10-Q 1 sept710q.txt FORM 10-Q FOR QUARTER ENDING SEPTEMBER 7, 2003 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------------------- FORM 10-Q ---------------------- (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 7, 2003 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ------------- Commission file number 333-57931 TUMBLEWEED, INC. (Exact name of registrant as specified in its charter) DELAWARE 61-1327945 (State or other jurisdiction of ( I.R.S. Employer Identification No.) incorporation or organization) 2301 River Road, Suite 200, Louisville, Kentucky 40206 (Address of principal executive offices) (502) 893-0323 (Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____ ---- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ____ No X ----- The number of shares of common stock, par value of $.01 per share, outstanding on October 15, 2003 was 5,916,153. TUMBLEWEED, INC. INDEX PART I. FINANCIAL INFORMATION PAGE Item 1. Financial Statements (Unaudited) a) Consolidated Statements of Operations for the thirty-six weeks and twelve weeks ended September 7, 2003 and September 8, 2002 3 b) Consolidated Balance Sheets as of September 7, 2003 and December 29, 2002 4 c) Consolidated Statements of Cash Flows for the thirty-six weeks ended September 7, 2003 and September 8, 2002 5 d) Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 Item 4. Controls and Procedures 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings 23 Item 6. Exhibits and Reports on Form 8-K 24 Signature 25 2 Tumbleweed, Inc. Consolidated Statements of Operations (Unaudited)

See accompanying notes. 3 Tumbleweed, Inc. Consolidated Balance Sheets

See accompanying notes. 4 Tumbleweed, Inc. Consolidated Statements of Cash Flows (Unaudited)

See accompanying notes. 5 TUMBLEWEED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) September 7, 2003 1. BASIS OF PRESENTATION Restaurant Facilities As of September 7, 2003, the Company owned, franchised or licensed 56 Tumbleweed restaurants. The Company owned and operated 31 restaurants in Kentucky, Indiana and Ohio. There were 21 franchised restaurants located in Indiana, Illinois, Kentucky and Wisconsin and four licensed restaurants located outside the United States in Germany, Jordan, Egypt and Turkey. The following table reflects changes in the number of Company-owned, franchise and licensed restaurants during the thirty-six weeks ended September 7, 2003. Company-owned restaurants: In operation, beginning of period 31 Restaurants opened 0 Restaurants closed 0 -------- In operation, end of period 31 Franchise and licensed restaurants: In operation, beginning of period 25 Restaurants opened 2 Restaurants closed (2) -------- In operation, end of period 25 -------- System Total 56 ======== Interim Financial Reporting The accompanying consolidated financial statements have been prepared by the Company without audit, with the exception of the December 29, 2002 consolidated balance sheet which was derived from the audited consolidated financial statements included in the Company's Form 10-K. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and in accordance with Rule 10-01 of Regulation S-X. These consolidated financial statements, note disclosures and other information should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2002. In the opinion of management, the unaudited interim consolidated financial statements contained in this report reflect all adjustments, consisting of a change in accounting principle and normal recurring accruals, which are necessary for a fair presentation. The results of operations for the thirty-six weeks and twelve weeks ended September 7, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ended December 28, 2003. Recently Issued Accounting Standards In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements No. 4,44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections," which is effective for the Company in 2003. SFAS No. 145 eliminates SFAS No. 4, which required all gains (losses) from extinguishment of debt to be classified as an extraordinary item, net of related income tax effect, and thus, gains (losses) from extinguishment of debt should be classified as extraordinary items only if they meet the criteria in APB Opinion No. 30. SFAS No. 145 amends SFAS No. 13 to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Additionally, SFAS No.145 rescinds SFAS No. 44 and 64 because the statements are no longer applicable. Tumbleweed will adopt SFAS No. 145 in 2003 which will result in reclassifying its loss on unamortized loan costs, which occured during the fourth quarter of 2002,from an extraordinary item to an operating item in the Consolidated Statement of Operations for the fiscal year ended December 29, 2002. 6 1. BASIS OF PRESENTATION (continued) In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51" ("FIN 46"). FIN 46 addresses the consolidation of entities whose equity holders have either (a) not provided sufficient equity at risk to allow the entity to finance its own activities or (b) do not possess certain characteristics of a controlling financial interest. FIN 46 requires the consolidation of these entities, known as variable interest entities ("VIEs"), by the primary beneficiary of the entity. The primary beneficiary is the entity, if any, that is subject to a majority of the risk of loss from the VIE's activities, entitled to receive a majority of the VIE's residual returns, or both. FIN 46 applies immediately to variable interests in VIEs created or obtained after January 31, 2003. For variable interests in a VIE created before February 1, 2003, FIN 46 was originally effective no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003 (the quarter beginning June 16, 2003 for the Company). However, on October 8, 2003, the FASB delayed the effective date for consolidating variable interests created before February 1, 2003 until the end of the period ending after December 15, 2003 (December 28, 2003 for the Company). The Company's management continues to evaluate the requirements of FIN 46 with respect to the Company's specific facts, including but not limited to certain advertising funds and franchise agreements, in order to determine the impact, if any, on its financial statements. Stock-Based Compensation Costs The Company has a stock-based compensation (stock option) plan which is described more fully in the Company's Form 10-K. The Company accounts for the plan using the intrinsic value method of APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Because all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant, no stock-based compensation cost has been recognized in the consolidated statements of operations. Had stock-based compensation cost for the plan been determined using the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," the effect on the Company's consolidated net income and earnings per share would have been as follows for the thirty-six weeks and twelve weeks ended September 7, 2003 and September 8, 2002:

2. GOODWILL AND INTANGIBLE ASSETS Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." During the first quarter of 2002, the Company determined that all goodwill as of January 1, 2002 related to two reporting units was impaired. The fair value of each unit was determined using appropriate valuation techniques. As a result of the transitional impairment test, an impairment loss in the amount of $1,503,773, net of tax, was recorded as a cumulative effect of a change in accounting principle during the first quarter of 2002. During the fourth quarter of 2002, the Company completed the annual test of impairment and determined that there was no impairment of the $174,657 goodwill acquired during the purchase of the remaining 50% interest in TW-Springhurst nor the $1,455,966 in Tumbleweed licensing rights acquired from Tumbleweed International, LLC. See Notes 7 and 8 for further discussion of this transaction. 7 2. GOODWILL AND INTANGIBLE ASSETS (continued) The Company acquired Tumbleweed International, LLC (see Note 8) during the first quarter of 2002, which resulted in the acquisition of an intangible asset in the amount of $1,525,966 and is included in the corporate segment. The intangible asset consists of $1,455,966 in international licensing rights, which are indefinitely lived assets not subject to amortization under SFAS No. 142, and $70,000 of existing franchise contracts, which are definite lived assets amortized over the 45 year contract period. During the first three quarters of 2003, the Company recorded amortization expense totaling $1,077 for the definite lived intangible. The amortization expense for each of the next five years will approximate $1,555 per year. 3. ACCRUED LIABILITIES Accrued liabilities consist of:

4. LONG-TERM DEBT Long-term debt consists of:

(Continued next page) 8 4. LONG-TERM DEBT (continued)

Based on the borrowing rates currently available to the Company for mortgages with similar terms and average maturities, the fair value of long term debt approximates carrying value. On December 31, 2002, the Company completed an $18.0 million financing package with GE Capital Franchise Finance Corporation. The financing package consolidated all of the Company's outstanding debt and equipment capital leases and provided approximately $2.9 million for the remodel and expansion of Company restaurants. The debt bears interest at both fixed rates ranging from 8.32% to 8.52% ($8,872,000) and a variable rate of LIBOR plus 4.20% ($9,128,000) with terms of 10 to 15 years. The debt is secured by fifteen fee simple properties and substantially all of the equipment owned by the Company with a net book value of approximately $22,500,000 at September 7, 2003. The Company is in compliance with various financial covenants at the end of the third quarter of 2003 and management expects to be in compliance with the various financial covenants throughout 2003. On August 4, 2003, the Company obtained construction financing in the amount of $1,300,000. The note bears interest at the prime rate plus 1/2% and is due February 1, 2005. At September 7, 2003, the note had a balance of $322,878. The proceeds of the loan along with cash reserves and an equipment operating lease will be used to fund the estimated new restaurant facility construction cost of $2,600,000. The restaurant is located in Dublin, Ohio and is currently expected to open in the fourth quarter of 2003. Upon its maturity, the Company plans to replace the construction loan with permanent financing. 9 5. EARNINGS PER SHARE The following is a reconciliation of the Company's basic and diluted earnings (loss) per share data for the thirty-six weeks and twelve weeks ended September 7, 2003 and September 8, 2002 in accordance with SFAS 128, "Earnings per Share."

6. SEGMENT INFORMATION The Company has three reportable segments: restaurants, commissary and corporate. The restaurant segment consists of the operations of all Company-owned restaurants and derives its revenues from the sale of food products to the general public. The commissary segment derives its revenues from the sale of food products to Company-owned and franchised restaurants and non-affiliated restaurant concepts. The corporate segment derives revenues from sale of franchise rights, franchise royalties and related services used in restaurant operations, and contains the selling, general and administrative activities of the Company. Generally, the Company evaluates performance and allocates resources based on pre-tax income. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company's Annual Report on Form 10-K. Segment information for the thirty-six weeks ended September 7, 2003 is as follows:

10 6. SEGMENT INFORMATION (continued) Segment information for the thirty-six weeks ended September 8, 2002 is as follows:

7. INVESTMENT IN TW-SPRINGHURST During the year ended December 31, 2000, the Company made a $200,000 investment in TW-Springhurst, LLC ("TW- Springhurst"), the owner and operator of a Tumbleweed restaurant in Louisville, Kentucky. Through December 31, 2001, the Company had a 50% interest with the remaining 50% held by TW-Springhurst Investors, LLC. A current and former director of the Company owned TW-Springhurst Investors, LLC. On January 1, 2002, the Company acquired the remaining 50% interest held by TW-Springhurst Investors for $267,000. The Company also assumed TW-Springhurst, LLC's note payable to a bank which had a balance of approximately $161,000 on the date of purchase. An independent business valuation appraisal was used to assist Company management in determining the purchase price. 11 7. INVESTMENT IN TW-SPRINGHURST (continued) The purchase price has been allocated as follows: Assets and liabilities acquired: Inventory $ 55,674 Property and equipment 317,601 Deposits 1,200 Other 5,677 Note payable (161,394) ------------- 218,758 Investment in TW-Springhurst (126,415) Goodwill 174,657 ------------- $ 267,000 ============= 8. ACQUISITION OF INTERNATIONAL On January 1, 2002, the Company purchased the ownership interest in Tumbleweed International, LLC ("International") for $1.5 million from TW-International Investors, Inc. and Chi-Chi's International Operations, Inc. ("CCIO"). CCIO owned 40% of International. The President and Chief Executive Officer of the Company is the sole shareholder of CCIO. Members of TW-International Investors, Inc. include three current directors of the Company. The acquisition gives the Company direct control and benefit of the international licensing of the Tumbleweed concept. In connection with the acquisition, the Company assumed an existing $1.4 million bank loan of TW-International Investors, Inc. and issued 76,923 shares of its common stock to CCIO. The Company has entered into a commission agreement with CCIO in connection with the sale of international regional licenses by International. The transaction was accounted for as a purchase and the purchase price was allocated to the intangible assets acquired - the Tumbleweed international licensing rights and existing franchise contracts. The allocation of the purchase price is summarized as follows. Note payable $ 1,425,968 Common stock 769 Paid-in capital 99,229 ------------- $ 1,525,966 ============= Intangible assets: Tumbleweed licensing rights $ 1,455,966 Contracts in place 70,000 ------------- $ 1,525,966 ============= 9. INCOME TAXES Income taxes on the Company's income before income taxes and cumulative effect of a change in accounting principle for the thirty-six weeks ended September 7, 2003 and September 8, 2002 have been provided for at an estimated effective tax rate of 44% and 58%, respectively. The effective tax rate differs from the statutory federal tax rate of 34% substantially due to the impact of permanent differences. 10. INVOLUNTARY CONVERSION OF NON-MONETARY ASSETS As a result of a fire on July 11, 2002 at a Company-owned restaurant in Ohio, an involuntary conversion of a non- monetary asset occurred. During the thirty-six weeks ended September 7, 2003 and September 8, 2002, the Company recorded as other revenues approximately $34,000 and $70,000, respectively, of business interruption income which was reimbursed by the Company's insurance. 12 11. COMMITMENTS AND CONTINGENCIES At September 7, 2003, the Company had a commitment of approximately $860,000 for the completion of the construction of one restaurant facility. The commitment will be funded by proceeds from the $1,300,000 note payable which had a balance of $322,878 at September 7, 2003 (see Note 4). The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company has agreed to assume and pay one of the equipment leases totaling approximately $125,000 and remains contingently liable on two other equipment leases that currently have a remaining balance of approximately $17,000 which the Company believes will be assumed and paid by other guarantors. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it assumed. As of September 7, 2003, the reserve balance is approximately $44,000 which management believes is sufficient to satisfy the remaining lease obligation. The Company's management believes it will not incur significant additional losses in connection with this matter. On December 16, 2002, the Company filed a Complaint in Jefferson County, Kentucky Circuit Court against American Federal, Inc. ("AFI") seeking a declaratory judgment that the Company has no contractual obligation to pay a commission to AFI, in connection with a Conditional Commitment entered into between AFI and the Company and is seeking damages for fraud and misrepresentation when AFI provided a commitment for a $20.1 million financing which the Company believes AFI never intended to fund as they had represented. In response, AFI filed suit in the United States District Court for the Eastern District of Missouri seeking payment of approximately $500,000 which includes a $405,000 commitment fee plus additional charges, fees and costs related to the Conditional Commitment, as well as damages for breach of contract, unjust enrichment and misrepresentation/fraud. This matter is in the early discovery stage. Management believes that AFI's claims are without merit, but it is too early to predict an outcome. The Company intends to vigorously defend itself in connection with this matter. As of September 7, 2003, the Company has not made an accrual in the accompanying consolidated financial statements for a potential liability in connection with this matter. We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us. 12. OTHER EVENTS On June 16, 2003, the Company's Board of Directors approved a one-for-5000 reverse stock split to be immediately followed by a 5000-for-one forward stock split, subject to stockholder approval. Persons otherwise entitled to receive less than one share in the reverse stock split would receive cash in the amount of $1.10 per share. The Board preliminarily approved the transaction on May 19, 2003, subject to receipt of a fairness opinion from FTN Financial Securities Corp. ("FTN"), financial advisor to the special committee of the Board, and stockholder approval. On June 16, 2003, the Board approved the transaction following the Committee's receipt of a fairness opinion with regard to the per share cash amount to be paid in the reverse split from FTN and the recommendation of the special committee. The transaction is subject to the approval of the stockholders. Stockholders will be asked to approve the transaction at the annual meeting of stockholders currently expected to be held in the fourth quarter of 2003. The transaction, if approved by the stockholders, would reduce the number of stockholders below the level at which the Company would be required to continue to file reports with the SEC, and the Company's stock would no longer be traded on the Nasdaq Small Cap Market. Any trading of the Company's common stock after the transaction would only occur in the "pink sheets" or in privately negotiated sales. Company's management currently estimates that the total funds required to pay the consideration to stockholders entitled to receive cash for their shares and to pay fees and expenses relating to the transaction will be approximately $1.0 million. Cash reserves will be used to fund the transaction. If the above described transaction is completed, it is expected that the remaining stockholders will be asked to approve a conversion of the Company from a Delaware corporation to a Delaware limited liability company. The conversion would be accomplished through the transfer of the Company's assets and liabilities to a newly-formed Delaware limited liability company and liquidation of the existing Delaware corporation. No additional equity contributions to the Company or the limited liability company would be required. 13 13. SUBSEQUENT EVENTS Subsequent to September 7, 2003, the Company purchased approximately 1.5 acres of land in Louisville, Kentucky for approximately $824,000. The Company plans to construct a 5,100 square foot Tumbleweed restaurant on this property. The total project cost, including preopening costs, is currently estimated at $2,500,000. The Company currently anticipates using sale leaseback financing and cash reserves to fund the project cost. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL We make various forward-looking statements about our business in the following discussion. When making these forward-looking statements, we use words such as expects, believes, estimates, anticipates, plans and similar expressions to identify them. We also identify important cautionary factors that could cause our actual results to differ materially from those projected in the forward-looking statements we make. Factors that realistically could cause results to differ materially from those projected in the forward-looking statements include the availability and cost of financing and other events that affect our restaurant expansion program, changes in food and other costs, changes in national, regional or local economic conditions, changes in consumer tastes, competitive factors such as changes in the number and location of competing restaurants, the availability of experienced management and hourly employees, and other factors set forth below. As of September 7, 2003, we owned, franchised or licensed 56 Tumbleweed restaurants. The Company owned and operated 31 restaurants in Kentucky, Indiana and Ohio. There were 21 franchised restaurants in Indiana, Illinois, Kentucky and Wisconsin and four licensed restaurants located outside the United States in Germany, Jordan, Egypt and Turkey. During the first quarter of 2002, the Company closed four Company-owned restaurant locations. The restaurants were located in Cincinnati, Ohio (2), Columbus, Ohio (1), and Evansville, Indiana (1). The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. On January 1, 2002, the Company purchased from its joint venture partner the remaining 50% interest in a restaurant location. See Note 7 to the consolidated financial statements for a further discussion of this transaction. During the second quarter of 2002, the Company sold one of its restaurant locations to a franchisee. This was in accordance with the Company's plan it established in the fourth quarter of 2001. In connection with the plan, the Company had taken a charge to earnings in accordance with SFAS No. 121, "Impairment of Long-Lived Assets." The personal property had no value on the books of the Company as a result of this special charge. The franchisee assumed the building lease and purchased the inventory for $11,000. The following section should be read in conjunction with our financial statements and the related notes included elsewhere in this filing. 15 RESULTS OF OPERATIONS The table below sets forth the percentage relationship to total revenues of certain income statement data, except where noted, for the periods indicated.

(1) As percentage of restaurant sales. (2) As percentage of commissary sales. COMPARISON OF THE FIRST THREE QUARTERS OF 2003 AND 2002 Total revenues increased by $300,954 or 0.7% for the first three quarters of 2003 compared to the same period in 2002 primarily as a result of the following: Restaurant sales decreased by $53,565 or 0.1% for the first three quarters of 2003 compared to the same period in 2002. The decrease in restaurant sales is primarily a result of the closing of four Company-owned restaurants during the first quarter of 2002, the temporary closing of one Company-owned restaurant in July 2002 as a result of a fire (restaurant reopened mid-February 2003), and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002. The decrease in restaurant sales is partially offset by a 0.7% increase in same store sales for the first three quarters of 2003 and a 2.0% menu price increase in mid-February 2003. Commissary sales to franchised and licensed restaurants and non-affiliated restaurant concepts increased by $371,972 or 31.4% for the first three quarters of 2003 compared to the same period in 2002. The increase in commissary sales is primarily a result of an increase in sales to non-affiliated restaurant concepts and the addition of two franchised restaurants during 2003. Franchise fees and royalties increased by $135,531 or 16.1% for the first three quarters of 2003 compared to the same period in 2002. Franchise income increased $70,000 as a result of having two franchise restaurant openings in the first three quarters of 2003 compared to no franchise restaurant openings during the first three quarters of 2002. Royalty 16 income increased $65,531 primarily as a result of the two franchise restaurant openings during the first three quarters of 2003 and increased royalties received from international licensees. Other revenues decreased by $152,984 or 35.3% for the first three quarters of 2003 compared to the same period in 2002 partially as a result of a temporary decrease in purchasing rebates. The decrease in other revenues can also be attributed to recognizing as income, in 2002, $55,000 of development fees which were forfeited by a franchisee. There was no similar income in 2003. Additionally, the decrease in other income is due to the fact that other income for the 2002 period includes $70,000 of insurance proceeds (business interruption income) compared to $34,000 of insurance proceeds in the 2003 period. The insurance proceeds were a result of a fire which occurred at a Company-owned restaurant in July 2002. Restaurant cost of sales decreased by $369,642 or 3.1% for the first three quarters of 2003 compared to the same period in 2002. The decrease in restaurant cost of sales is primarily a result of the closing of four Company-owned restaurants during the first quarter of 2002, the temporary closing of one Company-owned restaurant in July 2002 as a result of a fire (restaurant reopened mid-February 2003), and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002. Restaurant cost of sales decreased as a percentage of restaurant sales by 0.9% to 29.3% for the first three quarters of 2003 compared to 30.2% during the same period in 2002. The 0.9% decrease in cost of sales as a percentage of restaurant sales is primarily the result of improved operating efficiencies and lower product costs at the restaurant level combined with a 2.0% menu price increase in mid-February 2003. Commissary cost of sales increased $255,700 or 24.2% for the first three quarters of 2003 compared to the same period in 2002. The increase in commissary cost of sales is due primarily to the increase in sales. As a percentage of commissary sales, commissary cost of sales decreased 4.9% for the first three quarters of 2003 compared to the same period in 2002 primarily as a result of an increase in sales to non-affiliated restaurant concepts. Restaurant operating expenses decreased by $402,047 or 1.9% for the first three quarters of 2003 compared to the same period in 2002. The decrease in operating expenses is primarily a result of the closing of four Company-owned restaurants during the first quarter of 2002, the temporary closing of one Company-owned restaurant in July 2002 as a result of a fire (restaurant reopened mid-February 2003), and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002. Operating expenses decreased as a percentage of restaurant sales by 0.9% to 54.6% for the first three quarters of 2003 from 55.5% for the same period in 2002 primarily as a result of decreased hourly labor costs and administrative costs and a 2.0% menu price increase in mid-February 2003. Selling, general and administrative expenses increased by $310,720 or 7.7% for the first three quarters of 2003 compared to the same period in 2002. The increase in selling, general and administrative expenses is primarily a result of training costs incurred as a result of two franchise restaurant openings in the first three quarters of 2003 (no similar expense was incurred in the first three quarters of 2002), increased management development costs for Company-owned restaurants and increased incentive based compensation costs. As a percentage to total revenues, selling, general and administrative expenses were 10.5% and 9.8% for the first three quarters of 2003 and 2002, respectively. Preopening expenses were $65,846 for the first three quarters of 2003. These expenses represent the portion of preopening costs which were incurred in connection with the 2003 reopening of the restaurant which had been destroyed by fire in July 2002 that were not recoverable from insurance and start-up costs incurred in connection with the opening of two restaurants. These costs are expensed as incurred and will fluctuate based on the size of the restaurant and the number of restaurant locations which are in the process of being prepared for opening. The Company is currently preparing for restaurant openings in late 2003 and early 2004. Depreciation and amortization expense increased $72,414 or 5.3% for the first three quarters of 2003 compared to the same period in 2002 primarily as a result of capital improvements made to existing Company-owned restaurants. Net interest expense increased $233,490 or 33.4% for the first three quarters of 2003 compared to the same period in 2002. The increase in net interest expense is primarily a result of the approximately $3.2 million of additional debt the Company incurred in connection with the debt refinancing which was completed on December 31, 2002. See "Liquidity and Capital Resources" section below for a further discussion of this transaction. 17 Income taxes on the Company's income before income taxes and cumulative effect of a change in accounting principle for the first three quarters of 2003 and 2002 have been provided for at an estimated effective tax rate of 44% and 58%, respectively. The effective tax rate differs from the statutory federal tax rate of 34% substantially due to the impact of permanent differences. COMPARISON OF THE THIRD QUARTER OF 2003 AND 2002 Total revenues increased by $646,939 or 4.9% for the third quarter of 2003 compared to the same period in 2002 primarily as a result of the following: Restaurant sales increased by $556,755 or 4.5% for the third quarter of 2003 compared to the same period in 2002. The increase in restaurant sales is primarily due to the fact that a Company-owned restaurant which had been destroyed by fire in the third quarter of 2002 (July) was reopened in early 2003 (February). The increase in restaurant sales is also a result of a 1.3% increase in same store sales for the third quarter of 2003 and a 2.0% menu price increase in mid- February 2003. Commissary sales to franchised and licensed restaurants and non-affiliated restaurant concepts increased by $116,956 or 30.2% for the third quarter of 2003 compared to the same period in 2002. The increase in commissary sales is primarily a result of an increase in sales to non-affiliated restaurant concepts and the addition of two franchised restaurants during 2003. Franchise fees and royalties increased $41,579 or 13.8% for the third quarter of 2003 compared to the same period in 2002. Royalty income increased $41,579 primarily as a result of two franchise restaurant openings during the first two quarters of 2003 and increased royalties received from international licensees. There was no franchise income in either the 2003 or 2002 periods. Other revenues decreased by $68,351 or 49.2% for the third quarter of 2003 compared to the same period in 2002. The decrease in other revenues is due to the fact that the 2002 period includes $70,000 of insurance proceeds (business interruption income recorded as other revenue in 2002) which were a result of a fire in July 2002 at a Company-owned restaurant. There was no similar income in the same period of 2003. Restaurant cost of sales increased by $127,848 or 3.5% for the third quarter of 2003 compared to the same period in 2002. The increase in restaurant cost of sales is primarily due to the fact that a Company-owned restaurant which had been destroyed by fire in the third quarter of 2002 (July) was reopened in early 2003 (February). Restaurant cost of sales decreased as a percentage of sales by 0.3% to 29.7% for the third quarter of 2003 compared to 30.0% during the same period in 2002. The 0.3% decrease in cost of sales as a percentage of restaurant sales is primarily the result of improved operating efficiencies and lower product costs at the restaurant level combined with a 2.0% menu price increase in mid- February 2003. Commissary cost of sales increased $63,922 or 18.4% for the third quarter of 2003 compared to the same period in 2002. The increase in commissary cost of sales is due primarily to the increase in sales. As a percentage of commissary sales, commissary cost of sales decreased 8.0% for the third quarter of 2003 compared to the same period in 2002 as a result of an increase in sales to non-affiliated restaurant concepts. Restaurant operating expenses increased by $200,446 or 2.9% for the third quarter of 2003 compared to the same period in 2002 due to the fact that a Company-owned restaurant which had been destroyed by fire in the third quarter of 2002 (July) was reopened in early 2003 (February). Operating expenses decreased as a percentage of restaurant sales by 0.9% to 55.4% for the third quarter of 2003 from 56.3% for the same period in 2002 primarily as a result of decreased hourly labor costs and administrative costs and a 2.0% menu price increase in mid-February 2003. Selling, general and administrative expenses increased by $155,552 or 12.8% for the third quarter of 2003 compared to the same period in 2002. The increase in selling, general and administrative expenses is primarily a result of increased incentive based compensation costs. As a percentage to total revenues, selling, general and administrative expenses were 9.9% and 9.2% for the third quarter of 2003 and 2002, respectively. Preopening expenses were $36,981 for the third quarter of 2003. The expenses represent start-up costs incurred in connection with the opening of two restaurants. These costs are expensed as incurred and will fluctuate based on the size of the restaurant and the number of restaurant locations which are in the process of being prepared for opening. The 18 Company is currently preparing for restaurant openings in late 2003 and early 2004. Depreciation and amortization expense increased $36,378 or 8.1% for the third quarter of 2003 compared to the same period in 2002 primarily as a result of capital improvements made to existing Company-owned restaurants. Net interest expense increased $67,072 or 28.5% for the third quarter of 2003 compared to the same period in 2002. The increase in net interest expense for the third quarter is primarily a result of the approximately $3.2 million of additional debt the Company incurred in connection with the debt refinancing which was completed December 31, 2002. See below for a further discussion of this transaction. Income taxes on the Company's income before income taxes and cumulative effect of a change in accounting principle for the third quarter of 2003 and 2002 have been provided for at an estimated effective tax rate of 44% and 85%, respectively. The effective tax rate differs from the statutory federal tax rate of 34% substantially due to the impact of permanent differences. LIQUIDITY AND CAPITAL RESOURCES On December 31, 2002, the Company completed an $18.0 million financing package with GE Capital Franchise Finance Corporation (GE). The loan was divided into two real estate loans totaling $14.5 million secured by fifteen fee simple properties, one loan ($7,122,000 original amount) bearing interest at a fixed rate of 8.52% for 15 years and the other ($7,378,000 original amount) at a variable rate of LIBOR plus 4.20% over 15 years. The Company also entered into two equipment loan agreements totaling $3.5 million secured by substantially all the equipment of the Company. One equipment loan ($1,750,000 original amount) bears interest at a fixed rate of 8.32% over 10 years while the other equipment loan ($1,750,000 original amount) has a variable rate of LIBOR plus 4.20% over 10 years. The financing package consolidated all of the Company's outstanding debt and provides approximately $1.7 million for the remodel, modernization and / or upgrade of the properties described in the renovation agreements signed with GE. The Company has until June 30, 2004 to complete the renovations, unless the Company obtains GE's written consent for an extension of such date. Additionally, the financing package provides for $1.2 million to be used for expansion of Company restaurants. The loan imposes restrictions on the Company with respect to the maintenance of certain financial covenants, the incurrence of indebtedness, the sale of assets and capital expenditures. The Company is required to maintain two separate Fixed Charge Coverage Ratios. One is a Corporate Fixed Charge Coverage Ratio of 1.25:1 based on results of the entire company and the second, an aggregate Fixed Charge Coverage Ratio of at least 1.25:1 on the properties used as collateral on these loans. Both ratios are determined as of the last day of each fiscal year with respect to the twelve- month period of time immediately preceding the date of determination. The Company must also maintain a Funded Debt to EBITDA ratio not to exceed 5.5 to 1.0, determined as of the last day of each fiscal quarter for the twelve-month period of time immediately preceding the date of determination. With the exception of new store development, the Company shall not incur debt in excess of $500,000 per year without prior written consent of GE. The Company is in compliance with various financial covenants at the end of the third quarter of 2003, and management expects to be in compliance with the financial covenants throughout 2003. On August 4, 2003, the Company obtained construction financing in the amount of $1,300,000. The note bears interest at the prime rate plus 1/2% and is due February 1, 2005. At September 7, 2003, the note had a balance of $322,878. The proceeds of the loan along with cash reserves and an equipment operating lease will be used to fund the estimated construction cost of $2,600,000. Upon its maturity, the Company plans to replace the construction loan with permanent financing. In negotiating such financing, there can be no assurance that the Company will be able to obtain financing on terms satisfactory to the Company's management. Our capital needs during the first three quarters of 2003 arose from the reconstruction of a restaurant facility which was damaged by fire in July 2002, the maintenance and improvement of existing restaurant facilities, the purchase of 2.2 acres of land in Dublin, Ohio and the commencement of construction of a restaurant facility on this site which is anticipated to open during the fourth quarter of 2003. Our capital needs during the first three quarters of 2002 arose from the maintenance and improvement of existing restaurant facilities. The source of capital to fund the reconstruction was primarily insurance proceeds received in 2002 and 2003. The maintenance and improvement expenditures were funded by internally generated cash flow. The 2003 maintenance and improvement expenditures were also partially funded by the $1.7 million generated from the debt refinancing, as discussed above. The source of capital to fund the land purchase and restaurant facility construction costs was the $1.2 million generated from the $18.0 million financing package and the $1.3 million construction loan. (See discussion above regarding both loans). 19 The table below provides certain information regarding our sources and uses of cash for the periods presented. Thirty-Six Thirty-Six Weeks Ended Weeks Ended September 7, September 8, 2003 2002 ---------------- ----------------- Net cash provided by operations $ 2,398,235 $ 1,327,526 Purchases of property and equipment (2,577,038) (630,905) Business acquisition - (150,000) Net borrowings (payments) on long-term debt and capital lease obligations 3,117,068 (1,032,443) The Company's largest use of funds during the first three quarters of 2003 was for the reconstruction of a restaurant facility which was damaged by fire in July 2002 (restaurant reopened in mid-February 2003), payments of long-term debt, maintenance and improvement of existing restaurant facilities, the purchase of land in Dublin, Ohio, and restaurant facility construction costs. The Company's largest sources of funds during the first three quarters of 2003 were proceeds from the debt refinancing, cash reserves, cash flow from operations, and insurance proceeds for the property and equipment which was destroyed in July 2002. The Company's largest use of funds during the first three quarters of 2002 was for the payment of long-term debt and capital lease obligations and for the acquisition of the remaining 50% interest in TW-Springhurst. The Company's largest sources of funds during the first three quarters of 2002 were proceeds from the Company's two mortgage revolving lines of credit and cash flow from operations. Sales are predominantly for cash and the business does not require the maintenance of significant receivables or inventories. In addition, it is common within the restaurant industry to receive trade credit on the purchase of food, beverage and supplies, thereby reducing the need for incremental working capital to support sales increases. We both own and lease our restaurant facilities. Management determines whether to acquire or lease a restaurant facility based on its evaluation of the financing alternatives available for a particular site. In the next 12 months, the Company expects to construct one to two additional restaurant facilities in addition to the restaurant facility currently under construction. Our ability to expand our number of restaurants will depend on a number of factors, including the selection and availability of quality restaurant sites, the negotiation of acceptable lease or purchase terms, the securing of required governmental permits and approvals, the adequate supervision of construction, the hiring, training and retaining of skilled management and other personnel, the availability of adequate financing and other factors, many of which are beyond our control. The hiring and retention of management and other personnel may be difficult given the low unemployment rates in the areas in which we intend to operate. There can be no assurance that we will be successful in opening the number of restaurants anticipated in a timely manner. Furthermore, there can be no assurance that our new restaurants will generate sales revenue or profit margins consistent with those of our existing restaurants, or that these new restaurants will be operated profitably. In the next 12 months, the Company expects the demand on future liquidity to be principally from the ongoing maintenance and improvement of existing restaurant facilities and from the construction of one to two additional restaurant facilities in addition to the restaurant facility currently under construction. At September 7, 2003, the Company had a commitment of approximately $860,000 for the completion of the construction of one restaurant facility. The commitment will be funded by proceeds from the $1,300,000 note payable which had a balance of $322,878 at September 7, 2003. In addition to the $1.2 million reserve established as a result of the GE financing package, the Company will utilize mortgage, sale/leaseback and/or landlord financing, as well as equipment leasing and financing, for a portion of the development costs of restaurants the Company plans to open in the next 12 months. The remaining costs will be funded by available cash reserves and cash provided from operations. Management believes such sources will be sufficient to fund the Company's expansion plans in the next 12 months. Should the Company's actual results of operations fall short of, or the Company's rate of expansion significantly exceed plans, or should the Company's costs of capital expenditures exceed expectations, the Company may need to seek additional financing in the future. In negotiating such financing, there can be no assurance that the Company will be able to raise additional capital on terms satisfactory to the Company's management. On June 16, 2003, the Company's Board of Directors approved a one-for-5000 reverse stock split to be immediately followed by a 5000-for-one forward stock split, subject to stockholder approval. Persons otherwise entitled to receive less than one share in the reverse stock split would receive cash in the amount of $1.10 per share. The Board preliminarily approved the transaction on May 19, 2003, subject to receipt of a fairness opinion from FTN Financial 20 Securities Corp. ("FTN"), financial advisor to the special committee of the Board, and stockholder approval. On June 16, 2003, the Board approved the transaction following the Committee's receipt of a fairness opinion with regard to the per share cash amount to be paid in the reverse split from FTN and the recommendation of the special committee. The transaction is subject to the approval of the stockholders. Stockholders will be asked to approve the transaction at the annual meeting of stockholders currently expected to be held in the fourth quarter of 2003. The transaction, if approved by the stockholders, would reduce the number of stockholders below the level at which the Company would be required to continue to file reports with the SEC, and the Company's stock would no longer be traded on the Nasdaq Small Cap Market. Any trading of the Company's common stock after the transaction would only occur in the "pink sheets" or in privately negotiated sales. Company's management currently estimates that the total funds required to pay the consideration to stockholders entitled to receive cash for their shares and to pay fees and expenses relating to the transaction will be approximately $1.0 million. Cash reserves will be used to fund the transaction. If the above described transaction is completed, it is expected that the remaining stockholders will be asked to approve a conversion of the Company from a Delaware corporation to a Delaware limited liability company. The conversion would be accomplished through the transfer of the Company's assets and liabilities to a newly-formed Delaware limited liability company and liquidation of the existing Delaware corporation. No additional equity contributions to the Company or the limited liability company would be required. Subsequent to September 7, 2003, the Company purchased approximately 1.5 acres of land in Louisville, Kentucky for approximately $824,000. The Company plans to construct a 5,100 square foot Tumbleweed restaurant on this property. The total project cost, including preopening costs, is currently estimated at $2,500,000. The Company currently anticipates using sale leaseback financing and cash reserves to fund the project cost. In negotiating such financing, there can be no assurance that the Company will be able to obtain financing on terms satisfactory to the Company's management. The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company has agreed to assume and pay one of the equipment leases totaling approximately $125,000 and remains contingently liable on two other equipment leases that currently have a remaining balance of approximately $17,000 which the Company believes will be assumed and paid by other guarantors. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it assumed. As of September 7, 2003, the reserve balance is approximately $44,000 which management believes is sufficient to satisfy the remaining lease obligation. The Company's management believes it will not incur significant additional losses in connection with this matter. On December 16, 2002, the Company filed a Complaint in Jefferson County, Kentucky Circuit Court against American Federal, Inc. ("AFI") seeking a declaratory judgment that the Company has no contractual obligation to pay a commission to AFI, in connection with a Conditional Commitment entered into between AFI and the Company and is seeking damages for fraud and misrepresentation when AFI provided a commitment for a $20.1 million financing which the Company believes AFI never intended to fund as they had represented. In response, AFI filed suit in the United States District Court for the Eastern District of Missouri seeking payment of approximately $500,000 which includes a $405,000 commitment fee plus additional charges, fees and costs related to the Conditional Commitment, as well as damages for breach of contract, unjust enrichment and misrepresentation/fraud. This matter is in the early discovery stage. Management believes that AFI's claims are without merit, but it is too early to predict an outcome. The Company intends to vigorously defend itself in connection with this matter. As of September 7, 2003, the Company has not made an accrual in the accompanying consolidated financial statements for a potential liability in connection with this matter. We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us. IMPACT OF INFLATION The impact of inflation on the cost of food, labor, equipment, land and construction costs could harm our operations. The Company pays a majority of its employees hourly rates related to federal and state minimum wage laws. As a result of increased competition and the low unemployment rates in the markets in which the Company's restaurants are located, the Company has continued to increase wages and benefits in order to attract and retain management personnel and hourly workers. In addition, most of the Company's leases require the Company to pay taxes, insurance, maintenance, repairs and utility costs, and these costs are subject to inflationary pressures. Most of the leases provide for increases in rent based on increases in the consumer price index when the leases are renewed. The Company may attempt to offset the 21 effect of inflation through periodic menu price increases, economies of scale in purchasing and cost controls and efficiencies at existing restaurants. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not enter into derivative transactions or speculate on the future direction of interest rates. The Company's primary market risk exposure with regards to financial instruments is changes in interest rates. The Company's debt bears interest at both fixed and variable rates. On September 7, 2003, a hypothetical 100 basis point increase in interest rates would result in an approximately $450,000 decrease in fair value of debt and would increase annual interest expense on the variable rate mortgages by approximately $91,000. ITEM 4. CONTROLS AND PROCEDURES Within 90 days prior to the filing of this report, the Company's Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness, design and operation of the Company's disclosure controls and procedures as defined in Exchange Act Rule 13a-14. Based upon that evaluation, such officers concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed is recorded, processed, summarized, and reported in a timely manner. There have been no significant changes in the Company's internal controls or in other factors that could significantly effect these controls subsequent to the date of the evaluation referred to above. 22 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company has agreed to assume and pay one of the equipment leases totaling approximately $125,000 and remains contingently liable on two other equipment leases that currently have a remaining balance of approximately $17,000 which the Company believes will be assumed and paid by other guarantors. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it assumed. As of September 7, 2003, the reserve balance is approximately $44,000 which management believes is sufficient to satisfy the remaining lease obligation. The Company's management believes it will not incur significant additional losses in connection with this matter. On December 16, 2002, the Company filed a Complaint in Jefferson County, Kentucky Circuit Court against American Federal, Inc. ("AFI") seeking a declaratory judgment that the Company has no contractual obligation to pay a commission to AFI, in connection with a Conditional Commitment entered into between AFI and the Company and is seeking damages for fraud and misrepresentation when AFI provided a commitment for a $20.1 million financing which the Company believes AFI never intended to fund as they had represented. In response, AFI filed suit in the United States District Court for the Eastern District of Missouri seeking payment of approximately $500,000 which includes a $405,000 commitment fee plus additional charges, fees and costs related to the Conditional Commitment, as well as damages for breach of contract, unjust enrichment and misrepresentation/fraud. This matter is in the early discovery stage. Management believes that AFI's claims are without merit, but it is too early to predict an outcome. The Company intends to vigorously defend itself in connection with this matter. As of September 7, 2003, the Company has not made an accrual in the accompanying consolidated financial statements for a potential liability in connection with this matter. We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us. 23 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits - Exhibit 31 Certifications pursuant to Section 302, of the Sarbanes-Oxley Act of 2002 Exhibit 32 Certifications pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Reports on Form 8-K On June 16, 2003, the Company filed Form 8-K to report under Item 5 that its Board of Directors had approved a one-for-5000 reverse stock split to be immediately followed by a 5000-for-one forward stock split. The Board approved the transaction following the Special Committee's receipt of a fairness opinion with regard to the per share cash amount to be paid in the reverse split from FTN Financial Securities Corp. and the recommendation of the Special Committee. The transaction is subject to the approval of stockholders. Stockholders will be asked to approve the transaction at the annual meeting of stockholders currently expected to be held in the fourth quarter of 2003. The transaction, if approved by stockholders, would reduce the number of stockholders below the level at which the Company would be required to continue to file reports with the SEC. Items 2, 3, 4 and 5 are not applicable and have been omitted. 24 Signature Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned there unto duly authorized. Dated: October 21, 2003 Tumbleweed, Inc. By: /s/ Glennon F. Mattingly -------------------- Glennon F. Mattingly Senior Vice President Chief Financial Officer 25

TUMBLEWEED INC 10-Q