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Daily Trouble
November 9, 1999

Schlotzsky's Inc.

Ticker: (Nasdaq: BUNZ)
Phone: 512-236-3600
Website: http://www.schlotzskys.com
Price (11/8/99): $7 1/16

By Rick Aristotle Munarriz (TMF Edible)

How Did it Find Trouble?

Sour dough, indeed. For Schlotzsky's, and its signature line of sourdough sandwich rolls and pizzas, appearances are deceiving. Like a Schlotzsky's Deli storefront, it's solid on the outside. The chain has reported same-unit sales growth over each of the last 19 quarters. That five-year span of store level improvement is rare in the competitive food industry. Save for possibly Cheesecake Factory (Nasdaq: CAKE) and its streak of 29 quarters of same-store sales gains and a handful of upscale steakhouse chains, it's difficult to patch together more than a few strong quarters.

But, again, looks can mislead. Go a few rungs down on the income statement, past the healthy systemwide sales, and the financials begin to sink like a sub -- the vessel, not the sandwich.

After writing off some real estate purchase contracts that didn't fall in line with the company's revised expansion plans, third quarter earnings fell shy of 1998's showing and four cents below analyst estimates. It now appears as if the company is heading towards 1999 earnings of $0.82 a share, possibly a penny or two higher.

By itself, that isn't shabby. Unfortunately $0.71 a share is what Schlotzsky's reported in 1997. And in 1998, Schlotsky's reported $0.82.

For a company that an outsider might argue isn't broken, the company is paying the price for trying to fix it. Aggressive accounting. Indecisive execution. Any way you slice it, the most popular order at Schlotzsky's appears to be a sell order.

Business Description

Founded in Austin, Texas, Schlotzsky's is the franchisor of 760 counter service restaurants specializing in sandwiches, salads, and pizzas.

The company also has a retail product line that is being carried in select supermarket chains. Since January, Wal-Mart (NYSE: WMT) has stocked Schlotzsky's Deli potato chips at its supercenters.

Financial Facts

Income Statement
12-month sales: $49.1 million
12-month income: $6.2 million
12-month EPS: $0.83
Profit Margin: 12.6%
Market Cap: $53 million

Balance Sheet (as of June 30, 1999)
Cash and Equivalents: $3.1 million
Current Assets: $38.7 million
Current Liabilities: $22.2 million
Long-term Debt: $19.8 million

Price-to-earnings: 8.5
Price-to-sales: 1.1

How Could You Have Seen it Coming?

Last year the company recognized a 1997 accounting mistake. A seemingly innocent error in recording Turnkey Program franchise proceeds when they were received, rather than amortized, tainted the company's reputation. While shareholder lawsuits that ensued were ultimately dismissed this August, it was hard for a once bitten Wall Street to race back with open arms.

Yet, it did. The shares were back in the teens by January. It was hard to ignore the same-store sales growth and the consistent double-digit net margins. But there are more to those two feathers than meets the cap.

Sure, the comps were steady, but 1998 earnings came in at the adjusted 1997 level. Growing sales at the unit level was simply not enough for the company. The high margins are also more the product of the franchise system than that of a shrewd restaurateur.

Consider that Schlotzsky's now has an annual run-rate, systemwide, of just over $400 million in sales. However, as a franchisor, the company only records its own restaurant sales as revenues. The balance comes from the royalties and licensing and development fees it collects from its franchisees -- not the actual sales at those eateries.

With minimal overhead, the residuals are always margin enhancing. There is nothing wrong with the franchising system, but investors need to understand that the margins are based on the $49.1 million received by Schlotzsky's -- not the hundreds of millions in chainwide sales.

Looking past that, one found a restaurant in a bottom line rut -- one where the net income had grown as stale as the sandwiches were fresh.

Where to From Here?

While one might imagine that a franchise with the strong same-store sales record of Schlotzsky's is an easy sell to potential operators, it has decided to ease up on the accelerator.

The company is expecting just 40 new locations next year, a break from the whirlwind expansion of the past. The company plans to reduce its costs to offset the slower unit growth so, assuming that the third quarter balk on property deals is indeed a one-time event, the company should earn close to the $1.05 per share projected for next year.

Then again, after seeing the company fall short of earnings estimates over the last two quarters, Wall Street is even more jaded than it was before. Schlotzsky's is going to have to earn the respect this time. Pretty margins and same-store sales aren't going to be enough to get this order right.

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