Luby's, Inc. (Exact name of registrant as specified in its charter)

Transcription

1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C 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 February 12, 2003, or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From to Commission file number Luby's, Inc. (Exact name of registrant as specified in its charter) Delaware (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) 2211 Northeast Loop 410 San Antonio, Texas (Address of principal executive offices, including zip code) (210) (Registrant's telephone number, including area code, and Website) (Former name, former address and former fiscal year, if changed since last report) 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 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 As of March 19, 2003, there were 22,456,296 shares of the registrant's Common Stock outstanding, which does not include 4,946,771 treasury shares. Page 1

2 Luby's, Inc. Form 10-Q Quarter ended February 12, 2003 Table of Contents Part I - Financial Information Page Item 1 Financial Statements 3 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3 Quantitative and Qualitative Disclosures about Market Risk 23 Item 4 Controls and Procedures 23 Part II - Other Information Page Item 1 Legal Proceedings 24 Item 3 Defaults Upon Senior Securities 24 Item 4 Submission of Matters to a Vote of Security Holders 24 Item 6 Exhibits and Reports on Form 8-K 26 Signatures 31 Additional Information Additional Company information and access to Annual Reports and SEC filings can be obtained online free of charge at Page 2

3 Item 1. Financial Statements Part I - FINANCIAL INFORMATION Luby's, Inc. Consolidated Balance Sheets (In thousands) February 12, August 28, (unaudited) ASSETS Current Assets: Cash $ 191 $ 1,584 Short-term investments (see Note 3) 14,941 24,122 Trade accounts and other receivables Food and supply inventories 2,304 2,197 Prepaid expenses 1,730 1,667 Income tax receivable 7,245 7,245 Deferred income taxes (see Note 4) 2,726 2,726 Total current assets 29,432 39,726 Property held for sale 5,574 8,144 Investments and other assets 4,170 4,642 Property, plant, and equipment -- at cost, net (see Note 5) 282, ,967 Total assets $ 322,149 $ 342,479 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Accounts payable $ 19,004 $ 19,077 Accrued expenses and other liabilities 17,812 21,735 Current portion of debt (see Note 6) 108, ,448 Total current liabilities 145, ,260 Convertible subordinated notes, net - related party (see Note 6) 6,105 5,883 Accrued claims and insurance 4,403 5,142 Deferred income taxes and other credits (see Note 4) 5,366 5,460 Reserve for restaurant closings (see Note 7) 3,037 3,114 Total liabilities 164, ,859 Commitments and contingencies (see Note 8) SHAREHOLDERS' EQUITY Common stock, $.32 par value, authorized 100,000,000 shares, issued 27,403,067 shares in fiscal 2003 and ,769 8,769 Paid-in capital 36,916 37,335 Deferred compensation (1,384) (1,989) Retained earnings 218, ,062 Less cost of treasury shares, 4,946,771 and 4,970,024, in fiscal 2003 and 2003, respectively (105,063) (105,557) Total shareholders' equity 157, ,620 Total liabilities and shareholders' equity $ 322,149 $ 342,479 See accompanying notes Page 3

4 Luby's, Inc. Consolidated Statements of Operations (unaudited) (In thousands) Quarter Ended Two Quarters Ended February 12, February 13, February 12, February 13, (84 days) (84 days) (168 days) (166 days) SALES $ 88,263 $ 91,257 $ 176,492 $ 186,452 COSTS AND EXPENSES: Cost of food 25,563 22,540 50,581 47,190 Payroll and related costs 26,040 30,330 53,716 64,923 Occupancy and other operating expenses 33,826 34,208 68,196 70,593 General and administrative expenses 5,353 5,360 10,720 10,708 Provision for asset impairments and restaurant closings (see Note 7) (25) ,920 92, , ,544 INCOME (LOSS) FROM OPERATIONS (2,657) (1,181) (6,696) (7,092) Interest expense (2,173) (2,413) (4,177) (4,983) Other income, net 1, , INCOME (LOSS) BEFORE INCOME TAXES (3,405) (3,285) (6,506) (11,318) Provision (Benefit) For Income Taxes (see Note 4) -- (1,123) -- (3,811) NET INCOME (LOSS) $ (3,405) $ (2,162) $ (6,506) $ (7,507) NET INCOME (LOSS) PER SHARE -- basic and assuming dilution $ (0.15) $ (0.09) $ (0.29) $ (0.33) See accompanying notes. Page 4

5 Luby's, Inc. Consolidated Statements of Shareholders' Equity (unaudited) (In thousands) Common Stock Total Issued Treasury Paid-In Deferred Retained Shareholders' Shares Amount Shares Amount Capital Compensation Earnings Equity BALANCE AT AUGUST 28, ,403 $8,769 (4,970) $ (105,557) $37,335 $ (1,989) $ 225,062 $ 163,620 Net income (loss) for the year to date (6,506) (6,506) Executive compensation expense Common stock issued under nonemployee director benefit plans (419) 75 BALANCE AT FEBRUARY 12, ,403 $8,769 (4,947) $ (105,063) $36,916 $ (1,384) $ 218,556 $ 157,794 See accompanying notes. Page 5

6 Luby's, Inc. Consolidated Statements of Cash Flows (unaudited) (In thousands) Two Quarters Ended February 12, February 13, (168 days) (166 days) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ (6,506) $ (7,507) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 10,066 9,934 Amortization of deferred loss on interest rate swaps Amortization of discount on convertible subordinated notes Provision for (reversal of) asset impairments and restaurant closings (25) 130 (Gain) loss on disposal of property held for sale (3,223) (110) (Gain) loss on disposal of property, plant, and equipment (1,110) 94 Noncash nonemployee directors' fees Noncash executive compensation expense Cash (used in) provided by operating activities before changes in operating assets and liabilities 104 3,975 Changes in operating assets and liabilities: (Increase) decrease in trade accounts and other receivables (110) 145 (Increase) decrease in food and supply inventories (107) 34 (Increase) decrease in income tax receivable -- (6,829) (Increase) decrease in prepaid expenses (63) (29) (Increase) decrease in investments and other assets Increase (decrease) in accounts payable (73) 6,759 Increase (decrease) in accrued claims and insurance, accrued expenses, and other liabilities (4,662) (5,679) Increase (decrease) in deferred income taxes and other credits (94) 2,951 Increase (decrease) in reserve for restaurant closings (77) (258) Net cash (used in) provided by operating activities $ (4,610) $ 1,202 CASH FLOWS FROM INVESTING ACTIVITIES: (Increase) decrease in short-term investments $ 9,181 $ 2,331 Proceeds from disposal of property held for sale 6,916 1,093 Purchases of property, plant, and equipment (6,043) (6,097) Proceeds from disposal of property, plant, and equipment 2, Net cash provided by (used in) investing activities 13,037 (2,673) CASH FLOWS FROM FINANCING ACTIVITIES: Issuance (repayment) of debt, net (9,820) (1,056) Net cash provided by (used in) financing activities (9,820) (1,056) Net increase (decrease) in cash (1,393) (2,527) Cash at beginning of period 1,584 4,099 Cash at end of period $ 191 $ 1,572 See accompanying notes Page 6

7 Note 1. Basis of Presentation Luby's, Inc. Notes to Consolidated Financial Statements (unaudited) February 12, 2003 The accompanying unaudited financial statements are presented in accordance with the requirements of Form 10-Q and, consequently, do not include all of the disclosures normally required by accounting principles generally accepted in the United States. All adjustments which are, in the opinion of management, necessary to a fair presentation of the results for the interim periods have been made. All such adjustments are of a normal recurring nature. The results for the interim periods are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the consolidated financial statements and footnotes included in Luby's Annual Report on Form 10-K for the year ended August 28, The accounting policies used in preparing these consolidated financial statements are the same as those described in Luby's Annual Report on Form 10-K. Note 2. Accounting Period Change Beginning with the 2002 fiscal year, the Company changed its accounting intervals from 12 calendar months to 13 four-week periods. To properly accommodate this change, the first period in fiscal 2002 began September 1, 2001, and covered 26 days; subsequent periods covered 28 days. The first, second, third, and fourth quarters of fiscal year 2002 included 82, 84, 84, and 112 days, respectively. Fiscal year 2003 and most years going forward will be 364 days in length, comparatively, with the first and second quarters covering 84 days each. Note 3. Short-Term Investments The Company's balance in short-term investments was $14.9 million and $24.1 million as of February 12, 2003, and August 28, 2002, respectively. As of both period-ends, cash resources were invested in money-market funds and time deposits. As of February 12, 2003, approximately $1.1 million of the Company's short-term investments was also pledged as collateral to two separate letters of credit. Note 4. Income Tax Following is a summarization of deferred income tax assets and liabilities as of the current quarter and the prior fiscal year: February 12, August 28, (In thousands) Net deferred long-term income tax liability and other credits $ (5,366) $ (5,460) Other credits 1,559 1,653 Net deferred long-term income tax liability (3,807) (3,807) Net deferred short-term income tax asset 2,726 2,726 Net deferred income tax liability $ (1,081) $ (1,081) Page 7

8 The tax effect of temporary differences results in the following deferred income tax assets and liabilities as of the current quarter and the prior fiscal year: February 12, August 28, (In thousands) Deferred tax assets: Workers' compensation, employee injury, and general liability claims $ 3,197 $ 3,501 Deferred compensation 1,944 1,806 Asset impairments and restaurant closure reserves 16,907 19,243 Net operating loss 2, Other Subtotal 24,294 24,550 Valuation allowance (2,158) -- Total deferred tax assets 22,136 24,550 Deferred tax liabilities: Depreciation and amortization, including amortization of capitalized interest 23,217 23,650 Other -- 1,981 Total deferred tax liabilities 23,217 25,631 Net deferred tax liability $ (1,081) $ (1,081) The reconciliation of the benefit for income taxes to the expected income tax benefit computed using the statutory tax rate is as follows: February 12, 2003 Quarter Ended February 13, 2002 February 12, 2003 Two Quarters Ended February 13, 2002 Amount % Amount % Amount % Amount % (In thousands and as a percent of pretax income) Normally expected income tax benefit $ (1,192) (35.0)% $(1,150) (35.0)% $ (2,277) (35.0)% $ (3,961) (35.0)% State income taxes Jobs tax credits (51) (1.5) (96) (2.9) (101) (1.6) (191) (1.7) Other differences Valuation allowance 1, , $ -- --% $(1,123) (34.2)% $ -- --% $ (3,811) (33.7)% The Company generated an operating loss carry-forward of approximately $11.8 million for the two quarters ended February 12, The tax benefit for book purposes of $2.2 million was netted against a valuation allowance because loss carry-backs will be exhausted with the fiscal 2002 tax filing, making the realization of loss carryforward utilization uncertain. Page 8

9 Note 5. Property, Plant, and Equipment The cost and accumulated depreciation of property, plant, and equipment at February 12, 2003, and August 28, 2002, together with the related estimated useful lives used in computing depreciation and amortization, were as follows: Note 6. Debt February 12, August 28, Estimated Useful Lives (In thousands) Land $ 72,364 $ 73,664 Restaurant equipment and furnishings 139, ,846 3 to 15 years Buildings 235, , to 40 years Leasehold and leasehold improvements 31,765 33,107 Term of leases Office furniture and equipment 12,510 12,330 5 to 10 years Transportation equipment years 492, ,564 Less accumulated depreciation and amortization (209,805) (205,597) $ 282,973 $ 289,967 Credit-Facility Debt At August 28, 2002, the Company had a credit-facility balance of $118.4 million with the bank group (a syndicate of four banks). In accordance with provisions of that credit facility, the Company paid the outstanding balance down by $9.8 million during the first two quarters of fiscal 2003 from proceeds received from the sale of real and personal property. As a result, the balance was lowered to $108.6 million at the end of the second quarter of fiscal The interest rate was prime plus 3.5% and prime plus 1.5% at February 12, 2003, and August 28, 2002, respectively. In the second quarter of fiscal 2003, the Company executed a commitment letter with a third-party lender for an $80 million loan. Its purpose was to replace that amount of debt in the existing credit facility. The bank group of the credit facility amended its agreement with the Company to require that all the funds provided by the prospective lender be used to pay down the current debt. Subsequently, the Company did not finalize an agreement with the third-party lender because of unacceptable changes in the structure of the proposed loan. Consequently, the Company was in default under the existing credit facility as of January 31, 2003, not as a result of noncompliance with financial performance covenants, but because the replacement financing could not be finalized. The Company is current on all interest payments due under the credit facility. As of February 12, 2003, $237.8 million of the Company's total book value, or 73.9% of its total assets, including the Company's owned real estate, improvements, equipment, and fixtures, was pledged as collateral under the credit facility. Although the current lenders have reserved all rights and remedies they may have in connection with the January 31, 2003, default - including the right to demand immediate repayment of the entire outstanding balance or the right to pursue foreclosure on the assets pledged as collateral - they have not announced any intention to take such action. Management has been actively communicating with the bank group while developing a new two-year business plan focused on returning the Company to profitability. The Company has also engaged the financial advisory firms of Morgan Joseph & Co. and ING Capital LLC ("Morgan-ING") to review the new business plan and assist in coordinating its implementation with the group which holds the Company's debt. The Morgan-ING team may also assist the Company in exploring additional financing options that add value to the new business plan. Page 9

10 After thorough review of several strategic alternatives, including the proposed new business plan and after consultation with the Morgan-ING advisors, the Company's Board of Directors approved the plan on March 29, Subsequent to the approval decision, management initiated immediate implementation of the plan. Specifically, the plan calls for closure of approximately 50 of the Company's operating stores. In cases where those properties are owned by the Company, the proceeds from the sale of the properties are to be used to pay down bank debt under the existing agreement. The first 30 restaurants will be closed between March 31 and April 3, Most of the remaining locations are leased units that will close as soon as commercially feasible after negotiations with landlords or at the end of lease terms that expire in the near future. Initially, cash resources will be reduced under the new plan, especially relative to lease settlements and termination costs. The Company will be able to use its expected $7.2 million tax refund to lessen the burden but will also need to pursue other options, which may include retaining a portion of cash from proceeds from the sale of property. Such an allowance will be subject to approval by the current credit-facility bank group. The credit agreement includes a provision for the issuance of letters of credit in the amount of $1.2 million. There is no room to borrow additional funds under the current debt agreement. Subordinated Debt On March 9, 2001, the Company's CEO and COO, Christopher J. Pappas and Harris J. Pappas, respectively, committed to lending the Company a total of $10 million in exchange for convertible subordinated notes that were funded in the fourth quarter of fiscal The notes, as formally executed, bear interest at LIBOR plus 2%, payable quarterly, and have a stated redemption date of March 1, Interest through September 1, 2003, may be paid in a combination of cash, common stock, or both at the Company's election, subject to certain restrictions on the amount of stock issued. All interest to date has been paid in cash. Interest incurred after September 1, 2003, must be paid in cash. Notwithstanding any accrued interest that may also be converted to stock, the notes are convertible into the Company's common stock at $5.00 per share for 2.0 million shares at the option of the holders at any time after January 2, 2003, and prior to the stated redemption date. The per share market price of the Company's stock on the commitment date (as determined by the closing price on the New York Stock Exchange on the date of issue) was $7.34. The difference between the market price and strike price of $5.00, or $2.34 per share, multiplied by the 2.0 million convertible shares equaled approximately $4.7 million. Under the Company's adopted intrinsic value method, applicable accounting principles require that this amount, which represents the beneficial conversion feature, be recorded as both a component of paid-in capital and a discount from the $10 million. The conversion feature is being amortized over the term of the notes. The carrying value of the notes at February 12, 2003, net of the unamortized discount, was approximately $6.1 million. The comparative carrying value of the notes at August 28, 2002, was approximately $5.9 million. Note 7. Impairment of Long-Lived Assets and Store Closings Fiscal 2003 Year-to-Date Impairment costs in the second quarter of fiscal 2003 were $138,000, which related to a decrease in the expected value of a property held for sale. Year-to-date, this cost was completely offset by first-quarter increases in the expected value of three different properties held for sale. In no case were assets written above original impaired values. Two of the four related properties with adjusted values have been sold, and one is under contract to be sold, with an expected closing date scheduled within the next 90 days. Fiscal 2002 Year-to-Date During the first two quarters of fiscal 2002, the Company recorded a pretax charge to operating costs of $130,000 related to employee termination costs for 11 of 17 restaurants that met the Company's criteria for closure in fiscal The employees of those 11 units received notification during the first quarter of fiscal 2002, and each unit was subsequently closed. Termination costs for four other locations were not considered individually significant and were recorded to payroll and related costs in fiscal The two remaining locations were still in operation at the end of the quarter. Page 10

11 Operating Results for Restaurants Designated for Closure in Fiscal 2001 with a Remaining Reserve as of February 12, 2003 Of the 17 restaurants designated for closure in fiscal 2001, two were to be fully reconcepted, while two others continue to operate as cafeterias. The operating results of the cafeterias were as follows: Quarter Ended Two Quarters Ended February 12, February 13, February 12, February 13, (84 days) (84 days) (168 days) (166 days) Sales $ 557 $ 1,546 $ 1,215 $ 4,394 Operating loss (369) (676) (839) (1,993) Fiscal 2001 Reserve for Restaurant Closings Excluding lease termination settlements, it is anticipated that all material cash outlays required for the store closings planned as of August 31, 2001, will be made prior to the end of fiscal The following is a summary for the quarterly period ended February 12, 2003, for amounts recognized as accrued expenses together with cash payments made against such accruals under the fiscal year 2001 plan: Reserve Lease Settlement Other Total Costs Exit Costs Reserve (In thousands) As of August 28, 2002 $ 2,977 $ 137 $ 3,114 Additions (reductions) Cash payments -- (77) (77) As of February 12, 2003 $ 2,977 $ 60 $ 3,037 Note 8. Commitments and Contingencies Officer Loans In fiscal 1999, the Company guaranteed loans of approximately $1.9 million relating to purchases of Luby's stock by various officers of the Company pursuant to the terms of a shareholder-approved plan. Under the officer loan program, shares were purchased and funding was obtained from JPMorgan Chase Bank, one of the four members of the bank group that participate in the Company's credit facility. These instruments only require annual interest to be paid by the individual noteholders, and the entire principal balance is due at maturity in fiscal As of both February 12, 2003, and February 13, 2002, the notes had an outstanding balance of approximately $1.6 million. The Company has received notice from JPMorgan Chase Bank that the underlying guarantee on these loans includes a cross-default provision; consequently, the January 31, 2003, default in the Company's credit facility has led to a default in the officer loans. JPMorgan Chase Bank has requested that the Company repurchase the notes; however, such action cannot be completed without consultation with the entire bank group. The Company is therefore working constructively with all members of the bank group in an effort to cure both defaults and satisfactorily meet lender expectations. In the event of individual noteholder default, the Company would purchase the loans from JPMorgan Chase Bank, become holder of the notes, record the receivables, and pursue collection. The purchased Company stock has been and can be used by borrowers to satisfy a portion of their loan obligation. As of February 12, 2003, based on the market price on that day, approximately $120,000, or 7.4% of the note balances, could have been covered by stock, while approximately $1.5 million, or 92.6%, would have remained outstanding. Page 11

12 Pending Claims As reported in previous filings, a lawsuit was filed by two former Luby's assistant managers claiming violation of the Fair Labor Standards Act and the commission of certain fraudulent acts. An agreement to resolve this matter has been made between the parties, and the judge has signed an order preliminarily approving the settlement of class claims, sending of notice, plan of allocation, attorney's fees and expenses, and conditionally granted final approval of same. The Company is presently, and from time to time, subject to pending claims and lawsuits arising in the ordinary course of business. In the opinion of management, other than the litigation described above, the resolution of all other pending legal proceedings will not have a material adverse effect on the Company's operations or consolidated financial position. Note 9. Deferred Compensation - Executive Stock Options In connection with their employment agreements effective March 9, 2001, the CEO and the COO were granted approximately 2.2 million stock options at a strike price of $5.00 per share, which was below the quoted market price on the date of grant. From that date through fiscal 2004, the Company will recognize a total of $5.2 million in noncash compensation expense associated with these options. A total of $605,000 and $601,000 was recognized for the first two quarters of fiscal 2003 and 2002, respectively. Of the $5.2 million to be recognized, $3.8 million has been recognized through February 12, 2003, while $1.4 million remains to be amortized. Note 10. Related Parties Affiliate Services The CEO and COO of the Company, Christopher J. Pappas and Harris J. Pappas, respectively, own two restaurant entities that provide services to Luby's, Inc. as detailed in the Affiliate Services Agreement and the Master Sales Agreement. Under the terms of the agreements, the Pappas entities have provided specialized (customized) equipment fabrication; basic equipment maintenance; and accounting, architectural, and general business services. More specifically, the Master Sales Agreement includes the costs incurred for modifications to existing equipment, as well as custom-fabrication, including stainless steel stoves, shelving, rolling carts, and chef tables. The total cost of the custom-fabricated and refurbished equipment for the first two quarters of fiscal 2003 and 2002 was approximately $99,000 and $301,000, respectively. As of the report date, all amounts charged under the agreements through February 12, 2003, have been paid. The Finance and Audit Committee of the Company's Board of Directors uses independent valuation consultants to assist in periodically monitoring pricing of the transactions associated with the Master Sales Agreement and the Affiliate Services Agreement. The Company's external auditors performed agreed upon procedures related to the affiliate services. The scope and sufficiency of such procedures are determined by management and the Board of Directors, and results are submitted to the Board for its use in evaluating the fairness of the transactions. Operating Leases In a separate contract from the Affiliate Services Agreement and the Master Sales Agreement, the Company entered into a three-year lease which commenced on June 1, 2001, and ends May 31, The leased property is used to accommodate the Company's own in-house repair and fabrication center. The amount paid by the Company pursuant to the terms of this lease was approximately $40,000 for each of the two-quarter periods ended February 12, 2003, and February 13, In another separate contract, pursuant to the terms of a ground lease dated March 25, 1994, the Company paid rent to PHCG Investments for a Luby's restaurant operating in Dallas, Texas. Christopher J. Pappas and Harris J. Pappas are general partners of PHCG Investments. The amount paid by the Company to PHCG Investments pursuant to the terms of the lease agreement was approximately $42,000 for the two quarters ended February 12, 2003, and for the same period in fiscal Rents paid for both leases combined represent 2.4% of total rents paid by the Company for the two quarters ended February 12, Page 12

13 Relative to the PHCG Investments lease, in the first quarter of fiscal 2003, the Company entered into a termination agreement with a third party unaffiliated with the Pappas entities to sever its interest in the PHCG property in exchange for a payment of cash, the right to remove fixtures and equipment from the premises, and the release of any future obligations under the lease agreement now owned by PHCG Investments. The closing of the transaction was completed subsequent to the end of the second quarter of fiscal 2003, resulting in a gain of $735,000, while the gross proceeds were used to pay down debt. Subordinated Debt As described in Note 7 in the section entitled "Subordinated Debt," the CEO and the COO loaned the Company a total of $10 million in the form of convertible subordinated notes to support the Company's future operating cash needs. The entire balance was outstanding as of February 12, Board of Directors Pursuant to the terms of a separate Purchase Agreement dated March 9, 2001, entered into by and among the Company, Christopher J. Pappas and Harris J. Pappas, the Company agreed to submit three persons designated by Messrs. Pappas as nominees for election for directors. They designated themselves and Frank Markantonis as their nominees for directors, all of whom were subsequently elected. Christopher J. Pappas and Harris J. Pappas are brothers. As disclosed in the proxy statement for the January 31, 2003, annual meeting of shareholders, Frank Markantonis is an attorney whose principal client is Pappas Restaurants, Inc., an entity owned by Harris J. Pappas and Christopher J. Pappas. Key Management Personnel Ernest Pekmezaris, the Chief Financial Officer of the Company, is also the Treasurer of Pappas Restaurants, Inc. Compensation for the services provided by Mr. Pekmezaris to Pappas Restaurants, Inc. is paid entirely by that entity. Peter Tropoli, the Senior Vice President-Administration of the Company, is an attorney who, from time to time, has provided litigation services to entities controlled by Christopher J. Pappas and Harris J. Pappas. Mr. Tropoli is the stepson of Frank Markantonis, who, as previously mentioned, is a director of the Company. Paulette Gerukos, Administration Assistant of the Human Resources Department of the Company, is the sister-in-law of Harris J. Pappas, the Chief Operating Officer. Page 13

14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and footnotes for the two quarters ended February 12, 2003, and the audited financial statements filed on Form 10-K for the fiscal year ended August 28, Overview As of February 12, 2003, the Company operated 193 restaurants under the name "Luby's." These establishments are located in close proximity to retail centers, business developments, and residential areas throughout ten states (six in Arizona, five in Arkansas, one in Florida, two in Louisiana, two in Mississippi, two in Missouri, two in New Mexico, seven in Oklahoma, seven in Tennessee, and 159 in Texas). Of the 193 restaurants, 124 are at locations owned by the Company and 69 are on leased premises. Additionally, two of the restaurants primarily serve seafood, one is a steak buffet, 46 are full-time all-you-can-eat concepts, and 144 are traditional cafeterias. For additional information concerning Company restaurants, also see The New Business Plan/Debt under the Liquidity and Capital Resources section below. RESULTS OF OPERATIONS Quarter ended February 12, 2003, compared to the quarter ended February 13, 2002 Sales decreased $3.0 million, or 3.3%, in the second quarter of fiscal 2003 compared to the second quarter of fiscal Of the total decline, $3.4 million was due to the closure of twelve restaurants since November 21, 2001, and $0.5 million was due to a 0.6% decrease in same-store sales. These contributors to the total decline were offset by the opening of three restaurants since November 21, 2001, that accounted for $0.9 million in sales. Cost of food increased $3.0 million, or 13.4%, and as a percentage of sales increased from 24.7% to 29.0% in the current quarter in comparison with the same period last year. New "all-you-can-eat" offerings and buffets at selected locations have contributed to higher food costs. This increase in food cost was a planned part of a Company strategy aimed at increasing value while maintaining quality. Payroll and related costs decreased $4.3 million, or 14.1%, in the current quarter due primarily to restaurant closures, various Company initiatives to reduce labor costs, and lower workers' compensation expense. Of the total reduction, $3.1 million was due to lower wages and associated payroll taxes resulting from numerous store closures coupled with various Company initiatives to reduce labor costs. An additional $1.2 million of the total decline was due to lower workers' compensation costs resulting from the new in-house training and safety programs. Occupancy and other operating expenses decreased $382,000, or 1.1%. Although the dollar decrease is primarily due to store closures, other factors contributed to the fluctuation. Utility costs decreased principally due to lower commodity prices. Food-to-go packaging costs further declined due to less expensive packaging and a program to redirect these customers at many locations to inside dining. These were partially offset by property/employee insurance, which increased principally due to premium increases for owned properties coupled with pass-through insurance adjustments from landlords of leased properties. General and administrative expenses were approximately equal to the prior year, with only a slight decrease of $7,000, or 0.1%. Small variances exist among these expenses which, when taken as a whole, are not significant. The provision for asset impairments and restaurant closings increased by $138,000 primarily due to the write-down of properties held for sale to the appraisal values. No provision for asset impairments and restaurant closings was recorded in the second quarter of fiscal Interest expense decreased $240,000, or 9.9%, due primarily to fully exhausted amortization of the loss of interest rate swaps and payment reductions in the line of credit. These factors were offset by amortization of amendment fees for the credit facility. Page 14

15 Other income increased by $1.1 million primarily due to gains on the sale of assets, which reflect the sale of three previously closed stores. These gains were partially offset by a loan commitment fee expensed in the current quarter. The income tax benefit decreased by $1.1 million. While loss carry-backs are no longer available, the Company could use certain existing assets in a tax strategy that would support the recording of an estimated tax benefit in the current quarter. However, one was not recorded because loss carry-forward utilization is not certain. The Company had a reserve for restaurant closings of $3.0 million and $3.1 million at February 12, 2003, and August 28, 2002, respectively. Excluding lease termination settlements, it is anticipated that all material cash outlays required for the store closings planned as of August 31, 2001, will be made prior to the end of fiscal Two quarters ended February 12, 2003, compared to the two quarters ended February 13, 2002 Sales decreased $10.0 million, or 5.3%, for the first two quarters of fiscal 2003 compared to the first two quarters of fiscal Of the total decline, $8.1 million was due to the closure of 23 restaurants since August 31, 2001, and $5.5 million was due to a 3.1% decrease in same-store sales. These contributors to the total decline were offset by the positive impact of two additional days of sales of $2.3 million and the opening of three restaurants since August 31, 2001, that accounted for $1.3 million in sales. Cost of food increased $3.4 million, or 7.2%, and as a percentage of sales increased from 25.3% to 28.7% for the first two quarters of fiscal 2003 in comparison with the same period last year. New "all-you-can-eat" offerings and buffets at selected locations have contributed to higher food costs. Again, this increase in food cost was a planned part of a Company strategy aimed at providing value and quality to the customer. Payroll and related costs decreased $11.2 million, or 17.3%, due primarily to previous restaurant closures, various Company initiatives to reduce labor costs, and lower workers' compensation expense in the first two quarters of fiscal Of the total reduction, $8.5 million was due to lower wages and associated payroll taxes resulting from numerous store closures coupled with various Company initiatives to reduce labor costs. An additional $2.7 million of the total decline was due to lower workers' compensation costs resulting from the new in-house training and safety programs. Occupancy and other operating expenses decreased $2.4 million, or 3.4%. Although the dollar decrease is primarily due to store closures, other factors contributed to the fluctuation. Utility costs decreased principally due to lower commodity prices. Repair and maintenance costs decreased primarily due to more efficiencies from the Company's in-house repair program as provided by its in-house service center. Food-to-go packaging costs further declined due to less expensive packaging and a program to redirect these customers at many locations to inside dining. These again were offset by property/employee insurance, which increased principally due to premium increases for owned properties coupled with pass-through insurance adjustments from landlords of leased properties. General and administrative expenses were approximately equal to the prior year, with only a slight increase of $12,000, or 0.1%. Small variances exist among these expenses which, when taken as a whole, are not significant. The provision for asset impairments and restaurant closings was credited a net $25,000 for the first two quarters of fiscal This related to new and pending property sales contracts that were more favorable than previously obtained appraisals. Those amounts were partially offset by a write-down of another property held for sale. Costs in the first two quarters of fiscal 2002 were $130,000, which related to employee terminations. Interest expense decreased $806,000, or 16.2%, due primarily to lower effective interest rates on outstanding debt, the payoff of the loans on surrendered officers' life insurance policies, fully exhausted amortization of the loss of interest rate swaps, and payment reductions in the line of credit. These factors were offset by amortization of amendment fees for the credit facility. Other income increased by $3.6 million primarily due to gains on the sales of assets, which reflect the sale of five previously closed stores. These gains were partially offset by a loan commitment fee expensed in fiscal Page 15

16 The income tax benefit decreased by $3.8 million. While loss carry-backs are no longer available, the Company could use certain existing assets in a tax strategy that would support the recording of an estimated tax benefit in the current quarter. However, one was not recorded because loss carry-forward utilization is not certain. EBITDA EBITDA increased by $377,000 for the first two quarters of fiscal 2003 in comparison with the same period of the prior fiscal year. Two Quarters Ended February 12, February 13, (168 days) (166 days) (In thousands) Income (loss) from operations $ (6,696) $ (7,092) Less excluded items: Provision for asset impairments and restaurant closings (25) 130 Depreciation and amortization 10,066 9,934 Noncash executive compensation expense EBITDA $ 3,950 $ 3,573 The Company's operating performance is evaluated using several measures, one of which is EBITDA. The Company defines EBITDA as income from operations before interest, taxes, depreciation and amortization, and the noncash portion of the CEO's and the COO's stock option compensation. While the Company and many in the financial community consider EBITDA to be an important measure of operating performance, it should be considered in addition to, but not as a substitute for or superior to, other measures of financial performance prepared in accordance with accounting principles generally accepted in the United States, such as operating income and net income. In addition, the Company's definition of EBITDA is not necessarily comparable to similarly titled measures reported by other companies. LIQUIDITY AND CAPITAL RESOURCES Cash and Working Capital Cash decreased by $1.4 million from the end of the preceding fiscal year to February 12, 2003, primarily due to capital expenditures and operating cash flow needs, including the payment of approximately $8.0 million in property taxes. These items were partially offset by reductions in the Company's short-term investments. Excluding the reclassification of the credit-facility balance as explained in The New Business Plan/Debt section below, the Company had a working capital deficit of $7.4 million at February 12, 2003, in comparison to a working capital deficit of $1.1 million at August 28, The increase in the deficit was primarily attributable to a reduction in short-term investments. Capital expenditures for fiscal 2003 are expected to approximate $13 million. Management continues to focus on improving the appearance, functionality, and sales at existing restaurants. These efforts also include, where feasible, remodeling certain locations to other dining concepts. During the current quarter, the Company remodeled and reopened another previously closed location as a seafood restaurant. The new dining themes for the other two planned remodels in fiscal 2003 are still under consideration. Page 16

17 The New Business Plan/Debt During 1994, the Company acquired a revolving line of credit from a bank group to primarily be used for financing long-term objectives, including capital acquisitions and a stock repurchase program. Capacity under that credit facility was fully exhausted during fiscal Since then, management has financed its capital acquisitions and working capital needs through careful cash management and the provision of an additional $10 million in financing by the Company's CEO and the COO. At that same time, management recognized the need to arrange long-term financing that would better match longterm assets with the existing debt. Accordingly, early in the second quarter of fiscal 2003, the Company executed a commitment letter with a third-party lender for an $80 million loan to replace that amount of debt in the existing credit facility. Simultaneously, when the current bank group provided a recent waiver and amendment, it also added a stipulation that required the new $80 million financing be completed and funded by January 31, However, the Company was unable to finalize the new financing arrangement because of changes in the proposed agreement terms that were not in the best interest of the Company. This led to a default under the credit facility that the Company is currently focused on rectifying. Even though the lack of replacement financing has caused a default, the Company was in compliance with its financial performance covenants at the end of the quarter and no default in interest payments has occurred as of the report date. As of March 31, 2003, the existing bank group has taken no action other than to notify the Company that it reserves all rights and remedies they may have. Management has been actively communicating with the credit-facility bank group, while working on its new twoyear business plan focused on returning the Company to profitability. The Company also engaged the financial advisory firms of Morgan Joseph & Co. and ING Capital LLC ("Morgan-ING") to review the new business plan and assist in coordinating its implementation. The Morgan-ING team may also assist the Company in exploring additional financing options that add value to the new business plan. After thorough review of several strategic alternatives, including the proposed new business plan and after consultation with the Morgan-ING advisors, the Company's Board of Directors approved the plan on March 29, Subsequent to the approval decision, management initiated immediate implementation of the plan. Specifically, it calls for closure of approximately 50 of the Company's operating stores. In cases where those properties are owned by the Company, the proceeds from the sale of the properties are to be used to pay down bank debt under the existing agreement. The first 30 restaurants will be closed between March 31 and April 3, Most of the remaining locations are leased units that will close as soon as commercially feasible after negotiations with landlords or at the end of lease terms that expire in the near future. Over a time span starting in the third quarter of fiscal 2003 through the fourth quarter of fiscal 2004, the Company expects to report net losses from discontinued operations due to its decision to close the locations specified in the new business plan. General estimates have been formulated for the related net losses. The timing and actual incurred costs may differ from these estimates as plan specifics are finalized. The total current loss estimate of approximately $27 million includes net impairment charges associated with reducing applicable property values down to their net realizable values, employee termination costs, lease settlements, legal and professional fees, basic carrying costs while properties are being marketed, and other related charges. Initially, cash resources will be reduced under the new plan, especially relative to lease settlements and termination costs. The Company will be able to use its expected $7.2 million tax refund to lessen the burden but will also need to pursue other options, which may include retaining a portion of cash from proceeds from the sale of property. Such an allowance will be subject to approval by the current credit-facility bank group. Updated information about the financial costs of the new plan will be provided in the Company's fiscal 2003 thirdquarter filing since the plan was approved in that quarter. Those financials will include costs incurred to date. Credit-Facility Debt At August 28, 2002, the Company had a credit-facility balance of $118.4 million with the bank group (a syndicate of four banks). In accordance with provisions of that credit facility, the Company paid the outstanding balance down by $9.8 million from proceeds received from the sale of real and personal property. As a result, the balance was lowered to $108.6 million at the end of the second quarter of fiscal The interest rate was prime plus 3.5% and prime plus 1.5% at February 12, 2003, and August 28, 2002, respectively. The Company is current on all interest payments due under the credit facility. Page 17

18 As of February 12, 2003, $237.8 million of the Company's total book value, or 73.9% of its total assets, including the Company's owned real estate, improvements, equipment, and fixtures, was pledged as collateral under the credit facility. Although the current lenders have reserved all rights and remedies they may have as a result of the January 31, 2003, default - including the right to demand immediate repayment of the entire outstanding balance or the right to pursue foreclosure on the assets pledged as collateral - they have not announced any intention to take such action. (Also see the section above.) The credit agreement includes a provision for the issuance of letters of credit in the amount of $1.2 million. There is no room to borrow additional funds under the current debt agreement. Subordinated Debt On March 9, 2001, the Company's CEO and COO, Christopher J. Pappas and Harris J. Pappas, respectively, committed to lending the Company a total of $10 million in exchange for convertible subordinated notes that were funded in the fourth quarter of fiscal The notes, as formally executed, bear interest at LIBOR plus 2%, payable quarterly, and have a stated redemption date of March 1, Interest through September 1, 2003, may be paid in a combination of cash, common stock, or both at the Company's election, subject to certain restrictions on the amount of stock issued. All interest to date has been paid in cash. Interest incurred after September 1, 2003, must be paid in cash. Notwithstanding any accrued interest that may also be converted to stock, the notes are convertible into the Company's common stock at $5.00 per share for 2.0 million shares at the option of the holders at any time after January 2, 2003, and prior to the stated redemption date. The per share market price of the Company's stock on the commitment date (as determined by the closing price on the New York Stock Exchange on the date of issue) was $7.34. The difference between the market price and strike price of $5.00, or $2.34 per share, multiplied by the 2.0 million convertible shares equaled approximately $4.7 million. Under the Company's adopted intrinsic value method, applicable accounting principles require that this amount, which represents the beneficial conversion feature, be recorded as both a component of paid-in capital and a discount from the $10 million. The conversion feature is being amortized over the term of the notes. The carrying value of the notes at August 28, 2002, net of the unamortized discount, was approximately $5.9 million. The comparative carrying value of the notes at February 12, 2003, was approximately $6.1 million. COMMITMENTS AND CONTINGENCIES In fiscal 1999, the Company guaranteed loans of approximately $1.9 million relating to purchases of Luby's stock by various officers of the Company pursuant to the terms of a shareholder-approved plan. Under the officer loan program, shares were purchased and funding was obtained from JPMorgan Chase Bank, one of the four members of the bank group that participate in the Company's credit facility. These instruments only require annual interest to be paid by the individual noteholders, and the entire principal balance is due at maturity in fiscal As of both February 12, 2003, and February 13, 2002, the notes had an outstanding balance of approximately $1.6 million. The Company has received notice from JPMorgan Chase Bank that the underlying guarantee on these loans includes a cross-default provision; consequently, the January 31, 2003, default in the Company's credit facility has led to a default in the officer loans. JPMorgan Chase Bank has requested that the Company repurchase the notes; however, such action cannot be completed without consultation with the entire bank group. The Company is therefore working constructively with all members of the bank group in an effort to cure both defaults and satisfactorily meet lender expectations. In the event of individual noteholder default, the Company would purchase the loans from JPMorgan Chase Bank, become holder of the notes, record the receivables, and pursue collection. The purchased Company stock has been and can be used by borrowers to satisfy a portion of their loan obligation. As of February 12, 2003, based on the market price on that day, approximately $120,000, or 7.4% of the note balances, could have been covered by stock, while approximately $1.5 million, or 92.6%, would have remained outstanding. Page 18