ITEM 1. BUSINESS
IN GENERAL
Eateries, Inc. (the "Company") owns, operates and franchises a 51-unit (43 Company, 8 franchise) chain of Garfield's and Pepperoni Grill restaurants. These casual theme, dinnerhouse restaurants are located primarily in regional malls in 22 states. The Company opened its first restaurant in 1984 in Oklahoma City, Oklahoma. The Company's restaurants are family-oriented, providing an upscale alternative to traditional fast-food. The restaurants are designed to appeal to a divergent customer base that grew up on fast-food, but now prefers a more sophisticated menu, the availability of alcoholic beverages, a comfortable ambiance, speed, value and convenience. Both restaurant concepts feature a varied selection of moderately-priced, high quality food and beverage items with table service dining.
In January 1995, the Company acquired substantially all the assets of the "Pepperoni Grill" restaurant located in Oklahoma City, Oklahoma, along with all rights to the use of the trademarks associated with the concept. Pepperoni Grill features a variety of Italian entrees with special emphasis on brick-oven baked pizza. The warm European bistro atmosphere is accented with an exhibition kitchen, light woods and booths covered in tapestry. All menu items are prepared on the premises with the entire entree presentation being performed within view of the guest, making the kitchen part of the restaurant's atmosphere. An in-store bakery makes all the breads and daily desserts. Over 60 different wine selections are offered along with 25 wines available by the glass.
In 1996, the Company constructed and opened six (6) Garfield's and a test Casa Ole' Mexican restaurant in major regional malls and one Pepperoni Grill in a free-standing location. The Company expects to add up to five additional restaurants in 1997. The primary expansion emphasis will be on Company rather than franchised restaurants. However, management will visit with qualified, interested parties as potential franchisees. Early results of the Casa Ole' test do not indicate the likelihood of continuing its expansion.
The Company's principal offices are located at 3240 West Britton Road, Oklahoma City, Oklahoma 73120. Its telephone number is (405) 755-3607.
GARFIELD'S RESTAURANT & PUB
MENU
Each Garfield's restaurant offers a diverse menu of freshly prepared traditional and innovative entrees, including steak, seafood, chicken, hamburgers, Mexican, Italian, and sandwiches along with a variety of appetizers, salads and desserts. Menu offerings are revised by the Company semi-annually to improve sales. The Company's senior management actively participates in the search for new menu items. In February, 1996 the Company hired a Director of Product Research and Development to further assist in developing new menu selections. Garfield's restaurants also offer a separate lower-priced children's menu.
In an effort to further define the strengths of various mall-based Garfield's, management is testing six urban stores as "Garfield's Cafe's." These units are located in major urban markets and lack the ability to be marketed due to exorbitant advertising costs. This lack of visibility negatively impacts sales and profitability. Thus, "Garfield's Cafe's" have repositioned menus that offer greater value, lower costs, a simpler and thus faster mix of menu selections. Food costs for items in "Cafe" stores are lower than traditional Garfield's. "Cafe" stores also feature specials designed to drive sales and profits. Early results are very encouraging and management will continue to monitor and fine tune "Cafe" results.
RESTAURANT LAYOUT
Garfield's restaurants are constructed in regional malls in accordance with uniform design specifications and are generally similar in appearance and interior decor. Restaurants are furnished and styled in a colorful motif, highlighting the travels of the Company's namesake, "Casey Garfield", including exhibits, photographs, souvenirs and other travel-related furnishings. Tables are covered with paper and customers are encouraged to doodle with crayons provided at each table.
The size and shape of Garfield's restaurants vary depending largely upon the location but typically average 4,500 to 5,500 square feet, and seat approximately 200 guests. The Company's prototype Garfield's to be constructed in 1997 will approximate 4,700 square feet.
HOURS OF OPERATION
Depending on location, most restaurants are open from 11:00 a.m. until 11:00 p.m. on weekdays and Sunday, and later on Friday and Saturday.
UNIT ECONOMICS
Historically, the cost of opening a new Garfield's restaurant has varied widely due to the different restaurant configuration and sizes, regional construction cost levels, and certain other factors. The Company currently leases the restaurant premises in major regional malls and builds-out the leased space to meet the Garfield's concept specifications of style and decor. Total construction costs for a typical Garfield's opened in 1996 were approximately $968,000, of which approximately $428,000 was funded through landlord finish-out allowances, bringing the Company's net investment to approximately $540,000 per unit. Management believes it's unit economics are among the best in the industry.
SITE SELECTION
All Garfield's restaurants are located in regional shopping malls. The Company considers the location of a restaurant to be critical to its long-term success and has devoted significant effort to the investigation and evaluation of potential mall sites. The site selection process focuses on historical sales per foot by mall tenants and proximity to entertainment centers within and out of the mall as well as accessibility to major traffic arteries. The Company also reviews potential competition in the area and utilizes an Equifax site selection model to "rate" each potential location based upon a multitude of different criteria. Senior management inspects and approves each mall restaurant site. The Company expects to locate future Garfield's in regional malls. It takes approximately 18 weeks to complete construction and open a Garfield's.
RESTAURANT LOCATIONS
The following table sets forth the location of the existing Garfield's restaurants.
PEPPERONI GRILL RESTAURANTS
The original Pepperoni Grill restaurant, located in Oklahoma City, Oklahoma was purchased by Eateries, Inc. in January, 1995. It is located in a recently renovated mall and its menu features a variety of Italian entrees with special emphasis on brick-oven baked pizza. The warm European bistro atmosphere is accented with an exhibition kitchen, light woods and booths covered in tapestry. All menu items are prepared on the premises with the entire entree presentation being performed within view of the guest, making the kitchen part of the restaurant's atmosphere. An in-store bakery makes all the breads and daily desserts. Pepperoni Grill's signature bakery item is a Tuscan parmesan black pepper bread that is served with all entrees along with the traditional olive oil and balsamic vinegar. Over 60 different wine selections are offered along with 25 wines available by the glass.
The Company purchased the Pepperoni Grill restaurant primarily because of its many similarities to the existing Garfield's concept and its popular "Italian" based menu. The Pepperoni Grill restaurant concept is similar to Garfield's as it is a full service dinner house, located in a mall and is approximately the same size with many operational functions which parallel a Garfield's.
The Company opened a second Pepperoni Grill restaurant in a regional mall located in Terre Haute, Indiana in November, 1995, next to an existing Garfield's. After evaluating the benefits of this strategy and the future growth potential of the Pepperoni Grill restaurant concept, management decided to open a free-standing Pepperoni Grill in Edmond, Oklahoma to capitalize on its strong reputation in the Oklahoma City market. As part of this decision, management decided to convert the Terre Haute location into a test location for a Casa Ole' franchise and transferred assets with approximately $275,000 in net book value to the Edmond location. The Company is considering building one additional free-standing Pepperoni Grill in Oklahoma during 1997. At this time, management does not expect any further development of Casa Ole'.
RESTAURANT OPERATIONS
MANAGEMENT AND EMPLOYEES
Responsibility for the Company's restaurant operations is organized geographically with restaurant general managers reporting to area directors of operations who in turn report to the respective divisional vice president of operations for Garfield's and Pepperoni Grill. A typical restaurant has a general manager, two to four assistant managers and average 51 employees, approximately 81% of whom are part-time.
Area directors of operations as well as restaurant general managers and associate managers are eligible for cash and stock bonuses, travel incentives, professional training and attendance at industry conferences. Receipt of these incentives is based on reaching restaurant performance objectives. The Company's hourly employees are eligible for performance-based awards for superior service to the Company and its guests. Employee awards can include travel incentives, gift certificates, plaques and Company memorabilia. Most employees other than restaurant management and corporate management are compensated on an hourly basis.
QUALITY CONTROL
The Company has uniform operating standards and specifications relating to the quality, preparation and selection of menu items, maintenance and cleanliness of the premises, and employee conduct. Managers are responsible for assuring compliance with Company operating procedures. Executive and supervisory personnel routinely visit each restaurant to evaluate adherence to quality standards and employee performance.
TRAINING
The Company places a great deal of emphasis on the proper training of its hourly employees and general and associate managers. In 1995, the Company hired a full-time Director of Training to oversee all areas of employee education. The outline for the program is based on the individual expertise of the trainee and typically lasts about two weeks for hourly employees and up to 8 weeks for managers. Managers must be certified in a number of skills in restaurant management, including technical proficiency and job functions, management techniques and profit and loss responsibilities. These skills are taught primarily in the restaurant along with classroom training and assigned projects. Manager training is performed in several geographically dispersed restaurants. Standard manuals regarding training and operations, products and equipment and local marketing programs are provided by the Company.
PURCHASING
During 1994, the Company hired a purchasing director to oversee the relations and negotiations with manufacturers and regional distributors for most food and beverage products and to ensure uniform quality, competitive costs and adequate supplies of proprietary products. The Company and its franchisees purchase substantially all food and beverage products from several national and regional suppliers. The Company has not experienced any significant delays in receiving food and beverage inventories or restaurant supplies.
ADVERTISING AND MARKETING
The Company uses television, newspaper, radio and outdoor advertising to promote its restaurants. In markets where the Company shares a trade area with a franchisee, advertising cooperatives are utilized to maximize the Company's restaurant's visibility. Franchisees of Garfield's units are generally required to expend up to 4% of sales on restaurant related marketing efforts. In addition, all Company and franchise restaurants contribute 1/2% of their sales to a marketing fund used to produce advertising, menu development and point of sale material to promote increased sales. The Company engages in a variety of local market promotional activities such as contributing goods, time and money to charitable, civic and educational programs, in order to increase public awareness of the Company's restaurants.
RESTAURANT REPORTING
Financial controls are implemented through the use of computerized cash registers and management information systems. Sales reports and food, beverage and labor cost data are prepared and reviewed weekly for operational control.
EXPANSION STRATEGY
Eateries, Inc. intends to open Company-owned Garfield's restaurants in regional malls principally throughout the Southwest, Midwest and Southeast regions of the United States. This expansion strategy is designed to capitalize on the growing trend to include and expand dining and entertainment facilities in regional malls. Management believes this mall-based expansion strategy for Garfield's reduces the risks associated with locating restaurants in new markets because of the availability of historical trends regarding mall sales and customer traffic. Further, restaurant construction within a mall typically requires a substantially smaller investment than construction of a free-standing restaurant.
Management believes there are sufficient additional mall locations for its restaurant concepts, particularly as existing malls are expanding and remodeled with a view toward becoming entertainment and dining centers. The Company maintains relationships with several leading mall operators who provide the Company with an ongoing supply of potential mall locations for evaluation. This will not, however, preclude it from searching other expansion opportunities such as free-standing sites.
The Company has retained a Director of Real Estate to represent it in site negotiations. This individual is compensated on a success fee basis. The Company expects to focus its expansion primarily on the opening of Company-owned Garfield's and Pepperoni Grill restaurants. Additional franchising is possible but likely to be a minor part of expansion.
The Company currently is developing three additional Garfield's restaurants as follows: South Bend, Indiana; Bridgeport, West Virginia; Richmond, Indiana, and is negotiating for additional locations designated to open in 1997 and 1998. The Company is also negotiating for a third Pepperoni Grill location to open in 1997. The Company expects to open up to five Company-owned restaurants in 1997 and up to ten Company-owned restaurants in 1998.
In addition, management is actively seeking possible merger or acquisition candidates that it believes will add value to the Company.
FRANCHISE OPERATIONS
GENERAL TERMS
Eight franchised Garfield's are currently operating pursuant to agreements granted by the Company. The typical franchise agreement provides for (i) the payment of an initial franchise fee of up to $35,000 and a monthly continuing royalty fee expressed as a percentage (typically 3% or 4%) of gross sales with a minimum fee of $2,000 to $2,500 per month; (ii) the payment of 1/2% of gross sales to the Garfield's Creative Marketing Fund; (iii) quality control and operational standards; (iv) development obligations for the opening of new restaurants under the franchise; and (v) the creation and use of advertising. The franchise term usually ranges from five to 10 years with five-year renewals. The grant of a franchise does not ensure that a restaurant will be opened. Under the Company's typical franchise agreement, the failure to open restaurants can cause a termination of the franchise. Although the Company largely relies upon standardized agreements for its franchises, it will continue to adjust its agreements as circumstances warrant.
FUTURE FRANCHISE DEVELOPMENT
The Company has elected to emphasize Company restaurant development and as a result does not intend to aggressively pursue new restaurant franchising. The Company had not entered into any new franchise agreements as of April 1, 1997.
COMPANY MANAGED FRANCHISES
The Company currently manages three of its franchised restaurants in Oklahoma City pursuant to a management agreement with the franchisee who remains the owner of the restaurants. The Company receives fixed management and accounting fees in addition to its royalties and other charges under the franchise agreement.
FRANCHISE REVENUE DATA
The following table sets forth fees and royalties earned by the Company from franchisees for the years indicated.
COMPLIANCE WITH FRANCHISE STANDARDS
All franchisees are required to operate their Garfield's restaurants in compliance with the Company's methods, standards and specifications regarding such matters as menu items, ingredients, materials, supplies, services, fixtures, furnishings, decor and signs, although the franchisee has the discretion to determine the menu prices to be charged. However, as a practical matter, all franchisees utilize the Company's standardized Garfield's menu. In addition, all franchisees are required to purchase all food, ingredients, supplies and materials from suppliers approved by the Company. The Company enforces the standards required of franchisees. Such enforcement may result in the closure or non-renewal of certain franchise units, but any such closings or non-renewals are not expected to have a material adverse effect upon the Company's results of operations or financial position.
COMPETITION
The restaurant industry is intensely competitive with respect to price, service, location, food type and quality, and there are many well-established competitors with substantially greater financial and other resources than the Company. Some of the Company's competitors have been in existence for a substantially longer period than the Company and may be better established in the market area than the Company's restaurants. The restaurant business is often affected by changes in consumer taste, national, regional or local economic conditions, demographic trends, traffic patterns and type, number and location of competing restaurants. In addition, factors such as inflation, increased food, labor and benefit costs, and the lack of experienced management and hourly employees may adversely affect the restaurant industry in general and the Company's restaurants in particular.
SERVICE MARKS
"GARFIELD'S", "CASEY GARFIELD'S" and "PEPPERONI GRILL" are Company service marks registered with the United States Patent and Trademark Office. The Company pursues any infringement of its marks within the United States and considers its marks to be crucial to its operations.
EMPLOYEES
As of March 1, 1997, the Company employed 2,357 individuals, of whom 178 were management or administrative personnel (including 143 who were restaurant managers or trainees) and 2,179 were employed in non-management restaurant positions. As of this date, the Company employed 169 persons on a salaried basis and 2,188 persons on an hourly basis. Each restaurant employs an average of 51 people.
Most employees, other than restaurant management and corporate management personnel, are paid on an hourly basis. The Company believes that it provides working conditions and wages that compare favorably with those of its competition. As the Company expands, it will need to hire additional management and its continued success will depend in large part on its ability to attract and retain good management employees. The Company's employees are not covered by a collective bargaining agreement.
SEASONALITY
With 42 of the 43 Company-owned restaurants located in regional malls, the resulting higher pedestrian traffic during the Thanksgiving to New Year holiday season has caused the Company to experience a substantial increase in restaurant sales and profits in the Company's fourth fiscal quarter. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Impact of Seasonality."
GOVERNMENT REGULATIONS
The Company's restaurants are subject to licensing and regulation by alcoholic beverage control, health, sanitation, safety and fire agencies in each state and/or municipality in which restaurants are located. The Company has not experienced material difficulties in these areas, however, regulatory difficulties or failures in obtaining the required licenses or approvals could delay or prevent the opening of a new restaurant and affect profitability.
Approximately 15% of the Company's food and beverage revenues in 1996 were attributable to the sale of alcoholic beverages. Alcoholic beverage control regulations require each of the Company's restaurants to apply to a state authority and, in certain locations, county or municipal authorities, for a license or permit to sell alcoholic beverages on the premises and to provide service for extended hours and on Sundays. Typically, such licenses or permits must be renewed annually and may be revoked or suspended for cause at any time. Alcoholic beverage control regulations relate to numerous aspects of the daily operations of the Company's restaurants, including minimum age of patron and employees, hours of operation, advertising, wholesale purchasing, inventory control and handling, storage and dispensing of alcoholic beverages.
In certain states the Company may be subject to "dram-shop" statutes, which generally provide a person injured by an intoxicated patron the right to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person. The Company carries liquor liability coverage as part of its existing comprehensive general liability insurance.
The Company's restaurant operations are also subject to federal and state laws governing such matters as minimum wages, working conditions, overtime and tip credits. Significant numbers of the Company's food service and preparation personnel are paid at rates equal to or based upon the federal minimum wage and, accordingly, further increases in the minimum wage could increase the Company's labor costs. The enactment of future legislation increasing employee benefits, such as mandated health insurance, could also significantly adversely affect the industry and the Company, as could future increases in workers' compensation rates.
The Company is subject to Federal Trade Commission ("FTC") regulation and state laws that regulate the offer and sale of franchises. The Company may also become subject to state laws that regulate substantive aspects of the franchisor-franchisee relationship. The FTC requires the Company to furnish prospective franchisees a franchise offering circular containing prescribed information. A number of states in which the Company might consider franchising also regulate the offer and sale of franchises and require registration of the franchise offering with state authorities. The Company believes that it is in material compliance with such laws.
The Americans With Disabilities Act ("ADA") prohibits discrimination in employment and public accommodations on the basis of disability. While the Company believes it is in substantial compliance with the ADA regulations, the Company could be required to expend funds to modify its restaurants to provide service to, or make reasonable accommodations for the employment of disabled persons.
ITEM 2.

ITEM 2. PROPERTIES
All of the Company's facilities are occupied under leases, primarily in regional malls. The majority of the Company's restaurant leases provide for the payment of base rents plus real estate taxes, insurance and other expenses and for the payment of a percentage of the Company's sales in excess of certain sales levels. These leases typically provide for escalating rentals in future years and have initial terms expiring as follows:
* Includes two leases which have been executed for locations where restaurants have not yet been opened and two leases which were terminated subsequent to December 29, 1996.
The Company's executive offices, located in approximately 7,400 square feet of office space in Oklahoma City, Oklahoma, are occupied under a lease which expires in June, 1999.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
The Company is not presently engaged in any legal proceedings the outcome of which is expected to have a material adverse effect upon its business or financial condition. However, in the ordinary course of its business, the Company is named in various lawsuits related to the operation of its restaurants, most of which relate to on-the-job injury claims by its employees and are typically handled by the Company's insurance carriers.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of the Company's security holders during its fourth fiscal quarter of 1996.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock has been quoted on the NASDAQ National Market System under the symbol "EATS" since May 1994. Prior to that date, the Company's common stock was quoted on the NASDAQ Small-Cap Market. The following table sets forth, for the quarterly periods indicated, the high and low closing bid prices for the common stock, as reported by the NASDAQ Markets.
Such quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.
On April 1, 1997, the Company's stock transfer agent reported that the Company's common stock was held by 265 holders of record. However, management believes there are approximately 1,000 beneficial owners of the Company's common stock.
The Company has paid no cash dividends on its common stock. The Board of Directors intends to retain earnings of the Company to support operations and to finance expansion and does not intend to pay cash dividends on the common stock for the foreseeable future. The payment of cash dividends in the future will depend upon such factors as earnings levels, capital requirements, the Company's financial condition and other factors deemed relevant by the Board of Directors.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data of the Company. The selected financial data in the table are derived from the financial statements of the Company. The following data should be read in conjunction with, and are qualified in their entirety by, the Company's financial statements and related notes and with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein. (In thousands, except per share data).
(1) Based upon the weighted average number of common and dilutive common equivalent shares (if applicable) outstanding during the period. (See Note 2 of Notes to Consolidated Financial Statements.) (2) Includes capital leases and long-term debt obligations, net of current portions. (See Note 5 of Notes to Consolidated Financial Statements.)
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
From time to time, the Company may publish forward-looking statements relating to certain matters including anticipated financial performance, business prospects, the future opening of Company-owned and franchised restaurants, anticipated capital expenditures, and other similar matters. All statements other than statements of historical fact contained in this Form 10-K or in any other report of the Company are forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of that safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. In addition, the Company disclaims any intent or obligation to update those forward-looking statements.
INTRODUCTION
As of December 29, 1996, the Company owned and operated 45 restaurants and franchised eight Garfield's restaurants. The Company currently has three Garfield's restaurants in development and closed two under-performing Garfield's restaurants subsequent to December 29, 1996. As of the date of this report, the entire system includes 43 (40 Garfield's, two Pepperoni Grills and one Casa Ole') Company-owned restaurants and eight franchise Garfield's restaurants.
Unlike a majority of its publicly-held competitors which capitalize and amortize restaurant pre-opening costs over a period of up to 24 months, the Company expenses such costs as incurred. Pre-opening costs were $726,000 for the year ended December 29, 1996.
PERCENTAGE RESULTS OF OPERATIONS AND RESTAURANT DATA
The following table sets forth, for the periods indicated, (i) the percentages that certain items of income and expense bear to total revenues, unless otherwise indicated, and (ii) selected operating data:
(1) As a percentage of restaurant sales.
IMPACT OF SEASONALITY
The concentration of restaurants in regional malls where customer traffic increases substantially during the Thanksgiving to New Year holiday season, has resulted in the Company experiencing a substantial increase in restaurant sales and profits during the fourth quarter of each year. The following table presents the Company's revenues, net income (loss) and certain other financial and operational data for each fiscal quarter of 1994, 1995 and 1996.
(1) During the third quarter of 1995, the Company recorded a pre-tax charge of $897,000 to establish a provision for restaurant closures and other disposals. The effect of this provision on the reported net income (loss) and per share data for the third quarter and the fiscal year was $(639,000) or $(.17) per share.
FISCAL YEARS 1996, 1995, AND 1994
REVENUES
Revenues for the year ended December 29, 1996, increased 21% over the revenues reported for the year ended in 1995. Revenues in 1995 increased 18% over 1994 levels. The 1996 and 1995 increases were primarily due to increases in restaurant sales. Restaurant sales for the year ended December 31, 1994, increased 45% over the same period in 1993.
The number of restaurants operating at the end of each year, the number of operating months during that year and average sales per operating month were as follows:
A summary of restaurant sales and related costs expressed as a percentage of sales are listed below for the fiscal years:
Average monthly sales per unit were $108,600 during 1996 compared to $101,100 during 1995. The 1996 per unit monthly sales increased by $7,500 or 7.4% from 1995 levels. This increase is attributable to the following items:
A stronger, more experienced management team in place at the beginning of 1996. (Several key examples follow).
In November, 1995, the Company created and filled the position of Divisional Vice President of Operations/Garfield's. The individual responsible for this position brings 17 years of senior operations' management experience with two nationally recognized restaurant chains. The Divisional Vice President is responsible for improving service and sales of the Garfield's stores as well as recruiting and hiring experienced store management.
In August, 1995 the Company hired a Vice President of Marketing, a new position at the Company. The new Vice President of Marketing has over 17 years of marketing experience with a nationally recognized chain of dinnerhouse restaurants. During the fourth quarter of 1995, a detailed marketing plan was developed for 1996, with the primary objectives being to improve same store sales and guest satisfaction. The implementation of the marketing plan begun during the first quarter of 1996 positively impacted the Company's same store sales results during 1996.
Following the November, 1995, successful introduction of regional newspaper advertising, the Company ran four (one during each of the Company's fiscal quarters) regional newspaper print programs for Garfield's restaurants during 1996. These programs were used in the majority of the Company's restaurant markets and have all been successful in increasing revenues and customer visits.
During 1996, the Company began testing radio and direct mail advertising campaigns in selective restaurant markets. Initial results have been favorable and the Company plans to further utilize these campaigns in additional restaurant markets during fiscal year 1997.
The Company also rolled out two new menu revisions (in July and October, 1996) both of which included selective modest price increases (in line with competitor pricing on comparable food selections) and introduced several new product selections that were featured in the Company's radio, direct mail and newspaper advertising campaigns.
While these marketing programs resulted in increased short-term costs, management believes their effects, along with the local efforts of our restaurant management, contributed to the Company's significant average monthly sales per unit increases. (The Company experienced a 7.4% increase in average unit volumes during 1996 versus the comparable 1995 period). Management expects it will continue to experience improving sales trends during fiscal year 1997 with higher marketing and promotion costs, of which management believes the long-term benefits outweigh the short-term costs.
Average monthly sales per unit were $101,100 during 1995 compared to $108,600 during 1994. The 1995 per unit monthly sales decreased by $7,500 or 6.9% from 1994 levels. The decrease was attributable to the following items:
In late 1994, the Company began testing and rolled out to nineteen stores in January, 1995, a new menu which contained a combination of several new lower priced and a la carte selections. The stores with this menu experienced a reduction in average check amounts and revenues during the first five months of 1995, rather than the overall increase the Company expected. Management reacted quickly to reverse these declines by beginning implementation of a new menu to its stores in late June, 1995. The new menu contained many new food selections and incorporated a pricing strategy similar to menus used by the Company previous to the January, 1995 menu. A new drink menu was also rolled out to the stores in late June, 1995. The Company experienced increases in average check amounts and revenues beginning in the third quarter of 1995 as a result of the new menus and the trend continued through the end of the year.
The Company's first quarter 1995 three weeks television advertising campaign coincided with two consecutive weekends of bad weather in the Company's Northern and Midwestern stores. Thus, the Company incurred the advertising expense without the normal sales gains it has achieved during past advertising campaigns. The Company's next major 1995 television advertising campaign began in late July, 1995 to promote the Company's new food and drink menus. Advertising was minimal during the second quarter and lower than normal in the third quarter as management believed its advertising would be more effective if it was done in conjunction with the introduction of the new menus and under the direction of the new Vice President of Marketing. As previously mentioned, the Company hired a Vice President of Marketing in August, 1995. As a result of this advertising strategy, sales remained weak during the second and third quarters. When the campaigns were begun, the Company experienced improvement in sales.
A regional newspaper print program for Garfield's restaurants was developed and implemented in early November, 1995, for the majority of the Company's restaurants and resulted in an increase in revenues and operating results during the fourth quarter of 1995. Also, several new entree selections were developed during the 1995 fourth quarter holiday season. These items were priced higher than the usual entree pricing and achieved excellent sales results during the fourth quarter of 1995.
The affects of the previously noted items, along with the overall increase in casual dining restaurant development during 1994 and 1995 coupled with the 1995 soft consumer discretionary spending trend contributed to the Company's same store sales and average monthly sales per unit decreases.
The average monthly sales per unit decreases experienced during 1995 as compared to 1994 narrowed from $(11,300) during the second quarter to $(4,300) during the fourth quarter. Management believes its increased focus on and actions taken in the marketing area beginning in the second quarter of 1995 had a direct affect on the improvements in average monthly sales per unit experienced during the second half of 1995 and continuing through 1996.
Continuing royalties were $265,000 in 1996, $258,000 in 1995 and $267,000 in 1994. Continuing royalties were comparable as the same number of franchise restaurants (eight) were in operation during the three year period. During the second quarter of 1995, one franchise restaurant closed and a new one opened. Initial franchise fees recognized in 1995 were $50,000. No initial franchise fees were recorded in 1996 or 1994.
COSTS AND EXPENSES
The following is a comparison of cost of sales and labor costs (excluding payroll taxes and fringe benefits) as a percent of restaurant sales at Company-owned restaurants:
Cost of sales as a percent to sales increased slightly in 1996 (30.6%) as compared to 1995 (30.5%) primarily due to higher meat and dairy product costs. These 1996 product cost increases were partially offset by lower produce costs and the Company's continuing improvements in its purchasing techniques, which involves the Company entering into agreements with its vendors to fix purchase prices for certain high volume food products. The cost of sales as a percent to sales decreased to 30.5% in 1995 as compared to 31.0% in 1994 as a result of the Company's improvements in its purchasing techniques previously mentioned.
The Company's labor costs as a percent to sales decreased during the three year period to 27.6% in 1996 from 28.2% in 1994. The Company has continued to achieve reductions in its labor cost percents through improving store level monitoring of labor needs and enhanced scheduling techniques.
Restaurant operating expenses (which include labor costs) as a percent of restaurant sales were 57.5% in 1994, 57.6% in 1995 and 57.8% in 1996. The increase in operating expenses as a percent to restaurant sales in 1996 as compared to 1995 was due primarily to higher promotional and advertising expenses partially offset by lower occupancy costs (primarily rent and utilities). The modest increase in operating expenses as a percent to restaurant sales in 1995 versus 1994 was attributable to higher occupancy costs and repairs and maintenance expenses partially offset by lower advertising and promotional expenses.
PRE-OPENING COSTS
The Company's accounting policy for restaurant pre-opening costs is to expense such costs as incurred. Management anticipates that these pre-opening costs will remain stable with 1996 levels during 1997.
During each of the three years ended December 31, 1994, 1995, and December 29, 1996, the Company incurred and recognized as expense the following amounts for restaurant pre-opening development costs relative to the corresponding number of restaurants in various stages of development:
Under the Company's policy of expensing pre-opening costs as incurred, income from operations, on an annual and quarterly basis, could be adversely affected during periods of restaurant development.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative costs increased as a percentage of revenues from 6.2% in 1994 to 6.6% in 1995, and decreased to 6.5% in 1996. The higher absolute levels of general and administrative costs from 1994 to 1996 are related primarily to additional personnel costs and related costs of operating the Company's expanding restaurant group. General and administrative costs as a percent to sales decreased modestly in 1996 as compared to 1995 as a result of the Company's revenues increasing at a higher rate than its increase in general and administrative expenses. General and administrative costs as a percent to sales increased in 1995 as compared to 1994 primarily due to the strengthening of the Company's management group through hiring employees to fill new positions (Vice President of Marketing, Divisional Vice Presidents of Garfield's and Pepperoni Grill, Director of Training, etc.) management believed were necessary to effectively operate its restaurants and continue its expansion plans. The Company anticipates that its costs of supervision and administration of Company and franchise stores will increase at a slower rate than revenue increases during the next few years.
PROVISION FOR RESTAURANT CLOSURES AND OTHER DISPOSALS
During 1995, the Company approved and began the implementation of a plan to close certain under-performing restaurants. As of December 29, 1996, the Company has disposed of three of the four restaurants planned in 1995 for closure. The remaining restaurant closure was completed in the first quarter of 1997. In addition, the Company identified and closed two additional restaurant locations (one of which occupied land and building owned by the Company which is presently held for sale). These restaurants (the 1995 and 1996 identified closures) collectively accounted for $5,695,000, $3,498,000, and $1,784,000 of revenues and $(31,000), $(223,000), and $(68,000) of operating losses for fiscal years 1994, 1995, and 1996, respectively. Management expects the effect of closing under-performing restaurants to result in improved margins and increased profitability for the Company in future periods.
As a result of the completed and planned restaurant closures and other disposals, the Company recorded a pre-tax charge of $897,000 in the third quarter of 1995. The provision related to lease termination costs, litigation settlement costs, write-down of property, equipment and leasehold improvements, and other exits costs. As of December 29, 1996, the Company has a remaining reserve of approximately $145,000 for settlement of its remaining liabilities associated with the closures. Management expects to settle these liabilities in early 1997 and believes the reserve to be sufficient for such purposes.
The Company has eight restaurants as of December 29, 1996, with indicators of potential impairment. Considerable management judgment and certain significant assumptions are necessary to estimate future cash flows. Significant judgments and assumptions used by the Company in evaluating its assets for impairment include, but may not be limited to: estimations of future sales levels, cost of sales, direct and indirect costs of operating the assets, the length of time the assets will be utilized and the Company's ability to utilize equipment, fixtures and other moveable long-lived assets in other existing or future locations. In addition, such estimates and assumptions include anticipated operating results related to certain profit improvement programs implemented by the Company during 1996 as well as the continuation of certain rent reductions, deferrals, and other negotiated concessions from certain landlords. Actual results could vary significantly from management's estimates and assumptions and such variance could result in a change in the estimated recoverability of the Company's long-lived assets. Accordingly, the results of the changes in those estimates could have a material impact on the Company's future results of operations and financial position. During 1996, the Company recorded no provision for impairment as management believes there is no additional impairment under SFAS 121.
In the normal course of business, management performs a regular review of the strength of its operating assets. It is management's plan to continue to make such decisions to close under-performing restaurants and/or dispose of other assets it considers in the best long-term interest of the Company's shareholders.
DEPRECIATION AND AMORTIZATION EXPENSE
Depreciation and amortization expense increased in 1996 to $1,886,000 (3.4% of restaurant sales) compared to $1,337,000 (2.9% of restaurant sales) in 1995 and $927,000 (2.4% of restaurant sales) in 1994. The increase in expense in 1996 as compared to 1995 is primarily attributable to the increase in net assets subject to depreciation and amortization in 1996 versus 1995 as the result of opening additional restaurants. The expense increase in 1995 versus 1994 relates principally to the increase in net assets subject to depreciation and amortization because of opening additional restaurants, the purchase of the Pepperoni Grill restaurant in January, 1995 and the remodeling of existing restaurants.
INTEREST EXPENSE
Interest expense during the three year period ended December 29, 1996, was $48,000 in 1994, $41,000 in 1995, and $194,000 in 1996. Additionally, the Company has capitalized approximately $72,000 and $62,000 of interest costs during 1995 and 1996, respectively (none in 1994). The increase in interest expense in 1996 as compared to 1995 is attributable to an increase in the 1996 average borrowing balances under the Company's revolving credit agreement versus 1995 average borrowing balances. The interest rates incurred by the Company on its borrowings were at similar levels during 1996 and 1995. Interest expense during the 1995 and 1994 fiscal years were comparable as average borrowing balances and interest rates incurred during the periods remained steady.
INCOME TAXES
The Company records income taxes in accordance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes." The deferred provision (benefit) for income taxes was $316,400, $(131,000) and $74,000, respectively, for 1994, 1995 and 1996.
At December 29, 1996, the Company has recorded a benefit for its deferred tax assets of approximately $3,043,000. Management believes that approximately $1,681,000 of the assets will be recognized through the reversal of existing taxable temporary differences with the remainder to be recognized through realization of future income. It is management's opinion, based on the historical trend of normal and recurring operating results, present store development and forecasted operating results, that it is more likely than not that the Company will realize the approximately $3,700,000 in the future net income in the next three years necessary to recognize the deferred tax assets not otherwise offset by reversing taxable temporary differences; net operating loss carryforwards do not begin to expire until 2003 and general business tax credits until 2009. While management of the Company is not presently aware of any adverse matters, it is possible that the Company's ability to realize the deferred income tax assets could be impaired if there are significant future exercises of non-qualified stock options or if the Company were to experience declines in sales and/or profit margins as a result of loss of market share, increased competition or other adverse general economic conditions. Management intends to evaluate the reliazability of the net deferred tax asset at least quarterly by assessing the need for a valuation allowance.
NET INCOME PER SHARE AMOUNTS
Net income per share amounts are computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period as more fully described in Note 2 of the Notes to Consolidated Financial Statements. Per share amounts are based on total outstanding shares plus the assumed exercise of all dilutive stock options and warrants. Common and common equivalent share amounts were 3,939,750, 3,817,997, and 3,987,661 in 1994, 1995 and 1996, respectively.
IMPACT OF INFLATION
The impact of inflation on the cost of food and beverage products, labor and real estate can affect the Company's operations. Over the past few years, inflation has had a lesser impact on the Company's operations due to the lower rates of inflation in the nation's economy and the economic conditions in the Company's market area.
Management believes the Company has historically been able to pass on increased costs through certain selected menu price increases and increased productivity and purchasing efficiencies, but there can be no assurance that the Company will be able to do so in the future. Management anticipates that the average cost of restaurant real estate leases and construction costs could increase in the future which could affect the Company's ability to expand.
LIQUIDITY AND CAPITAL RESOURCES
At December 29, 1996, the Company's working capital ratio decreased to .50 to 1 compared to .72 to 1 at December 31, 1995. As is customary in the restaurant industry, the Company has consistently operated during the past two years with negative working capital and has not historically required large amounts of working capital. Historically, the Company has leased the vast majority of its restaurant locations. For the three years in the period ended December 29, 1996, the Company's expenditures for capital improvements were $5,453,000, $7,789,000, and $7,307,000, respectively, which were funded out of cash flows from operating activities of $2,557,000, $3,318,000, and $ 2,438,000, respectively, landlord finish-out allowances of $3,167,000, $2,492,000, and $3,022,000, respectfully, and borrowings under the Company's credit agreements. In addition, the Company expended approximately $529,000 in January 1995 for the acquisition of the Pepperoni Grill restaurant and trade name.
During 1997, the Company expects to construct and open up to five new Garfield's in regional malls and is considering one new Pepperoni Grill in a free-standing site. The Company believes the cash generated from its operations and borrowing availability under its credit facility (described below), will be sufficient to satisfy the Company's net capital expenditures and working capital requirements through 1997.
On August 31, 1995, the Company entered into an agreement with a bank for a revolving line of credit for $3,000,000. In July 1996, the Company's $3,000,000 revolving line of credit was increased to $5,000,000 and the term was extended by one year to August, 1999. This revolver is unsecured, has a three year term and contains customary financial covenants. This credit facility provides the Company additional borrowing capacity to continue its expansion plans over the next several years.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company are included in a separate section of this report.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
In accordance with General Instruction G(3), a presentation of information required in response to Items 10, 11, 12, and 13 appear in the Company's Proxy Statement to be filed pursuant to Regulation 14A within 120 days of the year end covered hereby, and shall be incorporated herein by reference when filed.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of the report:
1. Consolidated Financial Statements:
Management's Responsibility for Financial Reporting Report of Independent Auditors Consolidated Balance Sheets as of December 31, 1995 and December 29, 1996 Consolidated Statements of Income for each of the three years in the period ended December 29, 1996 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 29, 1996 Consolidated Statements of Cash Flows for each of the three years in the period ended December 29, 1996 Notes to Consolidated Financial Statements
2. Consolidated Financial Statement Schedules:
All schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
3. Exhibits.
The following exhibits are filed with this Form 10-K and are identified by the numbers indicated:
- --------------- (1) Filed as exhibit to Registrant's Registration Statement on Form S-18 (File No. 33-6818-FW). (2) Filed as exhibit to Registrant's Quarterly Report on Form 10-Q for the six months ended June 30, 1988 (File No. 0-14968) and incorporated herein by reference. (3) Filed as exhibit to Registrant's Registration Statement on Form S-2 (File No. 33-69896). (4) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 0-14968) and incorporated herein by reference. (5) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (File No. 0-14968) and incorporated herein by reference. (6) Filed as exhibit to Registrant's Registration Statement on form S-8 (File No. 33-41279). (7) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993 (File No. 0-14968) and incorporated herein by reference. (8) Filed as Appendix A to the Company's Notice of Annual Meeting of Shareholders dated April 29, 1994 and incorporated herein by reference. (9) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994 (File No. 0-14968) and incorporated herein by reference.
(b) No reports on form 8-K were filed during the fiscal quarter ended December 29, 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
REGISTRANT: EATERIES, INC.
Date: April 11, 1997 By: /s/ Vincent F. Orza, Jr. ---------------------------------- Vincent F. Orza, Jr. President Chief Executive Officer
Date: April 11, 1997 By: /s/ Corey Cable ---------------------------------- Corey Gable Vice President/Treasurer Chief Financial and Accounting Officer
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.
Date: April 11, 1997 By: /s/ Vincent F. Orza, Jr. ---------------------------------- Vincent F. Orza, Jr. Chairman of the Board, President and Director
Date: April 11, 1997 By: /s/ James M. Burke ---------------------------------- James M. Burke Vice President of Operations, Assistant Secretary and Director
Date: April 11, 1997 By: /s/ Edward D. Orza ---------------------------------- Edward D. Orza, Director
Date: April 11, 1997 By: /s/ Patricia L. Orza ---------------------------------- Patricia L. Orza, Secretary and Director
Date: April 11, 1997 By: /s/ Thomas F. Golden ---------------------------------- Thomas F. Golden, Director
Date: April 11, 1997 By: /s/ Philip Friedman ---------------------------------- Philip Friedman, Director
EATERIES, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING
The management of Eateries, Inc. has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles and include amounts that are based on management's best estimates and judgment where necessary. Management believes that all representations made to our external auditors during their examination of the financial statements were valid and appropriate.
To meet its responsibility, management has established and maintains a comprehensive system of internal control that provides reasonable assurance as to the integrity and reliability of the consolidated financial statements, that assets are safeguarded, and that transactions are properly executed and reported. This system can provide only reasonable, not absolute, assurance that errors and irregularities can be prevented or detected. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control is subject to close scrutiny by management and is revised as considered necessary.
The Board of Directors of Eateries, Inc. have engaged Ernst & Young LLP, independent auditors, to conduct an audit of and express an opinion as to the fairness of the presentation of the 1996 consolidated financial statements. Their report is included on the following page.
/s/ Vincent F. Orza, Jr. - ----------------------------- Vincent F. Orza, Jr. President and Chairman Chief Executive Officer
/s/ Corey Gable - ----------------------------- Corey Gable Vice President/Treasurer Chief Financial Officer
April 11, 1997
REPORT OF INDEPENDENT AUDITORS
Board of Directors Eateries, Inc. Oklahoma City, Oklahoma
We have audited the accompanying consolidated balance sheets of Eateries, Inc. and subsidiaries as of December 31, 1995 and December 29, 1996 and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 29, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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 Eateries, Inc. and subsidiaries at December 31, 1995 and December 29, 1996, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 29, 1996, in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
Oklahoma City, Oklahoma March 26, 1997, except for the last paragraph of Note 5, as to which the date is April 9, 1997
EATERIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
See accompanying notes.
EATERIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes.
EATERIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes.
EATERIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
EATERIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1995 AND DECEMBER 29, 1996
(1) ORGANIZATION
Eateries, Inc. (the "Company") was incorporated under the laws of the State of Oklahoma on June 1, 1984. The Company is engaged in the creation, design, management and operations of restaurants through Company-owned and franchise restaurants. The Company's restaurants are located primarily in regional malls in the Southwest, Midwest and Southeast regions of the United States. The Company's restaurants operate under the name "Garfield's Restaurant & Pub" ("Garfield's"), "Pepperoni Grill" and "Casa Ole" (as a franchisee). An analysis of Company-owned and franchised restaurants for the three years in the period ended December 29, 1996, is as follows:
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Eateries, Inc. and its wholly-owned subsidiaries, Pepperoni Grill, Inc. and Garfield's Management, Inc. All significant intercompany transactions and balances have been eliminated.
FISCAL YEAR
In 1996, the Company changed its fiscal year to a 52/53 week year ending on the last Sunday in December.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include certain highly liquid debt instruments with a maturity of three months or less when purchased.
INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out) or market and consist primarily of food, beverages and smallwares.
LANDLORD FINISH-OUT ALLOWANCES
Amounts received or receivable from landlords for reimbursement of improvements to leased facilities are recorded as a reduction of the costs incurred by the Company for property and equipment. As of December 31, 1995, there was $429,000 of noncurrent landlord finish-out receivables recorded in the balance sheet, which represents the amount of landlord finish-out receivables in excess of capital expenditures incurred.
DEPRECIATION AND AMORTIZATION
Property and equipment (which includes assets under capital leases) and landlord finish-out allowances are stated at cost (or amounts received with respect to landlord finish-out allowances) and are depreciated and amortized over the lesser of the estimated useful lives of the assets or the remaining term of the leases using the straight-line method. Estimated useful lives are as follows:
ADVERTISING COSTS
Cost incurred in connection with advertising and marketing of the Company's restaurants are expensed as incurred. Such costs amounted to $683,000 in 1994, $647,000 in 1995 and $797,000 in 1996.
PRE-OPENING COSTS
The costs related to the opening of restaurant locations are expensed when incurred.
INCOME TAXES
The Company is subject to Federal, State and local income taxes. The Company records income taxes in accordance with Statement of Financial Accounting Standards No. ("SFAS") 109 "Accounting for Income Taxes." Under SFAS 109, deferred income taxes are provided on the tax effect of presently existing temporary differences, net of existing net operating loss and tax credit carryforwards. The tax effect is measured using the enacted marginal tax rates and laws that will be in effect when the differences and carryforwards are expected to be reversed or utilized. Temporary differences consist principally of depreciation caused by using different lives for financial and tax reporting, the expensing of smallwares when incurred for tax purposes while such costs are capitalized for financial purposes and the expensing of costs related to restaurant closures and other disposals for financial purposes prior to being deducted for tax purposes.
DEFERRED CREDIT
Certain of the Company's long-term noncancellable operating leases for restaurant and corporate facilities include scheduled base rental increases over the term of the lease. The total amount of the base rental payments is charged to expense on the straight-line method over the term of the lease. The Company has recorded a deferred credit to reflect the net excess of rental expense over cash payments since inception of the leases.
FRANCHISE ACTIVITIES
The Company franchises the Garfield's Restaurant & Pub concept to restaurant operators and, at December 31, 1995 and December 29, 1996, eight restaurant units were operating under franchise agreements. The initial franchise fee paid to the Company is recognized as income when substantially all services have been performed by the franchisor to each franchised location, which is typically when the related restaurant is opened. The franchisor provides initial services to the franchisee in the selection of a site, approval of architectural plans, assistance in the selection of equipment for the restaurant, distribution of operations manuals and training of franchisee's personnel prior to the opening of the restaurant. The Company recognized $50,000 of initial franchise fees for franchised restaurants during 1995 (none were recognized in 1994 or 1996).
Continuing royalties are recognized as revenue based on the terms of each franchise agreement, generally as a percentage of sales of the franchised restaurants. During 1994, 1995 and 1996, the Company recognized $267,000, $258,000, and $265,000, respectively, of fees from continuing royalties.
Franchisees are required to remit an amount equal to 1/2% of their sales to the Garfield's Creative Marketing Fund. The franchisees' payments, which were $44,000, $39,000, and $41,000 during 1994, 1995 and 1996, respectively, are combined with the franchisor's expenditures to purchase services for creative advertising and design, market research and other items to maintain and further enhance the Garfield's concept.
Franchisee receivables at December 31, 1995 and December 29, 1996, are comprised principally of uncollected continuing royalties, which are generally unsecured; however, the Company has not experienced significant credit losses in prior years and is not aware of any significant uncollectible amounts at December 29, 1996.
CAPITALIZATION OF INTEREST
Interest attributed to funds used to finance restaurant construction projects is capitalized as an additional cost of the related assets. Capitalization of interest ceases when the related projects are substantially complete. The Company has capitalized approximately $72,000 and $62,000 of interest costs during 1995 and 1996, respectively (none in 1994). These costs are included in leasehold improvements in the accompanying balance sheets.
STOCK-BASED COMPENSATION
In 1996, the Company adopted SFAS 123, "Accounting for Stock-Based Compensation." As permitted by SFAS 123, the Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and related interpretations in accounting for its employee stock options because the alternative fair value accounting provided for under SFAS 123, requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
IMPAIRMENT OF LONG-LIVED ASSETS
In 1996, the Company adopted the provisions of SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." Pursuant to SFAS 121, the Company's restaurants are reviewed on an individual restaurant basis for indications of impairment, whenever events or circumstances indicate that the carrying value of its restaurants may not be recoverable. The Company's primary test for an indicator of potential impairment is operating losses. In order to determine whether an impairment has occurred, the Company estimates the future net cash flows expected to be generated from the use of its restaurants and the eventual disposition, as of the date of determination, and compares such estimated future cash flows to the respective carrying amounts. Those restaurants which have carrying amounts in excess of estimated future cash flows are deemed impaired. The carrying value of these restaurants is adjusted to an estimated fair value by discounting the estimated future cash flows attributable to such restaurants using a discount rate equivalent to the rate of return the Company expects to achieve from its investment in newly-constructed restaurants. The excess is charged to expense and cannot be reinstated.
Considerable management judgment and certain significant assumptions are necessary to estimate future cash flows. Significant judgments and assumptions used by the Company in evaluating its assets for impairment include, but may not be limited to: estimations of future sales levels, cost of sales, direct and indirect costs of operating the assets, the length of time the assets will be utilized and the Company's ability to utilize equipment, fixtures and other moveable long-lived assets in other existing or future locations. In addition, such estimates and assumptions include anticipated operating results related to certain profit improvement programs implemented by the Company during 1996 as well as the continuation of certain rent reductions, deferrals, and other negotiated concessions from certain landlords. Actual results could vary significantly from management's estimates and assumptions and such variance could result in a change in the estimated recoverability of the Company's long-lived assets. Accordingly, the results of the changes in those estimates could have a material impact on the Company's future results of operations and financial position.
Prior to adopting SFAS 121, the Company accounted for the impairment of long-lived assets by evaluating the recoverability of assets of restaurant locations for which management had identified and began a plan to close the location. The Company continues to use the guidance of FASB Emerging Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity" for guidance in recognizing costs related to closing restaurants.
NET INCOME PER COMMON SHARE
Per share amounts are computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
STATEMENTS OF CASH FLOWS
Interest of $48,000, $94,000 and $228,000 was paid for each of the three years in the period ended December 29, 1996, respectively.
For the three years in the period ended December 29, 1996 the Company had the following non-cash investing and financing activities.
FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating the fair values of financial instruments for purposes of complying with SFAS 107, "Disclosures About Fair Values of Financial Instruments":
Cash and cash equivalents, accounts receivable, deposits, accounts payable and accrued liabilities - The carrying amounts reported in the consolidated balance sheets approximate fair values because of the short maturity of these instruments.
Long-term obligations - The revolving credit agreement, which represents the material portion of long-term obligations in the accompanying consolidated balance sheets, bears interest at a variable rate, which is adjusted monthly. Therefore, the carrying values for these borrowings approximate their fair values.
(3) RESTAURANT ACQUISITION
In January 1995, the Company acquired substantially all of the assets of the "Pepperoni Grill' restaurant located in Oklahoma City, Oklahoma, along with rights to use trademarks associated with the restaurant, for a cash purchase price (including transaction expenses) of $529,000. Additionally, the Company assumed real estate and equipment leases for the restaurant. The acquisition has been accounted for under the purchase method. As a result, the Company recorded inventory, equipment and leasehold improvements totaling $199,000, trademarks of $125,000 and goodwill of approximately $205,000. The Company is amortizing the cost of the trademarks and goodwill over 20 years using the straight-line method and assesses the recoverability of such assets based upon the expected future cash flows from operations of the Pepperoni Grill concept. Pro forma results of operations for the year ended December 31, 1994, assuming that the restaurant acquisition had been made at the beginning of 1994, would not be materially different than the results reported.
(4) REAL ESTATE LEASES
The Company leases the majority of its restaurant facilities and its corporate office under operating leases with initial terms expiring at various dates through the year 2009. Certain leases contain renewal options ranging from five to ten years. Most, but not all, leases require the Company to be responsible for the payment of taxes, insurance and/or maintenance and include percentage rent and fixed rent escalation clauses. In the normal course of business, the Company may grant a landlord lien on certain personal property upon an event of default by the Company. At December 29, 1996, the remaining minimum rental commitments under long-term noncancellable leases, excluding amounts related to taxes, insurance, maintenance and percentage rent, are as follows:
Total minimum rental commitments includes $2,030,000 related to two locations scheduled for opening in 1997.
The components of rent expense for noncancellable operating leases are summarized as follows:
(5) LONG-TERM OBLIGATIONS
Long-term obligations consist of the following:
(A) At December 29, 1996 the future minimum lease payments for equipment under capital leases are $32,400 for 1997 and $21,600 for 1998 (amount representing interest is $4,977).
Maturities of long-term obligations at December 29, 1996 are:
In August 1995, the Company entered into a loan agreement with a bank (which replaced a $500,000 line of credit with another bank). This $3,000,000 loan agreement is a three year unsecured revolving facility allowing the Company to borrow at the national prime interest rate or the LIBOR plus 2.75% (the interest rate is reset monthly). The Company is required to pay a non-use fee of 1/2 of 1% per annum on the daily average of the unborrowed amount of the revolving loan facility. In July, 1996, the loan agreement was amended to allow the Company to borrow up to $5,000,000 through August 31, 1999. At December 29, 1996, the unborrowed amount under the amended agreement was $3,550,000. The loan agreement contains, among other things, certain financial covenants and restrictions. The more significant financial covenants require the Company maintain or achieve designated amounts of tangible net worth, current ratio and cash flow coverage ratio. The more significant restrictions contained in the amended loan agreement include amounts for capital expenditures, number of new stores, guaranteed debt obligations of any other corporation or individual, entering into merger, acquisition or significant asset sales agreements and limitation of borrowings during a designated period ("clean-down period"). The Company is required to maintain its borrowing under $2,000,000 for 30 consecutive days during the following clean-down periods; November 30, 1996 through January 31, 1997, November 30, 1997 through January 31, 1998 and November 30, 1998 through January 31, 1999.
During the year ended December 29, 1996, the Company had not met a financial covenant and certain restriction provisions under the loan agreement. In April, 1997, these violations were waived by the bank.
(6) RELATED PARTY TRANSACTIONS
An affiliate of the Company is providing marketing and advertising services. Total costs incurred for such services (primarily radio, television and print media) were approximately $607,000 in 1994, $424,000 in 1995 and $168,000 in 1996. A director of the Company is a partner in a law firm that provides legal services to the Company. During 1994, 1995 and 1996, the Company incurred $107,000, $127,000 and $148,000, respectively, in legal services with the firm.
During 1994 and 1996, the Company also acquired common stock from certain officers and directors (see Note 9).
(7) PROVISION FOR RESTAURANT CLOSURES AND OTHER DISPOSALS
During 1995, the Company approved and began the implementation of a plan to close certain under-performing restaurants. As of December 29, 1996, the Company has disposed of three of the four restaurants planned in 1995 for closure. The remaining restaurant closure was completed in the first quarter of 1997. In addition, the Company identified and closed two additional restaurant locations (one of which occupied land and building owned by the Company which is presently held for sale). These restaurants (the 1995 and 1996 identified closures) collectively accounted for $5,695,000, $3,498,000, and $1,784,000 of revenues and $(31,000), $(223,000), and $(68,000) of operating losses for fiscal years 1994, 1995, and 1996, respectively. Management expects the effect of closing under-performing restaurants to result in improved margins and increased profitability for the Company in future periods.
As a result of the completed and planned restaurant closures and other disposals, the Company recorded a pre-tax charge of $897,000 in the third quarter of 1995. The provision related to lease termination costs, litigation settlement costs, write-down of property, equipment and leasehold improvements, and other exits costs. As of December 29, 1996, the Company has a remaining reserve of approximately $145,000 for settlement of its remaining liabilities associated with the closures. Management expects to settle these liabilities in early 1997 and believes the reserve to be sufficient for such purposes.
The Company has eight restaurants as of December 29, 1996, with indicators of potential impairment. During 1996, the Company recorded no provision for impairment as management believes there is no additional impairment under SFAS 121.
(8) INCOME TAXES
The provision (benefit) for income taxes consist of the following (see Note 2):
The components of deferred tax assets and liabilities consist of the following at:
At December 29, 1996, the Company has recorded a benefit for its deferred tax assets of $3,043,000. Management believes that $1,681,000 of these assets will be recognized through the reversal of existing taxable temporary differences with the remainder to be recognized through realization of future income. It is management's opinion based on the historical trend of normal and recurring operating results, present store development, and forecasted operating results that it is more likely than not that the Company will realize the approximately $3,700,000 in future net income in the next three years necessary to realize the deferred tax assets not otherwise offset by reversing taxable temporary differences. Net operating loss carryforwards do not begin to expire until 2003 and general business tax credits until 2009. While management is not presently aware of any adverse matters, it is possible that the Company's ability to realize the deferred income tax assets could be impaired if there are significant future exercises of non-qualified stock options or the Company were to experience declines in sales and/or profit margins as a result of loss of market share, increased competition or other adverse general economic conditions.
A reconciliation of theoretical income taxes follows:
The Company estimates that at December 29, 1996, the tax net operating loss carryforward was approximately $5,900,000 (which principally relates to the tax benefit from the exercise of non-qualified stock options, the benefit of which was recognized through paid-in capital) which is available for utilization in various years through 2010.
(9) STOCKHOLDERS' EQUITY
The Company has authorized 10,000,000 shares of $.002 par value preferred stock. None of the preferred stock has been issued. The rights, preferences and dividend policy have not been established and are at the discretion of the Company's Board of Directors.
The Company has authorized 20,000,000 shares of common stock at a par value of $.002 per share. In conjunction with an offering of common stock in 1993, the Company issued to the underwriters warrants to purchase 67,500 common shares of the Company. Such warrants are exercisable beginning on November 22, 1994, at an initial exercise price of $5.89 per share. The exercise price escalates each anniversary date with a final exercise price of $6.56 per share on the fourth anniversary of the issuance of the warrants. The warrants expire on November 22, 1998. The exercise price and the number of shares of common stock for which the warrants are exercisable are subject to adjustment upon the occurrence of certain dilutive events.
In May 1989, the Company's shareholders approved the Eateries, Inc. Omnibus Equity Compensation Plan ("the Plan") (which was amended in June 1994 by approval of the shareholders). The Plan consolidated the Company's equity based award programs which are described as follows:
DIRECTOR OPTION PLAN
Non-qualified stock options granted and outstanding include 286,993 director options. Under the Plan each director receives options to purchase 50,000 shares of common stock upon initial election to the Board of Directors. These options vest over a five-year period at 20% per year and expire five years from the date vested (last expiring in 2001). As a result of an amendment to the Plan in 1994, any director who has served as a director of the Company for five years, upon election for any additional terms, shall be granted an option to purchase 10,000 shares of common stock for each additional year elected. These options fully vest after one year of additional service by the director and expire five years from the date vested (last expiring in 2002).
MANAGEMENT OPTIONS
Non-qualified stock options granted and outstanding include 542,500 management options, which are vested over three to five-year periods and expire five years from the date vested (last expiring in 2006).
A summary of stock option activity under the Plan is as follows:
As of December 29, 1996, the Plan provides for issuance of options up to 2,494,017 shares and has 619,380 shares of common stock reserved for future grant under the Plan.
RESTRICTED MANAGEMENT OPTIONS
As of December 31, 1995 and December 29, 1996, there were 120,000 and 20,000, respectively, restricted stock options (not granted under the Plan) which primarily vest over a four year period at 25% per year and expire five years from the date vested (last expiring in 2004). A summary of restricted stock option activity is as follows:
EMPLOYEE STOCK PURCHASE PLAN
In June 1994, the Company's shareholders approved the Employee Stock Purchase Plan under the Company's Omnibus Equity Compensation Plan. The Stock Purchase Plan enables substantially all employees to subscribe to shares of common stock on an annual offering date at a purchase price of 85% of the fair market value of the shares on the offering date or, if lower, 85% of the fair market value of the shares on the exercise date, which is one year from the annual offering date. A maximum of 200,000 shares are authorized for subscription over the ten year term of the plan (10,000 shares reserved for issuance at December 29, 1996, for the offering period ending on December 1, 1997). No shares were issued under the plan during 1994. During 1995 and 1996, 12,411 and 24,044 shares, respectively, were issued under the Plan.
STOCK BONUS PLAN
The Plan provides for up to 200,000 shares of stock to be awarded to non-executive employees at the Compensation Committee's discretion over specified future periods of employment. A total of 20,961 shares have been issued under the Plan leaving 179,039 shares available for issuance.
TREASURY STOCK TRANSACTIONS
As provided for in each stock option agreement, option holders can satisfy amounts due for the exercise price and applicable required withholding taxes on the exercise by delivery to the Company shares of common stock having a fair market value equal to such amounts due to the Company. During 1994, 1995 and 1996, the Company acquired 23,104, 1,917 and 8,722 common shares, respectively, in lieu of cash for such amounts due to the Company related to the exercise of stock options. (Also see Note 8 regarding the tax benefits from the exercise of stock options.)
PRO FORMA INFORMATION FOR STOCK OPTIONS
Pro forma information regarding net income and earnings per share is required by SFAS 123, which also requires that the information be determined as if the Company has accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1995 and 1996, respectively: risk-free interest rates of 6.34% and 5.71%; a dividend yield of 0%; volatility factors of the expected market price of the Company's common stock of .28 and .28 and a weighted-average expected life of the options of 7.7 years. The weighted average grant date fair value of options issued in 1995 and 1996 was $1.21 and $1.08, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options and stock purchase plan have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options and stock purchase plan.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows:
Because SFAS 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma effect will not be fully reflected until 2000.
(10) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (In thousands except per share data)
INDEX TO EXHIBITS
- --------------- (1) Filed as exhibit to Registrant's Registration Statement on Form S-18 (File No. 33-6818-FW). (2) Filed as exhibit to Registrant's Quarterly Report on Form 10-Q for the six months ended June 30, 1988 (File No. 0-14968) and incorporated herein by reference. (3) Filed as exhibit to Registrant's Registration Statement on Form S-2 (File No. 33-69896). (4) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 0-14968) and incorporated herein by reference. (5) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (File No. 0-14968) and incorporated herein by reference. (6) Filed as exhibit to Registrant's Registration Statement on form S-8 (File No. 33-41279). (7) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993 (File No. 0-14968) and incorporated herein by reference. (8) Filed as Appendix A to the Company's Notice of Annual Meeting of Shareholders dated April 29, 1994 and incorporated herein by reference. (9) Filed as exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994 (File No. 0-14968) and incorporated herein by reference.