ITEM 1. BUSINESS
At December 29, 2002, Tumbleweed, Inc. (the "Company") owned, franchised or licensed 56 Tumbleweed Southwest Mesquite Grill & Bar ("Tumbleweed") restaurants. We owned and operated 31 Tumbleweed restaurants in Kentucky, Indiana and Ohio. There were 19 franchised Tumbleweed restaurants located in Indiana, Illinois, Kentucky and Wisconsin, and six licensed restaurants located outside the United States in Germany, Jordan, Egypt, England and Turkey. Tumbleweed restaurants feature sophisticated Southwest and mesquite grilled food served in a casual dining atmosphere evoking the American Southwest. Tumbleweed restaurants are open seven days a week (excluding certain holidays) for lunch and dinner and generally offer a full service bar.
The Company makes available through its internet website, www.tumbleweedrestaurants.net , its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after electronically filing such material with the Securities and Exchange Commission. The reference to the Company's website address does not constitute incorporation by reference of the information contained on the website and should not be considered part of this document.
THE TUMBLEWEED CONCEPT
The Tumbleweed menu offers both distinctively seasoned, spicier versions of popular Mexican dishes, as well as an assortment of grilled steaks, ribs, pork chops, chicken and seafood selections. The Tumbleweed concept is designed to appeal to a broad range of customers by offering a wide selection of distinctive items at a broad range of price points while, in management's view, providing a consistent level of food quality and friendly and efficient service comparable or superior to that of other casual dining restaurants. Use of a centralized commissary system enhances Tumbleweed's ability to maintain consistently high food quality, minimizes restaurant kitchen space and equipment, reduces the need for skilled cooking personnel, and simplifies restaurant operations. The key elements of the Tumbleweed concept include the following:
ONE CONCEPT OFFERING AMERICAN SOUTHWEST GRILLED ITEMS AND MEXICAN FOOD. The Tumbleweed menu is intended to distinguish Tumbleweed from competing Mexican and casual dining concepts by offering both distinctively seasoned, spicier versions of burritos, enchiladas, tacos, salads, and other popular Mexican dishes, as well as an assortment of grilled steaks, ribs, pork chops, chicken and seafood selections. Management believes this approach appeals to a broader segment of the population and encourages customers to visit the restaurants more often.
The Tumbleweed menu features distinctively seasoned versions of popular Mexican dishes and mesquite grilled selections. Customers receive complementary chips and salsa, and can choose from a selection of appetizers including such Tumbleweed specialties as chile con queso and chili, as well as nachos, quesadillas, buffalo chicken strips, Southwest eggrolls and turkey wings. The Mexican menu offers burritos, enchiladas, tacos, chimichangas and other items served both individually and in various combination dinners accompanied by rice and refried or baked beans. Customers may also choose from an assortment of fajitas, ribs, chicken, steak, pork chops, and seafood prepared over an open gas- fired mesquite wood grill and served with Texas Toast, salad, and a choice of baked potato, baked sweet potato, southwest fries, smashed taters, corn on the cob, grilled veggies, Santa Fe rice, and refried or baked beans. Mesquite grilled items are available as sandwiches as well as entrees. A variety of salads featuring refried beans, seasoned beef, shredded or fried strips of chicken, mesquite grilled chicken or seafood, and other traditional ingredients rounds out the menu. In an effort to increase the frequency of guest visits, the Company introduces new items which complement present menu selections through seasonal menus. The Company also has a lunch menu which is available during lunch hours as a complement to the complete menu.
Tumbleweed restaurants typically contain full-service bars offering a wide assortment of mixed drinks, wines, domestic and imported beers and featuring the Tumbleweed margarita and Texas Tea. Alcoholic beverages accounted for approximately 10.4% of restaurant sales during 2002.
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Tumbleweed's menu pricing is designed to create a strong perception of value by consumers. Prices for Mexican dishes range from $4.39 for two tacos to $11.99 for the "Need the 'Weed" sampler dinner. Mesquite grilled items range from $6.29 for a hamburger to $19.99 for a 22 oz. USDA-choice ribeye steak dinner. Tumbleweed also offers several daily lunch specials for less than $6.00.
TARGETED ATMOSPHERE. Tumbleweed restaurants offer relaxed and comfortable surroundings where guests can enjoy a quality dining experience. Decorative features such as American Indian artifacts, cowboy memorabilia, wildlife replicas, rough-hewn timber and a creek stone fireplace in larger stores are used to evoke the feeling of the Great Southwest.
MAINTAINING A FAVORABLE PRICE-TO-VALUE RELATIONSHIP. Tumbleweed's pricing strategy is intended to appeal to value- driven customers as well as traditional casual dining customers. Tumbleweed offers a wide selection of distinctive items at a broad range of price points while, in management's view, providing a level of food quality and service comparable or superior to that of other casual dining restaurants. For 2002, the average check at a full-service Tumbleweed restaurant, including beverages, was $9.48 for lunch and $12.61 for dinner. Management believes that this pricing approach, together with Tumbleweed's emphasis on variety and quality, creates a favorable price-to-value perception that can increase customer volume and generate more frequent repeat visits.
ACHIEVING TOTAL GUEST SATISFACTION. We are committed to providing prompt, friendly and attentive service and consistent food quality to our customers. We use a "mystery shopper" program to compare actual performance of restaurants to Tumbleweed standards and solicit comment cards from customers to monitor and modify restaurant operations.
OPERATING STRATEGY
We use the following key operating strategies to make certain that we exceed the expectations of our customers:
TARGET FOR TOTAL GUEST SATISFACTION. Tumbleweed's organizational and management philosophy is based on five core values and a commitment to Total Guest Satisfaction ("TGS"). Our training procedures are intended to instill in all managers and employees an appreciation of the core values and to encourage a shared commitment to TGS and teamwork.
COMMITMENT TO ATTRACTING AND RETAINING QUALITY EMPLOYEES. By providing extensive training and attractive compensation, and by emphasizing clearly defined organizational values, we foster a strong corporate culture and encourage a sense of personal commitment from our employees. We have a monthly cash bonus program based on attaining sales growth and related performance goals on a restaurant-by-restaurant basis for each restaurant's management team.
CONSISTENT HIGH QUALITY FOOD PREPARATION. We are committed to offering distinctive Mexican and mesquite grilled foods to customers at reasonable prices through the use of a commissary-based system. Management believes that the use of a central commissary provides a significant strategic and competitive advantage by enhancing our ability to maintain consistently high food quality, minimizing restaurant kitchen space and equipment, and reducing the number of skilled cooking positions. The system also enables restaurant managers and kitchen staff to focus on the final preparation of menu items to Tumbleweed standards.
Whenever feasible, the cooked ingredients used in Tumbleweed menu selections, such as ground beef, chile con queso, and Mexican beans, are prepared in advance at the commissary according to procedures designed to extend shelf life without the addition of preservatives. The kitchen staff at each restaurant uses commissary-supplied and other fresh ingredients for the final preparation of individual orders. Management believes this system enhances our ability to maintain rigorous operational and food preparation procedures and stringent product shelf life standards. The commissary operates according to stringent quality control standards and is subject to a daily inspection by a USDA inspector on the premises. We maintain a contingency plan under which centralized food preparation could be quickly resumed at another company's facility should the commissary be rendered inoperative by weather or other disaster.
GROWTH STRATEGY
Our strategy for growth will focus on the further development of new and existing markets by both the Company and franchisees. Since acquiring the Tumbleweed concept in 1995, we have added new Company-owned and franchised restaurants, while developing the infrastructure necessary to support our growth strategy. This approach has given
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management an opportunity to validate the Tumbleweed concept, refine operating systems, design and develop prototype restaurant buildings of different sizes and build a team of experienced corporate managers needed to support future internal and franchise growth. The following are key elements of our expansion strategy:
OPENING RESTAURANTS IN TARGET MARKETS. We target mid-sized metropolitan markets, initially concentrating in the Midwest and Mid-Atlantic regions, where income levels and the presence of shopping and entertainment centers, offices and/or colleges and universities indicate that a significant base of potential customers exists. Management considers the feasibility of opening multiple restaurants in a target market, which offers greater operating and advertising efficiency. As we add additional restaurants in a target market, there may be short-term decreases in same store sales. However, management believes this clustering strategy can enhance long-term performance through economies of scale and shared advertising expenses. Management also views smaller markets with fewer competing casual dining restaurants as presenting growth opportunities for the Company. Management believes that its target markets are less competitive than major metropolitan markets in terms of both site acquisition costs and number of casual dining restaurant options. On January 1, 2002, the Company purchased from its joint venture partner the remaining 50% interest in a restaurant location. During the first quarter of 2002, the Company closed four restaurant locations. The restaurants were located in Cincinnati, Ohio (2), Columbus, Ohio (1), and Evansville, Indiana (1). The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. During the second quarter of 2002, the Company sold one of its restaurant locations to a franchisee in accordance with the Company's plan established in the fourth quarter of 2001. In the next 12 months, the Company expects to construct one or two additional restaurant facilities.
SELECTING AND DEVELOPING QUALITY RESTAURANT SITES. In selecting potential restaurant sites, management analyzes a variety of factors, including, but not limited to, local market demographics, site visibility, competition in the vicinity, and accessibility and proximity of significant generators of potential customers such as major retail centers, hotels, universities, and sports and entertainment facilities. The acquisition of sites may involve leases, purchases, and joint venture arrangements, and will require either the construction of new buildings or the conversion of existing buildings. The site selection process is conducted by our management and other employees, as well as with the assistance of consultants when deemed advisable. We believe that our site selection strategy and procedures, together with our menu and pricing strategies, our commitment to quality food products and excellent service, and our advertising, marketing and promotional efforts, will enhance our ability to generate our anticipated customer volumes.
FRANCHISING. We expect that continued growth will come from the further development of new and existing markets by us and by franchisees. We intend to pursue an active franchising program with current and new franchisees under controlled guidelines. We offer franchisees both rights to develop individual restaurants as well as area development rights for the establishment of more than one new restaurant over a defined period of time and in a defined geographic area. The specific locations of the restaurants are subsequently designated by us and the franchisee in separate franchise agreements. Under the standard area development agreement currently in use, a franchisee is required to pay at the time the agreement is signed a non-refundable fee of $5,000 per potential restaurant in the defined geographic area, to be applied against the initial franchise fee payable for each restaurant. Our current area development agreement also provides for a franchise fee of $40,000 for each restaurant. The franchise fee is due when the franchise agreement for a restaurant is signed. Each franchise agreement generally provides for royalties of three to five percent of restaurant sales, minimum marketing expenditures of 2.0% of gross sales, and a twenty-year term. All franchisees are required to operate their Tumbleweed restaurants in compliance with our policies, standards and specifications, including matters such as menu items, ingredients, materials, supplies, services, fixtures, furnishings, decor and signs. Under our criteria for selecting new franchisees, Tumbleweed requires that potential franchisees have adequate capital, experience in the restaurant industry, and access to locations suitable for development. We generally require that a franchisee have a principal operator with at least a ten percent ownership interest who must devote full time to the restaurant operation. In addition, we may acquire restaurants from our franchisees from time to time.
During 2002, there were no franchise restaurant openings, and two franchisees elected to close their Tumbleweed restaurant locations (a total of 3 locations).
MATCHING INVESTMENT TO SALES POTENTIAL. When developing a new Tumbleweed restaurant, we generally use one of two prototype designs management believes is best suited to a particular site. Our Buffalo Hunter and Gunslinger prototype restaurants accommodate approximately 250 and 200 guests, respectively. Each size restaurant offers full service casual dining and a menu containing a wide assortment of Mexican and mesquite grilled selections. Management believes that
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the use of multiple prototypes permits us to more closely match the investment in a restaurant site with the site's estimated sales potential. These factors allow for more efficient utilization of financial resources by us and our franchisees.
INTERNATIONAL. In 2002, the Company purchased Tumbleweed International, LLC. See below for a detail discussion of this transaction. The acquisition gives the Company direct control and benefit of the international licensing of the Tumbleweed concept.
RESTAURANT DESIGN
USING PROTOTYPE RESTAURANT DESIGNS. Tumbleweed full service restaurants have historically proven successful in several different formats and sizes. It is anticipated that new units will be full service restaurants employing one of two basic prototype designs. Management believes using multiple prototype designs allows greater flexibility to match the investment by us or our franchisees with the revenue potential of a particular restaurant site. Each prototype generally contains a full-service bar and utilizes the distinctive "Old West" logo and motif that has characterized Tumbleweed restaurants for several years.
Management believes our prototype designs can be adapted for developing Tumbleweed restaurants in existing structures. This capability may give us access to quality sites not otherwise available and may reduce the time or expense of development in certain circumstances.
RESTAURANT OPERATIONS
RESTAURANT MANAGEMENT. We employ area directors who are responsible for supervising the operations of Tumbleweed restaurants within their geographic region and the continuing development of each restaurant's managers and employees. Through regular visits to the restaurants, the area directors ensure that the Tumbleweed concept, strategies, core values and standards of quality are being observed in all aspects of restaurant operations. Area directors are chiefly responsible for the implementation of the TGS program.
Each of our restaurants has one general manager, one kitchen manager and from one to three assistant managers, based on restaurant volume. The general manager of each restaurant has primary responsibility for the day-to-day operations of the entire restaurant, including sales, physical plant, financial controls and training, and is responsible for maintaining the standards of quality and performance established by us. In selecting managers, we generally seek persons who have significant prior experience in the restaurant industry as well as employees who have demonstrated managerial potential and a commitment to the Tumbleweed concept and philosophy. We seek to attract and retain high caliber managers and hourly employees by providing them with competitive salaries, monthly bonuses and a casual, entertaining and challenging working environment.
COMPREHENSIVE TRAINING AND DEVELOPMENT. We have developed a comprehensive training program for managers and hourly employees. Managers are required to complete a ten-week initial training course and regular training programs. The course emphasizes our culture, commitment to TGS, operating procedures and standards, and internal controls.
The general managers and the area directors are responsible for selecting and training hourly employees at each restaurant. We employ training coordinators to assist with training and development of employees. Before the opening of each new restaurant, one of our training managers leads a team of experienced employees to train and educate the new employees. The training period for new employees includes 10 days of general training prior to opening and one week of on-the-job supervision at the new Tumbleweed restaurant. Ongoing employee training remains the responsibility of the general manager and training coordinator of each restaurant under the supervision of the area director.
RESTAURANT REPORTING. We closely monitor sales, costs of food and beverages, and labor at each of our restaurants. Management analyzes daily and weekly restaurant operating results to identify trends at each location, and acts promptly to remedy negative trends where possible. We use an accounting and management information system that operates at the restaurant level to ensure the maintenance of financial controls and operations. Administrative staff prepare daily reports of sales, labor and customer counts. Cost of sales and condensed profit and loss statements compiled weekly by store-level personnel and at the end of each reporting period by our accounting department are provided to management for analysis and comparison to past performance and budgets. We use a specialized software system to measure theoretical food costs against actual costs.
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SEASONALITY. We consider restaurant operations to be somewhat seasonal in nature with late first quarter and second quarter being the peak sales periods.
SUPPORT OPERATIONS
COMMISSARY OPERATIONS. Use of a centralized commissary system enhances Tumbleweed's ability to maintain consistently high food quality, minimizes the kitchen space and equipment needed at each restaurant, reduces the need for highly skilled cooking personnel, and simplifies restaurant operations. Managers and kitchen staff at each restaurant focus on the final preparation of menu items to Tumbleweed standards. We currently operate our commissary principally to enhance food quality and operational efficiency of Company-owned and franchised restaurants. Management believes this approach increases Tumbleweed's ability to offer its customers a consistently high level of food quality at a moderate price.
The commissary charges an amount approximately equal to its cost for the items it supplies to Company-owned and franchised restaurants. The Commissary sometimes contracts for the production of food products for other companies, and has granted the right to an outside food producer to produce and market in grocery stores a chili con queso product utilizing the "Tumbleweed" name and recipe for which we receive a royalty based upon production and sales.
DEVELOPMENT AND CONSTRUCTION. The President, Vice President and Chief Financial Officer, Vice President of Company Operations and the Director of Construction oversee the construction process utilizing outside architectural services and construction services. Individual site selection analysis is handled by Company management, with final approval by the President of the Company.
ADVERTISING AND MARKETING. We use radio, print, billboard, and direct mail advertising in our various markets, as well as television advertising in certain larger markets. We also engage in a variety of other promotional activities, such as contributing goods, time and money to charitable, civic and cultural programs, in order to increase public awareness of our restaurants. The cost associated with these promotional activities in 2002 was approximately 3.3% of restaurant sales.
RESTAURANT LOCATIONS
As of December 29, 2002, we owned and operated 31 Tumbleweed restaurants. The following table sets forth the markets (including the number of restaurants in each market) of these 31 restaurants:
NO. OF STATE LOCATION RESTAURANTS - ----- -------- ----------- Indiana Evansville 3 Indiana Ft. Wayne 2 Indiana Terre Haute 1 Kentucky Bowling Green 1 Kentucky Louisville 9 Ohio Cincinnati 5 Ohio Columbus 5 Ohio Dayton 3 Ohio Cleveland 2 -- TOTAL 31 ==
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FRANCHISED RESTAURANTS
As of December 29, 2002, we had six franchisees that owned and operated 19 Tumbleweed restaurants. The following table sets forth the franchisee and the location (including the number of restaurants at each location) of these 19 restaurants:
LICENSED RESTAURANTS
As of December 29, 2002, we had six licensed restaurants located outside the United States. The following table sets forth the location by country (including the number of restaurants in each country) of these six restaurants:
No. of Country Restaurants ------- -----------
England 2 Turkey 1 Egypt 1 Germany 1 Jordan 1 -
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INTERNATIONAL LICENSING AGREEMENT
Prior to January 1, 2002, the Company had a license agreement (the "International Agreement") with Tumbleweed International, LLC ("International"), a restaurant developer based in Hanau, Germany, to develop Tumbleweed restaurants outside of the Western Hemisphere. On January 1, 2002, the Company purchased the ownership interest in International for $1.5 million from TW-International Investors, Inc. and Chi-Chi's International Operations, Inc. ("CCIO"). CCIO owned 40% of International. The President and Chief Executive Officer of the Company is the sole shareholder of CCIO. Members of TW-International Investors, Inc. include three current directors of the Company. The acquisition gives the Company direct control and benefit of the international licensing of the Tumbleweed concept. In connection with the acquisition, the Company assumed an existing $1.4 million bank loan of TW-International Investors, Inc. and issued 76,923 shares of its common stock to CCIO. The Company has entered into a commission agreement with CCIO in connection with the sale of international regional licenses by International.
SERVICE MARKS
A wholly-owned subsidiary of the Company owns and licenses to the Company various service marks and trademarks that are registered on the Principal Register of the United States Patent and Trademark Office. We regard our service marks and trademarks as having significant value and being an important factor in the development of the Tumbleweed concept. Our policy is to pursue and maintain registration of our service marks and trademarks whenever possible and to oppose vigorously any infringement or dilution of our service marks and trademarks.
GOVERNMENT REGULATION
We are subject to a variety of federal, state and local laws. Our commissary is licensed and subject to regulation by the USDA. Each of our restaurants is subject to permitting, licensing and regulation by a number of government authorities, including alcoholic beverage control, health, safety, sanitation, building and fire agencies in the state or municipality in which the restaurant is located. Difficulties in obtaining or failure to obtain required licenses or approvals could delay or prevent the development of a new restaurant in a particular area.
Approximately 10.4% of our restaurant sales were attributable to the sale of alcoholic beverages for the fiscal year ended December 29, 2002. Alcoholic beverage control regulations require each of our restaurants to apply to a state authority and, in certain locations, county or municipal authorities for a license or permit to sell alcoholic beverages on the premises. Typically, licenses must be renewed annually and may be revoked or suspended for cause at any time. Alcoholic beverage control regulations relate to numerous aspects of restaurant operations, including minimum age of patrons and employees, hours of operation, advertising, wholesale purchasing, inventory control and handling, storage and dispensing of alcoholic beverages.
The failure of a restaurant to obtain or retain liquor or food service licences would have a material adverse effect on the restaurant's operations. To reduce this risk, each of our restaurants are operated in accordance with procedures intended to assure compliance with applicable codes and regulations.
The Federal Americans With Disabilities Act (The "ADA") prohibits discrimination on the basis of disability in public accommodations and employment. The ADA became effective as to public accommodations in January 1992 and as to employment in July 1992. We currently design our new restaurants to be accessible to the disabled, and believe that we are in substantial compliance with all current applicable regulations relating to restaurant accommodations for the disabled. We intend to comply with future regulations relating to accommodating the needs of the disabled, and we do not currently anticipate that such compliance will require us to expend substantial funds.
We are subject in certain states to "dram shop" statutes, which generally provide a person injured by an intoxicated person the right to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person. We carry liquor liability coverage as part of our existing comprehensive general liability insurance, as well as excess liability coverage. We have never been named as a defendant in a lawsuit involving "dram shop" liability.
Our restaurant operations are also subject to federal and state laws governing such matters as the minimum hourly wage, unemployment tax rates, sales tax and similar matters, over which we have no control. Significant numbers of our service, food preparation and other personnel are paid at rates related to the federal minimum wage, and increases in the minimum wage could increase our labor costs.
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The development and construction of additional restaurants are subject to compliance with applicable zoning, land use and environmental laws and regulations.
EMPLOYEES
As of December 29, 2002, we had approximately 1,800 employees, of whom 35 are executive and administrative personnel, 117 are restaurant management personnel, and the remainder are hourly restaurant and commissary personnel. Many of our hourly restaurant employees work part-time. None of our employees are covered by a collective bargaining agreement. We consider our employee relations to be good.
FORWARD-LOOKING STATEMENTS/RISK FACTORS
We make various forward-looking statements about our business in this report. When making these forward-looking statements, we use words such as expects, believes, estimates, anticipates, plans and similar expressions to identify them. We also identify important cautionary factors that could cause our actual results to differ materially from those projected in forward-looking statements made by us. Factors that realistically could cause results to differ materially from those projected in the forward-looking statements include the availability and cost of financing and other events that affect our restaurant expansion program, changes in food and other costs, changes in national, regional or local economic conditions, changes in consumer tastes, competitive factors such as changes in the number and location of competing restaurants, the availability of experienced management and hourly employees, and other factors set forth below. We do not have any obligation to revise any of these forward-looking statements for events occurring after the date of this report or for unanticipated events.
EXPANSION RISKS. Since 1995, we have grown while developing the operational systems, internal controls, and management personnel that management believed was necessary to support our plans for continued expansion. In the course of expanding our business, we may enter new geographic regions in which we have no previous operating experience. There can be no assurance that the Tumbleweed concept will be viable in new geographic regions or particular local markets. In addition, when feasible, we intend to open multiple restaurants in a target market to achieve operating and advertising efficiencies. Although such "clustering" of restaurants in a market may adversely affect same store sales in the short-term, management believes clustering can enhance long-term performance.
The continued growth of our business will depend upon our ability to open and operate additional restaurants profitably, which in turn will depend upon several factors, many of which are beyond our control. These factors include, among other things, the selection and availability of suitable locations, negotiations of acceptable lease, purchase and/or financing terms, the timely construction of restaurants, the securing of required governmental permits and approvals, the employment and training of qualified personnel, and general economic and business conditions. Our ability to expand into new geographic regions is also dependent upon our ability to expand our existing commissary facilities or open and successfully operate additional commissaries, as may be necessary to support additional restaurants. There can be no assurance that we will be successful in achieving our growth plans or managing our expanding operations effectively, nor can there be any assurance that new restaurants we open will be operated profitably.
RESTAURANT BASE. As of December 29, 2002, we operated 31 Tumbleweed restaurants. Because of the number of restaurants we currently operate, poor operating results at a small number of restaurants could negatively affect the profitability of the entire Company. An unsuccessful new restaurant or unexpected difficulties encountered during expansion could have a greater adverse effect on our results of operations than would be the case in a restaurant company with more restaurants. In addition, we lease certain of our restaurants. Each lease agreement provides that the lessor may terminate the lease for a number of reasons, including if we default in payment of any rent or taxes or breach any covenants or agreements contained in the lease. Termination of any of our leases pursuant to such terms could adversely affect our results of operations.
CHANGES IN FOOD AND OTHER COSTS; SUPPLY RISKS. Our profitability is significantly dependent on our ability to anticipate and react to changes in food, labor, employee benefits and similar costs over which we have no control. Specifically, we are dependent on frequent deliveries of produce and fresh beef, pork, chicken and seafood. As a result, we are subject to the risk of possible shortages or interruptions in supply caused by adverse weather or other conditions which could adversely affect the availability, quality and cost of such items. While in the past we have been able to anticipate and react to changing costs through our purchasing practices or menu price adjustments without a material adverse effect on profitability, there can be no assurance that we will be able to do so in the future.
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Industry Risks. The restaurant business is affected by changes in consumer tastes, national, regional and local economic conditions, demographic trends, traffic patterns and the type, number and location of competing restaurants. In addition, factors such as inflation, increased food, labor, energy and employee benefit costs, fluctuating insurance rates, national, regional and local regulations, regional weather conditions, and the availability of experienced management and hourly employees also may adversely affect the restaurant industry in general and our restaurants in particular.
Competition. The restaurant industry is intensely competitive with respect to price, service, location and food quality. We will compete with a variety of other casual full-service dine-in restaurants, fast food restaurants, take-out food service companies, delicatessens, cafeteria-style buffets, and other food service establishments. The number of value-oriented, casual dining restaurants has increased in the past few years, and competitors include national and regional chains, franchisees of other restaurant chains, and local owner-operated restaurants. Many competitors have been in existence longer, have a more established market presence, and substantially greater financial, marketing, and other resources than us. A significant change in pricing or other business strategies by one or more of our competitors, including an increase in the number of restaurants in our territories, could have a materially adverse impact on our sales, earnings and growth.
Government Regulation. The restaurant business is subject to extensive national, state, and local laws and regulations relating to the development and operation of restaurants, including those regarding the sale of alcoholic beverages, building and zoning requirements, the preparation and sale of food and employer-employee relationships, such as minimum wage requirements, overtime, working and safety requirements, and citizenship requirements. In addition, we are subject to regulation by the Federal Trade Commission and must comply with certain state laws that govern the offer, sale, and termination of franchises, the refusal to renew franchises, and the scope of noncompetition provisions. The failure to obtain or retain food or beverage licenses or approvals to sell franchises, or an increase in the minimum wage rate, employee benefits costs (including costs associated with mandated health insurance coverage), or other costs associated with employees, could adversely affect us.
EXECUTIVE OFFICERS
The following table lists the executive officers of the Company as of December 29, 2002, who serve at the pleasure of the Board of Directors. There are no family relationships among any officers of the Company.
Name Age Position - ---- --- -------- Terrance A. Smith. ... 57 President, Chief Executive Officer, and Director Glennon F. Mattingly . 51 Vice President and Chief Financial Officer Gary T. Snyder........ 48 Vice President of Company Operations Lynda J. Wilbourn..... 40 Vice President and Controller
Terrance A. Smith has served as President and Chief Executive Officer of the Company since August 2000, and is a Director of the Company. Mr. Smith was elected as a director of the Company in September 1997. From 1997 to 2002, Mr. Smith also served as the President of Tumbleweed International, LLC. From 1987 to 1997, Mr. Smith was the President and CEO of Chi-Chi's International Operations, Inc.
Glennon F. Mattingly joined Tumbleweed, LLC, the Company's predecessor, as Controller in March 1995 and was named Vice President-Controller in April 1998 and Chief Financial Officer in August 2001. Mr. Mattingly continues to serve the Company in that capacity. Before coming to Tumbleweed, Mr. Mattingly held various positions with Chi- Chi's, Inc. including six years as Director of Budgeting and Financial Analysis.
Gary T. Snyder joined Tumbleweed, LLC, the Company's predecessor, as Director of Training and Human Resources in June 1996 and was appointed Vice President of Company Operations in April 1998. Mr. Snyder continues to serve the Company in that capacity. He previously served for 17 years with Bob Evans Farms, Inc.
Lynda J. Wilbourn joined Tumbleweed, Inc. in March 1999 as Director of Accounting and was named Vice President and Controller in November 2001. Ms. Wilbourn continues to serve the Company in that capacity. From 1987 to 1999,
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Ms. Wilbourn held various positions with NTS Corporation, a regional real estate development firm headquartered in Louisville, Kentucky, including five years as Vice President of Accounting.
SEGMENT INFORMATION
Segment information for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 are presented in Note 19 to our Consolidated Financial Statements contained in Item 8.
ITEM 2.
ITEM 2. PROPERTIES
Of the 31 Company-owned restaurants in operation at December 29, 2002, 15 are owned by us in fee simple while the remainder are leased. Two of the leased locations are owned by entities whose principals are affiliated with us. Restaurant lease expirations range from 2007 to 2018, with the majority of the leases providing for an option to renew for additional terms ranging from five to twenty years. All of our leases provide for a specified annual rental, and some leases call for additional rental based on sales volume at the particular location over specified minimum levels. Generally, the leases are net leases which require us to pay the cost of insurance and taxes. Our executive offices are located in Louisville, Kentucky in leased space. The lease expires in 2007 and has two 5-year renewal options. We own the commissary and warehouse space in fee simple.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company has agreed to assume and pay one of the equipment leases totaling approximately $125,000 and remains contingently liable on two other equipment leases that currently have a remaining balance of approximately $36,000 which the Company believes will be assumed and paid by other guarantors. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it assumed. As of December 29, 2002, the reserve balance is approximately $74,000 which management believes is sufficient to satisfy the remaining lease obligation. The Company's management believes it will not incur significant additional losses in connection with this matter.
On December 16, 2002, the Company filed a Complaint in Jefferson County, Kentucky Circuit Court against American Federal, Inc. ("AFI") seeking a declaratory judgment that the Company had no contractual obligation to pay a $270,000 commission to AFI, in connection with a Conditional Commitment entered into between AFI and the Company and seeking damages for fraud and misrepresentation. In response, AFI filed suit in the United States District Court for the Eastern District of Missouri seeking payment of a $405,000 commitment fee plus additional charges, fees and costs all in the excess of $500,000 relating to the Conditional Commitment, as well as damages for breach of contract, unjust enrichment and misrepresentation/fraud. This matter is in the early discover stage. Management believes that AFI's claims are without merit, but it is too early to predict an outcome. The Company intends to vigorously defend itself in connection with this matter. As of December 29, 2002, the Company has not made an accrual for a potential liability in connection with this matter.
We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the shareholders during the fourth quarter ended December 29, 2002.
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PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
As of March 3, 2003, 5,916,153 shares of Common Stock were issued and outstanding. There were approximately 1,400 stockholders, including beneficial owners of shares held in nominee name.
On January 11, 1999, Tumbleweed, Inc. completed its initial public offering of common stock. We sold 776,630 shares at the offering price of $10 per share in a direct offering of our common stock to the public, raising a total of $7,766,300.
On January 1, 1999, the merger of Tumbleweed, LLC into Tumbleweed, Inc. became effective. The merger reorganized Tumbleweed, LLC, which had owned, franchised or licensed 43 Tumbleweed Southwest Mesquite Grill & Bar restaurants, into a corporation for purposes of the stock offering. In the reorganization, the membership interests of the approximately 80 former members of Tumbleweed, LLC were converted into a total of 5,105,000 shares of Company common stock. As required by the Tumbleweed, LLC operating agreement, the former Class B members made additional cash contributions of $747,500 in connection with the reorganization.
The Company received net proceeds of approximately $6,800,000 from the stock offering. The Company used the offering proceeds, plus the additional cash contributions of $747,500 we received in the reorganization, to repay bank indebtedness totaling $7,043,366 and to pay offering expenses. The bank indebtedness was an obligation of the former Class A members of Tumbleweed, LLC, including certain directors and officers of the Company, and had been accounted for as redeemable members' equity. Offering expenses totaled approximately $1,000,000, none of which were commissions or other underwriting expenses.
The registration statement for the stock offering also included the 5,105,000 shares issued in the reorganization, which may be sold from time to time in the future by the former members of Tumbleweed, LLC for their own accounts.
Our common stock trades on the Nasdaq Small Cap Market under the symbol "TWED." The following table shows quarterly high and low closing prices for the Common Stock during 2002 and 2001 for the periods indicated, as reported by the Nasdaq Small Cap Market.
2002 2001 ---- ---- High Low High Low ---- --- ---- --- First Quarter $ 1.65 $ 1.10 $ 3.13 $ 1.81 Second Quarter 1.75 0.81 2.99 2.17 Third Quarter 1.60 1.22 2.30 1.30 Fourth Quarter 1.38 0.50 1.50 0.92
We have never paid a dividend on our Common Stock nor do we expect to pay a cash dividend in the foreseeable future. We currently intend to retain any future earnings to finance the development of additional restaurants and the growth of our business generally. We are also prohibited from paying dividends under the terms of our two mortgage revolving lines of credit.
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ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Effective January 1, 1999, Tumbleweed, LLC was merged into Tumbleweed, Inc. as a result of the sale of common stock in an initial public offering. Tumbleweed, Inc. had not conducted any operations prior to the merger. In the following table, the income statement and balance sheet data of Tumbleweed, Inc. for the fiscal years ended December 29, 2002 and December 31, 2001, 2000 and 1999 and Tumbleweed, LLC for the year ended December 31, 1998 have been derived from financial statements which have been audited by Ernst & Young LLP, independent auditors, whose report thereon is included elsewhere in this filing. The information set forth on the following page should be read in conjunction with, and are qualified in their entirety by the financial statements (and the notes thereto) and other financial information appearing elsewhere in this filing and the information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations."
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
We make various forward-looking statements about our business in the following discussion. When making these forward-looking statements, we use words such as expects, believes, estimates, anticipates, plans and similar expressions to identify them. We also identify important cautionary factors that could cause our actual results to differ materially from those projected in forward-looking statements made by us. Factors that realistically could cause results to differ materially from those projected in the forward-looking statements include the availability and cost of financing and other events that affect our restaurant expansion program, changes in food and other costs, changes in national, regional or local economic conditions, changes in consumer tastes, competitive factors such as changes in the number and location of competing restaurants, the availability of experienced management and hourly employees, and other factors set forth below and in "Forward-Looking Statements/Risk Factors" in Item 1. Business.
As of December 29, 2002, we owned, franchised or licensed 56 Tumbleweed restaurants. We owned and operated 31 restaurants in Kentucky, Indiana and Ohio. There were 19 franchised restaurants located in Indiana, Illinois, Kentucky, and Wisconsin and six licensed restaurants located outside the United States in Germany, Jordan, Egypt, England and Turkey. The following table reflects changes in the number of Company-owned, franchised and licensed restaurants for the years presented.
Company-owned Restaurants 2002 2001 2000 ------------------------- ---- ---- ----
In operation, beginning of fiscal year 36 36 29 Restaurants opened - - 4 Restaurant sold to franchisee (1) - - Restaurants closed (4) - - Joint venture restaurant opened - - 1 Restaurants purchased from franchisee - - 2 -- -- -- In operation, end of fiscal year 31 36 36 -- -- --
Franchise and Licensed Restaurants ----------------------------------
In operation, beginning of fiscal year 29 27 22 Restaurants opened - 3 10 Restaurants closed (5) (1) (3) Restaurant purchased from Tumbleweed, Inc. 1 - - Restaurants sold to Tumbleweed, Inc. - - (2) -- -- --- In operation, end of fiscal year 25 29 27 -- -- -- System total 56 65 63 == == ==
On January 1, 2002, the Company purchased from its joint venture partner the remaining 50% interest in a restaurant location. See Note 10 to the accompanying consolidated financial statements for a further discussion of this transaction. During the first quarter of 2002, the Company closed four Company-owned restaurant locations. The restaurants were located in Cincinnati, Ohio (2), Columbus, Ohio (1), and Evansville, Indiana (1). The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the on the continued improvement of per-store average sales volumes. During the second quarter of 2002, the Company sold one of its restaurant locations to a franchisee in accordance with the Company's plan established in the fourth quarter of 2001. See below for a discussion regarding a special charge, which was recorded in 2001 as a result of the store closings and sale.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
General
The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted
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in the United States. The preparation of these financial statements requires the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates these estimates. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
The Company believes the following critical accounting policies affect its more significant assumptions and estimates used in the preparation of its consolidated financial statements.
Valuation of Long-Lived Assets
On January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 requires that long-lived assets to be disposed of by sale be measured at the lower of net book value or fair market value less cost to sell, whether reported in continuing operations or discontinued operations. SFAS No. 144 also broadens the presentation of discontinued operations to include components of an entity that have been or will be disposed of rather than limiting such reporting to discontinued segments of a business.
We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:
o a significant underperforming store relative to expected historical or projected future operating results;
o a significant change in the manner of our use of the acquired asset or the strategy for our overall business;
o a significant negative industry or economic trend;
Through December 29, 2002, we determined whether the carrying value of long-lived assets may not be recoverable based upon the existence of one or more indicators of impairment. We determined that there was no impairment based on the estimated undiscounted future cash flows of assets. If long-lived assets are not recoverable based upon estimated undiscounted cash flows, we write assets down to fair value. This fair value is generally determined on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model for assets held for use or at the lower of net book value less cost to sell for assets held for sale.
In the fourth quarter of 2001, the Company recorded special charges of approximately $4,295,000. The special charges include a $3,683,353 charge to earnings in accordance with Statement of Financial Accounting Standards (SFAS) No. 121, "Impairment of Long-Lived Assets." This charge reflects the write-down of assets associated with six restaurants, four of which were closed in the first quarter of 2002. The Company sold one of the remaining two restaurants to a current franchisee and continues to operate the other restaurant for the present. The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. The special charges also included approximate amounts totaling $611,200 for lease obligations and other costs related to the decision to close these restaurants of which approximately $295,000 remains accrued at December 29, 2002. Although we do not anticipate significant changes, the actual net proceeds from anticipated sales of assets and store closing costs may differ from the estimated amounts.
Impairment of Goodwill
Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS). SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment annually, or more frequently if certain indicators arise. The provisions of SFAS No. 142 also require the completion of a transitional impairment test within six months of adoption, with any impairments identified treated as a cumulative effect of a change in accounting principle.
During the first quarter of 2002, the Company determined that all goodwill as of January 1, 2002 related to two reporting units was impaired. The fair value of each unit was determined using accepted valuation techniques. As a result of the
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transitional impairment test, an impairment loss in the amount of approximately $1,504,000, net of tax, was recorded as a cumulative effect of a change in accounting principle during the first quarter of 2002.
As of December 29, 2002, the Company completed the annual test of impairment and determined that there is no further impairment of goodwill.
The following section should be read in conjunction with "Selected Financial Data" included above in Item 6 and our consolidated financial statements and the related notes included below in Item 8.
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RESULTS OF OPERATIONS
The following table sets forth the percentage relationship to total revenues of certain operating statement data, except where noted, for the periods indicated.
Beginning January 1, 2002, the Company changed its fiscal year to end on the last Sunday in December from a December 31 year end. As a result of this change, the 2002 fiscal year has two fewer days than the 2001 fiscal year.
COMPARISON OF THE FISCAL YEARS ENDED DECEMBER 29, 2002 AND DECEMBER 31, 2001
Total revenues decreased by $1,826,913 or 3.1% in 2002 compared to 2001 primarily as a result of the following:
Restaurant sales decreased by $1,949,862 or 3.5% in 2002 compared to 2001. The decrease in restaurant sales is primarily a result of the closing of four Company-owned restaurants during the first quarter of 2002, the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 and the Company's change in its fiscal year. The decrease in restaurant sales is partially offset by a 1.4% increase in same store sales for the fiscal year ended December 29, 2002.
Commissary sales to franchised and licensed restaurants decreased by $116,661 or 6.5% in 2002 compared to 2001. The decrease in commissary sales is primarily a result of the decreased number of franchised and licensed restaurants during 2002.
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Franchise fees and royalties decreased by $3,636 or 0.3% in 2002 compared to 2001. Franchise fees decreased by $105,000 in 2002 compared to 2001. The decrease in franchise fee income is a result of having three franchise restaurant openings in 2001 compared to no franchise restaurant openings in 2002. The decrease in franchise fees is partially offset by $101,364 increase in royalty income from 2001 to 2002. Royalty income increased primarily as a result of the Company's acquisition of the ownership interest in Tumbleweed International, LLC on January 1, 2002.
Other revenues increased $243,246 or 58.1% in 2002 compared to 2001 primarily as a result of an increase in insurance proceeds which relate to business interruption as a result of fires at two Company-owned restaurants. Other revenues includes $200,000 of insurance proceeds in 2002, as a result of a fire which occurred in July 2002, compared to $100,000 of insurance proceeds in 2001, as a result of a fire which occurred in June 2000. In addition, other revenues increased as a result of recognizing, as income in 2002, $55,000 of development fees which were forfeited by a franchisee and an increase in volume related purchasing rebates in 2002 compared to 2001.
Restaurant cost of sales decreased by $1,195,169 or 6.9% in 2002 compared to 2001. The decrease in restaurant cost of sales is primarily a result of the closing of four Company-owned restaurants during the first quarter of 2002, the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 and the Company's change in its fiscal year as discussed above. Restaurant cost of sales decreased as a percentage of sales by 1.1% to 30.0% for 2002 compared to 31.1% during 2001. The 1.1% decrease in cost of sales is primarily the result of a temporary increase in the cost of beef and pork (primarily steaks and ribs, respectively) during the first part of 2001.
Commissary cost of sales decreased $65,462 or 4.2% in 2002 compared 2001 primarily as a result of decreased commissary sales. As a percentage to sales, commissary cost of sales increased 2.2% from 87.7% in 2001 to 89.9% in 2002 primarily as a result of higher raw material product costs.
Restaurant operating expenses decreased by $627,450 or 2.1% in 2002 compared to 2001. The decrease in operating expenses is primarily a result of the closing of four Company-owned restaurants during the first quarter of 2002, the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 and the change in the Company's fiscal year. The decrease in operating expenses from 2001 to 2002 is partially offset by increased local marketing costs and increased repair and maintenance costs. Operating expenses as a percentage of sales increased by 0.8% from 54.6% in 2001 to 55.4% in 2002 primarily due to a 0.4% increase in local marketing costs and a 0.3% increase in repair and maintenance costs.
Selling, general and administrative expenses decreased by $123,302 or 2.0% in 2002 compared to 2001. The decrease in selling, general and administrative expenses is primarily due to the fact that the 2001 period includes the cost of implementing a new menu of approximately $95,000. There was no similar expense in 2002. The decrease in selling, general and administrative expenses is also attributable to decreased advertising costs. As a percentage to total revenues, selling, general and administrative expenses was 10.4% and 10.3% for 2002 and 2001, respectively.
Depreciation and amortization expense decreased $337,842 or 14.8% in 2002 compared to 2001 as a result of goodwill no longer being amortized in accordance with SFAS No. 142 and the write-down of assets in the fourth quarter of 2001.
The Company recorded special charges of $103,773 in the fourth quarter of 2002. The special charges represent the write- off of various costs that were incurred as a result of the proposal to acquire all outstanding shares in a going private transaction which was originally announced in June 2002. See below for a discussion regarding the 2001 special charges.
Net interest expense decreased $269,777 or 21.1% in 2002 compared to 2001. The decrease in net interest expense is due primarily to the decreases in the prime interest rate during 2002.
The $338,482 gain on sale of property is a result of the sale of one of the Company-owned restaurants (land and building) which had been closed, as discussed above, for $1,575,000. A portion of the proceeds from the sale were used to pay off a $224,611 mortgage payable and other closing costs.
The gain of $91,693 from insurance proceeds during 2002 was due to the involuntary conversion of non-monetary assets from a fire at a Company-owned restaurant. See Note 12 of the accompanying consolidated financial statements for a detail discussion. There was no similar income during 2001.
Income taxes on the Company's income before income taxes, extraordinary item and cumulative effect of a change in accounting principle for 2002 and 2001 have been provided for at an estimated effective tax rate of 54% and 26%, respectively. The effective tax rate differs from the statutory federal tax rate of 34% as a result of the impact of
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employment tax credits, state income taxes and an increase in the valuation allowance for the deferred tax asset. In 2003, the Company expects the effective tax rate to moderate closer to the statutory rate.
The extraordinary item - write off of unamortized loans costs, net of tax, of $76,743 relates to loan costs associated with the Company's long-term debt. The unamortized loan costs were expensed due to the fact that a commitment letter was signed prior to December 29, 2002 for financing which will repay all long-term debt prior to its maturity. See below for a discussion regarding the $18.0 million financing package that was obtained subsequent to fiscal year end on December 31, 2002.
COMPARISON OF THE FISCAL YEARS ENDED DECEMBER 31, 2001 AND 2000
Total revenues increased by $3,707,280 or 6.7% in 2001 compared to 2000 primarily as a result of the following:
Restaurant sales increased by $4,205,286 or 8.1% in 2001 compared to 2000. The increase in restaurant sales is due primarily to 42 additional Company-owned restaurant store months during 2001 compared to 2000. The increase in restaurant sales is also attributable in part to a 0.7% increase in same store sales.
Commissary sales to franchised and licensed restaurants increased by $118,044 or 7.1% in 2001 compared to 2000. The increase is due primarily to 38 additional franchised or licensed restaurant store months in 2001 compared to 2000.
Franchise fees and royalties decreased by $43,951 or 3.5% in 2001 compared to 2000. Franchise fees decreased by $145,000 in 2001 compared to 2000. The decrease in franchise fee income is a result of having seven franchise restaurant openings in 2000 compared to three franchise restaurant openings in 2001. The decrease in franchise fees is partially offset by a $101,049 increase in royalty income from 2000 to 2001. Royalty income increased primarily as a result of 38 additional franchised or licensed restaurant store months in 2001 compared to 2000.
Other revenues decreased by $572,099 or 57.7% in 2001 compared to 2000 primarily due to a decrease in volume related purchasing rebates in 2001 compared to 2000. The decrease in other revenues is also due to a decrease in insurance proceeds which relate to a business interruption as a result of a fire which occurred in June 2000 at a Company-owned restaurant. Other revenues includes $100,000 and $280,000 of insurance proceeds related to a business interruption in 2001 and 2000, respectively.
Restaurant cost of sales increased by $2,150,498 or 14.1% in 2001 compared to 2000. The increase was principally due to 42 additional Company-owned restaurant store months in 2001 compared to 2000. Restaurant cost of sales increased as a percentage of sales by 1.6% to 31.1% in 2001 compared to 29.5% in 2000. The 1.6% increase in cost of sales is primarily the result of a temporary increase in the cost of beef and pork (primarily steaks and ribs, respectively) and as a result of improving the quality of the beef product served in the restaurants.
Commissary cost of sales increased $101,345 or 6.9% in 2001 compared to 2000. The increase in commissary cost of sales is due primarily to 38 additional franchised and licensed restaurant store months in 2001 compared to 2000. As a percentage of commissary sales, commissary cost of sales were 87.7% and 87.8% in 2001 and 2000, respectively.
Restaurant operating expenses increased by $3,110,914 or 11.3% in 2001 compared to 2000. The increase in operating expenses reflects 42 additional Company-owned restaurant store months in 2001 compared to 2000. Operating expenses increased as a percentage of restaurant sales by 1.6% to 54.6% in 2001 from 53.0% in 2000 primarily due to a 0.6% increase in utilities and a 0.4% increase in payroll costs.
Selling, general and administrative expenses decreased by $491,140 or 7.4% in 2001 compared to 2000. The decrease in selling, general and administrative expenses is primarily due to decreased payroll costs for corporate personnel. The decrease in payroll costs is partially offset by increased advertising costs, the cost of implementing a new menu during the first quarter of 2001and increased legal costs. As a percentage to total revenues, selling, general and administrative expenses were 10.3% and 11.8% for 2001 and 2000, respectively.
Preopening expenses are start-up costs which are incurred in connection with opening new restaurant locations. These costs are expensed as incurred and will fluctuate based on the number of restaurant locations which are in the process of being prepared for opening. There were no preopening expenses incurred during 2001. Preopening expenses were $490,394 in 2000.
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Depreciation and amortization expense increased $138,044 or 6.4% in 2001 compared to 2000 due primarily to 42 additional Company-owned restaurant store months in 2001 compared to 2000.
The Company recorded special charges of $4,294,539 in the fourth quarter of 2001. The special charges include a $3,683,353 charge to earnings in accordance with SFAS No. 121, "Impairment of Long-Lived Assets." This charge reflects the write-down of assets associated with six restaurants, four of which closed in the first quarter of 2002. The Company sold one of the remaining two restaurants to a current franchisee and continues to operate the other restaurant for the present. The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. The special charges also included $611,186 for lease obligations and other costs related to the decision to close these restaurants of which approximately $295,000 remains accrued at December 29, 2002.
Net interest expense decreased $181,747 or 12.5% in 2001 compared to 2000. The decrease in net interest expense is the result of decreases in the prime interest rate during 2001 partially offset by higher borrowings incurred during 2000 to fund the growth in Company-owned restaurants.
The gain of $554,864 from insurance proceeds during 2000 was due to the involuntary conversion of non-monetary assets from a fire at a Company-owned restaurant. There was no similar income during 2001.
The equity in income of TW-Springhurst was $81,318 in 2001 compared to equity in losses of $58,903 in 2000. TW- Springhurst experienced a loss in 2000 primarily as a result of pre-opening costs.
The combined effective federal and state income tax rate was approximately 26% and 10% for the years ended December 31, 2001 and 2000, respectively. The effective tax rate is lower than the statutory federal tax rate of 34% as a result of the impact of employment tax credits and state income taxes on the effective rate, as well as the impact on the rate in 2001 of the valuation allowance against deferred income tax assets.
LIQUIDITY AND CAPITAL RESOURCES
Subsequent to fiscal year end on December 31, 2002, the Company completed an $18.0 million financing package with GE Capital Franchise Finance Corporation (GE). The loan was divided into two real estate loans totaling $14.5 million secured by fifteen fee simple properties, one loan ($7,122,000) bearing interest at a fixed rate of 8.52% for 15 years and the other ($7,378,000) at a variable rate of LIBOR plus 4.20% over 15 years. The Company also entered into two equipment loan agreements totaling $3.5 million secured by substantially all the equipment of the Company. One equipment loan ($1,750,000) bears interest at a fixed rate of 8.32% over 10 years while the other equipment loan ($1,750,000) has a variable rate of LIBOR plus 4.20% over 10 years. The financing package consolidates all of the Company's outstanding debt and provides approximately $1.7 million for the remodels, modernization and / or upgrades to the properties described in renovation agreements signed with GE. The Company has until June 30, 2004 to complete the renovations, unless the Company obtains GE's written consent for an extension of such date. Additionally, the financing package provides for $1.2 million to be used for expansion of Company restaurants. The loan imposes restrictions on the Company with respect to the maintenance of certain financial ratios, the incurrence of indebtedness, the sale of assets and capital expenditures. The Company is required to maintain two separate Fixed Charge Coverage Ratios. One is a Corporate Fixed Charge Coverage Ratio of 1.25:1 based on results of the entire company and the second, an aggregate Fixed Charge Coverage Ratio of at least 1.25:1 on the properties used as collateral on this loan. Both ratios are determined as of the last day of each fiscal year with respect to the twelve-month period of time immediately preceding the date of determination. The Company must also maintain a Funded Debt to EBITDA ratio not to exceed 5.5 to 1.0, determined as of the last day of each fiscal quarter for the twelve-month period of time immediately preceding the date of determination. With the exception of new store development, the Company shall not incur debt in excess of $500,000 per year without prior written consent of GE. With respect to each of the required covenants the Company expects to be in compliance throughout 2003.
Our capital needs during 2002 and 2001 arose from the reconstruction of restaurant facilities which were damaged by fire during July 2002 and June 2000, respectively, and the maintenance and improvement of existing restaurant facilities. The source of capital to fund the reconstruction was insurance proceeds received during 2002 and 2000. The maintenance and improvement expenditures were funded by internally generated cash flow. Our capital needs for 2000 arose from the development of new restaurants, and to a lesser extent, maintenance and improvement of existing restaurant facilities. The principal sources of capital to fund these expenditures were internally generated cash flow, bank borrowings and lease financing. The table below provides certain information regarding our sources and uses of capital for the years presented:
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The table below provides information regarding our contractual obligations and commitments as of December 29, 2002, giving effect to the refinancing on December 31, 2002.
Our largest use of funds during 2002 was for the reconstruction of a restaurant facility which was damaged by fire during 2002, for payments of long-term debt and capital lease obligations, maintenance and improvement of existing restaurant facilities, and for the acquisition of the remaining 50% interest in TW-Springhurst. Our largest source of funds in 2002 was cash flow from operations, proceeds from the sale of property in the fourth quarter and proceeds from the Comapny's two mortgage revolving lines of credit. Our largest use of funds during 2001 was for the reconstruction of a restaurant facility, which was damaged by fire during 2000, and for payments on long-term debt and capital lease obligations. Our largest use of funds during 2000 was for capital expenditures consisting of land, building and equipment, the acquisition of the assets of two Tumbleweed restaurants from two related party franchisees and for payments on long-term debt and capital lease obligations. Our largest source of funds in 2000 was from insurance proceeds for property and equipment which were damaged in June 2000 and proceeds from long-term debt. Sales are predominantly for cash and the business does not require the maintenance of significant receivables or inventories. In addition, it is common within the restaurant industry to receive trade credit on the purchase of food, beverage and supplies, thereby reducing the need for incremental working capital to support sales increases.
The Company guaranteed renewals of certain guaranteed indebtedness and any replacement indebtedness of TW- Tennessee, LLC, a former franchisee (TW-Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members, to the extent and in amounts not to exceed the amounts guaranteed as of September 30, 1998. The Company had guaranteed certain TW-Tennessee obligations as follows, jointly and severally with TW-Tennessee common members: a) up to $1,200,000 under a bank line of credit, b) approximately $2,800,000 of a lease financing agreement, and c) equipment leases with a bank.
Beginning in 2001, the Company had settlement discussions with the bank holding the TW-Tennessee line of credit, the other guarantors of that line of credit and certain of the shareholders of TW International Investors, Inc. and TWI-B, Inc. regarding the resolution of the suit which had been filed in March 2001 by the bank which had held the line of credit extended to TW-Tennessee (the "Tennessee Litigation") and related matters.
On February 28, 2002, the Company entered into a Confidential Settlement Agreement and Mutual Release (the "Settlement Agreement") which resolved the Tennessee Litigation and related matters. The Settlement Agreement provided for a cash payment by the Company to the bank holding the TW-Tennessee line of credit of $75,000 and the execution of a promissory note, payable to the bank, in the face amount of $300,000. In addition, subject to certain conditions, the Company will pay to the bank an additional amount of up to $200,000 in the event Tumbleweed International, LLC successfully sells regional international licenses and receives proceeds in excess of the $1,400,000 in indebtedness assumed by the Company in connection with its acquisition of the interests of TW International Investors,
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Inc. and TWI-B, Inc. in Tumbleweed International, LLC. The completion of the acquisition of the interests of TW International Investors, Inc. and TWI-B, Inc. in Tumbleweed International, LLC is included in the Settlement Agreement.
As a result of the Settlement Agreement, the Tennessee Litigation was dismissed. In addition, the parties to the settlement, including certain Directors of the Company (George Keller, David M. Roth and Minx M. Auerbach), granted mutual releases to one another regarding all matters, other than those specifically excluded. Among the matters excluded from the mutual release contained in the Settlement Agreement are claims asserted by the holder of the equipment leases granted to TW-Tennessee relative to guarantees by the Company and others, including David M. Roth, a Director of the Company, relative to such equipment leases. The Company agreed to assume and pay one of the equipment leases totaling approximately $125,000 and remains contingently liable on two other equipment leases that currently have a remaining balance of approximately $36,000 which the Company believes will be assumed and paid by other guarantors.
In the fourth quarter of 2001, as a result of the settlement discussions, the Company increased a reserve established in 2000 by the additional amount of $565,000, for a total of $1,290,000, of which $1,215,427 had been paid out as of December 29, 2002. The Company increased this reserve in 2001 to cover its portion of the settlement payments to the bank holding the TW-Tennessee line of credit and pay related costs, including legal expenses. The reserve also included an additional charge for the equipment lease which the Company assumed, and for payments made by the Company in 2001 on other lease financing claims related to TW-Tennessee. As of December 29, 2002, the reserve balance is approximately $74,000 which management believes is sufficient to satisfy the remaining lease obligation. The Company's management believes it will not incur significant additional losses in connection with these matters.
On December 16, 2002, the Company filed a Complaint in Jefferson County, Kentucky Circuit Court against American Federal, Inc. ("AFI") seeking a declaratory judgment that the Company had no contractual obligation to pay a $270,000 commission to AFI, in connection with a Conditional Commitment entered into between AFI and the Company and seeking damages for fraud and misrepresentation. In response, AFI filed suit in the United States District Court for the Eastern District of Missouri seeking payment of a $405,000 commitment fee plus additional charges, fees and costs all in the excess of $500,000 relating to the Conditional Commitment, as well as damages for breach of contract, unjust enrichment and misrepresentation/fraud. This matter is in the early discover stage. Management believes that AFI's claims are without merit, but it is too early to predict an outcome. The Company intends to vigorously defend itself in connection with this matter. As of December 29, 2002, the Company has not made an accrual for a potential liability in connection with this matter.
We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us.
We both own and lease our restaurant facilities. Management determines whether to acquire or lease a restaurant facility based on our evaluation of the financing alternatives available for a particular site.
In 2003, the Company expects to construct one to two additional restaurant facilities. Our ability to expand our number of restaurants will depend on a number of factors, including the selection and availability of quality restaurant sites, the negotiation of acceptable lease or purchase terms, the securing of required governmental permits and approvals, the adequate supervision of construction, the hiring, training and retaining of skilled management and other personnel, the availability of adequate financing and other factors, many of which are beyond our control. The hiring and retention of management and other personnel may be difficult given the low unemployment rates in the areas in which we intend to operate. There can be no assurance that we will be successful in opening the number of restaurants anticipated in a timely manner. Furthermore, there can be no assurance that our new restaurants will generate sales revenue or profit margins consistent with those of our existing restaurants, or that these new restaurants will be operated profitably.
In the next 12 months, the Company expects the demand on future liquidity to be principally from the ongoing maintenance and improvement of existing restaurant facilities and from the construction of one to two additional restaurant facilities. As of December 29, 2002, the Company had no material commitments for the construction of new restaurants, maintenance or improvement of existing restaurant facilities. In addition to the $1.2 million reserve established as a result of the GE financing package, we will utilize mortgage, sale/leaseback and/or landlord financing, as well as equipment leasing and financing, for a portion of the development costs of restaurants we plan to open in 2003. The remaining costs will be funded by available cash reserves and cash provided from operations. Management believes such sources will be sufficient to fund our expansion plans through 2003. Should our actual results of operations fall short of, or our rate of expansion significantly exceed plans, or should our costs of capital expenditures exceed expectations, we may need to
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seek additional financing in the future. In negotiating such financing, there can be no assurance that we will be able to raise additional capital on terms satisfactory to us.
OTHER EVENTS
Beginning January 1, 2002, the Company implemented a 401(k) plan. All employees who are at least 21 years of age with one year of service in which they worked a minimum of 1,000 hours are eligible. An employee can contribute up to 15% of their gross salary. The Company matches 25% of the first 4% an employee contributes. The employee becomes vested in the Company contribution based on a five-year vesting schedule. The Company match was approximately $67,000 in 2002.
On June 3, 2002, a group consisting of Gerald Mansbach, the Company's largest stockholder, Terrance A. Smith, the Company's Chairman, President and Chief Executive Officer, and David M. Roth, a director of the Company, submitted a proposal to the Company's Board of Directors to acquire of the Company's common stock not currently owned by them or others they may invite to join their group. The proposal contemplated a cash tender offer price of $1.75 per share. On June 5, 2002, three additional directors, Minx Auerbach, George Keller and Lewis Bass joined Gerald Mansbach, Terrance A. Smith and David M. Roth in their proposal to acquire all the Company's common stock not owned by their group at a price of $1.75 per share. The group owns approximately 60% of the Company's outstanding common stock.
The Board appointed a Special Committee of independent directors to evaluate the proposal. The Special Committee engaged an investment banking firm and a law firm to act as advisors in connection with its review of the tender offer proposal.
On or about October 28, 2002, the proposal to acquire all outstanding shares in the going private transaction was withdrawn. Mr. Gerald Mansbach, the largest shareholder of Tumbleweed shares and the lead participant in the going private proposal, notified Tumbleweed that he had decided, for personal reasons, to withdraw the going private proposal and would explore options for disposition of his existing shares.
IMPACT OF INFLATION
The impact of inflation on the cost of food, labor, equipment, land and construction costs could harm our operations. The Company pays a majority of its employees hourly rates related to federal and state minimum wage laws. As a result of increased competition and the low unemployment rates in the markets in which the Company's restaurants are located, the Company has continued to increase wages and benefits in order to attract and retain management personnel and hourly workers. In addition, most of the Company's leases require the Company to pay taxes, insurance, maintenance, repairs and utility costs, and these costs are subject to inflationary pressures. Most of the leases provide for increases in rent based on increases in the Consumer Price Index when the leases are renewed. The Company may attempt to offset the effect of inflation through periodic menu price increases, economies of scale in purchasing and cost controls and efficiencies at existing restaurants.
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ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company does not enter into derivative transactions or speculate on the future direction of interest rates. The Company is exposed to interest rate changes primarily as a result of our variable rate debt instruments. As of December 29, 2002, approximately $10,900,000 of our debt bore interest at variable rates. A 1% change in the variable interest rate on this debt equates to an approximate $109,000 change in interest for a twelve month period.
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ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS
PAGE ---- Report of Independent Auditors 28
Consolidated Statements of Operations for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 29
Consolidated Balance Sheets as of December 29, 2002 and December 31, 2001 30
Consolidated Statements of Stockholders' Equity for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 31
Consolidated Statements of Cash Flows for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 32
Notes to Consolidated Financial Statements 33
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REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders Tumbleweed, Inc.
We have audited the accompanying consolidated balance sheets of Tumbleweed, Inc. as of December 29, 2002 and December 31, 2001, and the related consolidated statements of operations, stockholders' equity, and cash flows for the fiscal year ended December 29, 2002 and each of the two fiscal years in the period ended December 31, 2001. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tumbleweed, Inc. at December 29, 2002 and December 31, 2001 and the consolidated results of its operations and its cash flows for the fiscal year ended December 29, 2002 and each of the two fiscal years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 4 to the consolidated financial statements, in 2002 the Company changed its method for accounting for goodwill and other intangible assets.
/s/ Ernst & Young LLP Louisville, Kentucky March 7, 2003
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See accompanying notes.
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Tumbleweed, Inc.
Consolidated Balance Sheets
See accompanying notes.
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Tumbleweed, Inc. Consolidated Statements of Stockholders' Equity
Fiscal Years Ended December 29, 2002 and December 31, 2001 and 2000
See accompanying notes.
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Tumbleweed, Inc.
Consolidated Statements of Cash Flows
See accompanying notes.
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TUMBLEWEED, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
Merger of Tumbleweed, LLC and Tumbleweed, Inc.
Tumbleweed, Inc. (the Company) was legally formed in December 1997 and capitalized on June 23, 1998 with the issuance of 13 shares of Company common stock at $10 per share. Effective January 1, 1999, and as a result of the sale of 776,630 shares of common stock in an initial public offering (IPO), Tumbleweed, LLC (Tumbleweed) was merged into the Company. The interests of Tumbleweed members at the time of the merger were converted into a total of 5,105,000 shares of Company common stock.
Prior to the merger, Tumbleweed and its owners (Members) operated pursuant to an Operating Agreement dated September 19, 1994. Members of Tumbleweed consisted of Common Members, Class A Members, Class B Members and a Class C Member. The capital accounts of the Common, Class B and Class C Members were $(394,000), $747,959 and $500, respectively, as of December 31, 1998. Class A Members had, in addition to their cash contributions, provided financing which was accounted for as redeemable members' equity prior to Tumbleweed's assumption of the debt on December 31, 1998. Certain Common Members acted as the Managers of Tumbleweed and, acting unanimously, generally had voting control of Tumbleweed.
Restaurant Facilities
As of December 29, 2002, the Company owned, franchised or licensed 56 Tumbleweed restaurants. The Company owned and operated 31 restaurants in Kentucky, Indiana and Ohio. There were 19 franchised restaurants located in Indiana, Illinois, Kentucky and Wisconsin and six licensed restaurants located outside the United States in Germany, Jordan, Egypt, England and Turkey. The following table reflects changes in the number of Company-owned, franchise and licensed restaurants during the fiscal years presented.
2002 2001 2000 ---- ---- ---- Company-owned restaurants: In operation, beginning of fiscal year 36 36 29 Restaurants opened - - 4 Restaurant sold to franchisee (1) - - Restaurants closed (4) - - Joint venture restaurant opened - - 1 Restaurants purchased from franchisee - - 2 -- -- -- In operation, end of fiscal year 31 36 36 -- -- --
Franchise and licensed restaurants: In operation, beginning of fiscal year 29 27 22 Restaurants opened - 3 10 Restaurants closed (5) (1) (3) Restaurant purchased from Tumbleweed, Inc. 1 - - Restaurants sold to Tumbleweed, Inc. - - (2) -- - -- In operation, end of fiscal year 25 29 27 -- -- -- System Total 56 65 63 == == ==
On January 1, 2002, the Company purchased from its joint venture partner the remaining 50% interest in a restaurant location. See Note 10 for a further discussion of this transaction. During the first quarter of 2002, the Company closed four Company-owned restaurant locations. The restaurants were located in Cincinnati, Ohio (2), Columbus, Ohio (1), and Evansville, Indiana (1). The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. During the second quarter of 2002, the Company sold one of its restaurant locations to a franchisee
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1. Basis of Presentation (continued)
in accordance with the Company's plan established in the fourth quarter of 2001. See Note 14 for a discussion regarding special charges which were recorded in 2001 as a result of these restaurant closings.
Fiscal Year
Beginning January 1, 2002, the Company changed its fiscal year to end on the last Sunday in December from a December 31 year end. The first three quarters of each fiscal year, beginning in 2002, consist of 12 weeks and the fourth quarter consists of 16 weeks. Fiscal year 2002 consists of 363 days compared to 365 days in 2001, which resulted in lower revenues of approximately $300,000.
Recently Issued Accounting Standards
Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminates the pooling of interest method of accounting and SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment annually, or more frequently if certain indicators arise. The provisions of SFAS No. 142 also require the completion of a transitional impairment test within six months of adoption with any impairments identified treated as a cumulative effect of a change in accounting principle. The adoption of SFAS No. 142 had a significant impact on the Company's financial position and results of operations as described in Note 4.
On January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 requires that long-lived assets to be disposed of by sale be measured at the lower of net book value or fair market value less cost to sell, whether reported in continuing operations or discontinued operations. SFAS No. 144 also broadens the presentation of discontinued operations to include components of an entity that have been or will be disposed of rather than limiting such reporting to discontinued segments of a business. The adoption of SFAS No. 144 had no impact on the Company's financial position and results of operations.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements No. 4,44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections," which is effective for the Company in 2003. SFAS No. 145 eliminates SFAS No. 4, which required all gains (losses) from extinguishment of debt to be classified as an extraordinary item, net of related income tax effect, and thus, gains (losses) from extinguishment of debt should be classified as extraordinary items only if they meet the criteria in APB Opinion No. 30. SFAS No. 145 amends SFAS No. 13 to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Additionally, SFAS No. 145 rescinds SFAS No. 44 and 64 because the statements are no longer applicable. Tumbleweed plans to adopt SFAS No. 145 in 2003 which will result in reclassifying its loss on unamortized loan costs from an extraordinary item to an operating item in the Consolidated Statement of Operations for the 2003 fiscal year.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated With Exit or Disposal Activities," which is effective for exit or disposal activities that are initiated after December 31, 2002. SFAS No. 146 nullifies EITF Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized at fair value when the liability is incurred. A commitment to an exit or disposal plan no longer will be sufficient basis for recording a liability for those activities. The adoption of SFAS No. 146 in 2003 is not expected to have an immediate material impact on the Company's financial condition or results of operations, however, the Company may have future exit or disposal activities to which SFAS No. 146 would apply.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123," which was effective for disclosure purposes for fiscal years ending after December 15, 2002. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock based compensation. In addition, it amends the disclosure requirements of SFAS No. 123 to require prominent disclosures about the method of accounting for stock based compensation and the effect on reported results. The provisions regarding alternative methods of transition do not apply to the Company which continues to account for stock-based compensation using the intrinsic value method. The disclosure provisions have been adopted in Note 2.
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1. Basis of Presentation (continued)
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 contains recognition and measurement provisions that require certain guarantees to be recorded as a liability, at the inception of the guarantee, at fair value. Current accounting practice is to record a liability only when a loss is probable and reasonably estimable. FIN 45 also requires a guarantor to make new disclosures. The recognition and measurement provisions are effective for guarantees issued after December 31, 2002. Management does not expect the adoption of FIN 45 to have a significant impact on the Company's financial condition or results of operations.
2. Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. Intercompany accounts and transactions have been eliminated in consolidation. Prior to January 1, 2002, the Company's investment in TW-Springhurst (see Note 10) was accounted for using the equity method, under which the Company's share of earnings or losses were reflected in income as earned.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in these financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and deposits at financial institutions with initial maturities of less than three months when purchased.
Inventories
Inventories, which consist of smallwares, food, beverages and supplies, are stated at the lower of average cost or market.
Property and Equipment
Property and equipment are stated at cost and depreciated on the straight-line method. Buildings and leasehold improvements are amortized over the lesser of the life of the leases, including renewal options, or the estimated useful lives of the assets, which range from ten to thirty years. Equipment is depreciated over the estimated useful lives of the assets, which range from five to ten years. Maintenance and repairs which do not enhance the value of or increase the life of the assets are charged to costs and expenses as incurred.
Construction in Progress
The Company capitalizes all direct costs incurred in the construction of new restaurants. Upon opening, these costs are depreciated or amortized and charged to expense based upon their property classification.
Goodwill
Prior to 2002, the Company amortized goodwill on the straight-line method over thirty years. As of January 1, 2002, the Company adopted the new accounting pronouncement related to goodwill (see Notes 1 and 4). In lieu of amortization, the Company tests goodwill for impairment on an annual basis, unless conditions exist which would require a more frequent evaluation. In assessing the recoverability of goodwill, projections regarding estimated future cash flows and other factors are made to determine the fair value of the respective assets. If these estimates or related projections change in the future, we may be required to record impairment charges for goodwill at that time.
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2. Significant Accounting Policies (continued)
Long-Lived Assets
The carrying amount of long-lived assets is reviewed if facts and circumstances suggest that it may be impaired. If this review indicates that long-lived assets will not be recoverable, as determined based on the estimated undiscounted cash flows of the asset over the remaining amortization period, the carrying amount of long-lived assets would be written down
to current fair value, which is generally determined from estimated discounted future net cash flows (assets held for use) or current fair value less cost to sell (assets held for sale). See Note 14 for a discussion regarding a write-down of assets in 2001.
Stock-Based Compensation Costs
The Company has a stock-based compensation (stock option) plan which is described more fully in Note 16. The Company accounts for the plan using the intrinsic value method of APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Because all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant, no stock-based compensation cost has been recognized in the consolidated statements of income. Had stock-based compensation cost for the plan been determined using the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," the effect on the Company's consolidated net income (loss) and earnings (loss) per share would have been as follows:
Fair Value of Financial Instruments
The carrying amounts of the Company's financial instruments approximate their fair value.
Revenue Recognition
Franchise fees are recognized when all material services, primarily site approval and management and staff training, have been substantially performed by the Company and the restaurant has opened for business. Fees received pursuant to development agreements, which grant the right to develop franchised restaurants in future periods in specific geographic areas, are deferred and recognized on a pro rata basis as the franchised restaurants subject to the development agreements begin operations. Franchise royalties, which are based on a percentage of monthly sales, are recognized as income when earned. Costs associated with franchise operations are expensed as incurred.
Advertising Costs
Advertising costs include Company-owned restaurant contributions to the Tumbleweed Marketing Fund, Inc. and TW- Louisville Marketing Fund, Inc. ("the Marketing Funds") and developing and conducting advertising activities, including the placement of electronic and print materials developed by the Tumbleweed Marketing Fund, Inc. All advertising and related costs are expensed as incurred. Contributions by Company-owned and franchised restaurants to the Marketing Funds are based on an established percentage of monthly restaurant revenues. The Tumbleweed Marketing Fund, Inc. is responsible for the development of marketing and advertising materials for use throughout the Company's system. The Marketing Funds are accounted for separately and are not consolidated with the financial statements of the Company.
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2. Significant Accounting Policies (continued)
Company contributions to the Marketing Funds for the fiscal years ended December 29, 2002 and December 31, 2001and 2000 were $455,152, $415,611 and $123,435, respectively. Advertising expense, which includes the Company's contributions to the Marketing Funds, for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 were $1,800,927, $1,915,577 and $1,570,179, respectively.
3. Property and Equipment
Property and equipment consist of:
December 29, December 31, 2002 2001 ---- ----
Land and land improvements $ 8,638,300 $ 9,048,317 Building and improvements 12,775,399 13,010,660 Leasehold improvements 2,382,305 2,195,482 Equipment 7,898,636 7,383,451 Building and equipment under capital leases 3,777,836 4,139,892 Construction in progress 309,335 13,011 ------------------------------ 35,781,811 35,790,813 Less accumulated depreciation and amortization (9,081,891) (7,410,775) ------------------------------ $ 26,699,920 $ 28,380,038 ==============================
4. Goodwill and Intangible Assets
Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations," and SFAS No. 142 "Goodwill and Other Intangible Assets." During the first quarter of 2002, the Company determined that all goodwill as of January 1, 2002 related to two reporting units was impaired. The fair value of each unit was determined using appropriate valuation techniques. As a result of the transitional impairment test, an impairment loss in the amount of $1,503,776, net of tax, was recorded as a cumulative effect of a change in accounting principle during the first quarter of 2002.
During the fourth quarter of 2002, the Company completed the annual test of impairment and determined that there was no impairment of the $174,657 goodwill acquired during the purchase of the remaining 50% interest in TW-Springhurst. See Note 10 for a further discussion of this transaction.
If the Company had accounted for its goodwill under SFAS No. 142 for all periods presented, the Company's net income (loss) and income (loss) per share would have been as follows:
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4. Goodwill and Intangible Assets (continued)
The following table sets forth changes in the Company's goodwill for the fiscal year ended December 29, 2002. All transactions occurred in the restaurant segment.
Balance as of January 1, 2002 $ 2,349,646 Goodwill acquired (see Note 10) 174,657 Impairment loss (2,349,646) ------------- Balance as of December 29, 2002 $ 174,657 =============
The Company acquired Tumbleweed International, LLC (see Note 11) during the first quarter of 2002, which resulted in the acquisition of an intangible asset in the amount of $1,525,966 and is included in the corporate segment. The intangible asset consists of $1,455,966 in international licensing rights, which are indefinitely lived assets not subject to amortization under SFAS No. 142, and $70,000 of existing franchise contracts, which are definite lived assets amortized over the 45 year contract period. During 2002, the Company recorded amortization expense totaling $1,436 for the definite lived intangible. The amortization expense for each of the next five years will approximate $1,555 per year.
5. Accrued Liabilities
Accrued liabilities consist of:
6. Long-Term Debt
Long-term debt consists of:
Property and equipment with a net book value of approximately $20,500,000 at December 29, 2002 collateralize the Company's long-term debt.
The terms of certain loan agreements include various provisions which require the Company to (i) maintain defined net worth and coverage ratios, (ii) limit the incurrence of certain liens or encumbrances in excess of defined amounts, (iii) maintain defined leverage ratios and (iv) prohibit the payment of dividends. The Company was in violation of the debt coverage ratio covenant related to the revolving lines of credit (balances as of December 29, 2002 were $5,801,148 and $874,868) as of December 29, 2002. As a result of the Company completing an $18.0 million financing package on December 31, 2002 (see discussion below), it was not necessary for the Company to obtain covenant waivers as these revolving lines of credit were repaid.
Subsequent to year end on December 31, 2002, the Company completed an $18.0 million financing package with GE Capital Franchise Finance Corporation. The financing package consolidates all of the Company's outstanding debt and equipment capital leases and provides approximately $3.0 million for the remodel and expansion of Company restaurants. The debt bears interest at both fixed rates ranging from 8.32% to 8.52% ($8,872,000) and a variable rate of LIBOR plus
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6. Long-Term Debt (continued)
4.20% ($9,128,000) with terms of 10 to 15 years. The debt is secured by fifteen fee simple properties and substantially all of the equipment owned by the Company. The Company is required to meet various financial ratios which management expects to be in compliance with throughout 2003.
The aggregate annual maturities of the long-term debt for the years subsequent to December 29, 2002, giving effect to the refinancing on December 31, 2002, are as follows:
2003 $ 744,540 2004 864,791 2005 929,483 2006 996,961 2007 1,069,550 Thereafter 9,390,298 ----------- Total $ 13,995,623 ===========
7. Leases
The Company leases certain buildings and equipment under capital lease agreements with related and third parties. The equipment leases have five to seven year terms. The building leases expire in 2016 and 2017. Subsequent to year end on December 31, 2002, the Company completed an $18.0 million financing package (see Note 6) which consolidated the Company's outstanding debt and equipment capital leases. The building capital leases which remain in effect subsequent to the refinancing have future minimum lease payments totaling approximately $2,492,000. The table below does not give effect to the refinancing on December 31, 2002. Future minimum lease payments under the building and equipment capital leases and the net present value of the future minimum lease payments at December 29, 2002 were as follows:
The Company leases certain restaurants and equipment under operating leases having terms expiring between 2003 and 2017. Most of the restaurant facility leases have renewal clauses of five to twenty years exercisable at the option of the Company and one of the leases is with a related party. Certain leases require the payment of contingent rentals based on a percentage of gross revenues. The related party operating lease requires the payment of contingent rent based on 30% of the restaurant's positive net cash flow.
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7. Leases (continued)
Future minimum lease payments on operating leases at December 29, 2002 were as follows:
Related Party Other Lease Leases Total -------------------------------- -------------
2003 $ 60,000 $ 1,881,106 $ 1,941,106 2004 60,000 1,881,506 1,941,506 2005 60,000 1,723,689 1,783,689 2006 60,000 1,709,342 1,769,342 2007 60,000 1,710,722 1,770,722 Thereafter 605,000 10,275,647 10,880,647 ---------------------------------------------- $ 905,000 $ 19,182,012 $ 20,087,012 ==============================================
Total rental expense was approximately $2,173,000 in 2002, $2,302,000 in 2001 and $1,975,700 in 2000 and included contingent rent of approximately $200,000 in 2002, $204,000 in 2001and $244,000 in 2000. Rental expense for related party leases was approximately $246,000 in 2002, $264,000 in 2001and $304,000 in 2000.
8. Income Taxes
The components of the provision (benefit) for income taxes for the fiscal years ended December 29, 2002, and December 31, 2001 and 2000 related to income (loss) before extraordinary item and cumulative effect of a change in accounting principle consists of the following:
2002 2001 2000 ----------- ----------- ------------ Current - federal $ (125,416) $ (150,773) $ 2,424 Deferred 855,650 (1,027,371) 63,015 ----------- ----------- ------------ 730,234 $ (1,178,144) $ 65,439 =========== =========== ============
The provision (benefit) for income taxes for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 on income (loss) before income taxes, extraordinary item and cumulative effect of a change in accounting principle differs from the amount computed by applying the statutory federal income tax rate due to the following:
2002 2001 2000 ----------- ----------- ------------ U.S. federal income taxes at 34% $ 457,671 $ (1,547,212) $ 213,792 State income taxes, net of federal tax effect - (180,205) (138,034) Valuation allowance against deferred income tax assets 332,168 655,770 - Employment tax credits (185,361) (139,632) (97,483)
Other items 125,756 33,135 87,164 ----------- ----------- ------------ Provision (benefit) for income taxes $ 730,234 $ (1,178,144) $ 65,439 =========== =========== ============
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8. Income Taxes (continued)
Significant components of the Company's deferred tax assets and liabilities are as follows:
Deferred tax assets and liabilities are classified as current or long-term according to the related asset and liability classification of the item generating the tax.
As of December 29, 2002, the Company has state net operating loss carryforwards of approximately $6,200,000 which begin expiring in 2015. Also, as of December 29, 2002, the Company has a $20,222 alternative minimum tax credit carryforward which has no expiration date, as well as $465,000 of employment tax credit carryforwards which begin expiring in 2019, available to offset future U.S. federal income taxes. Management has concluded that it is more likely than not that certain of the Company's deferred tax assets related to state net operating loss carryforwards and general business tax credits will not be realized. Accordingly, these deferred tax assets have been offset by a valuation allowance at December 29, 2002.
9. Related Party Transactions
Franchise fees and royalties recorded by the Company in relation to TW-Tennessee were approximately $36,800 in 2000. The Company also provided management and accounting services for TW-Tennessee for which fees were charged. Such management and accounting fees recorded in other revenues totaled approximately$12,200 in 2000. During 2002 and 2001, the Company recognized no income in relation to TW-Tennessee.
During the year ended December 31, 2000, the Company assumed a TW-Tennessee equipment lease which it had previously guaranteed. The equipment is being utilized to replace the equipment in the Company-owned restaurant which was destroyed as result of a fire in June 2000 (see Note 12). The capital lease had a balance of approximately $225,000 on the date the lease was assumed, and as of December 29, 2002 the lease has a balance of approximately $107,000.
Two common stockholders, one of which is also a director of the Company, are members in TW-Indiana, LLC, which in April 1998 acquired the franchise rights to five full-service Tumbleweed restaurants in Indiana and Kentucky from a third party. As of December 29, 2002, TW-Indiana, LLC operated eight full-service Tumbleweed restaurants. Franchise fees and royalties recorded by the Company in relation to this entity were approximately $477,000, $448,000 and $300,000 in
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9. Related Party Transactions (continued)
2002, 2001 and 2000, respectively. As of December 29, 2002 and December 31, 2001, the Company had an interest free note receivable of $45,000 from TW-Indiana, LLC with a maturity date of December 31, 2002. Subsequent to December
29, 2002, the note receivable was repaid.
TW-Indiana, LLC and a director of the Company are also members of TW-Seymour, LLC, a franchisee of the Company which opened a full-service Tumbleweed restaurant in Indiana during 1999. Franchise fees and royalties recorded by the Company in relation to this entity were approximately $50,000, $59,000 and, $45,000 in 2002, 2001 and 2000, respectively.
During the year ended December 31, 2000, the Company entered into management agreements with five companies who own Tumbleweed franchise restaurants with respect to five restaurant locations. The management agreements require the franchisees to pay certain fees to the Company in exchange for the Company providing operations management and accounting services to the franchisees. Certain current and former directors and officers of the Company owned substantial interests in these companies. Franchise fees and royalties recorded by the Company in 2001and 2000 in relation to these entities were approximately $11,000 and $227,000, respectively. Management and accounting fees recorded in other revenues by the Company in 2001and 2000 in relation to these entities were approximately $4,300 and $65,000, respectively. During the year ended December 31, 2000, the Company purchased the assets of two of these companies. See Note 10 for information regarding these transactions. Also during 2000, one of the five restaurant locations discussed above ceased operations. During 2001, the Company received equipment in exchange for an approximately $79,000 note receivable from a related party franchisee at the time the franchisee ceased operations. During 2002, the last managed store ceased operations. The Company had not recorded any royalties, management or accounting fees from this franchisee during 2002.
A provision for doubtful accounts of approximately $68,000 was recorded during 2000 for the write-off of the balance due from a related party franchisee (discussed in the paragraph above) for accounting fees, royalties and franchise fees.
Additional related party transaction information is provided in Notes 10 and 11.
10. Business Acquisitions
During the year ended December 31, 2000, the Company made a $200,000 investment in TW-Springhurst, LLC ("TW- Springhurst"), the owner and operator of a Tumbleweed restaurant in Louisville, Kentucky. During the year ended December 31, 2001, the Company received a cash distribution of $96,000 from TW-Springhurst. Through December 31, 2001, the Company had a 50% interest with the remaining 50% held by TW-Springhurst Investors, LLC. A current and former director of the Company owned TW-Springhurst Investors, LLC. The Company's share of TW-Springhurst's net income (loss) was $81,318 and ($58,903) for the years ended December 31, 2001 and 2000, respectively. On January 1, 2002, the Company acquired the remaining 50% interest held by TW-Springhurst Investors for $267,000. The acquisition was funded from cash reserves ($150,000) and a note payable to TW-Springhurst Investors ($117,000). The Company also assumed TW-Springhurst, LLC's note payable to a bank which had a balance of approximately $161,000 on the date of purchase. An independent business valuation appraisal was used to assist Company management in determining the purchase price.
The purchase price has been allocated as follows:
Assets and liabilities acquired: Inventory $ 55,674 Property and equipment 317,601 Deposits 1,200 Other 5,677 Note payable (161,394) --------------- 218,758 Investment in TW-Springhurst (126,415) Goodwill 174,657 --------------- $ 267,000 ===============
10. Business Acquisitions (continued)
On August 14, 2000, the Company purchased the assets of an Evansville, Indiana Tumbleweed restaurant from TW- Evansville, LLC (a limited liability company in which former directors and officers of the Company owned a substantial interest) for $929,400. The Company also assumed TW-Evansville, LLC's equipment capital lease which had a balance of approximately $197,000 on the date of purchase. The purchase price for the business and property was at fair market value as determined by an independent business valuation appraisal.
The purchase price has been allocated as follows based upon the fair values of the assets acquired and liabilities assumed:
Inventories $ 47,356 Building 585,000 Equipment 235,000 Deposits 3,000 Accrued property taxes (10,600) Capital lease obligation (197,008) ------------- 662,748 Goodwill 266,652 ------------- $ 929,400 =============
On October 1, 2000, the Company purchased the assets of the Medina, Ohio Tumbleweed restaurant from TW-Medina, LLC (a limited liability company in which a current director of the Company owned a substantial interest) for $876,933. The purchase price for the business and property was at fair market value as determined by an independent business valuation appraisal. The purchase price has been allocated as follows based upon the fair values of the assets acquired and liabilities assumed:
Inventories $ 57,010 Equipment 235,000 Accrued property taxes (5,694) ------------- 286,316 Goodwill 590,617 ------------- $ 876,933 =============
The acquisitions have been accounted for as purchases and, accordingly, the results of operations of the acquired businesses are included in the Company's results of operations since the date of each acquisition.
11. Acquisition of International
In August 1997, Tumbleweed, LLC entered into the International Agreement with Tumbleweed International, LLC ("International"), a restaurant developer based in Hanau, Germany. The International Agreement granted certain licensing and franchising rights to International for the development of Tumbleweed restaurants outside of the Western Hemisphere. International was a limited liability company owned by three corporations which are controlled by current directors and stockholders of the Company. In 2001 and 2000, International paid approximately $10,600 and $7,400, respectively, in fees to the Company under the International Agreement.
On January 1, 2002, the Company purchased the ownership interest in International for $1.5 million from TW-International Investors, Inc. and Chi-Chi' International Operations, Inc. ("CCIO"). CCIO owned 40% of International. The President and Chief Executive Officer of the Company is the sole shareholder of CCIO. Members of TW-International Investors, Inc. include three current directors of the Company. The acquisition gives the Company direct control and benefit of the international licensing of the Tumbleweed concept. In connection with the acquisition, the Company assumed an existing $1.4 million bank loan of TW-International Investors, Inc. and issued 76,923 shares of its common stock to CCIO. The Company has entered into a commission agreement with CCIO in connection with the sale of international regional licenses by International.
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11. Acquisition of International (continued)
The transaction was accounted for as a purchase and the purchase price was allocated to the intangible assets acquired - the Tumbleweed international licensing rights and existing franchise contracts.
The allocation of the purchase price is summarized as follows:
Note payable $ 1,425,968 Common stock 769 Paid-in capital 99,229 ------------- $ 1,525,966 ============= Intangible assets: Tumbleweed licensing rights $ 1,455,966 Contracts in place 70,000 ------------- $ 1,525,966 =============
12. Involuntary Conversion of Non-Monetary Assets
As a result of a fire on July 11, 2002 at a Company-owned restaurant in Ohio, an involuntary conversion of a non-monetary asset occurred which resulted in a gain of approximately $92,000. The gain represents the difference between the carrying amount of the Company's assets which were destroyed in the fire (equipment and inventories of approximately $313,000, in total, at the time of the fire) and the amount collected and estimated amounts to be collected from the insurance company (approximately $405,000). In addition, the Company recorded other revenues of approximately $200,000 (business interruption) and continuing expense reimbursement of $157,000 in 2002 as a result of the fire. As of December 29, 2002, the Company has received a total of approximately $1,222,900 from the insurance company for Company and landlord assets which were destroyed in the fire ($884,400), business interruption ($198,700) and continuing expense reimbursement ($139,800).
As a result of a fire which occurred June 7, 2000 at a Company-owned restaurant in Kentucky, an involuntary conversion of non-monetary assets occurred which resulted in a $554,864 gain. The gain represents the difference between the carrying amount of the restaurant's assets which were destroyed (building, equipment and inventories of $744,488, in total, at the time of the fire) and the amount collected from the insurance company ($1,299,352). The Company also received approximately $605,000 from the insurance company for business interruption ($280,000) and continuing expenses ($120,000) through December 31, 2000. The additional $205,000 received was for estimated business interruption and continuing expenses in 2001. Accordingly, the Company recorded this as deferred income in the accompanying consolidated balance sheet as of December 31, 2000 and subsequently recognized the $205,000 as other income during 2001.
13. Sale of Property
In December 2002, the Company sold the land and building of a Company-owned restaurant which closed in the first quarter of 2002 (see Note 1) for $1,575,000. The sale resulted in a gain of $338,482 and cash proceeds prior to debt repayment of $1,125,815. A portion of the cash proceeds were used to pay off the $224,611 mortgage note payable associated with the restaurant. The remaining proceeds will be used for capital improvements to existing stores and to provide partial funding for the construction of additional restaurants.
14. Special Charges
The Company recorded special charges of $103,773 in the fourth quarter of 2002. The special charges represent the write- off of various costs that were incurred as a result of the proposal to acquire all outstanding shares in a going private transaction which was originally announced in June 2002. In the fourth quarter of 2002, Mr. Gerald Mansbach, the largest shareholder of Tumbleweed shares and the lead participant in the going private transaction, notified Tumbleweed that he had decided, for personal reasons, to withdraw the going private proposal and is exploring other options for the disposition of his existing shares.
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14. Special Charges (continued)
The Company recorded special charges of $4,294,539 in the fourth quarter of 2001. The special charges include a $3,683,353 charge to earnings in accordance with SFAS No. 121, "Impairment of Long-Lived Assets." This charge reflects the write-down of assets associated with six restaurants, four of which closed in the first quarter of 2002. The Company sold one of the remaining two restaurants to a current franchisee and continues to operate the other restaurant for the present. The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. The special charges also included $611,186 for lease obligations and other costs related to the decision to close these restaurants, of which approximately $306,000 was paid out during 2002. At December 29, 2002, approximately $295,000 remains accrued for lease obligations and for anticipated costs connected with the disposal of one restaurant site. No additional accrual was required during 2002 in connection with the closing of these restaurants.
The following is a summary of the impairment charges:
Carrying Value Value at at Commitment December 31, Date Charge 2001 --------------- ------------- -------------- Property and equipment $ 4,260,428 $ 2,485,428 $ 1,775,000 Goodwill 993,811 993,811 - Other assets 215,837 204,114 11,723 --------------- ------------- -------------- $ 5,470,076 $ 3,683,353 $ 1,786,723 =============== ============= ==============
The value at December 31, 2001 was determined as follows. For stores being disposed of, the value was based on the estimated net proceeds from the sale of the assets. For the other store being operated, the Company estimated the fair value of the restaurant based on estimated future discounted cash flows from its use and eventual disposition.
The operating results of the restaurants to be disposed of before the special charges included in the accompanying consolidated statements of operations are as follows:
2001 2000 --------------- ------------- Revenues $ 5,513,743 $ 4,324,921 Loss from operations (378,843) (209,863)
15. Treasury Stock
On January 14, 2000, the Board of Directors approved the repurchase from time to time of up to $500,000 of the Company's common stock. Purchases are to be made in the open market as well as by private transaction at times and prices considered appropriate by the Company, subject to applicable rules and regulations. The purchases were funded by cash reserves. Through December 29, 2002, the Company had repurchased 42,400 shares at a total cost of $254,695.
16. Stock Incentive Plan
In June 1998, the Company adopted a Stock Option and Incentive Compensation Plan (the "Plan"). The Plan provides for the granting of any of the following awards to eligible employees or directors of the Company and its subsidiaries: (i) employee stock options, including both "incentive stock options" within the meaning of Section 422 of the Internal Revenue Code ("ISOs") and options that do not qualify as ISOs; (ii) automatic grants of options to nonemployee directors; (iii) stock appreciation rights; and (iv) restricted stock and performance stock awards. The Plan is intended to provide incentives and rewards for employees and directors to support the implementation of the Company's business plan and to align the interests of employees and directors with those of the Company's stockholders.
The Plan is administered by the Compensation Committee of the Company's Board of Directors (the "Committee"). The Committee is comprised of three independent directors, who are not current employees of the Company and who do not receive any remuneration from the Company in any capacity other than as a director. The Committee is authorized, among other things, to determine employees to whom grants of awards will be made and take such action as it deems necessary or advisable for the administration of the Plan.
The common stock subject to the Plan will be authorized but unissued shares or previously acquired shares. The number of shares of common stock available for grant of awards under the Plan equals the greater of 1,235,000 shares, or 10% of
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16. Stock Incentive Plan (continued)
the number of shares of common stock outstanding from time to time, including 170,000 shares reserved for options automatically granted to nonemployee directors under the Plan.
As of December 29, 2002, cumulative total options to purchase 1,481,077 shares of the Company's common stock had been granted to employees and directors of the Company at prices ranging from $0.85 to $10.00 per share which expire at various dates from 2009 to 2012 with a contractual life of 10 years. Initial grants of approximately 492,000 options were made at an exercise price equal to the Company's initial public offering price of $10.00 per share . The exercise price of subsequent grants were equal to the market price at the time of the grant.
Stock options granted under the Plan will be exercisable for a term of not more than ten years, as determined by the Committee. The option grants, with the exception of those granted to the Company's President and Chief Executive Officer in August 2000, are exercisable for 33% of the number of shares subject to the option on each of the first, second and third anniversaries of the date of grant and expire ten years from the date of grant. In August 2000, 367,236 options were granted to the Company's President and Chief Executive Officer at prices ranging from $2.69 to $3.88 which become immediately vested and exercisable in the event of a change in control of the Company.
Activity in the Plan during the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 was:
The following table summarizes information about employee stock options outstanding at December 31, 2002:
Range of Number Weighted Average Exercise Prices Outstanding Exercise Price --------------- $10.00 191,955 $10.00 $4.50 - $6.25 43,525 $5.38 $0.93 - $3.88 696,336 $3.28 ------------- 931,816 =============
The remaining contractual life of the outstanding stock options ranges from 6.1 years to 9.9 years.
The Company accounts for the Plan as described in Note 2. The weighted average fair value of options granted was determined using the Black-Scholes option pricing model with the following assumptions:
(1) risk-free interest rate of 4.6% to 6.50 %; (2) dividend yield of 0%; (3) expected life of 6.5 years; and (4) volatility of .921% in 2002, .842% in 2001 and .885% in 2000. Results may vary depending on the assumptions applied within the model. The weighted average fair value per share of options granted was $0.82, $1.38 and $3.68 for 2002, and 2001 and 2000, respectively.
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17. 401(k) Plan
Beginning January 1, 2002, the Company implemented a 401(k) plan. All employees who are at least 21 years of age with one year of service in which they worked a minimum of 1,000 hours are eligible. An employee can contribute up to 15% of their gross salary. The Company matches 25% of the first 4% an employee contributes. The employee becomes vested in the Company contribution based on a five-year vesting schedule. The Company match was approximately $67,000 in 2002.
18. Earnings per Share
The following is a reconciliation of the Company's basic and diluted earnings per share for the fiscal years ended December 29, 2002 and December 31, 2001 and 2000 in accordance with SFAS No. 128, "Earnings per Share."
Options to purchase common stock with an exercise price greater than the average market price were not included in the computation of the dilutive effect of common stock options because the effect would have been antidilutive. The number of antidilutive options was 905,816 in 2002, 912,385 in 2001 and 858,254 in 2000.
19. Segment Information
The Company has three reportable segments: restaurants, commissary and corporate. The restaurant segment consists of the operations of all Company-owned restaurants and derives its revenues from the sale of food products to the general public. The commissary segment derives its revenues from the sale of food products to Company-owned and franchised restaurants. The corporate segment derives revenues from sales of franchise rights, franchise royalties and related services used in restaurant operations, and contains the selling, general and administrative activities of the Company. Generally, the Company evaluates performance and allocates resources based on pre-tax income. The accounting policies of the segments are the same as those described in the summary of significant accounting policies.
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19. Segment Information (continued)
Segment information is as follows:
For the fiscal year ended December 29, 2002:
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20. Selected Quarterly Data
The following is a summary of certain unaudited quarterly results of operations for the fiscal years ended December 29, 2002 and December 31, 2001.
21. Contingencies
The Company guaranteed renewals of certain guaranteed indebtedness and any replacement indebtedness of TW-Tennessee, LLC, a former franchisee (TW-Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members, to the extent and in amounts not to exceed the amounts guaranteed as of September 30, 1998. The Company had guaranteed certain TW-Tennessee obligations as follows, jointly and severally with TW-Tennessee common members: a) up to $1,200,000 under a bank line of credit, b) approximately $2,800,000 of a lease financing agreement, and c) equipment leases with a bank.
In March 2001, the bank which held the line of credit extended to TW-Tennessee filed suit in the Circuit Court of Jefferson County, Kentucky against the Company, the Director and others to enforce certain limited guaranty agreements (the "Tennessee Litigation"). The Company paid the sum of $195,044 against its line of credit guarantee in September 2000.
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21. Contingencies (continued)
The Company undertook settlement discussions with the bank and the other guarantors during 2001. On December 28, 2001, the court entered summary judgment against the Company and certain other guarantors including the affected Director. The amount of the judgment against the Company was $1,004,956. Prior to enforcement of the judgment by the bank, the parties continued settlement discussions which resulted in the settlement described below.
By complaint dated October 4, 2001, Douglas H. Morris, II and Michael R. Greene, plaintiffs, filed an action (the "Morris and Greene Lawsuit") in the Circuit Court of Jefferson County, Kentucky against the Company, Tumbleweed International, LLC and others, including David Roth, a current Director of the Company, alleging damage to the plaintiffs as a result of (i) the management of the TW-Tennessee restaurants by the Company, (ii) the alleged wrongful application of proceeds of the Company's purchase of the Medina, Ohio restaurant and (iii) the alleged wrongful conversion of loan proceeds belonging to TW-International, LLC to TWED-Charleston, Inc. Prior to answering the complaint, the Company entered into settlement discussions with the plaintiffs which resulted in the settlement described below.
Beginning in 2001, the Company had settlement discussions with the bank holding the TW-Tennessee line of credit, the other guarantors of that line of credit, the plaintiffs in the Morris and Greene Lawsuit and certain of the shareholders of TW International Investors, Inc. and TWI-B, Inc. regarding the resolution of the Tennessee Litigation, the Morris and Greene Lawsuit and related matters.
On February 28, 2002, the Company entered into a Confidential Settlement Agreement and Mutual Release (the "Settlement Agreement") which resolved the Tennessee Litigation, the Morris and Greene Lawsuit and related matters. The Settlement Agreement provided for a cash payment by the Company to the bank holding the TW-Tennessee line of credit of $75,000 and the execution of a promissory note, payable to the bank, in the face amount of $300,000. In addition, subject to certain conditions, the Company will pay to the bank an additional amount of up to $200,000 in the event Tumbleweed International, LLC successfully sells regional international licenses and receives proceeds in excess of the $1,400,000 in indebtedness assumed by the Company in connection with its acquisition of the interests of TW International Investors, Inc. and TWI-B, Inc. in Tumbleweed International, LLC (see Note 11). The completion of the acquisition of the interests of TW International Investors, Inc. and TWI-B, Inc. in Tumbleweed International, LLC is included in the Settlement Agreement.
As a result of the Settlement Agreement, the Tennessee Litigation and the Morris and Greene Lawsuit were dismissed. In addition, the parties to the settlement, including certain Directors of the Company (George Keller, David M. Roth and Minx Auerbach), granted mutual releases to one another regarding all matters, other than those specifically excluded. Among the matters excluded from the mutual release contained in the Settlement Agreement are claims asserted by the holder of the equipment leases granted to TW-Tennessee relative to guarantees by the Company and others, including David M. Roth, a Director of the Company, relative to such equipment leases. The Company has agreed to assume and pay one of the equipment leases totaling approximately $125,000 and remains contingently liable on two other equipment leases that currently have a remaining balance of approximately $36,000 which the Company believes will be assumed and paid by other guarantors. These negotiations are ongoing and no agreement has been reached.
In the fourth quarter of 2001, as a result of the settlement discussions, the Company increased a reserve established in 2000 by the additional amount of $565,000, for a total of $1,290,000, of which $1,215,427 had been paid out as of December 29, 2002. The Company increased this reserve in 2001 to cover its portion of the settlement payments to the bank holding the TW-Tennessee line of credit and pay related costs, including legal expenses. The reserve also included an additional charge for the equipment lease which the Company assumed, and for payments made by the Company in 2001 on other lease financing claims related to TW-Tennessee. The Company's management believes it will not incur significant additional losses in connection with these matters.
On December 16, 2002, the Company filed a Complaint in Jefferson County, Kentucky Circuit Court against American Federal, Inc. ("AFI") seeking a declaratory judgment that the Company had no contractual obligation to pay a $270,000 commission to AFI, in connection with a Conditional Commitment entered into between AFI and the Company and seeking damages for fraud and misrepresentation. In response, AFI filed suit in the United States District Court for the Eastern District of Missouri seeking payment of a $405,000 commitment fee plus additional charges, fees and costs all in excess of $500,000 relating to the Conditional Commitment, as well as damages for breach of contract, unjust enrichment and misrepresentation/fraud. This matter is in the early discovery stage. Management believes that AFI's claims are without merit, but it is too early to predict an outcome. The Company intends to vigorously defend itself in connection with this matter. As of December 29, 2002, the Company has not made any accrual for a potential liability in connection with this matter.
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21. Contingencies (continued)
We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us.
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Item 9.
Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
The Proxy Statement issued in connection with the shareholders meeting to be held on June 25, 2003, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6b, contains under the caption "Election of Directors" information required by Item 10 of Form 10-K as to directors of the Company and is incorporated herein by reference. Pursuant to General Instruction G(3), certain information concerning executive officers of the Company is included in Part I of this Form 10-K, under the caption "Executive Officers."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Proxy Statement issued in connection with the shareholders meeting to be held on June 25, 2003, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(b), contains under the caption "Executive Compensation" information required by Item 11 of Form 10-K and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The Proxy Statement issued in connection with the shareholders meeting to be held on June 25, 2003, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(b), contains under caption "Beneficial Ownership Of Common Stock"and "Election of Directors" information required by Item 12 of Form 10-K and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Proxy Statement issued in connection with the shareholders meeting to be held on June 25, 2003, to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6(b) contains under the caption "Certain Relationships and Related Transactions" information required by Item 13 of Form 10-K and is incorporated herein by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Within 90 days prior to the date of the filing of this report, the Company's Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness, design and operation of the Company's disclosure controls and procedures as defined in Exchange Act Rule 13a-14. Based upon that evaluation, such officers concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed is recorded, processed, summarized, and reported in a timely manner. There have been no significant changes in the Company's internal controls or in other factors that could significantly effect these controls subsequent to the date of the evaluation referred to above.
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PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) Financial Statements: See Item 8.
(2) Financial Statement Schedules: Schedule II- Valuation and Qualifying Accounts Page 56
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.
(3) Listing of Exhibits:
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT 2.1 Agreement and Plan of Merger, dated as of June 23, 1998, between Tumbleweed, LLC and Registrant**
3.1 Certificate of Incorporation of Tumbleweed, Inc., as amended**
3.2 Bylaws of Registrant*
10.1 Master International License Agreement, dated August 29, 1997, between Tumbleweed International LLC and Tumbleweed, LLC*
10.4 Sublease Agreement, dated February 5, 1997, between TW-Dixie Bash, LLC and Tumbleweed, LLC (for Bardstown Road restaurant)*
10.5 Sublease Agreement, dated February 5, 1997, between TW-Dixie Bash, LLC and Tumbleweed, LLC (for Valley Station restaurant)*
10.7 Tumbleweed, Inc. 1998 Stock Option and Incentive Compensation Plan*
10.8 Form of Standard Franchise Agreement for Tumbleweed, LLC*
10.9 Articles of Incorporation of Tumbleweed Marketing Fund, Inc.*
10.10 By-laws of Tumbleweed Marketing Fund, Inc.*
10.11 Bonus Compensation Plan for Senior Executives*
10.12 Revolving Line of Credit Note, dated April 21, 1999, between Tumbleweed, Inc. and National City Bank of Kentucky and related Loan Agreement***
99.1 Registration Rights Agreement between Tumbleweed, Inc. and Tumbleweed, LLC*
99.2 Certifications pursuant to 18U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
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* Incorporated by reference to exhibits filed with the Commission on September 29, 1998, in Form S-1 Registration No. 333-57931.
** Incorporated by reference to exhibits filed with the Commission in Form 8-A filed by Tumbleweed, Inc. on February 25, 1999.
*** Incorporated by reference to exhibits filed with the Commission on May 12, 1999 in Form 10-A, File No. 333-57931.
(b) Tumbleweed, Inc. filed Form 8-K on October 28, 2002 to report under Items 5 and 7, Exhibit 99.1, that the proposal to acquire all the outstanding shares in a going private transaction, which had been announced in June 2002, had been withdrawn.
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Tumbleweed, Inc.
Schedule II - Valuation and Qualifying Accounts
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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, in the City of Louisville, State of Kentucky.
TUMBLEWEED, INC.
/s/ Terrance A. Smith ------------------------- By: Terrance A. Smith President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in capacities and on the dates indicated.
Title Date
/s/ Terrance A. Smith - ------------------------------ Terrance A. Smith President, Chief Executive Officer and Director March 28, 2003
/s/ Glennon F. Mattingly - ------------------------------ Glennon F. Mattingly Vice President and March 28, 2003 Chief Financial Officer (Principal Accounting Officer)
/s/ David M. Roth - ------------------------------ David M. Roth Director March 28, 2003
/s/ Minx Auerbach - ------------------------------ Minx Auerbach Director March 28, 2003
/s/ Lewis Bass - ------------------------------ Lewis Bass Director March 28, 2003
/s/ George R. Keller - ------------------------------ George R. Keller Director March 28, 2003
/s/ James F. Koch - ------------------------------ James F. Koch Director March 28, 2003
/s/ David Lloyd - ------------------------------ David Lloyd Director March 28, 2003
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I, Glennon F. Mattingly, certify that:
(1) I have reviewed this annual report on Form 10-K of Tumbleweed, Inc.; (2) Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; (3) Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; (4) The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; (5) The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors: (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and (6) The registrant's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003 /s/ Glennon F. Mattingly ------------------------ Glennon F. Mattingly Vice President and Chief Financial Officer
I, Terrance A. Smith, certify that:
(1) I have reviewed this annual report on Form 10-K of Tumbleweed, Inc.; (2) Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; (3) Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; (4) The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared: (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; (5) The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors: (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the
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registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and (6) The registrant's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28,2003 /s/ Terrance A. Smith --------------------- Terrance A. Smith President and Chief Executive Officer