ITEM 1. BUSINESS
GENERAL
EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS FORM 10-K ARE FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY, INCLUDING, WITHOUT LIMITATION, RISKS ASSOCIATED WITH THE COMPANY'S ABILITY TO SUCCESSFULLY AND TIMELY INTEGRATE CERTAIN ACQUISITIONS, INCLUDING THE LOTS A' BAGELS RESTAURANTS AND BAGEL COMMISSARY, THE COMPANY'S ABILITY TO DEVELOP, CONSTRUCT, ACQUIRE OR FRANCHISE ADDITIONAL RESTAURANTS IN ACCORDANCE WITH THE COMPANY'S DEVELOPMENT SCHEDULE, MANAGEMENT OF QUARTER TO QUARTER EARNINGS AND INCREASES IN OPERATING COSTS. CERTAIN OF THESE RISKS ARE SET FORTH IN THE "RISK FACTORS" SECTION OF THIS FORM 10-K. UPDATED INFORMATION WILL BE PERIODICALLY PROVIDED BY THE COMPANY AS REQUIRED BY THE SECURITIES EXCHANGE ACT OF 1934.
As of March 1, 1997, New York Bagel Enterprises, Inc. (the "Company") owned and franchised 61 quick-service New York Bagel restaurants and seven Lots A' Bagels restaurants in 16 states that serve generous portions of fresh, high quality food with fast, friendly service at an attractive price-value relationship. The Company has grown by developing Company-owned restaurants, making acquisitions and by selectively adding franchisees. As of March 1, 1997, there were 36 Company-owned restaurants located in Oklahoma, Kansas, Tennessee, Texas, Colorado, Missouri and New Mexico and 32 franchised restaurants located in 12 states operated by 19 franchisees.
The Company believes that consumption of bagels has increased in recent years, as consumers have discovered that bagels are a healthier, lower fat alternative to other quick-service foods and are a suitable substitute for sandwich breads. Management believes that the market for retail bagel restaurants is fragmented and underserved, and that the Company can capitalize on the demand for fresh bagels by expanding the New York Bagel concept in targeted markets.
The Company opened its first restaurant in 1986, and has developed, as of March 1, 1997, 24 of its 36 Company-owned restaurants in Oklahoma, Kansas, Tennessee, Texas and Missouri. In addition to developing new restaurants, as of March 1, 1997 the Company has acquired one bagel restaurant in Tennessee, seven Lots A' Bagels restaurants and a bagel commissary in Colorado and four franchised New York Bagel restaurants in Texas, Kansas and New Mexico. See Note 11 of the Notes to Consolidated Financial Statements.
The Company's business was previously operated through six separate entities, each of which was owned by one or more stockholders that existed prior to the Company's initial public offering (collectively, the "Prior Entities"). The Company was incorporated in December 1995 under the laws of Kansas, and on December 31, 1995, the Prior Entities were merged into the Company (the "Reorganization"). The financial statements herein include the results of operations of the Prior Entities on a combined basis for all periods. See Note 1 of the Notes to Consolidated Financial Statements.
The Company completed its initial public offering of its Common Stock on August 27, 1996. Reference to "New York Bagel" restaurants include the Company's Lots A' Bagels restaurants unless otherwise indicated.
THE NEW YORK BAGEL CONCEPT
PREPARE FRESH, HIGH QUALITY PRODUCTS. New York Bagel restaurants serve up to 20 varieties of bagels that are made from scratch, boiled and baked throughout the day in the traditional "New York style." The Company believes its five-ounce bagel is larger than those served by many of its competitors. Menu items are prepared in accordance with the Company's specifications using high quality ingredients such as Philadelphia-Registered Trademark- Brand cream cheese, Kraft-Registered Trademark- cheeses and premium deli meats. Generous portions of cream cheese are applied on its breakfast bagel and four ounces of meat are served on each of its deli sandwiches. The Company believes that the quality and portion size of its menu items generally equals or exceeds those
of its competitors. Because its menu pricing is competitive, the Company believes that it offers customers an attractive price-value relationship.
MAXIMIZE TRAFFIC THROUGHOUT THE DAY. Management has recognized the versatility of the bagel and has developed a menu to attract customers throughout the day. The breakfast menu at New York Bagel restaurants includes a variety of bagels and custom-blended cream cheeses, breakfast sandwiches on bagels, gourmet coffees, muffins and croissants. Lunch and dinner items include a wide range of delicatessen sandwiches made on bagels or other breads, salads, cookies and soft drinks. Management believes that Company-owned restaurants typically generate approximately 40% of their sales before 11:00 a.m., with an average ticket of approximately $3.00 during such period and $4.00 thereafter.
COMMITMENT TO TIMELY SERVICE. The Company believes that timely service is essential in the quick-service restaurant business. Service time is minimized through the division of employee functions, efficient store layout and design and queuing mechanisms. The Company conducts time studies of its restaurants on a periodic basis and believes that on average, breakfast customers are served within three minutes of placing their order and lunch and dinner customers are served within five minutes. As a result, the Company also has been able to successfully operate drive-through windows at certain New York Bagel restaurants.
FOCUS ON TRAINING. The Company believes that comprehensive training is essential to the efficiency and consistency of its operations. Accordingly, the Company conducts an extensive 90-day training program for its restaurant managers and franchisees that is composed of approximately ten days of classroom instruction and approximately 80 days of on-site instruction. In addition, the Company's training team provides on-site assistance during the initial ten days of operation at each Company-owned restaurant and at a franchisee's initial franchised restaurant.
EXPANSION STRATEGY
EMPHASIZE MID-SIZED AND SMALLER METROPOLITAN MARKETS. The Company presently targets its expansion efforts in mid-sized and smaller metropolitan markets. Management believes that these markets are attractive because they typically have fewer competing bagel restaurants and more favorable lease and labor environments than larger metropolitan markets.
ESTABLISH STRONG MARKET PRESENCE. Since the bagel industry is highly fragmented and increasingly competitive, the Company seeks to establish a strong market presence in its targeted markets. To develop a strong market presence rapidly and efficiently, the Company employs a multiple store strategy involving a bakery restaurant which produces bagels for itself and one or more nearby satellite restaurants. By entering underserved markets and opening multiple restaurants, the Company seeks to maximize market share and establish brand awareness. The Company and its franchisees have implemented this bakery/ satellite restaurant combination 21 times.
FOCUS ON UNIT AND MARKET ECONOMICS. Consistent with its market share objective, the Company focuses not only on generating attractive unit level economics, but also on the economic returns of a particular target market. The Company believes that bakery restaurants can be opened for an initial investment, including leasehold improvements, furniture, fixtures, equipment, initial working capital and pre-opening expenses, excluding real estate, of approximately $275,000, with satellite restaurants requiring approximately $175,000. By averaging these initial investment amounts within markets, the Company believes it achieves attractive returns on investment.
MAINTAIN BALANCED RESTAURANT DEVELOPMENT. The Company intends to expand through a balanced development of Company-owned and franchised New York Bagel restaurants. While Company-owned restaurants generally provide the Company with greater revenues and profits than franchised restaurants, franchising allows the Company to accelerate its expansion and name recognition with less investment of the Company's capital or human resources.
MAKE SELECTIVE ACQUISITIONS. During 1996, the Company acquired eight bagel restaurants, including seven Lots A' Bagels restaurants from an unaffiliated restaurant chain in Colorado Springs, Colorado, a new market, and a franchised restaurants in Santa Fe, New Mexico. The Company intends to pursue other acquisitions of local and regional bagel operations with an established market presence.
ACQUISITION
On December 6, 1996 the Company acquired substantially all of the operating assets, business operations and facilities (the "Acquisition") of Lots A' Bagels, Inc. ("Lots A' Bagels"), including seven restaurants and a bagel commissary located in Colorado Springs and Monument, Colorado for $2.1 million in cash and the assumption of certain liabilities of Lots A' Bagels. Additionally, certain contingent consideration may be required as discussed below. In connection with the Acquisition, Lots A' Bagels and its shareholders, Mr. Stephen K. Goldstone and Mrs. Linda F. Goldstone, executed noncompete agreements in favor of the Company.
Pursuant to the Asset Purchase Agreement (the "Agreement"), the Company acquired from Lots A' Bagels seven leased restaurants, a leased bagel commissary and substantially all of Lots A' Bagels' inventory, property, operating equipment, intellectual property and certain other assets. Lots A' Bagels restaurants are similar in design to New York Bagel restaurants and offer similar products. However, fresh baked products are supplied daily to Lots A' Bagels restaurants from the bagel commissary. In connection with the Acquisition, all lease agreements for the restaurants were assigned to and assumed by the Company. The Company intends to operate the restaurants in substantially the same manner as they were operated by Lots A' Bagels. The intellectual property acquired from Lots A' Bagels consists principally of the trademarks and logos of Lots A' Bagels.
The Agreement also provides for contingent consideration which includes a $563,000 promissory note from the Company. The principal amount and accrued interest payable under such promissory note are subject to offset (up to the full amount of such principal and interest) for (i) certain adjustments to be made upon the completion of a final statement of operations for the period from July 1, 1996 through March 30, 1997 (the "Final Statement of Operations") and (ii) any amounts required to be paid by Lots A' Bagels pursuant to the indemnification provisions of the Agreement. In addition, depending upon adjustments which may result from the Final Statement of Operations, the Company may be required to pay up to an additional $325,000 in cash and issue to Lots A' Bagels a promissory note in the amount, if any, by which the Final Statement of Operations adjustment exceeds $325,000. In addition, the Company issued a warrant to purchase common stock entitling Lots A' Bagels to purchase a to be determined number of shares of the Company's Common Stock equal to the total amount of debt issued to Lots A' Bagels times 60% divided by the exercise price which is the average final "close" price per share of the Company's Common Stock for the ten trading days ending three trading days prior to December 6, 1996.
The Company's source of the cash portion of the purchase price was a portion of the net proceeds from the Company's initial public offering of Common Stock completed in August 1996. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
RESTAURANT DESIGN AND SITE SELECTION
The Company's prototypical restaurant is decorated in rich colors and dark woods and contains a mixture of booth, table and barstool seating and, where available, outdoor seating. Exposed ceilings with drop lighting and a combination of tile and carpeted flooring are used to enhance its comfortable ambiance. Walls are covered with black and white photographs depicting classic New York scenes. The Company's restaurants are configured to facilitate a smooth flow of dine-in and carry-out traffic while retaining a casual, cafe atmosphere. Bagels and other baked products are displayed prominently behind a glass counter while other items such as salads, packaged cream cheese for take-out and specialty sodas and drinks are located in an open, self-serve refrigerated area next to the cash register. Restaurant staff prepare sandwich and other menu items behind the counter for dine-in and take-out customers. Dine-in customers' food is delivered directly to the table. The restaurants serve cappuccino and espresso, and a
fountain drink and gourmet coffee station are placed in the dining area for customer convenience. Retail merchandise, including logo clothing, coffee mugs and gift items, are displayed throughout the restaurant.
The Company believes that the layout and design of each restaurant contributes to the success of its operations. The Company continually reviews the restaurant design package for its restaurants and remodels as required. Pursuant to the franchise agreement, franchised restaurants' decor must be updated every five years or upon renewal of each particular franchise agreement. Remodeling typically requires closing the restaurant for one to four weeks. Although restaurants may vary in size, layout and design are generally consistent.
The Company considers the location of a restaurant to be important, and, therefore, devotes significant resources to the investigation and evaluation of potential sites. The site selection process focuses on area demographics, including population density, traffic patterns, income levels and competitive factors. The Company generally targets locations that possess a population density of at least 50,000 residents within a three mile radius and are situated on the morning side of commuter traffic. The Company's restaurants are typically located in strip shopping centers or free-standing buildings that provide visibility, curb appeal and accessibility. Certain limited hour satellite restaurants are located in office buildings and are open during business hours Monday through Friday. The Company's restaurant design may be configured to fit a wide variety of building shapes and sizes, thereby increasing the number of suitable sites for new locations.
UNIT ECONOMICS
In targeted markets, the Company employs a multiple store strategy involving a bakery restaurant which produces bagels for itself and one or more nearby satellite restaurants. The Company's approach to opening new restaurants has been to minimize its required investment by leasing substantially all of its locations. The Company believes that bakery restaurants can be opened for an initial investment, including leasehold improvements, furniture, fixtures, equipment, initial working capital and pre-opening expenses, excluding real estate, of approximately $275,000, with satellite restaurants requiring approximately $175,000. By averaging these initial investment amounts within a particular market, the Company believes it achieves attractive returns on investment within markets.
PLANNED EXPANSION
The Company intends to expand through the balanced development of Company-owned and franchised restaurants. Since January 1, 1997, the Company has opened or acquired three Company-owned restaurants and plans to open 11 to 14 additional Company-owned restaurants during the remainder of 1997 and approximately 20 to 25 in 1998. Since January 1, 1997, franchisees have opened two franchised restaurants and the Company, as of March 1, 1997, has 19 franchisees operating 32 restaurants in 12 states. The Company considers franchisees to be an integral component of its continued growth. The Company expects franchisees to open an additional 10 to 12 restaurants during the remainder of 1997 and approximately 15 to 20 franchised restaurants during 1998, although there can be no assurance that all of these restaurants will be opened.
OPERATIONS
RESTAURANT PERSONNEL. A typical New York Bagel restaurant employs a restaurant manager, an assistant manager and approximately 25 to 30 hourly employees for a bakery restaurant and 15 to 20 hourly employees for a satellite restaurant, most of whom work part-time. The restaurant manager is responsible for the day-to-day operation of the restaurant and for compliance with Company-established operating standards. The Company also employs eight area managers, each of whom has responsibility for overseeing three to seven Company-owned restaurants. The Company seeks to hire experienced restaurant managers and staff, and to motivate and retain them by providing opportunities for advancement and performance-based, financial incentives. Training and compensation programs are intended to instill restaurant managers and area managers with a sense of ownership in their restaurants. The Company believes the issuance
of stock awards under the New York Bagel Enterprises, Inc. 1996 Incentive Plan and the restaurant management bonus program will enhance its ability to attract and retain restaurant and area managers. To date, the Company has experienced a low managerial turnover rate which it believes results in decreased training costs and higher productivity.
REPORTING. The Company's restaurant managers prepare daily and weekly reports of sales, cash deposits and operating costs. Physical inventories of all food and beverage items are taken biweekly. The Company conducts monthly meetings with area managers to discuss restaurant sales, profitability and operations, personnel needs and product quality.
HOURS OF OPERATIONS. The restaurants are generally open Monday through Saturday from 6:30 a.m. to 8:00 p.m. and on Sunday from 8:00 a.m. to 5:00 p.m. Management believes that Company-owned restaurants typically generate approximately 40% of their sales before 11:00 a.m. Although the majority of restaurants are open seven days a week, certain satellite restaurants are located in downtown business districts and are open during business hours Monday through Friday.
TRAINING
The Company believes that comprehensive training is essential to the efficiency and consistency of its restaurants. Accordingly, the Company conducts an extensive 90-day training program for its restaurant managers and franchisees that is composed of approximately ten days of classroom instruction on administration, record keeping and inventory control and approximately 80 days of on-site instruction on baking and food preparation at the Company's training facility in Oklahoma City, Oklahoma. The Company has a team of three employees dedicated to training and new restaurant openings, including a full-time coordinator. In addition, the team provides on-site assistance during the initial ten days of operation at each Company-owned restaurant and at a franchisee's initial franchised restaurant. Management believes that its emphasis on training currently exceeds that of many of its competitors.
PURCHASING AND DISTRIBUTION
The Company establishes quality standards and specifications for food products and equipment used in New York Bagel restaurants and designates primary and secondary suppliers for all food items and restaurant supplies. In order to ensure product quality and consistency, franchisees purchase certain products from the Company's approved distributors. To obtain competitive prices, the Company contracts centrally for certain food products and supplies and negotiates volume discounts for the benefit of Company-owned and franchised restaurants. Most Company-owned and franchised restaurants purchase the majority of their food and non-food items from one nationally recognized distributor. The Company believes that the loss of this distributor would not materially affect the Company's results of operations.
MARKETING AND ADVERTISING
The Company and its franchisees advertise through newspapers, direct mail and radio. All advertising materials must be produced or pre-approved by the Company. The Company provides restaurants with pre-opening, grand opening and ongoing advertising and in-store promotional materials. In April 1996, the Company and its franchisees commenced payments of 0.5% of gross sales to the Company's advertising fund. The advertising fund is governed by a six-member board comprised of three Company representatives and three franchisee representatives who oversee the development of advertising materials. Prior to April 1996, the Company funded the development of advertising materials and furnished such materials to all restaurants for their use. Franchisees maintain sole discretion over the placement of advertisements in their market.
FRANCHISE PROGRAM
The Company commenced franchising its restaurant concept in 1993 and, as of March 1, 1997, has 19 franchisees operating 32 New York Bagel restaurants in twelve states. The Company expects that 42 to 44
franchised restaurants will be open by the end of 1997 and 57 to 64 by the end of 1998. However, there can be no assurance that all of these restaurants will be open or that the development schedule set forth in each development agreement will be achieved. During April 1996, a franchisee in the Houston, Texas market closed two restaurants. The Company anticipates refranchising the Houston, Texas market in the future. During July 1996, the Company agreed to purchase certain restaurant operating equipment of its existing Kansas City area franchisee and a franchisee in the Dallas, Texas market closed one restaurant. The Company anticipates refranchising the Kansas City market in the future. During February 1997, a franchisee in the Dallas, Texas market closed one restaurant.
The Company primarily seeks franchisees that have restaurant experience and that will enter into development agreements for multiple restaurants. Franchisees are approved on the basis of operational experience and financial resources. If the franchisee is not an owner-operator, the Company encourages the franchisee to provide the full-time operator an equity interest in the franchise operation.
DEVELOPMENT AGREEMENT. The Company enters into a development agreement with each franchisee (a "Development Agreement") for the exclusive development of a predetermined number of New York Bagel restaurants within a designated market area (the "Area of Exclusivity"). The Area of Exclusivity is negotiated prior to the signing of a Development Agreement and varies by agreement as to size, number of New York Bagel restaurants required and the schedule for restaurant development and opening. A Development Agreement generally requires a franchisee to develop the first restaurant within 12 months of signing the Development Agreement and the second restaurant within 18 months. Subsequent restaurants are generally required to be opened in six-month intervals thereafter. Development schedules vary based upon the size of the territory and the number of restaurants to be developed. Development Agreements contain cross-default provisions, and failure to develop the restaurants on schedule may result in a loss of exclusivity within the Area of Exclusivity. Under the Company's Development Agreement, the franchisee is required to pay, at the time of signing, a non-refundable fee equal to one-third of the initial franchise fee per restaurant covered by the Development Agreement. The amount is credited against the Company's standard franchisee fee, the remainder of which is payable to the Company upon signing the franchise agreement for a specific location.
FRANCHISE AGREEMENT. After signing a Development Agreement, the Company enters into a franchise agreement (a "Franchise Agreement") generally when a franchisee secures a location. The Franchise Agreement provides for a term of ten years with one ten-year renewal option and contains cross-default provisions. The Company has the right to terminate any Franchise Agreement under certain specified circumstances, including a franchisee's failure to make payments when due or failure to adhere to the Company's standards or procedures. Many state franchise laws limit the ability of a franchisor to terminate or refuse to renew a franchise. The current Franchise Agreement contains a right of first refusal for the Company to purchase an interest in the franchise and the franchisee. The current Franchise Agreement provides for an initial franchise fee of $21,000 for each bakery restaurant and $12,000 for each satellite restaurant. During 1995, the initial franchise fees for a bakery restaurant and a satellite restaurant were $18,000 and $9,000, respectively. Under the current Franchise Agreement, the franchisee pays the Company a monthly royalty fee of 4% of gross sales. Upon renewal of the Franchise Agreement, the monthly royalty fee cannot be increased to an amount greater than the monthly royalty fee then in effect for new franchisees. See "Business--Government Regulation."
SERVICES. The Company assists each franchisee in the site selection and development of restaurants and provides the physical specifications and plans for each franchised location. Each franchisee is responsible for recommending the location for its restaurants, but must obtain Company approval of each restaurant design and each location based on Company requirements. Company personnel also visit each site in connection with the site approval process. The Company provides standard design plans and equipment layout and specifications for most franchisees. In addition, Company personnel provide telephone support with respect to operations issues, as well as ongoing assistance with advertising and promotion.
QUALITY CONTROL. All franchisees are required to operate their New York Bagel restaurants in compliance with the Company's policies, standards and specifications, including matters such as menu items, ingredients, materials, supplies, fixtures, furnishings, decor and signage. Each franchisee has full discretion, however, to determine the prices to charge its customers. The Company collects sales and other operating information from its franchisees on a monthly, quarterly and annual basis. The Company monitors each franchisee's operations and product quality through review of monthly paperwork, review of quarterly financial statements and quarterly field visits. These overview mechanisms allow the Company to quickly identify potential problems and provide operational, marketing or accounting assistance.
FRANCHISE TRAINING AND SUPPORT. Each franchisee is required to have a restaurant manager, approved by the Company, who satisfactorily completes the Company's training program and who devotes his or her full business time and efforts to the operation of the franchisee's restaurant. In addition to this program, the Company also provides an on-site training crew for ten days during the opening of the franchisee's initial restaurant and ongoing supervision thereafter. Multi-unit franchisees are encouraged to hire a full-time training coordinator to train new employees for their restaurants. The Company regularly communicates with its franchisees, and encourages active communication among its franchisees, through franchise newsletters, special bulletins and periodic meetings.
GOVERNMENT REGULATION
The Company is subject to various federal, state and local laws affecting its business. Each of the Company's restaurants is subject to licensing and regulation by a number of governmental authorities, which include health, safety, sanitation, building and fire agencies in the state or municipality in which the restaurant is located. Difficulties in obtaining or failures to obtain required licenses or approvals could delay or prevent the opening of a new restaurant in a particular area.
The Company is subject to Federal Trade Commission ("FTC") regulation and various state laws which regulate the offer and sale of franchises. Several state laws also regulate substantive aspects of the franchisor-franchisee relationship. The FTC requires the Company to furnish to prospective franchisees a franchise offering circular containing prescribed information. The Company is currently required to register as a franchisor in three states. A number of states in which the Company may consider franchising also regulate the sale of franchises and require registration of the franchise offering circular with state authorities. Substantive state laws that regulate the franchisor-franchisee relationship presently exist in many states, and bills have been introduced in Congress from time-to-time which would provide for Federal registration of the franchisor-franchisee relationship in certain respects. The state laws often limit, among other things, the duration and scope of non-competition provisions and the ability of a franchisor to terminate or refuse to renew a franchise.
The Company's operations are also subject to federal and state laws governing such matters as wages, working conditions, citizenship requirements and overtime. The Company is also subject to the Americans with Disabilities Act of 1990, which, among other things, could require certain renovations to its restaurants to meet federal mandates. If such renovations are required, the Company believes the cost thereof will not materially affect the Company's results of operations. The Company believes it is in substantial compliance with all material laws.
COMPETITION
The quick-service restaurant industry is intensely competitive and generally characterized by low barriers to entry. There are a growing number of significant national, regional and local bagel restaurant chains, operating both owned and franchised bagel restaurants including Einstein/Noah Bagel Corp., Quality Dining, Inc. (Brueggers Bagel Bakery), Manhattan Bagel Company, Inc. and BAB Holdings, Inc., many of which have greater financial resources than the Company. New York Bagel restaurants also compete with other well established quick-service restaurants that have greater product and name recognition, larger financial and other resources than the Company and longer operating histories, as well
as numerous local food establishments, supermarkets and convenience stores that offer similar products. The Company believes that New York Bagel restaurants compete favorably in terms of taste, food quality, portions, service, convenience and value, which the Company believes are important factors to its targeted customers.
The Company competes for qualified franchisees with a wide variety of investment opportunities both in the restaurant business and in other industries. The Company's continued success is dependent to a substantial extent on its reputation for providing high quality and value with respect to its service, products and franchises, and this reputation may be affected not only by the performance of Company-owned restaurants, but also by the performance of its franchised restaurants over which the Company has limited operational control.
TRADEMARKS AND SERVICE MARKS
The Company operates and franchises bagel restaurants under the names "New York Bagel Shop & Delicatessen," "New York Bagel Shop & Deli," "NY Bagel Cafe," "New York Bagel Cafe & Deli," "NYB New York Bagel" and "the New York Bagel Shop." The Company's trademark "New York Bagel Shop & Delicatessen" and service mark "Like Bread With An Attitude" are registered under applicable federal trademark law. Under federal trademark law, the Company is required to renew these marks every 20 years. The Company's trademark "Lots A' Bagels, Inc." is registered in the State of Colorado. The Company claims common-law rights to the marks "New York Bagel Shop & Delicatessen," "NYB," "The City's Best Bagel," and "Where Yeast Meets West," but there have been no judicial determinations of the existence, validity, or extent of the Company's rights. Certain of the marks are licensed by the Company to franchisees pursuant to franchise agreements.
The Company is aware of the use by other persons and entities in certain geographic areas of names and marks which are the same or similar to the Company's marks. Some of these persons or entities may have prior rights to those names or marks in their respective localities. Therefore, there is no assurance that the "New York Bagel Shop & Delicatessen" mark or any other marks are available in all locations.
EMPLOYEES
As of March 1, 1997, the Company employed 523 persons, 390 of which are employed part-time. None of the Company's employees is subject to any collective bargaining agreements, and management considers its relations with its employees to be good.
ITEM 2.

ITEM 2. PROPERTIES
The average bakery restaurant contains approximately 2,750 square feet, and the average satellite restaurant contains approximately 2,000 square feet. Approximately 1,200 square feet of a bakery restaurant is used for dough production, baking and food preparation while approximately 500 square feet of a satellite restaurant is used for food preparation. The Lots A' Bagel restaurants are approximately 2,000 square feet, 500 square feet of which is used for food preparation. The restaurants have an average seating capacity of approximately 60 persons. The Company leases approximately 1,200 to 4,000 square feet of space for 34 of its Company-owned restaurant sites. The Company also leases a 19,479 square foot bagel commissary located at 4325 Northpark Drive, Colorado Springs, Colorado 80915 that provides all of the dough production, baking and food preparation for the seven Lots A' Bagels restaurants. Such lease expires during June 2004. The Company also owns two restaurant sites. As of March 1, 1997, the Company has entered into agreements to purchase land for development of three restaurants and leases for four restaurants under development. Although the terms of its leases for Company-owned restaurants vary, the Company typically seeks to obtain an initial five-year term lease with two or three five-year option terms. The following table sets forth certain information as of March 1, 1997 with respect to Company-owned and franchised restaurants currently in operation or under development. Restaurants under development include locations for which leases have been signed, a real estate purchase agreement has been executed, or construction has commenced, but are not currently in operation.
COMPANY-OWNED RESTAURANTS
FRANCHISED RESTAURANTS
The Company's principal executive offices are located at 300 I.M.A. Plaza, 250 North Water Street, Wichita, Kansas 67202-1213, where the Company subleases approximately 2,158 square feet of office space pursuant to a sublease agreement with Murfin Drilling Company, Inc., a wholly owned subsidiary of Murfin, Inc., on a month to month basis. The Company has the option to terminate such sublease upon 30 days' notice. Mr. David L. Murfin, a Director of the Company, is a 7.1% stockholder of Murfin, Inc. The Company believes that alternative office space is available at comparable rates from third parties. The Company's operational offices are located at 115 East 8th, Stillwater, Oklahoma 74074, where the Company leases approximately 2,200 square feet of office space, 600 square feet of which the Company subleases to an unaffiliated third party on a monthly basis, and 1,000 square feet of storage space pursuant to a lease agreement that expires during December 1999. The Company conducts its management and franchisee training at its Casady Square, Oklahoma City, Oklahoma facility in an approximately 3,400 square foot space contiguous to the restaurant. Such facility is subject to a lease that expires during July 2003. The Company believes that its current executive offices and training facilities are adequate for the near future and does not anticipate the need for significant expansion of these facilities in the foreseeable future.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
The Company is involved from time-to-time in various legal proceedings and claims incident to the normal conduct of its business. The Company believes that such legal proceedings and claims, individually and in the aggregate, are not likely to have a material adverse effect on its financial condition or results of operations.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
RISK FACTORS
EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS FORM 10-K ARE FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY, INCLUDING, WITHOUT LIMITATION, RISKS ASSOCIATED WITH THE COMPANY'S ABILITY TO SUCCESSFULLY AND TIMELY INTEGRATE CERTAIN ACQUISITIONS, INCLUDING THE LOTS A' BAGELS RESTAURANTS AND BAGEL COMMISSARY, THE COMPANY'S ABILITY TO DEVELOP, CONSTRUCT, ACQUIRE OR FRANCHISE ADDITIONAL RESTAURANTS IN ACCORDANCE WITH THE COMPANY'S DEVELOPMENT SCHEDULE, MANAGEMENT OF QUARTER TO QUARTER EARNINGS AND INCREASES IN OPERATING COSTS. CERTAIN OF THESE RISKS ARE SET FORTH HEREIN. UPDATED INFORMATION WILL BE PERIODICALLY PROVIDED BY THE COMPANY AS REQUIRED BY THE SECURITIES EXCHANGE ACT OF 1934.
EXPANSION. As of March 1, 1997, there were 68 restaurants in operation, consisting of 29 New York Bagel Company-owned and 32 franchised restaurants and seven Lots A' Bagels restaurants. In addition, there were seven Company-owned restaurants and two franchised restaurants in various stages of development. By the end of 1997, the Company contemplates having approximately 47 to 50 Company-owned and 42 to 44 franchised restaurants in operation. The Company expects to have approximately 67 to 75 Company-owned and 57 to 64 franchised restaurants in operation by the end of 1998. The Company has used and intends to continue to use a significant portion of the net proceeds of its initial public offering to develop additional Company-owned restaurants. There can be no assurance that the Company will be able to open all of its planned restaurants or that, if opened, such restaurants can operate profitably. The opening and success of New York Bagel restaurants will depend on various factors, not all of which are within the control of the Company, including customer acceptance of the Company's concept in new markets, the availability of suitable sites, the negotiation of acceptable lease or purchase terms for new locations, permit and regulatory compliance, the ability to meet construction schedules, the financial and other capabilities of the Company and its franchisees, the ability of the Company to successfully manage this anticipated expansion and to hire and train personnel, and general economic and business conditions. Furthermore, because of the Company's relatively small restaurant base, an unsuccessful restaurant could have a more significant adverse effect on the Company's results of operations than would be the case for a company with a larger restaurant base.
The Company's expansion will also require the implementation and integration of enhanced operational and financial systems and additional management, operational and financial resources. Failure to implement and integrate these systems and add these resources could have a material adverse effect on the Company's results of operations and financial condition. There can be no assurance that the Company will be able to manage its expanding operations effectively or that it will be able to maintain or accelerate its growth. The Company experienced growth in revenues and net income in 1996. There can be no assurance that the Company will continue to experience growth in, or maintain its present level of, revenues or net earnings. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business--Expansion Strategy."
DEPENDENCE ON FRANCHISEES. The Company realizes a portion of its revenues from initial franchise fees and continuing royalty payments from its franchisees. If the Company's franchisees encounter business or operational difficulties, the Company's revenues from royalties will be adversely affected. Such
difficulties may also negatively impact the Company's ability to sell new franchises. Consequently, the Company's financial prospects are significantly related to the success of its franchised restaurants, over which the Company has limited direct operational control. There can be no assurance that the Company will be able to successfully attract new franchisees or that the Company's franchisees will be able to successfully operate existing or develop and operate additional New York Bagel restaurants. See "Business--Expansion Strategy" and "Business--Franchise Program."
COMPETITION. The quick-service restaurant industry is intensely competitive and characterized by relatively low barriers to entry. New York Bagel restaurants compete against many well established, quick-service restaurants, local food establishments, supermarkets and convenience stores, many of which have greater product and name recognition and larger financial and other resources than the Company. An increase in the number of competitors, particularly bagel restaurants or delicatessens, in the Company's territories could have an adverse impact on the Company's results of operations and expansion plans. See "Business--Competition."
RESTAURANT INDUSTRY. The Company and the restaurant industry are significantly affected by factors such as changes in local, regional or national economic conditions, changes in consumer tastes and concerns about the nutritional quality of quick-service foods. Multi-unit food service chains such as the Company can also be substantially adversely affected by publicity resulting from food quality, illness, injury or other health concerns or operating issues stemming from one restaurant or a limited number of restaurants. In addition, factors such as increases in food, labor and energy costs, the availability and cost of suitable restaurant sites, fluctuating insurance rates, state and local regulations and the availability of an adequate number of hourly-paid employees can also adversely affect the restaurant industry.
DEPENDENCE ON KEY PERSONNEL. The Company's future success will be highly dependent on the continued efforts of senior management. The Company does not have employment agreements with any of its senior management. The loss of the services of one or more of such key personnel could have a material adverse effect upon the Company's results of operations. The Company's success is also dependent upon its ability to attract and retain skilled restaurant managers and employees and the ability of its key personnel to manage the Company's growth and integrate its operations. There can be no assurance that the Company will be successful in attracting and retaining such personnel.
INCREASES IN OPERATING COSTS; INTERRUPTIONS IN SUPPLIES. An increase in operating costs could adversely affect the profitability of the Company. Factors such as inflation, increased food and labor costs, including the additional increase in the minimum hourly wage requirement, and employee benefit costs and the availability of qualified management and other personnel may adversely affect the profitability of the Company. The cost and availability of many restaurant commodities are subject to fluctuations due to seasonality, weather, demand and other factors. The Company's restaurants are dependent on frequent deliveries of food supplies and any shortages or interruptions could have a material adverse effect on the Company. See "Business--Purchasing and Distribution."
GEOGRAPHIC CONCENTRATION. All but two of the Company-owned restaurants are located in Oklahoma, Kansas, Tennessee, Texas and Colorado. As a result, the Company's results of operations may be materially affected by adverse business, economic or weather conditions in these states. Although the Company plans to open additional restaurants in new geographic areas, there can be no assurance that the current geographic concentration of the Company's business will not have an adverse effect on its results of operations or financial condition in the future.
POSSIBLE ACQUISITIONS. The Company's growth strategy includes possible acquisitions of bagel restaurants. However, no assurance can be given that the Company will be able to find attractive acquisition candidates, consummate additional acquisitions or that it will successfully integrate, convert or operate any acquired business. In the event that the Company makes acquisitions, there can be no assurance that any such acquisition and resulting conversion expenses, including loss of restaurant sales during the remodel
period, will not have a material adverse effect upon the Company's operating results, particularly during the period in which such operations are being integrated into the Company. Furthermore, the Company's ability to make acquisitions may depend upon its ability to obtain financing. There can be no assurance that the Company will be able to obtain financing on acceptable terms. See "Business--Expansion Strategy."
FLUCTUATIONS IN QUARTERLY RESULTS. The timing of restaurant openings, remodelings or acquisitions, recognition of franchise fee income and seasonal factors may result in fluctuations in quarterly operating results of the Company. In accordance with generally accepted accounting principles, franchise and development fees and the corresponding deferred charges with respect to each franchise or development agreement are not recognized as income or expense until a restaurant commences operations. There can be no assurance that quarterly fluctuations will not continue and, accordingly, the Company's financial results for a particular quarter may not be indicative of results for an entire year.
CONTROL OF COMPANY. As of March 1, 1997 the directors and officers of the Company beneficially owned approximately 44.3% of the outstanding Common Stock of the Company. In addition, the stockholders that existed prior to the Company's initial public offering and the Company are parties to a certain stockholders' agreement (the "Stockholders' Agreement"), which, among other things, sets forth certain agreements regarding the designation and election of directors of the Company. As of March 1, 1997 these stockholders owned approximately 55.6% of the outstanding Common Stock. Due to their ownership position and the Stockholders' Agreement, such stockholders will retain the power to direct the Company's business and affairs through their ability to control the outcome of elections of the Company's Board of Directors and to take other actions that require the vote or approval of the stockholders of the Company.
GOVERNMENT REGULATION. The Company is subject to numerous federal, state and local government regulations, including those relating to the preparation and sale of food, the sale of alcoholic beverages, public health and building and zoning requirements. Also, the Company and its franchisees are subject to laws governing their relationship with employees, including minimum wage requirements, overtime, working conditions and citizenship requirements. The Company is also subject to federal regulation and certain state laws which govern the offer and sale of franchises. Many state franchise laws impose substantive requirements on franchise agreements, including limitations on non-competition provisions and termination or non-renewal of a franchise. Some states require that certain franchise offering materials be registered before franchises can be offered or sold in that state. The failure to obtain or retain food licenses, alcoholic beverage licenses or approvals to sell franchises could adversely affect the Company's and its franchisees' results of operations. The future enactment, adoption or amendment of laws or regulations, such as establishing basic franchisee rights, increasing the minimum wage or other costs associated with employees, could adversely affect the Company's results of operations. See "Business--Franchise Program" and "Business--Government Regulation."
TRADEMARKS AND SERVICE MARKS. The Company is aware of the use by other persons and entities in certain geographic areas of names and marks that are the same as or similar to the Company's marks. Some of these persons or entities may have prior rights to those names or marks in their respective localities. Negative publicity surrounding such businesses may adversely affect the Company's operations in those markets. In addition, the Company's marks contain common descriptive words and thus may be subject to challenge by users of these words, alone or in combination with other words, which describe other services or products. Accordingly, there is no assurance that the Company's marks will be available in all locations or that a challenge to the Company's use of such marks will not result in adverse consequences, including a judgment that would entail damages and/or the discontinuation of the Company's use of its marks. It is the Company's policy to utilize other compatible marks in areas where there are preexisting competing marks. See "Business--Trademarks and Service Marks."
CLASSIFIED BOARD OF DIRECTORS. The Company's Restated and Amended Articles of Incorporation and Restated and Amended Bylaws provide for a classified Board of Directors. The terms of each class expire in consecutive years so that only one class is elected in any given year. Such provisions could delay, deter or prevent a merger, consolidation, tender offer, or other business combination or change of control involving the Company that some or a majority of the Company's stockholders might consider to be in their best interests, including offers or attempted takeovers that might otherwise result in such stockholders receiving a premium over the market price for the Common Stock.
PREFERRED STOCK. The Company's Restated and Amended Articles of Incorporation and Restated and Amended Bylaws authorize shares of Preferred Stock with respect to which the Board of Directors of the Company have the power to fix the rights, preferences, privileges and restrictions without any further vote or action by the stockholders. Depending upon the rights of such Preferred Stock, the issuance of Preferred Stock could have an adverse effect on holders of Common Stock by delaying or preventing a change in control of the Company, diluting the voting rights of holders of Common Stock, making removal of the present management of the Company more difficult or reducing or restricting the payment of dividends and other distributions to the holders of Common Stock, including, without limitation, any liquidation preferences which may relate to such Preferred Stock. Such provisions could delay, deter or prevent a merger, consolidation, tender offer, or other business combination or change of control involving the Company that some or a majority of the Company's stockholders might consider to be in their best interests, including offers or attempted takeovers that might otherwise result in such stockholders receiving a premium over the market price for the Common Stock.
SUPERMAJORITY STOCKHOLDER VOTES. The Company's Restated and Amended Articles of Incorporation and Restated and Amended Bylaws require the affirmative vote of the holders of at least two-thirds of the outstanding capital stock in order to remove directors for cause, amend the Bylaws and approve certain business combinations with respect to a "related person." Such provisions could delay, deter or prevent a merger, consolidation, tender offer, or other business combination or change of control involving the Company that some or a majority of the Company's stockholders might consider to be in their best interests, including offers or attempted takeovers that might otherwise result in such stockholders receiving a premium over the market price for the Common Stock.
ABSENCE OF ACTIVE MARKET; VOLATILITY OF STOCK PRICE. There can be no assurance that an active market for the Company's Common Stock will exist; therefore, a purchaser of the Common Stock may not be able to readily liquidate its investment in the Common Stock. Market prices for the Common Stock may be influenced by a number of factors, including the Company's operating results and other factors affecting the Company specifically and the restaurant industry and the financial markets generally, as well as the liquidity of the market for the Common Stock. The Company believes that the market price of its Common Stock reflects expectations that the Company will be able to continue to operate its restaurants profitably and to develop new restaurants at a significant rate and operate them profitably. If the Company is unable to operate its restaurants as profitably and develop restaurants at a pace that reflects the expectations of the market, investors could sell shares of the Common Stock at or after the time that it becomes apparent that such expectations may not be realized, resulting in a decrease in the market price of the Common Stock. In recent years the stock market has experienced extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to their operating performance.
SHARES ELIGIBLE FOR FUTURE SALE. Shares of Common Stock outstanding prior to completion of the Company's initial public offering are "restricted securities" as that term is defined in Rule 144 ("Rule 144") promulgated under the Securities Act of 1933, as amended (the "Securities Act"). These "restricted securities," and any shares purchased by affiliates of the Company in such offering or thereafter may be publicly sold only if registered under the Securities Act or if sold in accordance with an available exemption from registration, such as those provided by Rule 144. No prediction can be made as to the effect, if any, that future sales of shares, or the availability of shares for future sales, will have on the
market price of the Common Stock. The sale of substantial amounts of Common Stock, or the perception that such sales could occur, could adversely affect the prevailing market price for the Common Stock.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "NYBS." For the period commencing on August 27, 1996, (the date of the Company's initial public offering) through December 29, 1996, high and low closing sale prices for the Common Stock as reported by the Nasdaq National Market were $11.13 and $5.50, respectively. Prior to the initial public offering, there was no public market for the Company's Common Stock.
The table sets forth, for the periods indicated, the reported high and low close sale prices of the Company's Common Stock, as reported on the Nasdaq National Market:
According to the records of the Company's transfer agent, the Company had 104 holders of record of the Common Stock as of March 1, 1997. The Company believes that a substantially larger number of beneficial owners hold such shares in depository or nominee form.
DIVIDENDS AND DISTRIBUTIONS
S CORPORATION DISTRIBUTIONS. From January 1, 1994 until August 25, 1996 (the "Termination Date"), the Company and certain of the Prior Entities were treated for federal and state income tax purposes as S corporations under Subchapter S of the Internal Revenue Code of 1986, as amended (the "Code"). During such period, the Company's earnings were taxed for federal and most state income tax purposes directly to the Company's stockholders, rather than to the Company. The Company is responsible for the payment of all federal and state income taxes on earnings subsequent to the Termination Date and continuing thereafter. See Notes 2 and 8 of the Notes to Consolidated Financial Statements.
Certain Prior Entities paid cash distributions to their stockholders in the aggregate amounts of approximately $2.5 million during 1995. The distributions made in 1995 were in excess of the earnings of such Prior Entities and were partially funded by borrowings of such Prior Entities which were assumed by the Company in connection with the Reorganization. The Company repaid all of its bank borrowings with a portion of the net proceeds of its initial public offering. The Company used a portion of the net proceeds of its initial public offering to fund a distribution on March 4, 1997 of $156,000 to the stockholders that existed prior to the Company's initial public offering in connection with their estimated federal and state income tax obligations attributable to the Company's 1996 earnings through the Termination Date. Under federal tax laws, if the Company failed to distribute its undistributed S corporation earnings within a limited period of time following the Termination Date, a later distribution could be taxed as a dividend to the stockholders. No S corporation distributions have been or are anticipated to be made to the stockholders in connection with the Company's earnings for any period after the Termination Date.
DIVIDEND POLICY. The Company currently intends to retain all earnings to provide funds for its operations and expansion, and therefore does not anticipate paying cash dividends or making any other distributions on its shares of Common Stock in the foreseeable future. The Company's future dividend policy will be determined by its Board of Directors based on various factors, including the Company's results of operations, financial condition, business opportunities, capital requirements, credit restrictions and such other factors as the Board of Directors may deem relevant.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected consolidated financial data for the Company at the dates and for the periods indicated. The selected consolidated financial data at December 31, 1994 and 1995 and December 29, 1996 and for each of the years in the three-year period ended December 31, 1995 and for the fifty-two weeks ended December 29, 1996 have been derived from the audited Consolidated Financial Statements of the Company. The selected consolidated financial data at December 31, 1992 and 1993, and for the year ended December 31, 1992, have been prepared on the same basis as the audited financial statements, have been derived from the unaudited financial statements of the Company for such periods and include, in the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for the fair presentation of the financial position and results of operations at and for such periods. Selected financial data should be read in conjunction with, and is qualified in its entirety by, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company and the Notes thereto appearing herein.
- ------------------------
(1) The Company acquired seven restaurants in December 1996, a restaurant in September 1996 and two restaurants in December 1995. If such transactions had occurred on January 1, 1996 and January 1, 1995, respectively, "Total revenues," "Net earnings" and "Net earnings per share" would have been approximately $15,315,000, $647,000 and $0.18, respectively, for the fifty-two weeks ended December 29, 1996 and $12,104,000, $264,000 and $0.09, respectively, for the year ended December 31, 1995, on a pro forma basis. The pro forma results do not necessarily reflect what would have occurred if the acquisitions had been made at the beginning of the respective periods or the results that may occur in the future. See Note 11 of the Notes to Consolidated Financial Statements.
(2) Effective January 1, 1996, the Company elected to change its fiscal year end from a calendar year end to a 52/53-week fiscal year, ending on the last Sunday of the year, which consists of four 13-week periods.
(3) Reflects a pro forma adjustment assuming the Company had been treated as a C corporation rather than as an S corporation for income tax purposes for the periods presented. See "Market for Registrant's Common Equity and Related Stockholder Matters-Dividends and Distributions-S Corporation Distributions" and Notes 2(h) and 2(k) of the Notes to Consolidated Financial Statements.
(4) See Note 2(k) of the Notes to Consolidated Financial Statements.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS FORM 10-K ARE FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY, INCLUDING, WITHOUT LIMITATION, RISKS ASSOCIATED WITH THE COMPANY'S ABILITY TO SUCCESSFULLY AND TIMELY INTEGRATE CERTAIN ACQUISITIONS, INCLUDING THE LOTS A' BAGELS RESTAURANTS AND BAGEL COMMISSARY, THE COMPANY'S ABILITY TO DEVELOP, CONSTRUCT, ACQUIRE OR FRANCHISE ADDITIONAL RESTAURANTS IN ACCORDANCE WITH THE COMPANY'S DEVELOPMENT SCHEDULE, MANAGEMENT OF QUARTER TO QUARTER EARNINGS AND INCREASES IN OPERATING COSTS. CERTAIN OF THESE RISKS ARE SET FORTH IN THE "RISK FACTORS" SECTION OF THIS FORM 10-K. UPDATED INFORMATION WILL BE PERIODICALLY PROVIDED BY THE COMPANY AS REQUIRED BY THE SECURITIES EXCHANGE ACT OF 1934.
The Company opened its first restaurant in 1986, and has developed, as of March 1, 1997, 24 of its 36 Company-owned restaurants in Oklahoma, Kansas, Tennessee, Texas and Missouri. In addition to developing new restaurants, as of March 1, 1997 the Company has acquired one bagel restaurant in Tennessee, seven Lots A' Bagels restaurants in Colorado and four franchised New York Bagel restaurants in Kansas, New Mexico and Texas. The Company commenced franchising the New York Bagel concept in 1993 and has 19 franchisees operating 32 restaurants. See Note 11 of the Notes to Consolidated Financial Statements.
The Company's business was previously operated through the Prior Entities. The Company was incorporated in December 1995 under the laws of Kansas, and on December 31, 1995, the Prior Entities were merged into the Company (the "Reorganization"). The financial statements herein include the
results of operations of the Prior Entities on a combined basis for all periods. See Note 1 of the Notes to Consolidated Financial Statements.
The Company's revenues are derived from sales from Company-owned restaurants and franchise revenues, which consist of royalties from franchised restaurant sales as well as franchise and development fees. Franchise and development fees are initially recorded as deferred revenue until each franchised restaurant opens, at which time these fees are recorded as revenue.
Cost of sales includes food, paper and beverage costs associated with Company-owned restaurants. Restaurant operating expenses consist primarily of labor costs, rent, advertising, utilities, maintenance and insurance associated with Company-owned restaurants. General and administrative expenses include corporate and administrative salaries, accounting, legal and direct costs associated with franchise operations.
RESULTS OF OPERATIONS
The following table sets forth the percentage relationship of certain operating statement data to total revenues, except as otherwise indicated:
- ------------------------
(1) As a percentage of sales from Company-owned restaurants.
FISCAL YEAR 1996 COMPARED TO FISCAL YEAR 1995
Total revenues increased by $4.2 million, or 56.8%, to $11.6 million for 1996 compared to $7.4 million for 1995, primarily due to an increase in the number of Company-owned and franchised restaurants open.
Sales from Company-owned restaurants increased $4.0 million, or 58.0%, to $10.9 million for 1996 compared to $6.9 million for 1995. This is primarily the result of opening nine restaurants throughout 1996, acquiring seven restaurants in December 1996 and acquiring one restaurant in September 1996. In addition, the Company experienced a 4.4% increase in same restaurant sales (sales from restaurants that were open during the entire period indicated and the entire corresponding prior period) during 1996. At December 29, 1996, the Company had 33 Company-owned restaurants compared to 15 restaurants at December 31, 1995.
Franchise revenues increased by $188,000, or 38.8%, to $672,000 for 1996 compared to $484,000 for 1995. This increase is primarily due to the full year of royalty revenues from franchise restaurants opened in 1995 and the new franchise restaurants opened in 1996. There were 33 franchised restaurants at the end
of 1996 and 25 franchised restaurants at the end of 1995, which impacted both initial franchise fees and royalty revenue. Initial franchise and development fees decreased $22,000, or 8.8%, to $229,000 for 1996 compared to $251,000 for 1995, due to a decrease in the number of franchise restaurants opened in 1996 as compared to 1995. Franchise royalty revenue increased by $210,000, or 89.7%, to $444,000 for 1996 compared to $234,000 for 1995.
Cost of sales increased by $1.1 million, or 43.5%, to $3.7 million for 1996 compared to $2.6 million for 1995. This increase is primarily attributable to the increase in sales from Company-owned restaurants. As a percentage of sales from Company-owned restaurants, cost of sales decreased to 34.5% in 1996 from 38.0% in 1995 as a result of purchasing and operating efficiencies, portioning refinements and, to a lesser extent, modest price increases in 1996. Prices of the Company's commodities (meat and cheese, flour and other bakery ingredients) have generally remained stable during the comparable periods.
Restaurant operating expenses increased by $2.1 million, or 68.1%, to $5.2 million for 1996 compared to $3.1 million for 1995. This increase is primarily due to the increase in sales from Company-owned restaurants discussed above. As a percentage of sales from Company-owned restaurants, restaurant operating expenses increased to 47.7% for 1996 from 44.9% for 1995. This increase is primarily the result of remodeling five Company-owned restaurants for an aggregate of 16 weeks in 1996. The increase is also attributable to increased labor costs as a result of an increase in the minimum wage rate. Finally, labor and occupancy rates associated with the Nashville market, a market developed in 1996 with the acquisition of a bagel restaurant in December 1995 and the opening of three additional New York Bagel restaurants in 1996, are higher than rates historically experienced by Company-owned restaurants.
General and administrative expenses increased by $126,000, or 15.0% to $964,000 for 1996 compared to $838,000 for 1995. This increase is primarily attributable to the continued growth of the Company. As a percentage of total revenues, general and administrative expenses decreased to 8.4% in 1996 from 11.4% in 1995, primarily as a result of increased economies of scale in management infrastructure as it relates to new Company-owned and franchised restaurant activities.
Depreciation and amortization increased by $393,000, or 247.4%, to $552,000 for 1996 compared to $159,000 for 1995. As a percentage of total revenues, depreciation and amortization increased to 4.8% for 1996 from 2.2% in 1995. This increase is primarily attributable to the significant addition of capital expenditures to develop and acquire the additional Company-owned restaurants discussed above.
Interest expense increased by $198,000 to $238,000 for 1996 compared to $40,000 for 1995 as a result of increased bank borrowings during the first seven months of 1996.
Interest income was $152,000 in 1996 compared to $0 for 1995 as a result of investing proceeds from the initial public offering in interest-bearing, short-term, investment grade securities until such proceeds are used to fund Company growth.
Income tax expense increased by $263,000 to $270,000 for 1996 compared to $7,000 for 1995 as a result of the Company changing from an S corporation to a C corporation concurrent with the Company's initial public offering of its Common Stock. See Note 8 of Notes to Consolidated Financial Statements.
FISCAL YEAR 1995 COMPARED TO FISCAL YEAR 1994
Total revenues increased by $1.5 million, or 26.4%, to $7.4 million for 1995 compared to $5.8 million for 1994, primarily due to an increase in the number of Company-owned and franchised restaurants open.
Sales from Company-owned restaurants increased $1.2 million, or 21.6%, to $6.9 million for 1995 compared to $5.7 million for 1994. This is primarily the result of the opening of one additional Company-owned restaurant in October 1995 and two additional Company-owned restaurants in late 1994. In
addition, the Company experienced an 9.8% increase in same restaurant sales during 1995. At December 31, 1995, the Company had 15 Company-owned restaurants compared to 12 restaurants at December 31, 1994.
Franchise revenues increased by $315,000, or 187.1%, to $484,000 for 1995 compared to $169,000 for 1994. This increase is primarily due to the opening of franchised restaurants in 1995. There were 25 franchised restaurants at the end of 1995 and nine franchised restaurants at the end of 1994, which impacted both franchise fees and royalty revenue. Franchise and development fees increased $143,000, or 132.4%, to $251,000 for 1995 compared to $108,000 for 1994. Franchise royalty revenue increased by $173,000, or 283.6%, to $234,000 for 1995 compared to $61,000 for 1994.
Cost of sales increased by $333,000, or 14.6%, to $2.6 million for 1995 compared to $2.3 million for 1994. This increase is primarily attributable to the increase in sales from Company-owned restaurants. As a percentage of sales from Company-owned restaurants, cost of sales decreased to 38.0% in 1995 from 40.3% in 1994 as a result of purchasing and operating efficiencies and portioning refinements achieved in 1995. Prices of the Company's commodities (meat and cheese, flour and other bakery ingredients) have generally remained stable during the comparable periods.
Restaurant operating expenses increased by $758,000, or 32.6%, to $3.1 million for 1995 compared to $2.3 million for 1994. This increase is primarily due to the increase in sales from Company-owned restaurants discussed above and to approximately two weeks of operating expenses attributable to the acquisition of the bagel restaurant in Tennessee subsequent to its acquisition by the Company on December 14, 1995. As a percentage of sales from Company-owned restaurants, restaurant operating expenses increased to 44.9% for 1995 from 41.1% for 1994. This increase is primarily the result of higher operating expenses attributable to a restaurant which opened in October 1995, the above acquisition and two restaurants which were closed for remodeling during a portion of the fourth quarter of 1995.
General and administrative expenses increased by $386,000, or 85.5%, to $838,000 for 1995 compared to $452,000 for 1994. This increase is primarily attributable to the increase in franchise activity and to merger-related expenses related to the Reorganization in 1995. As a percentage of total revenues, general and administrative expenses increased to 11.4% in 1995 from 7.8% in 1994, primarily as a result of the further development of the franchise program.
Depreciation and amortization increased by $42,000, or 35.9%, to $159,000 for 1995 compared to $117,000 for 1994. As a percentage of total revenues, depreciation and amortization increased to 2.2% for 1995 from 2.0% in 1994. This increase is primarily attributable to the opening of the additional restaurants discussed above.
Interest expense decreased by $12,000 to $40,000 for 1995 compared to 52,000 for 1994. This decrease in interest expense is primarily the result of lower bank borrowings during 1995.
LIQUIDITY AND CAPITAL RESOURCES
The Company requires capital primarily for the development of new restaurants, possible acquisitions and the remodeling of existing Company-owned restaurants. Capital expenditures totaled $285,000, $475,000 and $4.7 million for 1994, 1995 and 1996, respectively. Acquisition expenditures totaled $656,000 and $2.5 million for 1995 and 1996, respectively. Prior to the Company's initial public offering, the Company historically funded its capital expenditures with cash provided by operations and bank borrowings. Net cash provided by operating activities was $696,000, $777,000 and $1.3 million for 1994, 1995 and 1996, respectively.
At June 30, 1996, the Company had outstanding bank borrowings of $3.8 million consisting of (i) $2.5 million under a loan agreement which accrued interest at the prime rate plus 1.0% and matures on December 28, 2000, (ii) aggregate outstanding borrowings under certain term notes of $800,000, each of which accrued interest at the prime rate plus 0.5% and have a maturity date of June 15, 2003 and
(iii) $487,000 under a certain promissory note which accrued interest at the prime rate plus 0.5% and matures on March 26, 2003. Subsequent to June 30, 1996, the Company incurred additional bank borrowings to finance capital expenditures of $747,500, consisting of (i) $300,000 under a certain promissory note which accrued interest at the prime rate plus 0.5% and matures on January 10, 2007, (ii) $125,000 under a certain promissory note which accrued interest at the prime rate plus 0.5% and matures on October 8, 2001, (iii) $172,500 under a certain promissory note which accrued interest at the prime rate plus 0.5% and matures on July 8, 2001, and (iv) $150,000 under a certain promissory note which accrued interest at the prime rate plus 0.5% and matures on October 15, 2003. The outstanding indebtedness under these bank financings, which were secured by substantially all of the assets of the Company, were repaid from the proceeds of the Company's initial public offering.
The Company distributed $156,000 on March 4, 1997 to the stockholders existing prior to its initial public offering in connection with their estimated federal and state income tax obligations attributable to the Company's 1996 earnings prior to the Termination Date. See "Market for Registrant's Common Equity and Related Stockholder Matters--Dividends and Distributions--S Corporation Distributions."
Based on its contemplated expansion plans, the Company estimates that its total capital expenditures will be approximately $4.0 million in 1997 and $5.5 million in 1998. These estimates include the estimated costs of developing new restaurants and renovating Company-owned restaurants. The Company expects that the remaining net proceeds of its initial public offering and cash provided by operating activities will provide sufficient funds to finance its capital expenditures through 1997.
INFLATION
The Company believes that the relatively moderate rates of inflation over the past few years have not had a significant impact on its results of operations or net sales.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the Consolidated Financial Statements referred to in the Index on page setting forth the consolidated financial statements of New York Bagel Enterprises, Inc. and Subsidiary, together with the report of KPMG Peat Marwick LLP dated February 21, 1997.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by this Item 10 is incorporated herein by reference to "Directors and Executive Officers of the Company" in the Company's Proxy Statement.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item 11 is incorporated herein by reference to "Executive Compensation--Compensation Committee Interlocks and Insider Participation, --Summary Compensation Table, -- Stock Option Grant Table, - --Aggregate Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values Table, --Employment Arrangements, and --Incentive Plan" and "Directors and Executive Officers of the Company--Compensation of Directors" in the Company's Proxy Statement.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this Item 12 is incorporated herein by reference to "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item 13 is incorporated herein by reference to "Certain Relationships and Related Transactions" in the Company's Proxy Statement.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS. Reference is made to the Index to Consolidated Financial Statements on page for a list of all financial statements filed as part of this Report.
(a)(2) FINANCIAL STATEMENT SCHEDULES. Reference is made to the Index to Financial Statements on page for a list of all financial statement schedules filed as part of this Report.
(a)(3) EXHIBITS. Reference is made to Item 14(c) of this Report.
(b) REPORTS ON FORM 8-K. A current report was filed on December 23, 1996 with respect to the acquisition of Lots A' Bagels, Inc.
REPORTS ON FORM 8-K/A. An amendment to the 8-K was filed on February 18, 1997 with respect to the acquisition of Lots A' Bagels, Inc. including the following financial statements:
(c) EXHIBITS.
NEW YORK BAGEL ENTERPRISES, INC.
INDEX TO EXHIBITS
- ------------------------
* Incorporated by reference from Exhibit No. 2 of the Company's Form 8-K filed December 23, 1996.
+ Incorporated by reference from Exhibit No. 4 of the Company's Form 8-K filed December 23, 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized this 27th day of March, 1997.
NEW YORK BAGEL ENTERPRISES, INC.
By: /s/ ROBERT J. GERESI ----------------------------------------- Robert J. Geresi CHIEF EXECUTIVE OFFICER AND PRESIDENT
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - ------------------------------ -------------------------- -------------------
Chairman of the Board, /s/ ROBERT J. GERESI Chief Executive Officer - ------------------------------ and President (Principal March 27th, 1997 Robert J. Geresi Executive Officer)
Chief Financial Officer, /s/ JON H. CRAMER Secretary and Treasurer - ------------------------------ (Principal Financial and March 27th, 1997 Jon H. Cramer Accounting Officer)
/s/ PAUL T. SORRENTINO - ------------------------------ Vice President--New Store March 27th, 1997 Paul T. Sorrentino Development and Director
/s/ PAUL R. HOOVER - ------------------------------ Vice President--Strategic March 27th, 1997 Paul R. Hoover Planning and Director
/s/ WILLIAM S. ATHERTON - ------------------------------ Director March 27th, 1997 William S. Atherton
/s/ STANLEY K. CLARK - ------------------------------ Director March 27th, 1997 Stanley K. Clark
/s/ DAVID L. MURFIN - ------------------------------ Director March 27th, 1997 David L. Murfin
/s/ WILLIAM J. WALSH, JR. - ------------------------------ Director March 27th, 1997 William J. Walsh, Jr.
NEW YORK BAGEL ENTERPRISES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
The Board of Directors New York Bagel Enterprises, Inc.:
We have audited the accompanying consolidated balance sheets of New York Bagel Enterprises, Inc. as of December 29, 1996 and December 31, 1995, and the consolidated statements of operations, stockholders' equity (deficit), and cash flows for the fifty-two weeks ended December 29, 1996 and for each of the years in the two-year period ended December 31, 1995. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of New York Bagel Enterprises, Inc. as of December 29, 1996 and December 31, 1995, and the results of its operations and its cash flows for the fifty-two weeks ended December 29, 1996 and for each of the years in the two-year period ended December 31, 1995, in conformity with generally accepted accounting principles.
KPMG Peat Marwick LLP
Wichita, Kansas February 21, 1997
NEW YORK BAGEL ENTERPRISES, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 29, 1996 AND DECEMBER 31, 1995
ASSETS
See accompanying notes to consolidated financial statements.
NEW YORK BAGEL ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE FIFTY-TWO WEEKS ENDED DECEMBER 29, 1996 AND THE YEARS ENDED DECEMBER 31, 1995 AND 1994
See accompanying notes to consolidated financial statements.
NEW YORK BAGEL ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
FOR THE FIFTY-TWO WEEKS ENDED DECEMBER 29, 1996 AND THE YEARS ENDED DECEMBER 31, 1995 AND 1994
See accompanying notes to consolidated financial statements.
NEW YORK BAGEL ENTERPRISES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE FIFTY-TWO WEEKS ENDED DECEMBER 29, 1996 AND THE YEARS ENDED DECEMBER 31, 1995 AND 1994
See accompanying notes to consolidated financial statements.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) REORGANIZATION AND OPERATIONS
REORGANIZATION
The Company was formed as a result of a merger (the Merger) between New York Bagel Enterprises, Inc., which became the surviving corporation, and New York Bagel Shop, Inc.; New York Bagel Shop & Delicatessen, Inc.; Bagels of Norman, Inc.; Bagel Boss, Inc.; and VPR Incorporated (the five restaurant entities). The Merger was effective on December 31, 1995 whereby each of the five restaurant entities were merged into New York Bagel Enterprises, Inc. (collectively the five restaurant entities and New York Bagel Enterprises, Inc. are referred to as the Prior Entities). The term Company as used herein refers to New York Bagel Enterprises, Inc. including the five restaurant entities unless the context otherwise requires.
To effect the Merger, New York Bagel Enterprises, Inc. issued 1,368,704 shares of its Class B non-voting common stock in exchange for all the outstanding stock of each of the five restaurant entities.
Since the primary stockholders of each of the five restaurant entities prior to the Merger were also the primary stockholders of the Company subsequent to the Merger, the Merger essentially represents a transfer to New York Bagel Enterprises, Inc. of nonmonetary assets in exchange for stock and has been accounted for at historical cost.
The accompanying financial statements for periods prior to the effective date of the Merger are presented on a combined basis since this is the most meaningful presentation of the business and due to substantial commonality of ownership and management of the Prior Entities throughout such prior periods.
The Company converted the number of shares of Class A common stock outstanding in connection with the Merger (effectively a 3373.78:1 stock split). The outstanding shares of common stock, as reflected in the accompanying financial statements, include the effect of such stock conversion and the shares issued to effect the Merger for all periods presented.
On June 4, 1996, the Company effected a 1.4 for 1 stock split. The stock split has been reflected in the accompanying financial statements and, accordingly, all applicable dollar and share amounts have been restated to reflect the stock split.
Effective August 27, 1996, the Company completed an initial public offering (IPO) in which it sold 1,867,500 shares of its Class A common stock and realized net proceeds, net of offering costs of $951,943, of $14,679,032. Concurrent with the IPO, (i) the number of authorized shares of Class A common stock increased to 30,000,000, (ii) each share of outstanding Class B non-voting common stock was converted into one share of Class A common stock, and (iii) the Class B non-voting common stock ceased to exist.
OPERATIONS
The Company owns and franchises New York Bagel and Lots A' Bagels restaurants that provide a wide variety of bagels that are made from scratch, boiled and baked in the traditional "New York style". Breakfast menu items include a wide variety of bagels and custom-blended cream cheeses, gourmet coffees, muffins and croissants. Lunch and dinner items include an assortment of bagel delicatessen sandwiches, prepared salads, cookies and soft drinks. As of December 29, 1996, the Company has 33 Company-owned restaurants (15 at December 31, 1995) primarily located in Oklahoma, Kansas, Colorado and Tennessee and 33 franchised restaurants (25 at December 31, 1995) located throughout the United States.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of New York Bagel Enterprises, Inc. and its wholly-owned subsidiary. All material intercompany activity has been eliminated.
(b) FRANCHISE REVENUES
Franchise agreements are executed for each franchise restaurant and provide the terms of the franchise arrangement between the Company and the franchisee. The franchise agreement requires the franchisee to pay an initial, non-refundable franchise fee plus continuing royalties based upon a percentage of restaurant sales. Additionally, the Company executes development agreements with certain franchisees which stipulates the area, the number of restaurants, and the timeframe for development in exchange for an initial, non-refundable development fee based on a standard price per type of restaurant.
Initial franchise fees are recognized as revenue when the Company performs substantially all initial services required by the franchise agreement, which generally occurs shortly after restaurant opening. Continuing royalties are recognized as earned with an appropriate provision for estimated uncollectible amounts. Initial franchise fees received applicable to restaurants for which substantially all initial services required by the franchise agreement have not been performed are recorded as deferred franchise fees in the accompanying balance sheets. Development fees are received upon signing the agreement and are initially recorded as deferred franchise fees. Such fees are applied to reduce the initial franchise fees paid for each restaurant opened and are accounted for as a component of the initial franchise fees.
Deferred initial and development fees that are expected to be recognized within twelve months of the balance sheet date are classified as current portion of deferred franchise fees in the accompanying balance sheets.
(c) INVESTMENT SECURITIES AVAILABLE FOR SALE
Investment securities at December 29, 1996 consist of highly liquid debt securities with maturities of less than six months. The Company classifies its debt securities as available for sale which are recorded at fair value. Unrealized holding gains and losses, net of related tax effect, on available for sale securities are excluded from earnings and are reported as a separate component of stockholders' equity until realized. Realized gains and losses from sales and maturities of available for sale securities are determined on a specific identification basis.
Gross unrealized holding gains and gross unrealized holding losses were immaterial as of December 29, 1996.
(d) INVENTORIES
Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method.
(e) DEFERRED FRANCHISE COSTS
Direct, incremental costs incurred to secure franchise agreements are charged to expense in the same period the related initial franchise fees are recognized as revenue. Costs applicable to initial franchise fees not yet recognized as revenue are recorded as deferred franchise costs.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (f) PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on a straight-line basis over the lesser of the remaining lease term, including renewal periods when the Company intends to exercise renewal options, or the estimated useful life of the asset. Estimated useful lives are as follows:
(g) GOODWILL
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over 20 years. The Company periodically assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill impairment, if any, is measured based on projected future operating cash flows discounted at a rate commensurate with the risks involved. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved.
(h) INCOME TAXES
Effective January 1, 1994, New York Bagel Enterprises, Inc. and certain of the restaurant entities elected and received approval to become S corporations. During the periods the entities operated as S corporations, income tax expense or benefit was not recorded in the accompanying financial statements as the entities' results of operations were reported to the entities' stockholders for inclusion in their individual income tax returns.
Concurrent with the IPO, the Company terminated its S corporation status. Accordingly, income taxes subsequent to the effective date of the IPO are accounted for under the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Any effect on deferred tax assets and liabilities due to a change in tax rates is recognized in income in the period that includes the enactment date.
(i) STATEMENTS OF CASH FLOWS
For purposes of the consolidated statements of cash flows, the Company considers cash and cash equivalents to include currency on hand, demand deposits and money market funds.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Noncash investing and financing activities during 1996, 1995 and 1994 included:
(j) PREOPENING COSTS
Direct, incremental restaurant preopening costs, comprised primarily of the cost of hiring and training restaurant employees and rent, are amortized over the initial twelve months of a restaurant's operations.
(k) PRO FORMA INCOME TAX EXPENSE AND PRO FORMA NET EARNINGS PER SHARE
PRO FORMA INCOME TAX EXPENSE
Subsequent to the IPO, the Company no longer operates as an S corporation. Pro forma income tax expense, as set forth in the accompanying 1996 and 1995 statements of operations, reflects what the income tax expense of the Company would have been for the fifty-two weeks ended December 29, 1996 and the year ended December 31, 1995 if none of the entities included in the financial statements had operated as S corporations during such periods.
PRO FORMA NET EARNINGS PER SHARE
Pro forma net earnings per share information, as set forth in the accompanying statements of operations, is computed based on pro forma net earnings of $610,475 and $380,158 which is based on reported earnings before income taxes less pro forma income tax expense of $389,505 and $245,628 for the fifty-two weeks ended December 29, 1996 and the year ended December 31, 1995, respectively.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Pro forma weighted average common shares outstanding have been determined as follows:
The effect on pro forma earnings per share of stock options and a convertible debenture were excluded from the determination of pro forma weighted average common shares outstanding due to immateriality.
(l) USE OF ESTIMATES
The preparation of financial statements in accordance with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.
(m) STOCK AWARDS
The Company accounts for its stock options in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, which permits entities to continue to apply the cost measurement provisions of APB Opinion No. 25 but also requires that pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1996 and future years be provided as if the fair-value- based cost measurement method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.
(n) FISCAL PERIODS
Prior to 1996, the Company's financial reporting was done on a calendar basis. Effective January 1, 1996, the Company changed to a 52/53-week fiscal year comprised of four thirteen-week periods.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (o) IMPAIRMENT OF LONG-LIVED ASSETS
The Company adopted the provisions of SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, on January 1, 1996. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Adoption of this Statement did not have an impact on the Company's financial position, results of operations, or liquidity in 1996.
(3) FRANCHISE REVENUES
Franchise revenues for the fifty-two weeks ended December 29, 1996 and the years ended December 31, 1995 and 1994 consist of the following:
The associated franchise receivables included within accounts receivable in the accompanying balance sheets at December 29, 1996 and December 31, 1995 are as follows:
(4) DEFERRED COSTS
Deferred costs as of December 29, 1996 and December 31, 1995 include the following:
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(5) PROPERTY, PLANT AND EQUIPMENT
A summary of property, plant and equipment and accumulated depreciation as of December 29, 1996 and December 31, 1995 is as follows:
(6) LEASES
The Company leases several restaurant facilities under noncancelable operating leases. These leases generally contain renewal options for periods ranging from 3 to 15 years and require the Company to pay executory costs such as maintenance and insurance. Rent expense for operating leases aggregated $631,021, $296,950 and $193,418 for the fifty-two weeks ended December 29, 1996 and the years ended December 31, 1995 and 1994, respectively.
Future minimum lease payments under noncancelable operating leases with initial or remaining lease terms in excess of one year as of December 29, 1996 are:
The Company is party to certain operating leases with companies that are owned by certain stockholders of the Company. Rent expense paid to these related companies pursuant to lease agreements aggregated $60,177, $63,249 and $14,100 in 1996, 1995 and 1994, respectively.
Deferred rents payable in the accompanying balance sheets represent accruals for escalating rental payments on operating leases.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(7) LONG-TERM DEBT
Long-term debt at December 29, 1996 and December 31, 1995 consists of the following:
The aggregate maturities of long-term debt for each of the three years subsequent to December 29, 1996 are as follows: 1997--$28,750; 1998--$28,750; and 1999--$28,750.
(8) INCOME TAXES
Income tax expense (benefit) for the fifty-two weeks ended December 29, 1996 and the years ended December 31, 1995 and 1994 consists of the following:
As described in note 2, certain entities included in the consolidated financial statements elected S corporation status as of January 1, 1994, and as a result did not pay corporate income taxes. Additionally, as a result of the Merger discussed in note 1, the consolidated Company was an S corporation effective December 31, 1995 and, accordingly, no deferred tax assets or liabilities are recorded in the accompanying 1995 consolidated balance sheet. Consequently, income tax expense (benefit) for the years ended December 31, 1995 and 1994 include the reversal of existing deferred tax assets and liabilities for those entities which first became S corporations in each year. Finally, concurrent with the IPO, the Company terminated its S corporation status and, consequently, incurred a one-time charge of $74,000 to deferred tax expense to properly record deferred tax assets and liabilities that existed as of the effective date of the IPO.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8) INCOME TAXES (CONTINUED) Actual income tax expense (benefit) differs from the "expected" tax expense computed by applying the U.S. Federal corporate tax rate of 34% to earnings before income taxes for the fifty-two weeks ended December 29, 1996 and the years ended December 31, 1995 and 1994 as follows:
The tax effects of temporary differences that give rise to deferred tax assets and deferred tax liabilities at December 29, 1996 are presented below:
(9) STOCKHOLDERS' EQUITY
CAPITAL CONTRIBUTIONS AND DISTRIBUTIONS TO STOCKHOLDERS
In July 1994, pursuant to a contract for sale of stock (the contract) of New York Bagel Enterprises, Inc. (NYBE), the then existing stockholders (sellers) of NYBE sold a 50% ownership interest in NYBE to certain individuals (buyers) in exchange for a cash payment from the buyers directly to the sellers and a $50,000 contribution by the buyers to NYBE of which $49,250 has been recorded as contributed
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(9) STOCKHOLDERS' EQUITY (CONTINUED) capital and $750 has been applied as payment of amounts owed to NYBE by the sellers. The remaining $1,000 of capital contribution in 1994 was a cash contribution to one of the five restaurant entities. Pursuant to the contract, NYBE is obligated to pay to the sellers (as distributions) collections of franchise fees NYBE receives subsequent to closing of the contract for certain specified locations. To the extent such fees have been recognized as income but have not yet been distributed to the sellers, such amounts are recorded as distributions payable in the accompanying balance sheets.
In 1996, as a result of the Company's termination of its S corporation status immediately prior to the effective date of the IPO, the Company declared a distribution to the then current stockholders in an amount commensurate with their federal and state income tax obligations arising from the Company's 1996 results of operations while an S corporation which are reported to the stockholders for inclusion in their individual income tax returns. The distribution has been accrued and is included in distributions payable at December 29, 1996.
Distributions to stockholders for the fifty-two weeks ended December 29, 1996 and the years ended December 31, 1995 and 1994 are comprised of the following:
As disclosed in note 2(i), distributions of the five restaurant entities include two transfers to certain stockholders in 1994 of real estate net of related indebtedness and the transfer in 1995, prior to the Merger, of certain assets and liabilities (primarily restaurant related current assets and liabilities) to the stockholders of the five restaurant entities.
(10) FINANCIAL INSTRUMENTS FAIR VALUE INFORMATION
The carrying value of the Company's long-term debt approximates its fair value based on current interest rates of similar instruments. The carrying values of the Company's other financial instruments at December 29, 1996, including cash and cash equivalents, investment securities available for sale, accounts receivable, other current assets, accounts payable, and accrued expenses approximate their fair values because of their short maturity.
(11) ACQUISITIONS
Effective December 6, 1996, the Company purchased substantially all of the operating assets and business operations and assumed certain liabilities of Lots A' Bagels, Inc. for an initial cash payment of $2,100,000. In addition, certain contingent consideration, potentially comprised of promissory notes, additional cash, and issuance of a warrant to purchase the Company's common stock, may be paid as additional purchase price based on Lots A' Bagels, Inc.'s earnings (as defined in the purchase agreement) for the period July 1, 1996 through March 30, 1997. Acquisition expenses incurred through December 29, 1996 amounted to $81,869. The acquisition has been accounted for by the purchase method of accounting and, accordingly, the operations of Lots A' Bagels, Inc. have been included in the accompanying statements
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(11) ACQUISITIONS (CONTINUED) of operations subsequent to December 6, 1996. The initial purchase price has been allocated to the assets and liabilities acquired based on their estimated fair values at date of acquisition. Goodwill as of December 29, 1996 arising from the acquisition amounted to $279,124.
Effective September 27, 1996, the Company purchased certain assets of Jeff Eateries Limited Partnership for $245,000. The acquisition has been accounted for by the purchase method of accounting. The purchase price has been allocated to the assets acquired based on their estimated fair values at date of acquisition. Goodwill arising from the acquisition amounted to $94,182.
Effective December 14, 1995, the Company purchased all the outstanding common stock of Nashville Bagel Co., Inc. for $565,000. Acquisition expenses amounted to $23,338. The acquisition has been accounted for by the purchase method of accounting and, accordingly, the operations of Nashville Bagel Co., Inc. have been included in the accompanying statements of operations subsequent to December 14, 1995. The purchase price has been allocated to the assets and liabilities acquired based on their estimated fair values at date of acquisition. Goodwill arising from the acquisition amounted to $434,451.
Effective December 31, 1995, the Company purchased certain assets of Central & Ridge Yogurt, Inc. by assuming liabilities amounting to $225,000. The acquisition has been accounted for by the purchase method of accounting. The purchase price has been allocated to the net assets acquired based on their estimated fair values at date of acquisition. Goodwill arising from the acquisition amounted to $24,600. A Company officer was also an officer and stockholder of Central & Ridge Yogurt, Inc.
The following table summarizes the pro forma results of operations for the fifty-two weeks ended December 29, 1996 and the years ended December 31, 1995 and 1994 as if the acquisitions consummated in 1996 had been consummated at the beginning of 1996 and 1995, respectively, and the acquisitions consummated in 1995 had been consummated at the beginning of 1995 and 1994, respectively. In presenting the pro forma information, depreciation, amortization and interest expense have been adjusted to reflect the purchase accounting recorded in the acquisitions and income taxes have been recognized as if none of the entities included in the pro forma results had operated as an S corporation. The pro forma results do not necessarily reflect what would have occurred if the acquisitions had been made at the beginning of the respective periods or the results that may occur in the future.
(12) STOCK AWARDS
In 1996, the Company adopted the 1996 Incentive Plan (the Plan) pursuant to which the Company may grant incentive stock options, nonqualified stock options or restricted stock to officers, directors, employees, consultants and advisors. The Plan authorizes grants of up to 400,000 shares of authorized but unissued common stock. In addition to the stock options granted under the Plan, the Company entered into nonqualified stock option agreements with two of its non-employee directors to purchase a total of 35,000 shares of authorized but unissued common stock. Stock options are granted with an exercise price equal to the stock's fair market value at the date of grant except for options granted to employees and directors that are also greater than 10% stockholders of the Company in which case such options are
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(12) STOCK AWARDS (CONTINUED) granted with an exercise price equal to 110% of the stock's fair market value at the date of grant. Stock options granted in 1996 have terms of either ten years or five years. One-fifth of the options are exercisable six months after date of grant and one-fifth on each of the first four anniversaries of the date of grant.
At December 29, 1996, there were 138,500 additional shares available for grant under the Plan. The per share weighted-average fair value of stock options granted during 1996 was $3.70 on the date of grant using the Black Scholes option-pricing model with the following weighted average assumptions: expected dividend yield 0%, expected volatility of 38.5%, risk-free interest rate of 6.58%, and an expected life of 5 years.
The Company applies APB Opinion No. 25 in accounting for its stock options and, accordingly, no compensation cost has been recognized for its stock options in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's 1996 pro forma net earnings and pro forma net earnings per share would have been reduced to the pro forma amounts indicated below.
Stock option activity during 1996 is as follows:
At December 29, 1996, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $6.125 - $9.90 and 8.22 years, respectively.
At December 29, 1996, the number of options exercisable was 47,300 and the weighted-average exercise price of those options was $9.29.
NEW YORK BAGEL ENTERPRISES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(13) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
Financial results by quarter are as follows:
- ------------------------
(a) Gross profit is sales from Company-owned restaurants less cost of sales.
(b) Pro forma net earnings and net earnings per share is based on reported earnings before income taxes less pro forma income tax expense.