<PAGE>
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE
SECURITIES AND EXCHANGE ACT OF 1934
For the Quarter Ended September 30, 1996
Commission File Number 0-27182
THE ITALIAN OVEN, INC.
(Exact name of registrant as specified in its charter)
Pennsylvania 25-1624305
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Eleven Lloyd Avenue, Latrobe, PA 15650
(Address of principal executive offices, including zip code)
(412) 537-5380
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed 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
------- -------
Number of shares of common stock, $.01 par value per share, outstanding at
November 14, 1996: 4,363,991
1
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THE ITALIAN OVEN, INC.
Index
Page
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets
September 30, 1996 and December 31, 1995 3-4
Consolidated Statements of Operations
Quarter and Nine Months Ended September 30, 1996
and 1995 5
Consolidated Statements of Cash Flows
Nine Months Ended September 30, 1996 and 1995 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition 11
Part II OTHER INFORMATION
The Company's fiscal year is comprised of 52 or 53 weeks, divided into four
periods of 13 or 14 weeks, which ends on the last Sunday in December. For
convenience, the Company has indicated throughout this Report, including in the
financial statements, that the fiscal year end is December 31, and each of the
four periods are referred to as three-month or quarterly periods which end on
March 31, June 30, September 30 and December 31. References in this Report to
the "Company" or "The Italian Oven" mean the Company, its predecessors, and its
and their subsidiaries, unless the context otherwise requires.
2
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THE ITALIAN OVEN, Inc.
Consolidated Balance Sheets
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
-------------- ---------------
(Unaudited)
<S> <C> <C>
ASSETS
------
CURRENT ASSETS:
Cash and cash equivalents $ 335,067 $ 11,425,916
Receivables, net of allowance of
$95,000 and $85,000 respectively 487,009 844,163
Notes receivable from related parties,
net of allowance of $732,450 in 1996 -0- 442,249
Inventories 316,013 286,427
Prepaid expenses and other current assets 71,349 51,479
-------------- ---------------
Total current assets 1,209,438 13,050,234
PROPERTY AND EQUIPMENT:
Restaurant equipment 3,920,212 2,010,179
Building and leasehold improvements 5,549,683 2,357,273
Office furniture and equipment 1,057,107 492,896
Construction-in-progress 1,735,080 1,238,814
-------------- ---------------
12,262,082 6,099,162
Less-Accumulated depreciation 2,673,721 1,723,444
-------------- ---------------
Property and equipment, net 9,588,361 4,375,718
INTANGIBLE ASSETS:
Preopening costs, net 914,384 179,415
Equity in and advances to joint venture -0- 10,958
Liquor licenses, net 149,202 53,460
Other long-term assets 88,277 25,302
Goodwill, net 880,672 197,731
-------------- ---------------
2,032,535 466,866
-------------- ---------------
TOTAL ASSETS $ 12,830,334 $ 17,892,818
============== ===============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
3
<PAGE>
THE ITALIAN OVEN, Inc.
Consolidated Balance Sheets (Continued)
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
------------- ------------
(Unaudited)
<S> <C> <C>
LIABILITIES AND SHAREHOLDERS' EQUITY
-----------------------------------
CURRENT LIABILITIES:
Current portion of long-term debt $ 43,319 $ 176,962
Notes payable and royalty advances 300,000 423,032
Notes payable to Sysco 739,184 -0-
Accounts payable 2,900,485 1,586,940
Deferred franchise and development revenue 933,577 1,264,577
Reserve for store closings 608,829 464,143
Accrued payroll and other employee benefits 757,446 360,223
Accrual for gift certificates outstanding 205,940 559,002
Other accrued expenses 602,655 450,741
------------ ------------
Total current liabilities 7,091,453 5,285,620
LONG-TERM LIABILITIES:
Deferred franchise and development revenue 1,257,000 1,715,125
Long-term debt 139,319 180,437
Equity in and advances to joint ventures 121,932 -0-
Other long-term liabilities 441,348 342,273
------------ ------------
Total long-term liabilities 1,959,599 2,237,835
SHAREHOLDERS' EQUITY:
Common stock, par value $.01 per share--
Authorized, 20,000,000 shares
issued, 4,386,991 shares 43,869 43,509
Additional paid-in-capital 22,232,862 22,053,222
Warrants outstanding 1,975,000 1,975,000
Accumulated deficit (20,241,081) (13,471,000)
------------ ------------
4,010,650 10,600,731
Less--Cost of common stock in treasury--
22,921 shares (231,368) (231,368)
------------ ------------
Total shareholders' equity 3,779,282 10,369,363
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 12,830,334 $ 17,892,818
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
4
<PAGE>
THE ITALIAN OVEN, Inc.
Consolidated Statements of Operations
(Unaudited)
<TABLE>
<CAPTION>
Quarter ended September 30 Nine Months Ended September 30,
------------------------------- -------------------------------
1996 1995 1996 1995
------------- ------------- ------------ -------------
<S> <C> <C> <C> <C>
REVENUE
Restaurant sales $ 5,505,219 $ 2,734,924 $ 13,353,703 $ 7,604,233
Franchise and development fees 79,000 161,925 835,125 1,045,757
Royalty fees 490,214 713,347 1,878,523 2,035,335
------------- ------------- ------------ -------------
Total revenue 6,074,433 3,610,196 16,067,351 10,685,325
COSTS AND EXPENSES:
Costs of restaurant sales 1,548,184 700,670 3,680,298 2,010,567
Other restaurant expenses:
Restaurant labor expenses 2,403,462 1,035,044 5,724,507 2,799,203
Occupancy and other costs 1,506,476 644,560 3,642,114 1,881,206
General and administrative 1,404,292 1,495,854 5,753,910 4,492,807
Provision for employment agreements -0- -0- 445,000 -0-
Provision for losses on advances and
loans to related parties -0- -0- 732,450 -0-
Provision for store closings 972,723 -0- 972,723 -0-
Loss on sale of restaurants 553,901 -0- 553,901 -0-
Depreciation and amortization 619,823 150,944 1,380,768 489,942
------------- ------------- ------------ -------------
Total costs and expenses 9,008,861 4,027,072 22,885,671 11,653,725
------------- ------------- ------------ -------------
Loss from operations (2,934,428) (416,876) (6,818,320) (968,400)
OTHER INCOME (EXPENSE):
Equity in loss of joint venture (6,385) (6,697) (35,318) (72,238)
Interest income 1,182 796 175,166 3,433
Interest expense (3,816) (66,177) (79,403) (132,476)
Other expense, net (3,693) (35,901) (6,578) (10,046)
------------- ------------- ------------ -------------
Total other income (expense) (12,712) (107,979) 53,867 (211,327)
------------- ------------- ------------ -------------
Loss before taxes and minority interest (2,947,140) (524,855) (6,764,453) (1,179,727)
PROVISION FOR INCOME TAXES (135) -0- (5,628) (375)
------------- ------------- ------------ -------------
Net loss (2,947,275) (524,855) (6,770,081) (1,180,102)
UNDECLARED DIVIDENDS ON PREFERRED STOCK -0- (53,751) -0- (161,254)
ACCRETION OF DISCOUNT ON PREFERRED STOCK -0- (1,140) -0- (3,419)
------------- ------------- ------------ -------------
NET LOSS APPLICABLE TO COMMON STOCK $ (2,947,275) $ (579,746) $ (6,770,081) $ (1,344,775)
============= ============= ============ =============
NET LOSS PER COMMON SHARE $ (0.68) $ (0.28)* $ (1.55) $ (0.65)*
============= ============= ============ =============
SHARES USED IN COMPUTING
PER SHARE AMOUNTS 4,363,991 2,067,168 4,355,991 2,067,168
============= ============= ============ =============
</TABLE>
* 1995 per share and share amounts are computed on a pro forma basis.
The accompanying notes are an integral part of these consolidated financial
statements.
5
<PAGE>
THE ITALIAN OVEN, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended September 30,
------------------------------
1996 1995
---- ----
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (6,770,081) $ (1,180,102)
Adjustments required to reconcile net loss to
net cash used for operating activities--
Depreciation and amortization 1,380,768 469,942
Bad debt expense and provision for losses 742,450 -0-
Equity in loss of joint venture 35,318 72,238
Provision for store closings 972,723 -0-
Loss on sale of assets 553,901 -0-
------------- ------------
3,685,160 542,180
Cash provided by (used for) working capital items--
Receivables 347,154 133,314
Inventories (29,586) 31,601
Prepaid expenses and other current assets (19,870) (445,967)
Accounts payable 2,052,729 1,166,370
Deferred franchise and development fees (789,125) (335,332)
Accrued payroll and other employee benefits 397,223 (166,568)
Change in gift certificates outstanding (353,062) (249,364)
Other accrued expenses 296,600 203,027
Other long-term liabilities and other 23,940 60,365
------------- ------------
Cash provided by working capital items 1,926,003 397,446
------------- ------------
Net cash used for operating activities (1,158,918) (240,476)
CASH FLOWS FROM INVESTING ACTIVITIES:
Net acquisitions of property, equipment
and liquor licenses (6,477,661) (770,792)
Acquisition of franchise restaurants (2,534,500) -0-
Proceeds from sale of restaurants 970,000 -0-
Preopening costs (1,242,733) (113,568)
Advances to joint venture (59,043) (34,995)
Net increase in notes receivable from related parties (290,201) -0-
------------- ------------
Net cash used for investing activities (9,634,138) (919,355)
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock -0- 80,000
Notes payable borrowings 300,000 1,700,775
Notes payable payments (423,032) (644,878)
Long-term debt payments (174,761) (206,159)
------------- ------------
Net cash (used for) provided by financing activities (297,793) 929,738
------------- ------------
Net decrease in cash and cash equivalents (11,090,849) (230,093)
Cash and cash equivalents, beginning of period 11,425,916 349,711
------------- ------------
Cash and cash equivalents, end of period $ 335,067 $ 119,618
============= ============
Supplemental disclosure of cash flow information:
Interest paid $ 79,403 $ 132,476
============= ============
Income taxes paid $ 5,628 $ 375
============= ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
6
<PAGE>
THE ITALIAN OVEN, INC.
Notes to Consolidated Financial Statements
November 19, 1996
1. Basis of Presentation
In the opinion of management, the accompanying consolidated financial
statements contain all normal recurring adjustments necessary for a fair
presentation. The results of operations for the quarter and nine months
ended September 30, 1996 are not necessarily indicative of the results to
be expected for the full year.
The interim consolidated financial statements have been prepared without
audit, pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain financial information and footnote disclosures normally
included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to
such rules and regulations. These consolidated financial statements should
be read in conjunction with the audited consolidated financial statements
and notes thereto for the year ended December 31, 1995 included on Form 10-
K/A.
2. Legal Proceedings
In July and August 1996, the Company and certain of its current and former
officers and directors and the managing underwriters for the Company's
November 1995 initial public offering of common stock were named as
defendants in three complaints (the "Class Action Suits") filed in the
United States District Court for the Western District of Pennsylvania by
stockholders who purport to represent a class of stockholders who purchased
shares of the Company's common stock, par value $.01 per share ("Common
Stock") during the Company's initial public offering or thereafter on the
secondary market, all during the period from November 21, 1995 to June 24,
1996. The complaints allege, among other things, that the defendants
caused, or controlled persons who caused, misrepresentations concerning the
Company's business and affairs to be made in, or materially adverse
information concerning the same to be omitted from, the Company's
registration statement and prospectus in violation of the anti-fraud
provisions of the Securities Act of 1933 and the Pennsylvania Securities
Act. The plaintiffs are demanding unspecified damages plus interest, costs
and attorney's fees. The Company believes that the allegations in the Class
Action Suits are without merit and intends to vigorously defend the
actions.
In April 1996, the Company, James A. Frye, a Director and formerly the
Chairman and Chief Executive Officer of the Company, and his wife, Janice
M. Frye, formerly the Vice President of Design of the Company, were named
as defendants in a complaint filed in the United States District Court for
the Western District of Pennsylvania (under the caption Bahl v. Frye) by
------------
four shareholders of the Company,
7
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Asish Bahl, Yashmeen Vij Bahl, Mohinder Bahl and Jerome Scherer. These
shareholders allegedly purchased 17,000 shares of Common Stock at $10 per
share and 11,000 shares of Common Stock at $20 per share from Mr. and Mrs.
Frye prior to the Company's November 1995 initial public offering of Common
Stock. The complaint alleges, among other things, that the defendants
violated the anti-fraud provisions of the Securities Act of 1933, the
Securities Exchange Act of 1934 and the Pennsylvania Securities Act and
made common law fraudulent misrepresentations, all in connection with the
sale to the plaintiffs of the Company's Common Stock. The plaintiffs are
demanding damages in excess of $390,000, plus interest, costs and
attorney's fees. The Company believes that the allegations in the complaint
are without merit and intends to vigorously defend the action.
In June 1996, the Company and Mr. Frye were named as defendants in a
complaint filed in the United States District Court for the Western
District of Pennsylvania (under the caption Stein v. The Italian Oven, Inc.)
------------------------------
by Steven Stein and Neal Holmes. These shareholders allegedly purchased
5,000 shares of Common Stock from unspecified shareholders at $20 per share
prior to the Company's November 1995 initial public offering of Common
Stock. The complaint alleges, among other things, that the defendants made
false statements and misrepresentations regarding the Company in violation
of the anti-fraud provisions of the Securities Exchange Act of 1934. The
plaintiffs are demanding unspecified damages plus interest, costs and
attorney's fees. The Company believes that the allegations in the complaint
are without merit and intends to vigorously defend the action. The Company
has filed a motion to dismiss the case which is presently pending before
the court.
The Company and Mr. Frye are parties to an indemnification agreement under
which Mr. Frye has agreed to indemnify the Company for claims arising from
his sale of shares of the Company's Common Stock owned by him.
On October 21, 1996, the Company filed its voluntary petition for
reorganization under Chapter 11 of the United States Bankruptcy Code.
Management of the Company determined that the protection from creditors of
the Company afforded by the bankruptcy code was necessary in light of
anticipated cash shortages.
The Company maintains Directors, Officers and Corporate Liability insurance
coverage in the amount of $5 million with a deductible of $100,000. The
policy provides coverage for securities claims, including defense costs, in
excess of the deductible.
3. Acquisition
Effective April 29, 1996, the Company acquired the operating assets of four
franchised restaurants in the western Pennsylvania market. Two of these
were sold by the Company effective July 29, 1996 (see Note 5). The
acquisition price was $2,534,500 in cash and 36,000 shares of Common Stock.
The acquisition was accounted for as a
8
<PAGE>
purchase with the excess of the purchase price over fair market value of
assets acquired being amortized on a straight-line basis over five years.
The Company's consolidated results of operations include the operations of
the four restaurants since the acquisition date.
The following unaudited pro forma consolidated results of operations give
effect to the above acquisition as though it had occurred on January 1,
1995.
<TABLE>
<CAPTION>
Nine Months Ended September 30,
------------------------------
1996 1995
---- ----
<S> <C> <C>
Total Revenue $17,357,000 $14,215,000
Net Loss (6,968,000) (1,129,000)
Net Loss per common share $ (1.60) $ (0.55)
</TABLE>
The unaudited pro forma information is not necessarily indicative either of
results of operations that would have occurred had the purchase been made
on January 1, 1995, or future results of operations of the combined
companies.
4. Going Concern
During the first nine months of 1996, the Company suffered losses from
operations of $6,818,000. The Company utilized all of the cash proceeds
from its initial public offering in November 1995 and has not been able to
obtain additional sources of financing to provide for its immediate and
future cash needs and for general operating purposes. At September 30,
1996, the current liabilities of the Company exceeded its current assets by
$5,882,000. Also, at September 30, 1996, the Company had $1,735,000 in
construction in progress for new restaurant sites. No assurance can be
given that the Company will obtain sufficient capital to complete the
construction of these restaurants. The first nine months of 1996 has shown
a decrease in cash and cash equivalents of $11,091,000.
These factors, among others, create a substantial doubt about the Company's
ability to continue as a going concern. (See Note 8.)
5. Sale of Restaurants
Effective July 29, 1996, in order to obtain cash for immediate operating
needs, the Company sold the operating assets of the Company's Erie and
Cranberry, Pennsylvania restaurants. These restaurants had been acquired by
the Company in April 1996. The assets were sold pursuant to an Asset
Purchase Agreement dated as of August 1, 1996
9
<PAGE>
(the "Asset Purchase Agreement") to Armstrong Restaurants, L.P.
("Armstrong"), a limited partnership affiliated with (i) a current
franchisee of the Company, The Armstrong Group of Companies, (ii) a
stockholder of the Company, Armstrong Holdings, Inc., and (iii) two of the
Company's directors, Kirby Campbell and Dru Sedwick. As a result of the
sale, the Company recorded a loss from the transaction of approximately
$554,000 during the third quarter of 1996.
Under the terms of the Asset Purchase Agreement, Armstrong purchased these
restaurant assets for aggregate consideration of $970,000, consisting of
$800,000 in cash and the relinquishment of $170,000 in prepaid franchise
fees under Armstrong's northeastern Ohio franchise development agreement.
The selling price was determined on the basis of arm's length negotiations
between the parties. To assist the Company in improving its cash position,
the Asset Purchase Agreement required Armstrong to prepay at closing
$300,000 in franchise royalties for these restaurants. The transaction was
approved by the Board of Directors at a special meeting at which Mr.
Sedwick was not present and Mr. Campbell abstained from voting on the
transaction.
Under the terms of the Asset Purchase Agreement, Armstrong also agreed to
waive its development rights to northeastern Ohio, preserving only a five
year right of first refusal to match the terms of any development proposed
by any other persons in that territory and certain other areas in Western
Pennsylvania. Should Armstrong elect to develop a restaurant in any of the
locations included in the right of first refusal, the Company must grant a
credit or reduction of $10,000 toward the franchise fees payable as to each
restaurant which Armstrong agrees to develop, such credit or reduction not
to exceed $40,000 in the aggregate.
6. Restaurant Closings
During the quarter ended September 30, 1996, the company determined to
close three of its owned restaurants due to declining results of operations
at such restaurants. As a result, the Company recorded a charge to
operations of approximately $973,000 for certain leasehold improvements at
the closed restaurants and costs associated with the closings.
On November 4, 1996, the Company closed two additional restaurants and will
record additional changes pertaining to such closing as in the fourth
quarter of 1996.
7. Sysco Note Payable
In July 1996, the Company entered into a demand promissory note to Mid-
Central Sysco Food Services, Inc. and Deaktor/Sysco Food Services Company
(collectively, "Sysco") in the amount of $1,088,000. The note bears
interest at the per annum rate of 6% (subject to an 18% default rate), and
provides for five daily installment payments per week of $30,000 through
December 30, 1996, with all outstanding
10
<PAGE>
indebtedness due and payable on December 31, 1996. The note is
collateralized by a Security Agreement dated July 30, 1996 under which the
Company granted to Sysco a security interest in substantially all of the
Company's assets. The note is further collateralized by the Collateral
Assignment of Trademarks, Copyrights and Licenses dated July 30, 1996 under
which the Company collaterally assigned to Sysco substantially all of its
intellectual property, including rights to the name "The Italian Oven."
8. Subsequent Event
On October 21, 1996, the Company filed its voluntary petition for
reorganization under Chapter 11 of the United States Bankruptcy Code in the
Bankruptcy Court for the Western District of Pennsylvania at Case No. 96-
25512.
Item 2. Management's Discussion and Analysis of Results of Operations and
Financial Condition.
Recent Developments.
The Company began to experience liquidity problems in the second quarter of
1996, following the use of all of the proceeds of the Company's initial public
offering in November 1995 (the "IPO") principally to acquire new restaurants and
for working capital purposes. The Company experienced weaker than projected
sales in the first nine months of 1996 due, in part, to adverse weather
conditions in the first quarter.
The Company's cash position was further weakened by amounts advanced to James A.
Frye, a Director of the Company and formerly its Chairman and Chief Executive
Officer, of $435,000 at June 24, 1996. The Company has demanded that Mr. Frye
repay all outstanding amounts. Since the date of such demand, Mr. Frye has
repaid $103,000 but has failed to repay the balance (as of November 14, 1996) of
$332,000 despite the Company's demand for repayment in full. The Company has
fully reserved for this outstanding balance.
In addition, PNC Bank, National Association terminated its credit agreement (the
"Credit Agreement") with the Company in June 1996. The Credit Agreement had
provided for a line of credit to the Company up to $2,500,000. However, the
Company never satisfied the requirements necessary to draw funds under the
Credit Agreement and, consequently, no funds were outstanding under the Credit
Agreement when it was terminated.
On June 24, 1996, the Board engaged Cornerstone Capital Advisors, Ltd.
("Cornerstone") as the Company's interim manager to seek to improve the
Company's liquidity. Mr. Frye relinquished the day-to-day responsibilities of
his office to Cornerstone on that date. In addition, the Company promoted
Michael Understein, formerly the Company's Senior Vice President of Operations,
to Chief Operating Officer. Subsequently, on July 10, 1996, Mr. Frye was
terminated by the Board as the Company's Chairman and Chief Executive Officer.
11
<PAGE>
Thereafter, J. Garvin Warden, a principal of Cornerstone, was appointed as the
Company's Interim Chief Executive Officer.
In an effort to reduce overhead costs, during the quarter ended September 30,
1996, the Company terminated (or suspended without pay) 42 employees
representing approximately 50% of the corporate staff of the Company immediately
prior to the reductions. In addition, during the quarter ended September 30,
1996, the Company continued to seek to improve its cash position through the
development and implementation of cost reduction plans. The Company entered into
agreements with various landlords to defer lease rentals, obtained the
assurances of certain contractors to forbear in seeking to collect amounts due
for the construction of restaurant improvements and entered into an agreement
with its principal restaurant supplier, as described below.
On July 30, 1996, the Company reached agreement with Mid-Central Sysco Food
Services, Inc. and Deaktor/Sysco Food Services Company (collectively, "Sysco")
to continue supplying food and restaurant supplies to the Company's restaurants,
to document the terms of repayment of existing and future payables and to
collateralize these obligations. In this connection, the Company delivered its
demand promissory note to Sysco in the original principal amount of $1,088,000
(the "Sysco Note"). The Sysco Note, which bears interest at the per annum rate
of 6% (subject to an 18% default rate), provides for five daily installment
payments per week of $30,000 through December 30, 1996, with all outstanding
indebtedness due and payable on December 31, 1996. The Sysco Note evidences
existing payables and will evidence future purchases by the Company from Sysco.
The Sysco Note is collateralized by a Security Agreement dated July 30, 1996
under which the Company granted to Sysco a security interest in substantially
all of the Company's assets. The Sysco Note is further collateralized by the
Collateral Assignment of Trademarks, Copyrights and Licenses dated July 30, 1996
under which the Company collaterally assigned to Sysco substantially all of its
intellectual property, including rights to the name "The Italian Oven."
In addition, effective July 29, 1996, in order to obtain cash for immediate
operating needs, the Company sold the operating assets of the Company's Erie
and Cranberry, Pennsylvania restaurants. These restaurants had been acquired by
the Company in April 1996. The assets were sold pursuant to an Asset Purchase
Agreement dated as of August 1, 1996 (the "Asset Purchase Agreement") to
Armstrong Restaurants, L.P. ("Armstrong"), a limited partnership affiliated with
(i) a current franchisee of the Company, The Armstrong Group of Companies, (ii)
a stockholder of the Company, Armstrong Holdings, Inc., and (iii) two of the
Company's directors, Kirby Campbell and Dru Sedwick. As a result of the sale,
the Company recorded a loss from the transaction of approximately $554,000 in
the third quarter of 1996.
Under the terms of the Asset Purchase Agreement, Armstrong purchased these
restaurant assets for aggregate consideration of $970,000, consisting of
$800,000 in cash and the relinquishment of $170,000 in prepaid franchise fees
under Armstrong's northeastern Ohio
12
<PAGE>
franchise development agreement. The selling price was determined on the basis
of arm's length negotiations between the parties. The transaction was approved
by the Board of Directors at a special meeting at which Mr. Sedwick was not
present and at which Mr. Campbell abstained from voting due to his interest in
the transaction.
The Erie and Cranberry, Pennsylvania restaurants will be operated by Armstrong
as franchised restaurants. To assist the Company in improving its cash
position, the Asset Purchase Agreement required Armstrong to prepay at closing
$300,000 in franchise royalties for these restaurants.
Under the terms of the Asset Purchase Agreement, Armstrong also agreed to waive
its development rights to northeastern Ohio, preserving only a five year right
of first refusal to match the terms of any development proposed by any other
persons in that territory and certain other areas in Western Pennsylvania.
Should Armstrong elect to develop a restaurant in any of the locations included
in the right of first refusal, the Company must grant a credit or reduction of
$10,000 toward the franchise fees payable as to each restaurant which Armstrong
agrees to develop, such credit or reduction not to exceed $40,000 in the
aggregate.
Despite these efforts to curtail costs and supplement available cash, on October
21, 1996, the Company filed its voluntary petition for reorganization under the
United States Bankruptcy Code. Management of the Company determined that the
protection from creditors of the Company afforded by the bankruptcy code was
necessary in light of continuing current and anticipated cash shortages. Since
its filing, the Company has closed two more of its owned restaurants (both of
which were in the Pittsburgh metropolitan area), further reduced its workforce
and taken other steps to reduce expenses. As a result, management believes the
cash to be generated from the Company's operations will be sufficient to meet
the Company's cash requirements for the next several weeks.
Management continues to work to develop a plan of reorganization for the
Company. Management believes that the Company requires a substantial capital
infusion in order to assure its long-term viability. As part of that effort,
the Company continues to work with its financial advisors to identify potential
investors. No assurance can be given that the Company will be successful in
obtaining suitable capital. Other factors which could adversely affect the
Company's liquidity include (but are not limited to) the following:
(i) Restaurant revenues and/or profits being lower than projected by
management as a result of changes in consumer tastes, adverse weather conditions
(as was the case during the first quarter of 1996), increased competition in the
casual dining sector, adverse publicity concerning the Company's operations and
bankruptcy filing (which management believes may have had an adverse effect on
sales in the Pittsburgh metropolitan area market), or higher restaurant
operating costs due to factors such as labor shortages or increases in food or
supply costs;
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<PAGE>
(ii) There being fewer franchised store openings than projected by
management due to the inability of developers to obtain needed financing, or due
to the decisions of developers to delay or terminate plans to open new
restaurants as a result of their incurring losses from existing franchised
restaurants (as has been the case with certain developers during the first nine
months of 1996), with the attendant loss to the Company of royalties from
franchised restaurant sales and of the ability to recognize income from
franchise fees; or
(iii) The Company being unable to sell the number of new franchises
projected by management, with the attendant loss to the Company of cash flow
from franchise and development fees payable prior to the opening of new
restaurants.
As reported in the Company's Annual Report on Form 10-K for the year ended
December 31, 1995, the Company anticipated that it would open or acquire 20-28
restaurants with the net proceeds of the IPO and revenues from operations. The
Company will be opening or acquiring fewer restaurants than had been targeted.
During the first nine months of 1996, the Company opened seven new Company-owned
restaurants, acquired the leasehold interests and operating assets of six
restaurants (three of which have been converted into The Italian Oven
restaurants, two of which are expected to be so converted subject to receipt of
necessary financing of approximately $650,000 and one of which is being held for
sale) and acquired the operating assets of four franchised restaurants currently
in operation (two of which were subsequently sold to meet the Company's
immediate cash needs (see Note 5 to the notes to the consolidated financial
statements)).
14
<PAGE>
Results of Operations
The following table sets forth the percentage relationship of certain income
statement data to total revenues, except as otherwise indicated:
<TABLE>
<CAPTION>
Nine Months
Quarter ended September 30, ended September 30,
----------------------------- ---------------------
1996 1995 1996 1995
-------------- ------------- ---------- ---------
<S> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS
OF OPERATIONS DATA:
Revenue:
Restaurant sales........................ 90.6% 75.8% 83.1% 71.2%
Franchise and development fees.......... 1.3% 4.5% 5.2% 9.8%
Royalty fees............................ 8.1% 19.7% 11.7% 19.0%
------ ------ ------ ------
100.0% 100.0% 100.0% 100.0%
Costs and Expenses
Cost of restaurant sales (1) 28.1% 25.6% 27.6% 26.4%
Other restaurant expenses:
Restaurant labor expenses(1) 43.7% 37.8% 42.9% 36.8%
Occupancy and other costs(1) 27.4% 23.6% 27.3% 24.7%
General and administrative 23.1% 41.4% 35.8% 42.0%
Reserves 16.0% 0.0% 13.4% 0.0%
Loss on sale of assets 9.1% 0.0% 3.4% 0.0%
Depreciation and amortization 10.2% 4.2% 8.6% 4.4%
Total operating expenses 148.3% 111.5% 142.4% 109.1%
Loss from operations (48.3)% (11.5)% (42.4)% (9.1)%
Net interest income (expense) 0.0% (1.8)% .6% (1.2)%
Net loss (48.0)% (14.5)% (42.1)% (11.0)%
</TABLE>
(1) As a percentage of restaurant sales.
Quarter Ended September 30, 1996 Compared to the Quarter Ended September 30,
1995.
Revenues. Total revenue increased by $2,464,000 to $6,074,000 or 68.3% for the
quarter ended September 30, 1996, compared to the quarter ended September 30,
1995. Restaurant sales at Company-owned restaurants increased $2,770,000 to
$5,505,000 or 101.3% for the quarter ended September 30, 1996, compared to the
same period in 1995. These increases were largely the result of the net
addition of ten Company-owned restaurants during 1996. Restaurant sales for same
Company-owned restaurants declined by 16.7% during the third quarter in 1996
compared to the same quarter in 1995. Management believes that this decline
15
<PAGE>
is due to a number of factors, including industry-wide declines in restaurant
sales and price increases implemented by the Company early in the second quarter
of 1996.
Franchise and development fees decreased by $83,000 or 51.2% for the quarter
ended September 30, 1996, compared to the quarter ended September 30, 1995.
This decrease was primarily due to the opening of two franchised restaurants
during the third quarter of 1996 compared to four in the third quarter of 1995.
Royalties decreased by $223,000 to $490,000 or 31.3% for the quarter ended
September 30, 1996, compared to the quarter ended September 30, 1995. This
decrease was principally due to same franchise restaurant sales being down 14.0%
during the quarter ended September 30, 1996, compared to the third quarter of
1995 and 12 fewer franchised restaurants.
Costs and expenses. Cost of restaurant sales at Company-owned restaurants
increased by $848,000 to $1,548,000 or 21.0% for the quarter ended September 30,
1996, compared to the quarter ended September 30, 1995, principally due to the
net addition of 10 Company-owned restaurants during 1996. Cost of restaurant
sales increased as a percentage of restaurant sales by 0.5% to 26.5% for the
same restaurants open during both periods due to a decrease in sales.
Labor expenses at Company-owned restaurants increased from 37.0% to 38.1% as a
percentage of restaurant sales for the quarter ended September 30, 1996,
compared to the quarter ended September 30, 1995, for the same restaurants open
during both periods. The percentage increase in labor costs is principally
attributable to lower restaurant sales for the quarter ended September 30, 1996,
compared to the same period in 1995, resulting in increased management labor
costs as a percent of restaurant sales. Occupancy and other costs at Company-
owned restaurants increased as a percentage of restaurant sales from 23.3% to
26.9% for the quarter ended September 30, 1996, compared to the same period in
1995, principally due to lower restaurant sales.
General and administrative. General and administrative expenses decreased by
$92,000 to $1,404,000 or 6.1% for the quarter ended September 30, 1996, compared
to the quarter ended September 30, 1995.
Provisions for restaurant closings. The Company has recorded non-recurring
charges of $973,000 during the quarter ended September 30, 1996 for the closing
of two of its restaurants in Ohio.
Depreciation and amortization. Depreciation and amortization expenses increased
by $469,000 to $620,000 or 310.6% for the quarter ended September 30, 1996,
compared to the quarter ended September 30, 1995. This increase was primarily
due to the net addition of 10 Company-owned restaurants during 1996.
16
<PAGE>
Loss on sale of assets. During the quarter ended September 30, 1996, the
Company sold two restaurants at a loss of $554,000. See Note 5 to the
consolidated financial statements, "Sale of Assets."
Nine Months Ended September 30, 1996 Compared to the Nine Months Ended September
30, 1995.
Revenues. Total revenue increased by $5,382,000 to $16,067,000 or 50.4% for the
nine months ended September 30, 1996, compared to the nine months ended
September 30, 1995. Restaurant sales at Company-owned restaurants increased
$5,749,000 to $13,354,000 or 75.6% for the nine months ended September 30, 1996,
compared to the same period in 1995. These increases were largely the result of
the net addition of 10 Company-owned restaurants during 1996. Restaurant sales
for same Company-owned restaurants declined by 9.6% during the period in 1996
compared to the same period in 1995. Management believes that this decline is
due to a number of factors, including adverse weather conditions in the first
quarter of 1996, industry-wide declines in restaurant sales, and price increases
implemented by the Company early in the second quarter of 1996.
Franchise and development fees decreased by $211,000 or 20.1% for the nine
months ended September 30, 1996, compared to the nine months ended September 30,
1995. This decrease was primarily due to the opening of nine franchised
restaurants during 1996 compared to fifteen in 1995.
Royalties decreased by $157,000 to $1,879,000 or 7.7% for the nine months ended
September 30, 1996, compared to the nine months ended September 30, 1995. This
decrease was principally due to 71 franchised restaurants being in operation at
the end of the third quarter of 1996 compared to 90 franchised restaurants at
the end of the third quarter of 1995 and drop of same restaurant sales of 9.5%.
Costs and expenses. Cost of restaurant sales at Company-owned restaurants
increased by $1,670,000 to $3,680,000 or 83.0% for the nine months ended
September 30, 1996, compared to the nine months ended September 30, 1995,
principally due to the net addition of ten Company-owned restaurants during
1996, and increased as a percentage of restaurant sales by only .3% to 26.6% for
the same restaurants open during both periods, principally due to more favorable
contract terms and volume discounts on product purchases.
Labor expenses at Company-owned restaurants increased from 36.2% to 37.6% as a
percentage of restaurant sales for the nine months ended September 30, 1996,
compared to the nine months ended September 30, 1995, for the same restaurants
open during both periods. Occupancy and other costs at Company-owned restaurants
increased as a percentage of restaurant sales from 24.7% to 27.3% for the nine
months ended September 30, 1996, compared to the same period in 1995,
principally due to the start-up costs associated with the net addition of 10
restaurants.
17
<PAGE>
General and administrative. General and administrative expenses increased by
$1,261,000 to $5,754,000 for the nine months ended September 30, 1996, compared
to the same period in 1995. These increases were due primarily to the opening
of ten Company-owned restaurants, the acquisition of four franchised restaurants
and the opening of nine franchised restaurants in 1996. The Company, in 1996,
also recorded non-recurring charges of $100,000 related to the shareholder
lawsuits (see Note 2 to the consolidated financial statements), non-recurring
charges of $150,000 for additional Workers Compensation accruals and charges of
$483,000 for supplier contracts the Company does not believe it can fulfill.
Provisions for losses. During the nine months ended September 30, 1996, the
Company has recorded non-recurring charges to reserve for contingent liabilities
under employment agreements with three Company officers who were terminated and
for advances made to the Company's former Chairman and Chief Executive Officer.
The Company also reserved $400,000 for a loan previously made to The Italian
Oven National Advertising Fund, Inc. and $973,000 for the closing of two
restaurants during 1996.
Depreciation and amortization. Depreciation and amortization expenses increased
by $911,000 to $1,381,000 or 193.8% for the nine months ended September 30,
1996, compared to the nine months ended September 30, 1995. This increase was
primarily due to the net addition of ten Company-owned restaurants during 1996.
Interest income. Interest income increased by $172,000 for the nine months
ended September 30, 1996, compared to the nine months ended September 30, 1995.
This increase was due to the investment income earned on the net proceeds of the
Company's IPO in November 1995.
Liquidity and Capital Resources
The following table presents a summary of the Company's cash flows for the
periods:
<TABLE>
<CAPTION>
Nine Months ended
September 30,
------------------------
1996 1995
------------ ----------
<S> <C> <C>
Net cash used for operating activities..... $( 1,158,918) $(240,476)
Net cash used for investing activities..... ( 9,634,138) (919,355)
Net cash (used for) provided by financing
activities................................ ( 297,793) 929,738
------------ ---------
Net decrease in cash and cash equivalents.. $(11,090,849) $(230,093)
============ =========
</TABLE>
During the nine months ended September 30, 1996, the Company has suffered losses
from operations of $6,818,320. The Company has also utilized all of the cash
proceeds from the
18
<PAGE>
IPO, and has not been able to obtain alternate sources of financing to cover
immediate and future cash needs for general operating purposes. The first nine
months of 1996 have shown a decrease in cash and equivalents of approximately
$11,091,000.
See also "Recent Developments" in this Item 2.
19
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In July and August 1996, the Company and certain of its current and former
officers and directors and the managing underwriters for the Company's November
1995 initial public offering of common stock were named as defendants in three
complaints (the "Class Action Suits") filed in the United States District Court
for the Western District of Pennsylvania by stockholders who purport to
represent a class of stockholders who purchased shares of the Company's common
stock, par value $.01 per share ("Common Stock") during the Company's initial
public offering or thereafter on the secondary market, all during the period
from November 21, 1995 to June 24, 1996. The complaints allege, among other
things, that the defendants caused, or controlled persons who caused,
misrepresentations concerning the Company's business and affairs to be made in,
or materially adverse information concerning the same to be omitted from, the
Company's registration statement and prospectus in violation of the anti-fraud
provisions of the Securities Act of 1933 and the Pennsylvania Securities Act.
The plaintiffs are demanding unspecified damages plus interest, costs and
attorney's fees. The Company believes that the allegations in the Class Action
Suits are without merit and intends to vigorously defend the action.
In April 1996, the Company, James A. Frye, a Director and formerly the Chairman
and Chief Executive Officer of the Company, and his wife, Janice M. Frye,
formerly the Vice President of Design of the Company, were named as defendants
in a complaint filed in the United States District Court for the Western
District of Pennsylvania (under the caption Bahl v. Frye) by four shareholders
------------
of the Company, Asish Bahl, Yashmeen Vij Bahl, Mohinder Bahl and Jerome Scherer.
These shareholders allegedly purchased 17,000 shares of Common Stock at $10 per
share and 11,000 shares of Common Stock at $20 per share from Mr. and Mrs. Frye
prior to the Company's November 1995 initial public offering of Common Stock.
The complaint alleges, among other things, that the defendants violated the
anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act
of 1934 and the Pennsylvania Securities Act and made common law fraudulent
misrepresentations, all in connection with the sale to the plaintiffs of Common
Stock. The plaintiffs are demanding damages in excess of $390,000, plus
interest, costs and attorney's fees. The Company believes that the allegations
in the complaint are without merit and intends to vigorously defend the action.
In June 1996, the Company and Mr. Frye, a Director and formerly the Chairman and
Chief Executive Officer of the Company, were named as defendants in a complaint
filed in the United States District Court for the Western District of
Pennsylvania (under the caption Stein v. The Italian Oven, Inc.) by Steven Stein
---------------------------------
and Neal Holmes. These shareholders allegedly purchased 5,000 shares of Common
Stock from an unspecified shareholders at $20 per share prior to the Company's
November 1995 initial public offering of Common Stock. The complaint alleges,
among other things, that the defendants made false statements and
misrepresentations regarding the Company in violation of the anti-fraud
provisions of the Securities Exchange Act of 1934. The plaintiffs are demanding
unspecified damages plus
20
<PAGE>
interest, costs and attorney's fees. The Company believes that the allegations
in the complaint are without merit and intends to vigorously defend the action.
The Company has filed a motion to dismiss the case which is presently pending
before the court.
The Company and Mr. Frye are parties to an indemnification agreement under
which Mr. Frye has agreed to indemnify the Company for claims arising from his
sale of shares of the Company's Common Stock owned by him, as is the case in the
Bahl action.
- ----
On October 21, 1996, the Company filed its voluntary petition for reorganization
under Chapter 11 of the United States Bankruptcy Code. Management of the
Company determined that the protection from creditors of the Company afforded by
the bankruptcy code was necessary in light of anticipated cash shortages.
The Company maintains Directors, Officers and Corporate Liability insurance
coverage in the amount of $5 million with a deductible of $100,000. The policy
provides coverage for securities claims, including defense costs, in excess of
the deductible.
The Company is a party to routine contract, negligence and employment-related
litigation matters in the ordinary course of its business. No such pending
matters, individually or in the aggregate, if adversely determined, are believed
by management to be material to the business, results of operations or financial
condition of the Company.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
11.1 Calculation of Net Loss Per Common Share.
15.1 Letter Re: unaudited interim financial information.
27.1 Financial Data Schedule
(b) Reports on Form 8-K
During the quarter ended September 30, 1996, the Company filed a Current
Report on Form 8-K dated August 19, 1996, which related to the Company's
sale of the operating assets of two of the Company's owned restaurants in
Western Pennsylvania.
21
<PAGE>
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, thereunto duly authorized.
THE ITALIAN OVEN, INC.
By: /s/ Gary L. Steib
------------------------------------
Gary L. Steib
Vice President of Finance,
Chief Financial Officer and Treasurer
Dated: November 19, 1996
22
<PAGE>
EXHIBIT 11.1
THE ITALIAN OVEN, INC.
Calculation of Net Loss Per Common Share
(Unaudited)
<TABLE>
<CAPTION>
Quarter Ended September 30
1996 1995*
---- -----
<S> <C> <C>
Net Loss $(2,947,275) $(579,746)
=========== ==========
Weighted average common shares outstanding
during the period 4,351,991 1,516,727
Effect of shares issued upon conversion of
preferred stock, after exercise of warrants,
to common -- 550,441
----------- ----------
Shares used in calculating loss per
common share 4,351,991 2,067,168
=========== ==========
Net loss per common share $ (0.68) $ (0.28)*
=========== ==========
</TABLE>
* 1995 per share and share amounts are computed on a pro forma basis.
<PAGE>
Exhibit 15.1
[LOGO OF ARTHUR ANDERSEN LLP]
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and
Shareholders of The Italian Oven, Inc.:
We have reviewed the accompanying consolidated balance sheet of The Italian
Oven, Inc. (a Pennsylvania corporation) as of September 30, 1996, the related
consolidated statements of operations for the three and nine month periods ended
September 30, 1996, and the related statement of cash flows for the nine month
period ended September 30, 1996. These financial statements are the
responsibility of the Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in
accordance with generally accepted auditing standards, the objective of which is
the expression of an opinion regarding the financial statements taken as a
whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the financial statements referred to above in order for them to be in
conformity with generally accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of The Italian Oven, Inc. as of
December 31, 1995, and, our report dated February 6, 1996, with respect thereto
contained an explanatory paragraph regarding the Company's ability to continue
as a going concern. In our opinion, the information set forth in the
accompanying consolidated balance sheet as of December 31, 1995, is fairly
stated, in all material respects, in relation to the consolidated balance sheet
from which it has been derived.
/s/ Arthur Andersen LLP
Pittsburgh, Pennsylvania,
November 7, 1996
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
COMPANY'S FINANCIAL STATEMENTS FOR THE QUARTER ENDED SEPT. 30, 1996 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JUL-01-1996
<PERIOD-END> SEP-30-1996
<CASH> 335,067
<SECURITIES> 0
<RECEIVABLES> 487,009
<ALLOWANCES> 0
<INVENTORY> 316,013
<CURRENT-ASSETS> 1,209,438
<PP&E> 9,588,361
<DEPRECIATION> 2,673,721
<TOTAL-ASSETS> 12,830,334
<CURRENT-LIABILITIES> 7,091,453
<BONDS> 0
0
0
<COMMON> 43,869
<OTHER-SE> 3,735,413
<TOTAL-LIABILITY-AND-EQUITY> 12,830,334
<SALES> 5,505,219
<TOTAL-REVENUES> 6,074,433
<CGS> 1,548,184
<TOTAL-COSTS> 9,008,861
<OTHER-EXPENSES> 12,712
<LOSS-PROVISION> 827,450
<INTEREST-EXPENSE> 3,816
<INCOME-PRETAX> (2,947,140)
<INCOME-TAX> 135
<INCOME-CONTINUING> (2,947,275)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,947,275)
<EPS-PRIMARY> (0.68)
<EPS-DILUTED> (0.68)
</TABLE>
