THE FISCAL YEAR ENDED DECEMBER 29, 2002 (IN THOUSANDS)
GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------ ------------ ------------ ------------ ----- Financing activities: --------------------- Mortgage principal repayments - (142) - - (142) Tax distribution (3,125) - - - (3,125) Intercompany balances 39,791 (33,031) (6,880) 120 - -------- ------- -------- --------- ------- Net cash provided by (used in) financing activities 36,666 (33,173) (6,880) 120 (3,267) -------- ------- -------- --------- ------- (Decrease) increase in cash and cash equivalents 17,963 1,102 (867) - 18,198 Cash and cash equivalents at beginning of year 29,694 5,437 1,842 - 36,973 -------- ------- -------- --------- ------- Cash and cash equivalents at end of period $47,657 $6,539 $975 $ - $55,171 ======== ======= ======== ========= ======= Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $533 $262 $1 $ - $796 ======== ======= ======== ========= ======= Cash paid during the period for interest $28,171 $1,327 $ - $ - $29,498 ======== ======= ======== ========= =======
-83- ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ------- ------------------------------------------------------------------- NONE Item 9A. CONTROLS AND PROCEDURES Disclosure Controls and Procedures The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is 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 such evaluation, the Company's Chief Executive Officer and Chief Financial Officer, have concluded that the disclosure controls and procedures are not effective for the reasons specified below. In connection with the year ended 2004 closing process and the delay in the filing of our Form 10-K, the following issues were identified: o We had insufficient staffing in the accounting and reporting function and certain changes in management and accounting personnel during the course of the audit which strained our existing resources. We have been addressing the issue of upgrading our finance, accounting and internal control functions since prior to the commencement of the audit to add personnel of skills and training that will not only enable us to accelerate the audit closing function but also will expand the number of members of our staff with knowledge of technical accounting literature. In this regard, we have changed certain senior accounting personnel and added a director of compliance. We are continuing to expand our personnel in these areas by adding three additional senior accountants in our corporate accounting department, one of whom just recently joined us. We will continue to review whether we need additional accounting personnel. o Our existing accounting resources were further strained by our need to analyze the impact of the views of the Staff of the Securities and Exchange Commission set forth in a letter dated February 7, 2005 from the Chief Accountant of the Securities and Exchange Commission to the Chairman of the Center for Public Company Audit Firms of the American Institute of Public Accountants concerning the accounting for operating leases, which has effected many companies, especially restaurant companies, with significant leases. As we have just completed this analysis, we are in the process of examining the steps to be taken to strengthen our procedures in this area, including providing training to all present and future staff accountants to ensure, on a prospective basis, the proper accounting, reporting, documentation and application of SFAS No. 13, "Accounting for Leases" and FASB Technical Bulletin No. 85-3, "Accounting for Operating Leases with Scheduled Rent Increases." Internal Control Over Financial Reporting. Except as described above, there have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) since the beginning of the fourth quarter of 2004 that have materially affected, or are reasonable likely to materially affect, the Company's internal control over financial reporting. -84- ITEM 9B. OTHER INFORMATION -------- ----------------- On February 17, 2005 our Board of Directors authorized our payment of bonuses to all of our salaried employees and certain hourly employees relating to our 2004 results of operations. The bonuses approximate $1.3 million and, with the exception of the bonuses to Messrs. Mario Sbarro, Joseph Sbarro and Anthony Sbarro (see "Executive Compensation" in Item 11 of this report), were based on percentages of the employee's compensation, which percentages varied depending upon their category of employment. The bonuses to the executive officers named in the summary compensation table under the caption "Executive Compensation" in Item 11 of this report were as follows: Michael O'Donnell $141,750 Mario Sbarro $157,500 Anthony Sbarro $157,500 Joseph Sbarro $157,500 Peter Beaudrault $ 94,500 As part of their at will employment agreements we entered into letter agreements on December 10, 2004 with, among others, Carmela Merendino, our Vice President-Administration, and Anthony Missano, President of our Business Development Division, which provide for them to receive a special bonus in the event of a public offering of our common stock, a change in control of Sbarro, including by merger, sale of stock or sale of assets, or a liquidation or dissolution of Sbarro. The special bonus will be based on the per share proceeds (as defined in the letter agreements) received by our shareholders in excess of a threshold amount. Similar agreements were previously entered into by us with Peter Beaudrault, our new President and Chief Executive Officer, and Anthony J. Puglisi, our Vice President and Chief Financial Officer, as part of their at will employment arrangements entered into at the time they joined us. (See "Executive Compensation" in Item 11 of this report.) -85- PART III -------- ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------- -------------------------------------------------- Our directors and executive officers and their ages at March 31, 2005 are: NAME AGE POSITION ---- --- -------- Mario Sbarro 63 Chairman of the Board and Director Anthony Sbarro 58 Vice Chairman of the Board, Treasurer and Director Joseph Sbarro 64 Senior Executive Vice President, Secretary and Director Carmela Sbarro 83 Vice President and Director Peter Beaudrault 50 President - Chief Executive Officer Anthony J. Missano 46 President, Business Development and Corporate Vice President Carmela N. Merendino 40 Vice President - Administration Anthony J. Puglisi 55 Vice President and Chief Financial Officer Harold L. Kestenbaum 55 Director Richard A. Mandell 62 Director Michael O'Donnell 49 Director Terry Vince 76 Director Bernard Zimmerman 72 Director MARIO SBARRO has been an officer, a director and a principal shareholder of Sbarro since its organization in 1977, serving as Chairman of our board of directors, and until September 2003, as our President and Chief Executive Officer. ANTHONY SBARRO has been an officer, a director and a principal shareholder of Sbarro since its organization in 1977, serving as Vice Chairman of our board of directors and Treasurer for more than the past five years. JOSEPH SBARRO has been an officer, a director and a principal shareholder of Sbarro since its organization in 1977, serving as Senior Executive Vice President and Secretary for more than the past five years. CARMELA SBARRO has been a Vice President for more than the past five years. Mrs. Sbarro was a founder of Sbarro, together with her late husband, Gennaro Sbarro. Mrs. Sbarro devotes a substantial portion of her time to recipe and product development. Mrs. Sbarro has been a director since January 1998. Mrs. Sbarro also served as a director from March 1985 until December 1988, following which she was elected director emeritus until her re-election to our board of directors. -86- PETER BEAUDRAULT was elected President and Chief Executive Officer in March 2005 to succeed Mr. O'Donnell. Prior there to, Mr. Beaudrault served as Corporate Vice President and President of our Quick Service Division since joining us in March 2004. Prior to joining Sbarro, Mr. Beaudrault was an industry consultant from January 2003 and for more than five years prior to that was the President and Chief Executive Officer of the Hard Rock Cafe International, a restaurant chain. ANTHONY J. MISSANO was elected President of Business Development in March 2004. He has been a Corporate Vice President for more than the past five years and served as President of our Quick Service Division from January 2000 until March 2004. CARMELA N. MERENDINO has been Vice President - Administration for more than the past five years. ANTHONY J. PUGLISI joined us as Vice President-Chief Financial Officer in February 2004. Prior to joining Sbarro, Mr. Puglisi was the Vice President and Chief Financial Officer of Langer, Inc., a provider of products used to treat muscle - skeletal disorders, from April 2002 to February 2004. Mr. Puglisi was Senior Vice President and Chief Financial Officer of Netrex Corporation, from September 2000 to October 2001 and Executive Vice President and Chief Financial Officer of Olsten Corporation, a provider of staffing and home health care services, from 1993 to March 2000. Mr. Puglisi has been a certified public accountant in New York for over twenty-five years and is a director of Hi Tech Pharmacal Company, Inc. HAROLD L. KESTENBAUM has been a practicing attorney in New York for more than the past five years. He became a director of Sbarro in March 1985. Mr. Kestenbaum is also a director of Rezconnect Technologies, Inc. and UFSI, Inc. RICHARD A. MANDELL has been a private investor and financial consultant since April 1998. Prior to that date, he was Vice President - Private Investments of Clariden Asset Management (NY) Inc., a subsidiary of Clariden Bank, a private Swiss bank, from January 1996 until February 1998. From 1982 until June 1995, Mr. Mandell served as a Managing Director of Prudential Securities Incorporated, an investment banking firm. He became a director of Sbarro in March 1986. Mr. Mandell is also a director of Encore Capital Group, Inc. and Smith & Wollensky Restaurant Group, Inc. Mr. Mandell has been a certified public accountant in New York for more than the past thirty years. MICHAEL O'DONNELL has been Chairman of the Board of Directors, Chief Executive Officer and President of Champps Entertainment, Inc., a restaurant chain operator and franchisor, since March 2, 2005, when he resigned as our President and Chief Executive Officer, a position he held since September 2003. Mr. O'Donnell remains a director of the Company, a position in which he has served since September 2003. He joined us as President, Chief Executive Officer and was elected to our Board of Directors in September, 2003. Prior to his joining Sbarro, Mr. O'Donnell was an industry consultant from January 2003 and for more than five years prior to that was the President and Chief Executive Officer of New Concepts at Outback Steakhouse Inc., a restaurant chain. Mr. O'Donnell is a director of Champps Entertainment and Boston Inner City Schools. -87- TERRY VINCE has been Chairman of the Board and President of Sovereign Hotels, Inc., a company that owns and manages hotels. Mr. Vince became a director of Sbarro in December 1988. BERNARD ZIMMERMAN has been President of Bernard Zimmerman & Co., Inc. a financial and management consulting firm, for over 30 years. In addition, Mr. Zimmerman is the President and Chief Executive Officer and a director of FCCC, Inc., and GVC Venture Corporation, both companies are engaged in seeking business combinations, mergers and/or acquisitions. Mr. Zimmerman has been a certified public accountant in New York for more than the past thirty-five years. He became a director of Sbarro in March 1985. Our by-laws provide that the minimum number of directors that can constitute our board is six and the maximum number of directors that can constitute our board is twelve. Our officers are elected annually by the board of directors and hold their respective offices until their successors are duly elected and qualified. Officers may be removed at any time by the board. Mario, Anthony and Joseph Sbarro are the sons of Carmela Sbarro. Carmela N. Merendino is the daughter, of Mario Sbarro. Anthony J. Missano is the son-in-law of Joseph Sbarro. Our board of directors has determined that Richard A. Mandell, Chairman of our Audit Committee, is the audit committee financial expert and is independent. During 2004, our officers, directors and shareholders were not required to file reports under Section 16(a) of the Securities Exchange Act of 1934. We have adopted a Code of Ethics that applies to, among others, our principal executive officer, principal financial officer, principal accounting officer, controller and other persons performing similar functions. We undertake to provide to any person, without charge, upon request, a copy of our Code of Ethics. If you wish a copy of our Code of Ethics, please write to our Chief Financial Officer, Sbarro, Inc., 401 Broadhollow Road, Melville, New York 11747-4714. -88- ITEM 11. EXECUTIVE COMPENSATION -------- ---------------------- SUMMARY COMPENSATION TABLE The following table sets forth information concerning the compensation of Michael O'Donnell who served as our chief executive officer during 2004 and other five most highly compensated persons who were serving as executive officers at the end of our 2004 year (including Peter Beaudrault, who replaced Mr. O'Donnell as our Chief Executive Officer in March 2005) for services in all capacities to us and our subsidiaries during our 2004, 2003 and 2002 years:
ANNUAL ALL OTHER COMPENSATION COMPENSATION NAME AND ------------ ------------ PRINCIPAL POSITION YEAR SALARY BONUS (1) ------------------ ---- ------ --------- Michael O'Donnell (2)................................. 2004 $465,418 $141,750 $1,080(3) President and Chief Executive Officer 2003 133,816 -- 360 Mario Sbarro.......................................... 2004 $726,321 $157,500 -- Chairman of the Board, President and 2003 700,000 -- -- Chief Executive Officer 2002 700,000 220,000 -- Anthony Sbarro........................................ 2004 $424,631 $157,500 -- Vice Chairman of the Board and Treasurer 2003 400,000 -- -- 2002 325,000 220,000 -- Joseph Sbarro......................................... 2004 $427,792 $157,500 -- Senior Executive Vice President and 2003 400,000 -- -- Secretary 2002 325,000 250,000 -- Peter Beaudrault (4).................................. 2004 $303,808 $94,500 -- Corporate Vice President and President - Quick Service Division
(1) Annual compensation includes bonuses in the year they are earned. Bonuses are paid the year following the year earned. (2) Mr. O'Donnell joined us on September 8, 2003 and resigned as an officer effective in March 2005. (3) Represents premium on a $1,000,000 life, accidental death and dismemberment insurance policy on Mr. O'Donnell. (4) Mr. Beaudrault was elected our President and Chief Executive Officer on March 4, 2005 to replace Mr. O'Donnell. -89- COMPENSATION OF DIRECTORS The compensation of non-employee directors previously in effect was increased effective March 29, 2004. Non-employee directors will now receive a retainer at the rate of $20,000 (formerly $16,000) per annum, a fee of $1,500 (formerly $1,000) for each meeting of the Board attended and a fee of $1,000 (formerly $500) for each meeting of a committee of the Board attended on which the director serves if the meeting is not held on the same day as a meeting of the Board. The Chairman of the Audit Committee will continue to receive a $2,500 per annum retainer in addition to regular committee compensation and non-employee directors will continue to be reimbursed for their reasonable travel and other expenses incurred in attending Board and committee meetings. EMPLOYMENT AGREEMENTS On March 2, 2005, Michael O'Donnell, who at the time was our President and Chief Executive Officer, resigned to take a similar position with a publicly-held non-competitive restaurant chain. In connection with his joining us on September 8, 2003, we entered into an employment agreement with him which was in effect until his resignation. That agreement provided for a term ending on December 31, 2006, subject to earlier termination by us or Mr. O'Donnell following specified notice. The agreement provided, among other things, for an annual salary of $450,000, subject to increase at the discretion of our board of directors, an annual performance bonus beginning in 2004 to be based upon the achievement of increases in EBITDA, as defined, and other objectives to be set forth in business plans and budgets approved from time to time by our board, which bonus, for the year ending December 31, 2004, would not be less than $112,500 (the bonus paid for 2004 was $141,750); $1,000,000 of life insurance; the reimbursement of Mr. O'Donnell for certain relocation, travel and housing expenses incurred; and a special incentive award. The special incentive award was designed to have rewarded Mr. O'Donnell for improvements in our adjusted EBITDA, cash position and long term debt position over the term of the agreement. Mr. O'Donnell forfeited his special incentive award and right to severance pay by virtue of his voluntary termination of employment. We are also a party to a letter agreement of employment dated December 29, 2003 with Peter J. Beaudrault providing for him to serve as Corporate Vice President and President - Quick Service Division. On March 4, 2005, Mr. Beaudrault was elected by our Board of Directors as our new President and Chief Executive Officer to replace Mr. O'Donnell. Mr. Beaudrault's letter agreement of employment is on an "at will" basis, provides for a salary of $300,000 per annum (which has been increased to $450,000 per annum with his election as our President and Chief Executive Officer) and a bonus under our corporate office employee bonus plan. In addition, in the event of a public offering of our common stock, a change in control of Sbarro, including by merger, sale of stock or sale of assets, or a liquidation or dissolution of Sbarro, he will be entitled to a special event bonus based on the per share proceeds (as defined in the letter agreement) received by our shareholders in excess of a threshold amount as if he held 160,000 shares of our common stock. We are in the process of negotiating a revised employment agreement with Mr. Beaudrault. -90- SPECIAL EVENT BONUS ARRANGEMENTS In addition to the special event bonus arrangement with Mr. Beaudrault described above, we have entered into a similar arrangement with three other executive officers. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISIONS Our board of directors does not presently have a Compensation Committee. Decisions regarding the compensation of executive officers are being made by our Board of Directors. Accordingly, Mario Sbarro, Anthony Sbarro and Joseph Sbarro, executive officers and employees, as well as directors, participated in deliberations of our board concerning executive officer compensation. Bernard Zimmerman & Company, Inc., of which Bernard Zimmerman, a director of Sbarro, is President and a majority shareholder, renders financial and consulting assistance to us, for which it received fees of approximately $26,000 for services rendered during our 2004 year. See Item 13, "Certain Relationships and Related Transactions" in this report, for information concerning related party transactions. -91- ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND -------- --------------------------------------------------- MANAGEMENT ---------- The following table sets forth certain information regarding the ownership of shares of our common stock as of March 31, 2005 by (1) holders known to us to beneficially own more than five percent of our outstanding common stock, (2) each of our directors, (3) the persons named in the summary compensation table in Item 11 of the report and (4) all of our directors and executive officers as a group. We understand that, except as noted below, each beneficial owner has sole voting and investment power with respect to all shares attributable to such owner.
SHARES BENEFICIALLY OWNED BENEFICIAL OWNER NUMBER PERCENT ---------------- ------ ------- Mario Sbarro (1)....................................................... 1,524,730 (2) 21.5% Anthony Sbarro (1)..................................................... 1,233,800 17.5% Joseph Sbarro (1)...................................................... 1,756,022 (3) 24.8% Trust of Carmela Sbarro (1)............................................ 2,497,884 (4) 35.4% All directors and executive officers as a group (13 persons) ..................................................... 7,038,382 (5) 99.6%
------------------ (1) The business address of these stockholders is 401 Broadhollow Road, Melville, New York 11747. (2) Excludes the 2,497,884 shares held by the Trust of Carmela Sbarro, of which trust Mario Sbarro serves as a co-trustee and as to which shares Mr. Sbarro may be deemed a beneficial owner with shared voting and dispositive power. (3) Excludes 25,946 shares beneficially owned by each of Mr. Sbarro's son and daughter. (4) The trust was created by Carmela Sbarro for her benefit and for the benefit of her descendants, including Mario, Joseph and Anthony Sbarro. The trustees of the trust are Franklin Montgomery, whose business address is 1270 Avenue of the Americas, New York, New York 10020, and Mario, Anthony and Joseph Sbarro. Each trustee may be deemed to be the beneficial owner of all these shares with shared voting and dispositive power. (5) Includes 25,946 shares owned by the wife of an executive officer. The executive officer disclaims beneficial ownership of these shares. No other executive officer included in the Summary Compensation Table in Item 11 or director beneficially owned any shares of our common stock as of March 31, 2005. We do not have any equity compensation plans, contracts or arrangements for employees or non-employees. -92- ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS -------- ---------------------------------------------- We were the sole tenant of an administrative office building which we leased from a partnership owned by Sbarro Enterprises, L.P., the limited partners of which are Mario Sbarro, our Chairman and a director, Joseph Sbarro, our Senior Vice President, Secretary and a director, Anthony Sbarro, our Vice Chairman, Treasurer and a director, and Carmela Sbarro, Vice President and a director. The annual rent paid was $100,000, $300,000 and $300,000 for 2004, 2003 and 2002, respectively. We were advised by a real estate broker that the rent to be paid by us was comparable to the rent that would have been charged by an unaffiliated third party. The lease was terminated upon the sale of the building by the partnership in April 2004. On April 5, 2001, we loaned $3.2 million to certain of our shareholders, including: Mario Sbarro, $1.1 million, Joseph Sbarro, $1.2 million and Anthony Sbarro, $0.9 million. The due dates of the related notes have been extended to April 6, 2007. The notes bear interest at the rate of 4.63% per annum, payable annually. As of January 2, 2005, the balance of these loans was $2.9 million. On December 28, 2001, we loaned $2.8 million to our shareholders, including: Mario Sbarro, $0.6 million, Joseph Sbarro, $0.7 million, Anthony Sbarro, $0.5 million, and the Trust of Carmela Sbarro, $1.0 million. The due dates of the related notes have been extended to December 28, 2007. The notes bear interest at the rate of 2.48% per annum payable annually. As of January 2, 2005, the balance of these loans was $2.6 million. In March 2004, we loaned $40,000 to Gennaro A. Sbarro, then our Corporate Vice President and President of our Franchising and Licensing Division. The note was repaid in February 2005 including interest at 2.69% per annum. In connection with his resignation in 2004 we entered into a severance agreement providing for a lump sum payment of approximately $453,000. In June 2003, Anna Missano, the daughter of Joseph Sbarro, issued to us a note for approximately $90,000 for royalties due us for 2001 and 2000. The note is repayable at approximately $10,000 per year, including interest at 2.96% per annum, with a balloon payment due on June 30, 2010. The principal balance of the notes at January 2, 2005 was approximately $79,000. The interest rates charged on the foregoing related party loans included above approximate the Applicable Federal Rate (AFR) published by the Internal Revenue Service at the time of the loan. We recorded interest income from related parties was approximately $211,000, $223,000 and $221,000 in 2004, 2003 and 2002, respectively. Bernard Zimmerman & Company, Inc., of which Bernard Zimmerman, a director of Sbarro, is President and a majority shareholder, renders financial and consulting assistance to us, for which it received fees of approximately $26,000 for services rendered during 2004 and $0.3 million in both 2003 and 2002. Harold Kestenbaum, a member of our Board of Directors, assisted one of our other concepts in the preparation of its initial Uniform Franchise Offering Circular in 2002 for which the fee was $20,000. -93- We and our other concepts have purchased printing services from a corporation owned by a son-in-law of Mario Sbarro, for which we and our other concepts paid, in the aggregate, $480,000, $340,000 and $422,000 in 2004, 2003 and 2002, respectively. Companies owned by a son of Anthony Sbarro are parties to franchise agreements with us containing terms similar to those in agreements entered into by us with unrelated franchises. Royalties under these agreements in 2004, 2003 and 2002 were approximately $89,000, $90,000 and $92,000, respectively. As of July 2002, we sold the assets of a restaurant to a corporation owned by the brother-in-law of our Chairman of the Board for $88,900. The sales price resulted in a loss of approximately $64,000 that was included in the provision for restaurant closings. That corporation also entered into a franchise agreement with us. We received promissory notes for each of the purchase price and initial franchise fee that were payable over seven years and bore interest on the unpaid principal balances at 7% per annum. In addition in 2002, we subleased this location to that franchisee. Payments under the sublease were being made directly to the landlord by the franchisee. Interest payments received relating to the promissory notes was approximately $4,000 in 2003. No interest payments were received in 2004. Royalties paid under this arrangement were approximately $1,800 in 2004, $3,300 in 2003 and $6,800 in 2002. In March 2005, we re-purchased the assets of the restaurant from the corporation for $88,900. The remaining unpaid principal balance of the promissory notes were offset against the purchase price of the assets. The remaining balance under the promissory notes of approximately $22,000, and accrued but unpaid royalties of approximately $31,000 had been fully reserved in 2004. In 2002, a company in which Gennaro J. Sbarro, then our Corporate Vice President and President of our Casual and Fine Dining Division and the son of Joseph Sbarro, has a 50% interest (the other 50% is owned by an unaffiliated third party) entered into a sublease for $50,000 greater than rent or other charges due under the lease. Rent and other charges due under the lease are paid directly to the landlord. Payment under the sublease are due to us. Rent of approximately $23,000 was included in the 2004 results of operations. To reimburse Sbarro for equipment costs, the Company owned by Mr. Sbarro, issued a non-interest bearing note in our favor for approximately $55,000, that is repayable in eighteen equal monthly installments of approximately $3,000 which commenced in November 2002. The principal balance on the note as of January 2, 2005 was approximately $16,000. As of October 31, 2003, Mr. Sbarro resigned from his positions with us and a corporation owned by Mr. Sbarro entered into an eighteen month agreement with us to provide consulting services to our quick service and casual dining division for approximately $23,000 per month and the reimbursement for customary and usual expenses that may be incurred by that corporation in the performance of its services. In October 2003, we sold the assets of three underperforming Sbarro-owned restaurants that we proposed to close to entities owned separately by each of three other of Anthony Sbarro's sons, each of which entered into a franchise agreement with us. Two of the locations, which had no remaining book value, were transferred for no consideration while the third was sold for $0.3 million that was paid in full, and resulted in a gain to Sbarro of approximately $0.1 million. In connection with the sale of the locations, the employment of these individuals with Sbarro was terminated and we included a charge for their total severance pay of approximately $60,000 in our results of operations for 2003. The franchise agreements provide for the payment of 5% of the location's sales -94- as a continuing franchise fee but did not provide for any initial franchise fee. We have waived continuing franchise fees through 2006. In addition, we subleased two of the locations to two of the franchisees. Payments under the subleases are being made directly to the landlord by the franchisees and they are not in default. In January 2004, one of Mario Sbarro's daughters, resigned from her position as Manager of Administration - Construction. A corporation owned by her entered into a one year agreement to provide consulting services related to construction matters to us for a series of monthly payments totaling $100,000. In addition, that corporation provided consulting services related to construction matters for our steakhouse joint venture of $18,900 in 2004. In February 2005, a joint venture in which we have a 70% interest sold the assets of one of our other joint venture restaurants to a company owned by Gennaro A. Sbarro our then Corporate Vice President and President of our Franchising and Licensing Division and the son of Mario Sbarro, for approximately $900,000 (which approximated fair value) resulting in a loss of approximately $284,000. The Company received $300,000 in cash and promissory notes of $600,000. The promissory notes are payable monthly in 72 equal monthly installments in the amount of $8,333 including interest at 5% per annum with a balloon payment of $111,375 at maturity. The joint venture also sold the inventory of the restaurant for approximately $67,000 with $50,000 paid at closing and the remainder of $17,000 payable in four equal monthly installments from March 2005 to June 2005. The company owned by Mr. Sbarro entered into a sublease, which we guarantee and a Security Agreement to secure the obligations under the promissory notes. The sublease and Security Agreement are intended to enable Sbarro to recapture the business in the event of an uncured default. Compensation of related parties includes salary, taxable benefits and accrued bonus. Salaries for 2004 include one additional week of salary due to our 53 week year in 2004. Compensation is as follows: o Mario Sbarro was our Chairman of the Board in 2004 and Chairman of the Board, President and Chief Executive Officer in 2003 and 2002. His compensation was approximately $884,000 in 2004, $700,000 in 2003 and $920,000 in 2002. o Anthony Sbarro was our Vice Chairman of the Board and Treasurer in 2004, 2003 and 2002. His compensation was approximately $582,000 in 2004, $400,000 in 2003 and $545,000 in 2002. o Joseph Sbarro was our Senior Executive Vice President and Secretary in 2004, 2003 and 2002. His compensation was approximately $585,000 in 2004, $400,000 in 2003 and $575,000 in 2002. -95- In addition to the compensation of Mario, Anthony, and Joseph Sbarro: o Carmela Sbarro, the mother of Mario, Anthony and Joseph Sbarro, who was a co-founder of Sbarro and serves as Vice President and a director, received $100,000 from us for services rendered in 2004, 2003 and 2002. o Other members of the immediate families of Mario, Anthony, Joseph and Carmela Sbarro who are our employees were paid an aggregate of approximately $860,000, $1,344,000 and $1,565,000 during 2004, 2003 and 2002, respectively. The company has a 40% equity interest in Boulder Creek Steakhouse and provided administrative services for $165,000, $172,000 and $148,000 in 2004, 2003 and 2002, respectively. TAX PAYMENT AGREEMENT We are 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. Therefore, we do not pay federal or, with certain limited exceptions, state and local income taxes for periods for which we are treated as a Subchapter S corporation ("S corporation"). Rather, our shareholders include their pro-rata share of our taxable income on their individual income tax returns and thus are required to pay taxes on their respective share of our taxable income, whether or not it is distributed to them. In connection with our going private transaction in 1999 and the related financing, we entered into a tax payment agreement with our shareholders. The tax payment agreement permits us to make periodic tax distributions to our shareholders in amounts determined under a formula 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 that income was taxed at the highest applicable federal and New York State marginal income tax rates. We may only make the tax distributions with respect to periods in which we are treated as an S corporation for income tax purposes. We made no distribution to our shareholders in accordance with the tax payment agreement with respect to 2004. However, in March 2004 we made distributions to our shareholders, in accordance with the tax payment agreement, of $0.7 million with respect to 2002 taxable income. Our shareholders taxable income is significantly higher and their taxable loss is significantly lower than the related book income or loss resulting from differences in the book and tax treatments of the provision for asset impairment and significant differences in book and tax depreciation. The tax payment agreement provides for adjustments of the amount of tax distributions previously paid in respect of a year upon the filing of our federal income tax return for that year, upon the filing of an amended federal income tax return or as a result of an audit. In these circumstances, if it is determined that the amount of tax distributions previously made for the year was less than the amount computed based upon our federal income tax return, our amended federal return or as adjusted based on the results of the audit, we may make additional tax distributions which might include amounts to cover any interest or penalties. Conversely, if it is determined in these circumstances that the amount of tax distributions previously made for a year exceeded the amount computed based on our federal income tax return, our amended federal return or the results of an audit, as the case may be, our shareholders will be required to repay the excess, with, in certain circumstances, interest. In addition, our shareholders will be required to return, with interest, any tax distributions previously distributed with respect to any taxable year for which it is subsequently determined that we were not an S corporation. -96- ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES -------- -------------------------------------- Our principal accountants for each of the past two years has been BDO Seidman, LLP. AUDIT FEES: The aggregate audit fees billed for each of the last two years for professional services rendered by our principal accountants for the audit of our annual financial statements included in our report on Form 10-K and review of our quarterly financial statements included in our Reports on Form 10-Q were $150,000 and $116,000 in 2004 and 2003, respectively. AUDIT-RELATED FEES: The aggregate fees billed in each of our last two years for assurance and related services by our principal accountants that are reasonably related to the performance of the audit or review of our financial statements not included in Audit Fees were $12,500 in 2004 and $19,400 in 2003. The services included the audit of our 401K savings plan in 2004, an individual store location audit in 2004 and 2003 and consultation on various new accounting pronouncements and their impact on us in 2003 and 2004. TAX FEES: The aggregate fees billed in each of the last two years for professional services rendered by our principal accountants for tax compliance, tax advice and tax planning were $59,000 and $64,550 in 2004 and 2003, respectively. These services included, in each year reported, a review of our corporate income and franchise tax returns, tax planning advice related to our tax returns and those of our shareholders and tax advice relating to contemplated corporate transactions. ALL OTHER FEES: Other than the fees described above, we have not incurred any fees for any services rendered by our principal accounting firm. PRE-APPROVAL POLICIES AND PROCEDURES: It is our policy that, before we engage our principal accountants for any audit or non - audit services, the engagement is approved by our audit committee. Our audit committee has delegated to Richard A. Mandell, its Chairman and an independent director, the authority to grant such pre-approvals during periods when the audit committee is not in session and a meeting cannot be readily convened. A decision by Mr. Mandell to pre-approve an audit or non-audit service must be presented to the full audit committee at its next scheduled meeting. All fees paid to and or billed by our principal accountants were approved in accordance with the policy described above beginning May 6, 2003. -97- PART IV ------- ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES -------- ------------------------------------------ (a) Consolidated Financial Statements The following consolidated financial statements of Sbarro, Inc. and the Report of Independent Auditors thereon are included in Item 8 above: Report of Independent Registered Public Accounting Firm 39 Consolidated Balance Sheets as of January 2, 2005 and December 28, 2003 40 Consolidated Statements of Operations for the years 42 ended January 2, 2005, December 28, 2003 and December 29, 2002 Consolidated Statements of Shareholders' Equity (as restated) for the 43 years ended January 2, 2005, December 28, 2003 and December 29, 2002 Consolidated Statements of Cash Flows for the years 44 ended January 2, 2005, December 28, 2003 and December 29, 2002 Notes to Consolidated Financial Statements 46 -98- (b) Exhibits: *2.01 Agreement and Plan of Merger dated as of January 19, 1999 among Sbarro, Inc., Sbarro Merger LLC, a New York limited liability company, Mario Sbarro, Joseph Sbarro, Joseph Sbarro (1994) Family Limited Partnership, Anthony Sbarro, and Mario Sbarro and Franklin Montgomery, not individually but as trustees under that certain Trust Agreement dated April 28, 1984 for the benefit of Carmela Sbarro and her descendants. (Exhibit 2 to our Current Report on Form 8-K dated (date of earliest event reported) January 19, 1999, File No. 1-8881) *3.01(a) Restated Certificate of Incorporation of Sbarro, Inc. as filed with the Department of State of the State of New York on March 29, 1985. (Exhibit 3.01 to our Registration Statement on Form S-1, File No. 2-96807) *3.01(b) Certificate of Amendment to our Restated Certificate of Incorporation as filed with the Department of State of the State of New York on April 3, 1989. (Exhibit 3.01(b) to our Annual Report on Form 10-K for the year ended January 1, 1989, File No. 1-8881) *3.01(c) Certificate of Amendment to our Restated Certificate of Incorporation as filed with the Department of State of the State of New York on May 31, 1989. (Exhibit 4.01 to our Quarterly Report on Form 10-Q for the quarter ended April 23, 1989, File No. 1-8881) *3.01(d) Certificate of Amendment to our Restated Certificate of Incorporation as filed with the Department of State of the State of New York on June 1, 1990. (Exhibit 4.01 to our Quarterly Report on Form 10-Q for the quarter ended April 22, 1990, File No. 1-8881) *3.02 By-Laws of Sbarro, Inc., as amended. (Exhibit 3.1 to our Registration Statement on Form S-4, File No. 333-90817) *4.01 Indenture dated as of September, 28, 1999 among Sbarro, Inc., our Restricted Subsidiaries named therein, as guarantors, and Firstar Bank, N.A., including the form of 11% Senior Notes of Sbarro, Inc. to be issued upon consummation of the Exchange Offer and the form of Senior Guarantees of the Guarantors. (Exhibit 4.1 to our Current Report on Form 8-K dated (date of earliest event reported) September 23, 1999, File No. 1-8881) *10.01(a) Building Lease between Sbarro Enterprises, L.P. and Sbarro, Inc. (Exhibit 10.04 to our Registration Statement on Form S-1, File No. 2-96807) *10.01(b) Amendment dated May 4, 2000 to Building Lease between Sbarro Enterprises, L.P. and Sbarro, Inc., (Exhibit 10.01(b) to our Annual Report on Form 10-K for the year ended December 30, 2001, File No. 333-90817) -99- *+10.02 Form of Indemnification Agreement between Sbarro, Inc. and each of its directors and officers. (Exhibit 10.04 to our Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-8881) *10.04 Tax Payment Agreement dated as of September 28, 1999 among Sbarro, Inc., Mario Sbarro, Joseph Sbarro, Joseph Sbarro (1994) Family Limited Partnership, Anthony Sbarro, and Mario Sbarro and Franklin Montgomery, not individually but as Trustees under that certain Trust Agreement dated April 28, 1984 for the benefit of Carmela Sbarro and her descendants (Exhibit 10.6 to our Registration Statement on Form S-4, File No. 333-90817) *10.05(a) Distribution Agreement dated January 1, 2003 between Sbarro, Inc. and Vistar Corporation (confidential treatment has been granted with respect to certain portions of this agreement).(Exhibit 10.05 of our Annual Report on Form 10-K for the year ended December 29, 2002, File No. 333-90817). *10.05(b) Letter Agreement dated January 1, 2003 between Sbarro, Inc. and Vistar Corporation (confidential treatment has been granted with respect to certain portions of this letter agreement). (Exhibit 10.05 (b) of our Annual Report on Form 10-K for the year ended December 28, 2004, File No. 333-908177. *+10.06 Employment agreement dated as of September 8, 2003 between Sbarro, Inc. and Michael O'Donnell. (Exhibit 99.01 to our Current Report on Form 8-K dated (date of earliest event reported) September 8, 2003, File No. 333-90817) +10.07 Letter agreement dated December 29, 2003 between Sbarro, Inc. and Peter J. Beaudrault regarding Mr. Beaudrault's employment with Sbarro. +10.08 Letter agreement dated December 23, 2003 between Sbarro, Inc. and Anthony J. Puglisi regarding Mr. Puglisi's employment with Sbarro. +10.09 Letter dated December 10, 2004 from Sbarro, Inc. to Anthony Missano regarding potential "Special Event Bonus." +10.10 Letter dated December 10, 2004 from Sbarro, Inc. to Carmela Merendino regarding potential "Special Event Bonus." *+10.11 Corporate Office Employee Bonus Plan (Exhibit 99.1 to our Current Report on Form 8-K dated (date of earliest event reported) April 7, 2005, File No. 333-90817) *+10.12 Resolution regarding non-employee director compensation (Exhibit 99.2 to our Current Report on Form 8-K dated (date of earliest event reported) April 7, 2005, File No. 333-90817) 12.01 Computation of ratio of earnings to fixed charges -100- *14.01 Code of Ethics - For Executive Officers and Directors of Sbarro, Inc. (Exhibit 14.01 of our Annual Report on Form 10-K for the year ended December 28, 2004, File No. 333-90817) *21.01 List of subsidiaries. (Exhibit 21.01 to our Annual Report on Form 10-K for the year ended January 2, 2000, File No. 333-90817) 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. --------------------------- * Incorporated by reference to the document indicated. + Management contract or compensatory plan. The following financial statement schedule is filed as a part of this Report: Report of Independent Registered Public Accounting Firm S-1 Valuation and Qualifying Accounts for 2004, 2003 and 2002 S-2 All other schedules called for by Form 10-K are omitted because they are inapplicable or the required information is shown in the financial statements, or notes thereto, included herein. -101- UNDERTAKING We hereby undertake to furnish to the Securities and Exchange Commission, upon request, all constituent instruments defining the rights of holders of long-term debt of us and our consolidated subsidiaries not filed with this Report. Those instruments have not been filed since none are, nor are being, registered under Section 12 of the Securities Exchange Act of 1934 and the total amount of securities authorized under any of those instruments does not exceed 10% of the total assets of us and our subsidiaries on a consolidated basis. -102- SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 22, 2005. SBARRO, INC. By: /s/ Mario Sbarro --------------------------------------- Mario Sbarro, Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ Peter Beaudrault President and Chief April 22, 2005 -------------------------- Executive Officer Peter Beaudrault Principal Executive Officer /s/ Anthony Puglisi Vice President, April 22, 2005 -------------------------- Chief Financial Officer Anthony Puglisi And Principal Accounting Officer /s/ Mario Sbarro Director April 22, 2005 -------------------------- Mario Sbarro /s/ Joseph Sbarro Director April 22, 2005 -------------------------- Joseph Sbarro /s/ Anthony Sbarro Director April 22, 2005 -------------------------- Anthony Sbarro /s/ Harold Kestenbaum Director April 22, 2005 -------------------------- Harold L. Kestenbaum /s/ Richard A. Mandell Director April 22, 2005 -------------------------- Richard A. Mandell /s/ Michael O'Donnell Director April 22, 2005 -------------------------- Michael O'Donnell /s/ Carmela Sbarro Director April 22, 2005 -------------------------- Carmela Sbarro /s/ Terry Vince Director April 22, 2005 -------------------------- Terry Vince /s/ Bernard Zimmerman Director April 22, 2005 -------------------------- Bernard Zimmerman S-1 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ------------------------------------------------------- Board of Directors and Shareholders Sbarro, Inc. Melville, New York The audits referred to in our report dated March 7, 2005 relating to the consolidated financial statements of Sbarro, Inc. and subsidiaries, which is contained in Item 8 of this Form 10-K included the audits of the accompanying financial statement schedule for the years ended January 2, 2005, December 28, 2003 and December 29, 2002. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based upon our audits. In our opinion, such financial statement schedule presents fairly, in all material respects, the information set forth therein. /s/ BDO Seidman, LLP Melville, New York March 7, 2005 S-2 SBARRO, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) FOR THE THREE YEARS ENDED
Balance Charged at to Charged to Balance at Beginning Costs and Other End of Description of Period Expenses Accounts(5) Deductions Period ----------- --------- -------- ----------- ---------- ------ January 2, 2005 --------------- Allowance for doubtful accounts receivable $488 $222 $279(1) $431 ====== ====== === ====== ====== Provision for store closings $987 $815 $(889) $851(2) $62 ====== ====== === ====== ====== December 28, 2003 ----------------- Allowance for doubtful accounts receivable $491 $435 438(1) $488 ====== ====== ====== ====== Provision for store closings $1,452 $2,030 $(111) $2,384(3) $987 ====== ====== === ====== ====== December 29, 2002 ----------------- Allowance for doubtful accounts receivable $175 $350 $34(1) $ 491 ====== ====== === ====== ====== Provision for store closings $1,467 $8,689 $42 $8,746(4) $1,452 ====== ====== === ====== ======
(1) Includes write off of uncollected accounts. (2) Includes write off of property and equipment of $1,089, payments to landlords and others for closed locations of $181 offset by proceeds received upon sale of equipment $419. (3) Includes write off of property and equipment of $2,474, payments to landlords and others for closed locations of $787 offset by proceeds received upon sale of equipment of $877. (4) Includes write off of property and equipment of $7,413 and payments to landlord and others for closed locations of $1,333. (5) Represents reclassifications to other accounts. EXHIBIT INDEX ------------- EXHIBIT NUMBER DESCRIPTION -------------- ----------- *2.01 Agreement and Plan of Merger dated as of January 19, 1999 among Sbarro, Inc., Sbarro Merger LLC, a New York limited liability company, Mario Sbarro, Joseph Sbarro, Joseph Sbarro (1994) Family Limited Partnership, Anthony Sbarro, and Mario Sbarro and Franklin Montgomery, not individually but as trustees under that certain Trust Agreement dated April 28, 1984 for the benefit of Carmela Sbarro and her descendants. (Exhibit 2 to our Current Report on Form 8-K dated (date of earliest event reported) January 19, 1999, File No. 1-8881) *3.01(a) Restated Certificate of Incorporation of Sbarro, Inc. as filed with the Department of State of the State of New York on March 29, 1985. (Exhibit 3.01 to our Registration Statement on Form S-1, File No. 2-96807) *3.01(b) Certificate of Amendment to our Restated Certificate of Incorporation as filed with the Department of State of the State of New York on April 3, 1989. (Exhibit 3.01(b) to our Annual Report on Form 10-K for the year ended January 1, 1989, File No. 1-8881) *3.01(c) Certificate of Amendment to our Restated Certificate of Incorporation as filed with the Department of State of the State of New York on May 31, 1989. (Exhibit 4.01 to our Quarterly Report on Form 10-Q for the quarter ended April 23, 1989, File No. 1-8881) *3.01(d) Certificate of Amendment to our Restated Certificate of Incorporation as filed with the Department of State of the State of New York on June 1, 1990. (Exhibit 4.01 to our Quarterly Report on Form 10-Q for the quarter ended April 22, 1990, File No. 1-8881) *3.02 By-Laws of Sbarro, Inc., as amended. (Exhibit 3.1 to our Registration Statement on Form S-4, File No. 333-90817) *4.01 Indenture dated as of September, 28, 1999 among Sbarro, Inc., our Restricted Subsidiaries named therein, as guarantors, and Firstar Bank, N.A., including the form of 11% Senior Notes of Sbarro, Inc. to be issued upon consummation of the Exchange Offer and the form of Senior Guarantees of the Guarantors. (Exhibit 4.1 to our Current Report on Form 8-K dated (date of earliest event reported) September 23, 1999, File No. 1-8881) *10.01(a) Building Lease between Sbarro Enterprises, L.P. and Sbarro, Inc. (Exhibit 10.04 to our Registration Statement on Form S-1, File No. 2-96807) *10.01(b) Amendment dated May 4, 2000 to Building Lease between Sbarro Enterprises, L.P. and Sbarro, Inc., (Exhibit 10.01(b) to our Annual Report on Form 10-K for the year ended December 30, 2001, File No. 333-90817) *+10.02 Form of Indemnification Agreement between Sbarro, Inc. and each of its directors and officers. (Exhibit 10.04 to our Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-8881) *10.04 Tax Payment Agreement dated as of September 28, 1999 among Sbarro, Inc., Mario Sbarro, Joseph Sbarro, Joseph Sbarro (1994) Family Limited Partnership, Anthony Sbarro, and Mario Sbarro and Franklin Montgomery, not individually but as Trustees under that certain Trust Agreement dated April 28, 1984 for the benefit of Carmela Sbarro and her descendants (Exhibit 10.6 to our Registration Statement on Form S-4, File No. 333-90817) *10.05(a) Distribution Agreement dated January 1, 2003 between Sbarro, Inc. and Vistar Corporation (confidential treatment has been granted with respect to certain portions of this agreement).(Exhibit 10.05 of our Annual Report on Form 10-K for the year ended December 29, 2002, File No. 333-90817). *10.05(b) Letter Agreement dated January 1, 2003 between Sbarro, Inc. and Vistar Corporation (confidential treatment has been granted with respect to certain portions of this letter agreement). (Exhibit 10.05 (b) of our Annual Report on Form 10-K for the year ended December 28, 2004, File No. 333-908177. *+10.06 Employment agreement dated as of September 8, 2003 between Sbarro, Inc. and Michael O'Donnell. (Exhibit 99.01 to our Current Report on Form 8-K dated (date of earliest event reported) September 8, 2003, File No. 333-90817) +10.07 Letter agreement dated December 29, 2003 between Sbarro, Inc. and Peter J. Beaudrault regarding Mr. Beaudrault's employment with Sbarro. +10.08 Letter agreement dated December 23, 2003 between Sbarro, Inc. and Anthony J. Puglisi regarding Mr. Puglisi's employment with Sbarro. +10.09 Letter dated December 10, 2004 from Sbarro, Inc. to Anthony Missano regarding potential "Special Event Bonus." +10.10 Letter dated December 10, 2004 from Sbarro, Inc. to Carmela Merendino regarding potential "Special Event Bonus." *+10.11 Corporate Office Employee Bonus Plan (Exhibit 99.1 to our Current Report on Form 8-K dated (date of earliest event reported) April 7, 2005, File No. 333-90817) *+10.12 Resolution regarding non-employee director compensation (Exhibit 99.2 to our Current Report on Form 8-K dated (date of earliest event reported) April 7, 2005, File No. 333-90817) 12.01 Computation of ratio of earnings to fixed charges *14.01 Code of Ethics - For Executive Officers and Directors of Sbarro, Inc. (Exhibit 14.01 of our Annual Report on Form 10-K for the year ended December 28, 2004, File No. 333-90817). *21.01 List of subsidiaries. (Exhibit 21.01 to our Annual Report on Form 10-K for the year ended January 2, 2000, File No. 333-90817) 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. ---------------------- * Incorporated by reference to the document indicated. + Management contract or compensatory plan.