ITEM 1. BUSINESS
GENERAL
Meritage Hospitality Group Inc. ("Meritage" or "the Company") was incorporated in 1986 and is engaged in the hospitality business through its operation of two distinct business segments. The Company's Food Service Group operates 25 "Wendy's Old Fashioned Hamburgers" restaurants throughout Western and Southern Michigan. The Company's Lodging Group owns and operates two full service hotels in Michigan. Meritage's principal executive office is located at 40 Pearl Street, N.W., Suite 900, Grand Rapids, Michigan 49503. Its telephone number is (616) 776-2600 and its facsimile number is (616) 776-2776.
FOOD SERVICE GROUP
In the Food Service Group, the Company owns, through a wholly owned subsidiary, a limited partnership known as Wendy's of Michigan which operates 25 "Wendy's Old Fashioned Hamburgers" restaurants throughout Western and Southern Michigan pursuant to franchise agreements with Wendy's International, Inc. Wendy's of Michigan is the successor to the Wendy's of West Michigan Limited Partnership (whose assets were acquired by Wendy's of Michigan) which was dissolved on January 30, 1998 (the "Dissolved Partnership"). MCC Food Service Inc., a wholly-owed subsidiary of Meritage Capital Corp. ("MCC") (the largest shareholder of Meritage), is the general partner of Wendy's of Michigan. Wendy's of Michigan employs approximately 900 people and reported revenue of approximately $27.1 million in fiscal 1997.
LODGING GROUP
In the Lodging Group, the Company owns and operates two full service hotels: the 149-room Thomas Edison Inn located on the St. Clair River in Port Huron, Michigan, and the 121-room Grand Harbor Resort located on the Grand River in Spring Lake, Michigan. Each hotel has a picturesque waterfront setting and seeks business and leisure travelers who desire full service accommodations, such as guest rooms and suites, a restaurant and cocktail lounge, and meeting/conference rooms. The Company also owned and operated the St. Clair Inn which was sold (along with certain associated assets) for $3,800,000 on November 30, 1997.
FOOD SERVICE GROUP
The Company's 25 Wendy's restaurants are located in the Michigan counties of Allegan, Calhoun, Kalamazoo, Kent, Muskegon, Ottawa and Van Buren. Wendy's of Michigan (i) owns the land and buildings comprising five restaurants, (ii) leases the land and buildings comprising 19 restaurants, and (iii) owns the building and leases the land comprising one restaurant. The term of the leases (including options to renew) range from one to 23 years. The ages of the restaurants range from two to 24 years. The restaurants are subject to encumbrances described in "Financing and Encumbrances".
Menu
Each Wendy's restaurant offers a diverse menu containing a variety of food items, featuring hamburgers, chicken sandwiches and pita sandwiches which are prepared to order with the customer's choice of condiments. The Wendy's menu also includes, among other things, baked and french fried potatoes, freshly prepared salads, soft drinks and "Frosty" desserts. Wendy's International maintains significant discretion over the menu items that may be offered in the Company's 25 Wendy's restaurants.
Restaurants Layout and Operations
The Company's 25 Wendy's restaurants typically range from 2,700 to 3,200 square feet with a seating capacity between 90 and 130 people, and are typically open from 10:30 a.m. until 10:00 p.m., with many restaurants open for extended evening hours. Generally, the dining areas are carpeted and informal in design, with tables for two to four people. These restaurants also feature drive-through windows. Sales to drive-through customers accounted for approximately half of Wendy's of Michigan's total sales in fiscal 1997.
A comprehensive reporting system provides restaurant sales and operating data (including product sales mix, food usage and labor cost information) with respect to each of the 25 Wendy's restaurants. Physical inventories of all food items are taken weekly, and inventories of critical food items are taken twice a day.
Marketing and Promotion
Wendy's International requires that at least 4% of restaurant sales be contributed to an advertising and marketing fund, 2.5% of which is used to benefit all restaurants owned and franchised by Wendy's International. The Wendy's National Advertising Program uses these moneys to develop advertising and sales promotion materials and concepts to be implemented nationally. The remainder of the fund must be used on local advertising. Wendy's of Michigan typically spends local advertising dollars in support of national television advertising, local television and radio advertising, print media, local promotions and community goodwill projects.
Raw Materials
The Company's 25 Wendy's restaurants comply with uniform recipe and ingredient specifications provided by Wendy's International, and purchase their food and beverage inventories and restaurant supplies from independent vendors approved by Wendy's International. Except for the New Bakery Co. of Ohio, Inc., a wholly-owned subsidiary of Wendy's International, Wendy's International does not sell food or supplies to its franchisees. Wendy's of Michigan purchases its sandwich buns from local bakeries, and its soft drink products from the Coca-Cola Company and its affiliates.
The Company has not experienced any significant shortages of food, equipment, fixtures or other products which are necessary to restaurant operations. While no such shortages are anticipated, the Company believes that alternate suppliers are available if any shortage were to occur.
Relationship with Wendy's International
Wendy's of Michigan operates pursuant to a consent agreement and 25 franchise agreements (one for each restaurant) with Wendy's International. These agreements grant privileges such as the right to utilize Wendy's International's trademarks, service marks, designs and other proprietary rights (such as "Wendy's" and "Wendy's Old Fashioned Hamburgers") in connection with the operation of its 25 Wendy's restaurants. These agreements also impose requirements regarding the preparation and quality of food products, the level of service, and general operating procedures. The franchise agreements currently in place generally expire in 20 years. Subject to certain conditions, the franchise agreements can be renewed for an additional 10 years.
The franchise agreements with Wendy's International provide, among other things, that a change in the operational control of Wendy's of Michigan cannot occur without the prior consent of Wendy's International. In addition, any proposed sale of the Wendy's business, interests or franchise rights is subject to the consent and right of first refusal of Wendy's International. These agreements also grant Wendy's International wide discretion over many aspects of restaurant operations, and often require the consent of Wendy's International to carry out certain operational transactions. If Wendy's International's consent is required and not obtained, Meritage will not be able to proceed with its plans which, in turn, could adversely effect Meritage's growth strategy. If Meritage were to proceed without Wendy's International's consent, Wendy's International could terminate the franchise agreements or exercise its right to purchase the Wendy's restaurants at fair market value.
Part of Meritage's business strategy is to expand its food service operations through the acquisition and development of additional Wendy's restaurants. In addition to paying monthly royalty fees, Meritage would be required to pay Wendy's International technical assistance fees upon the opening of new Wendy's restaurants. Meritage is permitted to develop new Wendy's restaurants and convert competitive units located in its designated market area (the Michigan counties of Allegan, Calhoun, Kalamazoo, Kent, Muskegon, Ottawa and Van Buren) subject to the standard expandability criteria and site standards of Wendy's International. Meritage is prohibited from acquiring or developing new Wendy's restaurants outside of the designated market area unless the prohibition is waived by Wendy's International in its sole and absolute discretion. Pursuant to its agreement with Wendy's International, Meritage is also limited in both the acquisition or development of other chain restaurant businesses. Wendy's International has restricted Meritage's involvement with any quick-service restaurants in Meritage's designated market area, and with any quick-service restaurants outside of Meritage's designated market area that sells chicken sandwiches, hamburgers or products similar to Wendy's International and which is located within a three mile radius of another Wendy's restaurant.
The reputation of Meritage's 25 Wendy's restaurants are largely dependent on the Wendy's restaurant chain, which in turn is dependent upon the management and financial condition of Wendy's International and the reputation developed by Wendy's restaurants operated by other Wendy's franchisees. Should Wendy's International be unable to compete effectively with similar restaurant chains in the future, Meritage would be materially and adversely affected. Furthermore, many of the attributes which lead to the success of Wendy's operations are factors over which Meritage has no control, such as marketing, introduction of new products, quality assurance and other operational systems.
Meritage cannot conduct its Wendy's operation without its affiliation with Wendy's International. Any termination of the franchise agreements would have a material adverse effect on Meritage's financial condition and results of operations.
COMPETITION AND INDUSTRY CONDITIONS
The food service industry serves as the nation's largest retail employer, providing jobs for over nine million people at over 730,000 locations in the United States. The growth rate of the quick-service segment has consistently exceeded that of the food service industry as a whole for more than 20 years. Historic changes in domestic lifestyles, favoring greater convenience, has significantly impacted this trend. Because of this growth rate, competition in the quick-service restaurant segment is intense and can be expected to increase.
Most of the Company's Wendy's restaurants are located in close proximity to their principal quick-service restaurant competitors (e.g. McDonald's, Burger King and Taco Bell)
which compete on the basis of price, service, location, food quality and menu variety. These competitors have attempted to draw customer traffic through a strategy of deeply discounting the price of their products. However, neither Wendy's International nor the Company believe this is a profitable long-term strategy.
The following table compares the Company's average Wendy's restaurant same store sales to the average same store sales of Wendy's International's company-owned restaurants and to all Wendy's franchised restaurants.
* Source: Wendy's International, Inc.
The Company intends to achieve growth by (i) developing new Wendy's restaurants in its existing market, (ii) acquiring Wendy's restaurants in other markets, and (iii) increasing sales at all Wendy's restaurants operated by the Company. In addition, the Company is exploring other strategic acquisitions in the chain restaurant industry that would significantly increase the size of its Food Service Group.
The restaurant industry is subject to seasonal fluctuations. Like the rest of the quick-service industry, traffic typically increases during the summer months, which results in increased revenues during those months. During fiscal 1997, food service revenue generated by quarter was as follows: first quarter - 22%; second quarter - 26%; third quarter - 27%; and fourth quarter - 25%.
RISKS AND GOVERNMENTAL REGULATIONS
The Company's Food Service Group is subject to numerous risks inherent in the food service industry. These include, among others, changes in local and national economic conditions; changes in consumer tastes and concerns about the nutritional quality of quick-service food; severe weather; changes in travel patterns; increases in food, labor and energy costs; the availability and cost of suitable restaurant sites; fluctuating insurance rates; the availability of an adequate number of hourly-paid employees; the general reputation of Wendy's restaurants; and the recurring need for renovation and capital improvements. Also, the Wendy's restaurants are subject to extensive federal, state and local government regulations relating to, among other things, zoning and the operation of its restaurants. Congress recently passed the Minimum Wage Bill which revised the minimum wage to $5.15 per hour as of September 1, 1997. Further changes regarding minimum wage or other laws governing the relationship with employees (e.g. overtime wage and health care coverage) could have an adverse effect on the operations of the Food Service group.
The Wendy's restaurants are also subject to public health certification regarding the preparation and sale of food. The Company believes its operations would be adversely affected if these permits were terminated. The Company does not anticipate, however, that its permits will be terminated.
LODGING GROUP
The Company's hotels are full service properties that attract business and leisure travelers. Each hotel provides fully appointed guest rooms and numerous amenities and services including a restaurant and cocktail lounge, meeting/conference rooms, a swimming pool and fitness facility. Approximately 340 employees are involved in the operation of the two hotels, none of whom are members of a labor union or part of a collective bargaining unit.
The following table summarizes key information for each hotel property:
Thomas Edison Inn
The Thomas Edison Inn, which opened in 1987, is located on approximately 7 acres bordering the St. Clair River in Port Huron, Michigan. The hotel has 149 guest rooms, a 250 seat restaurant that overlooks the St. Clair River and Lake Huron, a 150 seat cocktail lounge, and a variety of meeting/conference rooms accommodating up to 500 people. Other facilities include an indoor swimming pool, a pool side whirlpool, and a health club and retail shops leased to third party vendors. The hotel's room revenue is derived from business and leisure travelers. The hotel's food and beverage facilities are heavily patronized by local clientele which results in food and beverage revenues significantly higher than industry norms for similar size hotels. In 1996 and 1997, the hotel underwent a $717,000 renovation which included certain building improvements and the installation of point-of-sale, property management and telephone systems.
Grand Harbor Resort
The Grand Harbor Resort (formerly known as the Grand Haven Holiday Inn), which opened in 1969, is located on approximately 4 acres bordering the Grand River in Spring Lake, Michigan. The hotel has 121 rooms, a 185 seat restaurant that overlooks the Grand River, a 125 seat cocktail lounge, and a variety of meeting/conference rooms accommodating up to 300 people. Other facilities include an outdoor and indoor swimming pool. The Grand Harbor Yacht Club, a newly renovated 55-slip marina condominium project owned by the Company, borders the property. The hotel's market mix is similar to that of the Thomas Edison Inn, and the hotel also derives substantial food and beverage revenue from local clientele. In 1996 and 1997, the hotel underwent a $1,185,000 renovation whereby, among other things, the exterior of the hotel was redesigned and renovated to compliment and accentuate its nautical surroundings.
The hotels are subject to encumbrances described in "Financing and Encumbrances."
COMPETITION AND INDUSTRY CONDITIONS
The lodging industry is highly competitive. Since 1993, the industry has been steadily recovering from the recession of the early 1990's and the over-building of the late 1980's. Occupancy and average daily rates have consistently increased since 1993. New hotel construction has increased rapidly since the early 1990's. However, industry sources warn that while demand continues to increase, supply (especially within the past two years) is increasing quicker than overall demand resulting in occupancy rates that are beginning to trend downward. Industry sources predict that demand will continue an upward trend in 1998. But due to the rapid growth in supply, industry sources forecast that occupancy rates and profits may experience a general decline in 1998.
The following table illustrates the percentages of occupancy for 1996 and 1997 as compared to the state and national occupancy rate for independent hotels:
* Source: Smith Travel Research
The following table illustrates the average daily room rates for the Company's hotels during 1996 and 1997 as compared to the state and national average for independent hotels:
* Source: Smith Travel Research
The following table illustrates the revenue per available room (RevPAR) for the Company's hotels during 1996 and 1997 as compared to the state and national average for independent hotels:
* Source: Smith Travel Research
The Company's hotels compete with a wide range of lodging facilities offering various types of hospitality related services to the public. The competition includes several national and regional hotel chains offering a variety of accommodations, amenities and levels of service, as
well as independent hotels in each market segment. Business at the hotels varies seasonally. Historically, demand has been greatest during the summer, resulting in higher revenues during the Company's third fiscal quarter. During fiscal 1997, lodging revenue generated by quarter was as follows: first quarter - 21%; second quarter - 22%; third quarter - 35%; and fourth quarter - 22%.
The Company operates the dominant full service hotels in its respective markets. In an attempt to maintain its market share, the Company has expanded its sales and marketing programs and made significant capital improvements. In recent years, most newly constructed hotels in the Company's markets have been limited service hotel properties which offer mid-priced or economy level room rates. The Company anticipates increased competition in its markets as a result of these new properties.
RISKS AND GOVERNMENTAL REGULATIONS
The Company's Lodging Group is subject to all the risks inherent in the lodging industry. These include, among others, changes in local and national economic conditions; changes in federal, state and local government regulations relating to the operation of the hotels and its restaurants; changes in travel patterns, severe weather; changes in interest rates; fluctuating insurance rates; the availability of an adequate number of hourly-paid employees; and the recurring need for renovation and capital improvements. Because of the high level of fixed costs required to operate full service hotels, certain significant expenditures cannot generally be reduced when circumstances cause a reduction in revenue. The Lodging Group is also sensitive to laws governing relationships with its employees such as minimum and overtime wage laws, insurance coverage requirements, and working conditions. Congress recently passed the Minimum Wage Bill which revised the minimum wage to $5.15 per hour as of September 1, 1997. Further changes regarding minimum wage or health care coverage could have an adverse effect on the operations of the Company's hotels.
The hotel, restaurant and lounge operations within the Company's Lodging Group are also subject to licensing requirements, including, but not limited to, public health certification and liquor licenses. The Company believes its operations would be adversely affected if these licenses or permits were terminated. The Company does not anticipate that its licenses or permits will be terminated.
SALE OF HOTEL PROPERTIES
Market conditions in fiscal 1997 presented the Company with an opportune time to explore the sale of one or more of its hotels. Also, any sale would be consistent with the Company's desire to focus on the expansion and diversification of its chain restaurant business. On November 30, 1997, the Company's wholly-owned subsidiary sold the St. Clair Inn and certain associated assets for $3,800,000. This sale resulted in a pre-tax gain for Meritage of $1,479,095 and a reduction of long-term debt by approximately $3,200,000. In addition, another of the Company's wholly-owned subsidiaries has entered into a definitive agreement regarding the sale of the Thomas Edison Inn and certain associated assets for $12,200,000. A non-refundable $500,000 deposit has been paid by the prospective purchaser. If this sale is closed (and there are no assurances that the sale will close), the Company will realize a pre-tax gain of approximately $2,000,000 and a long-term debt reduction of approximately $9,000,000. The Company is also exploring the sale of the Grand Harbor Resort and the Grand Harbor Yacht Club.
FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS
* The Company's Food Service Group commenced operations on November 1, 1996.
OTHER ASSETS
The Company has other assets which do not directly relate to its hospitality business. These assets include (i) approximately 5.5 acres of undeveloped land adjacent to the Thomas Edison Inn, (ii) the Grand Harbor Yacht Club, a 55-slip marina condominium development which borders the Grand River adjacent to the Grand Harbor Resort, (iii) $5.1 million in life insurance policies on the life of the Company's former President and Chief Executive Officer, and (iv) a note receivable from the sale of shares in the outstanding principal amount of $9,750,000. Except for the note receivable, the Company intends to sell all of these assets to raise additional funds which may be used to pay down the Company's long-term indebtedness or fund acquisitions, capital expenditures or other corporate purposes.
The undeveloped land adjacent to the Thomas Edison Inn is among the assets to be sold in the agreement regarding the sale of the Thomas Edison Inn described in "Sale of Hotel Properties" above.
ITEM 2.
ITEM 2. PROPERTIES.
For a description of the properties that are owned and operated by the Company and its subsidiaries, see Item 1.
The Company leases approximately 4,600 square feet of office space located at 40 Pearl Street, N.W., Suite 900, Grand Rapids, Michigan 49503 as its corporate headquarters, the executive office of Wendy's of Michigan, and the registered office of the Company and its subsidiaries. Wendy's of Michigan also leases approximately 4,000 square feet of office space located at 4613 West Main, Kalamazoo, Michigan 49006 as its operating headquarters.
The Company believes that its properties are adequately covered by insurance.
FINANCING AND ENCUMBRANCES
On February 26, 1996, the Company entered into an agreement with Great American Life Insurance Company ("GALIC"), an affiliate of American Financial Group, Inc., to refinance all of its mortgage debt. The Company executed two promissory notes in favor of GALIC in the principal amount of $12,000,000 ("Loan A") and $3,000,000 ("Loan B"), respectively.
On October 31, 1996, the Company entered into Amendment No. 1 to the loan agreement with GALIC to obtain an additional $3,000,000 mortgage loan ("Loan C"). The proceeds from Loan C were used to pay for the limited partnership units of the Dissolved Partnership acquired in a tender offer conducted in the fall of 1996 and the costs associated therewith.
On November 26, 1996, the Company entered into a new loan agreement with GALIC to replace the existing loan agreement and restructure the Company's total indebtedness. Loan A was refinanced and an additional $2,000,000 was borrowed ("Loan I"). Loan I is with the subsidiaries of the Company and is secured by a first mortgage lien on the Company's hotels and a first priority security interest in the hotel personal property. Loan I is guaranteed by the Company. The loan terms were modified effective November 1, 1997, bearing a fixed interest rate of 10.3% through October 31, 1997 and 11.25% thereafter, and requiring equal monthly payments of principal and interest of $137,897 through October 1997. Effective December 1, 1997, the required equal monthly payments of principal and interest decreased to $118,724 (based upon a 20 year amortization as calculated on the remaining balance of Loan I after the principal payment of $3,050,000 following the sale of the St. Clair Inn) through December 1, 2003. At that time, the loan matures and any remaining unpaid principal and interest will be due. Loan I may not be prepaid, in whole or in part, within 48 months, except in the event of the sale of one of the hotels, in which case the prepayment amount is an amount equal to a predetermined release price for the property being sold plus a prepayment premium. The prepayment premium is 3% if the sale occurs before November 27, 1998; 2% if the sale is on or after November 27, 1998 but before November 27, 1999; and 1% if the sale is on or after November 27, 1999 but before November 27, 2000. If any sale occurs between November 27, 2000 and November 27, 2002, Loan I may be prepaid with a "make whole premium" as defined in the loan agreement.
At the same time, Loan B and Loan C (together totaling $5,250,000) were combined into one loan ("Loan II"). Loan II is with the Company and certain of its subsidiaries, and bears an interest rate of prime (based on The Provident Bank - Cincinnati, Ohio) plus 8%, fully floating. Loan II has a maturity date of June 1, 2002, with monthly payments of interest only during the first year; principal payments of $50,000 plus accrued interest from January 1, 1998 through March 1, 1998; and principal payments of $100,000 plus accrued interest thereafter. Loan II may be prepaid in whole or in increments of $100,000 upon payment of all accrued interest plus a prepayment premium of 10% of the principal balance so prepaid, except that no prepayment premium shall be payable if GALIC requires such prepayment from the proceeds resulting from the disposition of certain collateral securing Loan II. Loan II is secured by a second priority mortgage lien on the hotels; by a first priority security interest on undeveloped land adjacent to the Thomas Edison Inn, and the Grand Harbor Yacht Club; by a collateral assignment of all life insurance policies owned by the Company on the life of Mr. Reynolds; by an assignment of the Secured Promissory Note in the principal amount of $9,750,000 payable by MCC to the Company; by the Company's pledge of the common stock of each of its subsidiaries; and by the Company's pledge of its partnership interests in Wendy's of Michigan. Both Loan I and II contain cross-default provisions.
On May 23, 1997, the Company entered into Amendment No. 1 to the loan agreement with GALIC to obtain an additional $875,000 mortgage loan ("Loan III"). The proceeds from Loan III are being utilized to complete the improvements to the marina condominium project being developed by the Company's subsidiary, Grand Harbor Yacht Club Inc., which is adjacent to the Grand Harbor Resort. The loan, as modified effective November 1, 1997, bears an interest rate of prime plus 1%, fully floating through October 31, 1997 and 11.25% thereafter. Monthly payments of interest are required. Principal payments of $35,000 are required at the time of the sale of any of the marina condominium units. Any remaining outstanding balance of principal and accrued interest is due September 1, 2000. Loan III is secured by the following: a mortgage on the real property and marina facility owned by the Grand Harbor Yacht Club; third priority mortgages on the real property owned by the Grand Harbor Resort and the Thomas Edison Inn; a security agreement in all personal property owned by the Grand Harbor Yacht Club; a guaranty executed by Meritage, Thomas Edison Inn, MHG Food Service and Grand Harbor Resort; and an assignment of certain construction agreements, management agreements, permits and contracts. Loan III also contains cross-default provisions.
On September 30, 1997 the Company entered into Amendment No. 2 to the loan agreement with GALIC and obtained a moratorium on payments due in the last three months of 1997 on the mortgage loans (Loans I, II, and III). Also, interest rates were adjusted on Loans I and III as discussed above. Based on the terms of the loan agreement, the principal and interest payment moratorium extends to the payments due on the note payable to the Company's Chairman of the Board. Additionally, Amendment No. 2 grants a waiver of certain financial covenants through December 31, 1998.
The loan agreement contains a covenant that requires that (i) Christopher B. Hewett, or another person acceptable to GALIC, serve as the Company's President and Chief Executive Officer, (ii) Mr. Hewett own not less than 50% of MCC, and (iii) MCC own and control at least 25% of the Company's issued and outstanding Common Shares, or in the event of an issuance of Common Shares by the Company, that MCC own more Common Shares than any other person or group acting in concert and have sufficient control to cause the election of persons nominated by MCC as a majority of the Company's directors.
Wendy's of Michigan has a revolving term loan agreement with First of America Bank-Michigan, N.A. with permitted (amortized) borrowing of up to $2,727,802. The loan requires monthly payments of $43,313 based on a ten year amortization including interest at 1% over prime. The revolving loan agreement allows Wendy's of Michigan to apply its excess cash against the loan balance to reduce the interest charged on the loan. As of November 30, 1997, the loan was paid down to a balance of $2,037,111. The loan is secured by substantially all the assets of Wendy's of Michigan and guaranteed by Meritage.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is involved in certain routine legal proceedings which are incidental to its business. Except as described below, all of these proceedings arose in the ordinary course of the Company's business and, in the opinion of the Company, any potential liability of the Company with respect to these legal actions will not, in the aggregate, be material to the Company's financial condition or operations. The Company maintains various types of insurance standard to the industry which would cover most actions brought against the Company.
On December 5, 1996, the Company received a notice from the Internal Revenue Service that approximately $2.1 million, which Meritage deducted as a business expense in connection with litigation in 1995 and 1996 relating to the replacement and restructuring of former management, should be treated as a capital expenditure and, therefore, disallowed as a deduction. Meritage vigorously contested the disallowance. In January 1998, Meritage and the IRS reached a settlement whereby the IRS agreed to reduce its claim by 65% resulting in a total tax liability for the Company of approximately $76,000. This tax liability will be offset by the Company's net operating loss available for carry-back and, therefore, should have no impact on the Company's financial statements or cash flow.
On May 19, 1997, a majority limited interest of the Dissolved Partnership (the former operator of the Company's 25 Wendy's restaurants) removed Wendy's West Michigan, Inc. as general partner of the Dissolved Partnership and appointed MCC Food Service, an affiliate of Meritage, as the substitute general partner. This action was carried out in connection with Meritage's acquisition of a controlling interest in the Dissolved Partnership, and in accordance
with Meritage's representations during its tender offer in September 1996 that it may remove the general partner and substitute itself or its designee as the new general partner. On May 21, 1997, the former general partner commenced a lawsuit against Meritage, MHG Food Service, MCC Food Service, Meritage Capital Corp. and Meritage's principal officers (Case No. 97-05360-CB, Kent County (Michigan) Circuit Court). The former general partner and its principal shareholders sought, among other things, (i) a declaration that Wendy's West Michigan, Inc. is the general partner of the Dissolved Partnership, (ii) injunctive relief in the form of a temporary restraining order or a preliminary injunction which would prohibit the defendants from participating in the management of the Dissolved Partnership, (iii) unspecified damages for breach of contract, and (iv) unspecified damages for various business torts and misrepresentation. The former general partner attempted to assert claims on behalf of the Dissolved Partnership as well. The former general partner's motion for a temporary restraining order was denied on May 21, 1997. Three limited partners and a former limited partner intervened into the lawsuit. In September 1997, the Dissolved Partnership, Meritage, MHG Food Service, MCC Food Service and Meritage Capital Corp. filed claims against the former general partner and its principal shareholders alleging (i) breach of contract, (ii) violation of SEC Rule 10b-5, (iii) business defamation, (iv) tortious interference, and (v) breach of fiduciary duty. In January 1998, the former general partner filed a motion to enjoin the dissolution of the Dissolved Partnership. The Court denied this motion and the Dissolved Partnership was thereafter dissolved on January 30, 1998. Wendy's International has consented to MCC Food Service serving as the general partner and to the dissolution of the Dissolved Partnership.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS.
There were no matters submitted to a vote of security holders of the Company during the fourth quarter of fiscal 1997.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
MARKET INFORMATION
Meritage's Common Shares are quoted on the OTC Bulletin Board under the symbol "MHGI" and listed on the Chicago Stock Exchange under the symbol "MHG." Prior to October 18, 1995, there was no established public trading market for the Company's Common Shares.
The following table sets forth the high and low bid prices for the Company's Common Shares for the two most recent fiscal years as quoted on the OTC Bulletin Board:
The following table sets forth the high and low sales prices for the Company's Common Shares beginning on October 22, 1996 (the first day of trading) and ending on November 30, 1997 (the last day of fiscal 1997) as reported by the Chicago Stock Exchange:
HOLDERS
As of February 10, 1998, there were approximately 900 record holders of the Company's Common Shares, which the Company believes represents approximately 1,700 beneficial holders.
DIVIDENDS
No dividends on Meritage's Common Shares were paid in fiscal 1997. Pursuant to the Company's loan agreement with GALIC (see Item 2 "Financing and Encumbrances"), the Company may not pay any further Common Share dividends without GALIC's consent until Loan II has been paid in full. The Company does not intend to pay any dividends on its Common Shares in 1998. Cash dividends on Common Shares for the two most recent fiscal years are set forth below:
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following table sets forth the selected financial information of the Company.
(In thousands except for per share information)
(1) For comparative purposes, long-term obligations include current portions of long-term obligations.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
RESULTS OF OPERATIONS
Comparison of Years Ended November 30, 1997 and 1996
LODGING GROUP
The following summarizes the results of operations for the Lodging Group for the years ended November 30, 1997, 1996 and 1995.
REVENUE
Total revenue for the Lodging Group was $14,034,053 for fiscal 1997 compared to
$14,762,822 for fiscal 1996, a decrease of 4.9%. The following table outlines revenues (excluding sundry and telephone) by category:
The decrease in room revenue was attributable to a decrease in hotel occupancy from 60.6% in fiscal 1996 to 58.7% in fiscal 1997. The decrease in occupancy was partially offset by an increase in the overall average daily rate of $4.36 (5.6%), from $77.40 in fiscal 1996 to $81.76 in fiscal 1997.
The decline in hotel occupancy was primarily attributable to increased competition. Specifically, the hotels are experiencing the impact of new limited service hotels which are targeting the price sensitive guest by offering lower rates. In addition to the increased competition, the Grand Harbor Resort and the adjacent Grand Harbor Yacht Club were under renovation during the past year causing a negative impact on room revenue.
The decrease in food and beverage revenue of 9.8% from fiscal 1996 to fiscal 1997 was also primarily attributable to increased competition in the area. Catering sales declined at the Thomas Edison Inn and St. Clair Inn due to the opening of two new banquet facilities in their market area. Additionally, a new restaurant located a short distance from the St. Clair Inn was in operation throughout fiscal 1997. While increased competition was the primary reason for the decline in food and beverage revenue, certain changes in lounge entertainment and menu offerings at the St. Clair Inn were not well received by the local clientele, thus compounding the impact of increased competition.
The Company has addressed the effect of the increased competition by implementing new marketing programs, hiring locally experienced sales personnel and by continually reviewing and updating its menu offerings. Although the long-term results of these marketing efforts cannot be determined at this time, food and beverage revenue decreased only 1.3% during the last six months of fiscal 1997 compared to an 18.5% decrease for the first six months of fiscal 1997, compared to the same periods in fiscal 1996.
Telephone and other revenue increased $221,908 (31.9%), from $694,957 in fiscal 1996 to $916,865 in fiscal 1997. The increase in other revenue was primarily attributable to the sale of four marina condominium units for $229,700 in fiscal 1997. Increased telephone revenue in fiscal 1997 was offset by a reduction in other income from fiscal 1996 which included the recognition of significant income from expired gift certificates.
COST OF FOOD AND BEVERAGES
Cost of food and beverages as a percentage of food and beverage revenue for fiscal 1997 was 35.0% compared to 34.7% in fiscal 1996. The slight increase in cost of food and beverages was attributable to the decline in catering functions at the hotels, which have a relatively lower cost.
OPERATING EXPENSES
Operating expenses for fiscal 1997 and fiscal 1996 were $8,546,219 and $8,166,380, respectively, an increase of $379,839 (4.7%). As a percentage of total revenue, operating expenses increased 5.6 percentage points, from 55.3% in fiscal 1996 to 60.9% in fiscal 1997. The increase in fiscal 1997 compared to fiscal 1996 is partially due to a one-time accounting adjustment of approximately $171,000 which decreased property tax expenses in 1996. Cost of marina condominium unit sales and an increase in property tax expenses in fiscal 1997 resulted in increased operating expenses of approximately $176,000 in fiscal 1997 compared to fiscal 1996.
GENERAL AND ADMINISTRATIVE
General and administrative expenses decreased $889,614 (23.1%), from $3,853,537 in fiscal 1996 to $2,963,923 in fiscal 1997. The decrease in fiscal 1997 compared to fiscal 1996 was partially due to approximately $375,000 of non-recurring expenses including legal and professional fees and relocation costs incurred in 1996 in connection with the replacement and restructuring of management of the Company. Also contributing to the decrease was a reduction in year-end bonuses. The remaining decrease was due to a significant reduction in other legal and professional fees in fiscal 1997 compared to fiscal 1996.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expense increased $157,218, from $1,009,771 in fiscal 1996 to $1,166,989 in fiscal 1997. The increase was attributable to significant property, plant and equipment additions in the second half of 1996 which were depreciated for the full year in fiscal 1997.
INTEREST EXPENSE
Interest expense in fiscal 1997 and 1996 was $2,499,438 and $1,605,047 respectively. The increase of $894,391 from fiscal 1996 to fiscal 1997 was due to additional borrowings. The additional debt included acquisition financing relating to the acquisition of the units of the Dissolved Partnership in October 1996 and the development of the marina condominium project at the Grand Harbor Yacht Club in 1997. See "Liquidity and Capital Resources," Item 2 "Financing and Encumbrances," and Note G to the Meritage financial statements for details of the Company's long-term debt.
INTEREST INCOME
Interest income decreased from $658,007 in fiscal 1996 to $580,095 in fiscal 1997. The decrease in interest income was due to a decrease in cash and cash equivalents during fiscal 1997. The decrease was also attributable to the reduction in note receivable interest income from the sale of stock due to the reduction in the note receivable as a result of a $750,000 principal payment received in May 1996.
GAIN ON SALE OF ASSETS
The Company sold substantially all of the hotel assets of the St. Clair Inn on November 30, 1997 for $3,800,000. The sale resulted in a pre-tax gain of $1,479,095 before the extraordinary charge of $177,291 related to a prepayment penalty and the write off of existing finance costs on the related long-term debt. The Company ceased operating the hotel on November 30, 1997, which had revenue of approximately $3,854,000 during fiscal 1997.
FOOD SERVICE GROUP
On October 31, 1996, the Company acquired a majority interest in the Dissolved Partnership. At November 30, 1997, the Company owned approximately 54% of the Dissolved Partnership, all of which was acquired in fiscal 1996. Because of this acquisition, the results of operations of the Wendy's business have been included in the Company's Consolidated Statements of Operations beginning November 1, 1996. Below is a summary of the results of the Food Service Group (comprised of the Dissolved Partnership) for the year ended November 30, 1997 and unaudited pro forma results for comparative purposes for the year ended November 30, 1996. Because the Dissolved Partnership was not a wholly owned subsidiary during fiscal 1997 and because its daily operations are managed separately, the Dissolved Partnership has its own administrative expenses related solely to its operations. Therefore, all executive level general and administrative expenses of the Company are included in the Lodging Group operations.
REVENUE
Sales (excluding other income) increased 1.0% from $26,405,513 in fiscal 1996 to $26,860,546 in fiscal 1997. Excluding the store that was opened in March 1996 and the store that was closed in August 1997, sales on a per restaurant basis for the Company's twenty-four restaurants in operation during the entire twelve months of both fiscal 1997 and fiscal 1996 increased 1.2%, from an average of $1,052,485 per restaurant in fiscal 1996 to $1,064,558 per restaurant in fiscal 1997. Although sales increased only slightly for the year, they (i) were comparable to the sales of Wendy's International's corporate owned restaurants which had average sales of approximately $1,110,000 per restaurant in 1997, and (ii) compared favorably with all Wendy's franchised restaurants which had average sales of approximately $1,002,000 per restaurant in 1997.
COST OF FOOD AND BEVERAGES
Cost of food and beverages decreased $130,663 in fiscal 1997 compared to fiscal 1996, while revenue increased $455,033 for the same period. This decrease was the result of a 1.0 percentage point decrease in the Company's food and beverage cost percentage (from 29.3% of revenue in fiscal 1996 to 28.3% of revenue in fiscal 1997). The decrease in the Company's cost of food and beverage percentage was primarily the result of relatively stable food costs throughout fiscal 1997, and effective cost controls including the closing of the hot bar portion of the restaurant "Superbars" which had a higher food cost than its menu replacement - pita sandwiches.
RESTAURANT OPERATING EXPENSES
As a percentage of revenue, restaurant operating expenses remained at 59.6% in fiscal 1997, the same as fiscal 1996. Increases in payroll costs of approximately 0.7 percentage points and increased repair and maintenance costs were offset by decreases in advertising and insurance expenses. On a per restaurant basis, restaurant operating expenses increased from an average of $620,000 per restaurant in fiscal 1996 to an average of $629,000 per restaurant in fiscal 1997, an increase of 1.5% which is comparable to the 1.2% increase in same store sales.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased $212,881 in fiscal 1997 compared to fiscal 1996 (from $1,149,318 to $1,362,199). As a percentage of revenue, general and administrative expenses increased from 4.3% of revenue in fiscal 1996 to 5.0% of revenue in fiscal 1997. An increase in the Michigan Single Business Tax of $117,218 (0.4 percentage points as a percentage of revenue) was the primary reason for this increase. The Michigan Single Business Tax for fiscal 1996 was abnormally low due to a partial refund of taxes paid in four previous years. Increases in administrative salaries, recruiting costs and a significant increase in professional fees accounted for the remaining increase.
LOSS ON DISPOSAL OF ASSETS
The loss on disposal of assets was primarily attributable to the closing of one of the Company's restaurants due to its continuing operating losses. As a result of this restaurant closing, and the Company's decision not to exercise the option to extend the lease of the restaurant building, the Company incurred a loss on disposal of assets of $197,102.
Comparison of Years Ended November 30, 1996 and 1995
LODGING GROUP
REVENUE
Total revenue for the Lodging Group was $14,762,822 for fiscal 1996 compared to $14,441,020 for fiscal 1995, an increase of 2.2%. The following table outlines revenues (excluding sundry and telephone) by category:
The increase in room revenue was attributable to an increase in the overall average daily rate of $2.94 (4.0%), from $74.46 in fiscal 1995 to $77.40 in fiscal 1996. Also contributing to the increase in room revenue was a slight increase in hotel occupancy from 60.3% in fiscal 1995 to 60.6% in fiscal 1996. The decrease in food and beverage revenue from fiscal 1995 to fiscal 1996 was primarily attributable to a decrease in social function bookings at the hotels during the second half of fiscal 1996.
Telephone and sundry revenue increased $498,841, from $196,116 in fiscal 1995 to $694,957 in fiscal 1996. A large portion of the increase was attributable to the recognition of approximately $217,000 of expired gift certificates as income in fiscal 1996. Also contributing to the increase was the recovery of approximately $68,000 from the collection of amounts due from parties related to the Company prior to the change in control of the Company, which had been written off to bad debt expense in fiscal 1995. In addition, new telephone systems were installed at the Thomas Edison Inn and the St. Clair Inn. Rate schedules used to calculate telephone charges were updated generating additional telephone income.
COST OF FOOD AND BEVERAGES
Due to a change in revenue mix between room revenue and food and beverage revenue (as a percentage of total revenue), cost of food and beverages was 18.3% in fiscal 1996 and 19.8% in fiscal 1995. As a percentage of food and beverage revenue, cost of food and beverages was 34.7% in both fiscal 1996 and fiscal 1995.
OPERATING EXPENSES
Operating expenses for fiscal 1996 and fiscal 1995 were $8,166,380 and $7,215,061, respectively, an increase of $951,319 (13.2%). As a percentage of total revenue, operating expenses increased 5.3 percentage points, from 50.0% of total revenue in fiscal 1995 to 55.3% of total revenue in fiscal 1996. The increase in operating expenses in fiscal 1996 compared to fiscal 1995 was primarily the result of a 4.0 percentage point increase in payroll costs due to increased staffing, and salary and wage increases aimed at improving service. Increases in sales and marketing expenses, entertainment expense, and repairs and maintenance also contributed to the increase in operating expenses.
GENERAL AND ADMINISTRATIVE
General and administrative expenses decreased $1,126,084 in fiscal 1996 compared to fiscal 1995. General and administrative expenses were abnormally high in fiscal 1995 as a result of $2,154,163 of expenses related to various lawsuits in fiscal 1995 resulting in the replacement and restructuring of management. Excluding this $2,154,163 of expenses, general and administrative expenses increased $1,028,079 in fiscal 1996 compared to fiscal 1995. In fiscal 1996, the Company decided to manage the hotels directly as compared to fiscal 1995 when the hotels were managed by a management company (owned by the former majority
shareholder of the Company). This decision eliminated the fees and expenses assessed by the management company, but increased payroll costs attributable to the corporate management staff. This additional staffing was also required to implement the Company's strategy to expand the Company through the acquisition of new businesses (including the Dissolved Partnership). The Company did not receive any significant financial benefits in fiscal 1996 as a result of the Dissolved Partnership acquisition which occurred on October 31, 1996.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expense decreased $416,871, from $1,426,642 in fiscal 1995 to $1,009,771 in fiscal 1996. Amortization expense was abnormally high in fiscal 1995 due to the write-off of deferred loan costs of approximately $350,000 because of the refinancing of the Company's long-term debt in February 1996. Also, certain property and equipment acquired in 1986 (the year of incorporation) which had a ten year life became fully depreciated during fiscal 1995. As a result, depreciation expense for fiscal 1996 was lower compared to fiscal 1995.
INTEREST EXPENSE
Interest expense for fiscal 1996 and 1995 was $1,605,047 and $1,355,389, respectively. The increase of $249,658 from fiscal 1995 to fiscal 1996 was due to additional borrowings in fiscal 1996. See Note G to the Company's Financial Statements for details of the Company's long-term debt. Also see Item 2 "Financing and Encumbrances."
INTEREST INCOME
Interest income increased from $387,099 in fiscal 1995 to $658,007 in fiscal 1996. The increase was due to an increase in cash and cash equivalents in fiscal 1996 compared to fiscal 1995, and an increase in interest income from the note receivable from the sale of stock which is described in Note K to the Company's Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows - Year Ended November 30, 1997
Cash and cash equivalents ("cash") decreased $1,204,022 from $2,265,497 as of November 30, 1996 to $1,061,475 as of November 30, 1997. The decrease in cash was the result of the following:
Net cash provided by operating activities of $7,726 was a combination of the net loss before depreciation, amortization and net gain on disposal of assets of $531,005 which was offset by other non-cash effects on net income and net cash provided by operating activities totaling $310,303. The net change in non-cash current assets and liabilities accounted for the remaining $228,428 of cash provided by operating activities. The net change in non-cash current assets and liabilities included an increase in marina development costs of $352,773.
Net cash used in investing activities of $1,348,766 was the result of cash purchases of property, plant and equipment of $1,127,537. Increases in other assets accounted for the remaining $221,229.
Net cash provided by financing activities of $137,018 was the result of proceeds of long term debt of $750,000, and proceeds from the issuance of preferred and common shares of $313,519. These two items were offset by principal payments of long term debt and payments of capital lease obligations totaling $824,787. Preferred dividends paid during the year were $101,714, making up the remaining portion of this item.
The Company incurred two new non-cash long-term debt borrowings during the fiscal year. In addition to the $750,000 net proceeds from long term debt discussed above, $244,637 was borrowed to finance an equipment purchase, and $800,000 was borrowed to finance a portion of the marina development project at the Grand Harbor Yacht Club.
Cash Flows - Year Ended November 30, 1996
Cash increased $928,606 from $1,336,891 as of November 30, 1995, to $2,265,497 as of November 30, 1996. The increase in cash was the result of the following:
Net cash used in operating activities of $1,496,419 was primarily due to the net loss before depreciation and amortization of $843,866. Other non-cash effects on net income and net cash used in operating activities totaled $243,620. The net change in non-cash current assets and current liabilities of $408,933 accounted for the remaining net cash used in operating activities.
Net cash used in investing activities of $5,601,790 was primarily the result of purchases of property, plant and equipment of $2,211,392 and the acquisition of the majority interest in the Dissolved Partnership for $3,184,460 (net of cash acquired upon consolidation of the Dissolved Partnership).
Net cash provided by financing activities of $8,026,815 was primarily the result of net proceeds from long-term borrowings of $8,271,698 (proceeds of $37,717,705 less retirement of debt $29,446,007) resulting from the Company's long-term debt refinancing discussed under "Financing and Encumbrances." Other significant items which effected net cash provided by financing activities included $750,000 in principal payments received on the note receivable from sale of shares and proceeds from the issuance of preferred and common shares of $545,000. These two items were offset by the payment of a one time special dividend of $0.50 per Common Share on April 26, 1996. Total dividends paid were
$1,510,075. Of this amount $435,124 was withheld from the Company's former majority shareholder (Mr. Reynolds) and applied against amounts due to the Company from Mr. Reynolds and companies related to Mr. Reynolds. A dividend of $775,000 was received by MCC which then paid $750,000 to the Company as an early prepayment on the Company's note receivable from the sale of shares to MCC.
Financial Condition
At November 30, 1997, the Company's current liabilities exceeded its current assets by $2,183,568 compared to November 30, 1996 when current assets exceeded current liabilities by $103,112. At these dates, the ratios of current assets to current liabilities were 0.73:1 and 1.03:1 respectively. The discussion above of cash flows for the year ended November 30, 1997 explains the decrease in cash as well as the most significant reasons for the decrease in working capital. The other reason for the decrease in working capital was a $932,000 increase in the current portion of long-term debt, representing the principal payment requirements on Loan II which began January 1, 1998. Prior to January 1, 1998, Loan II required payments of interest only. See point 2 below for a description of the terms of Loan II.
As of November 30, 1997, the Company's long-term debt consists primarily of the following:
1) $14,205,288 Loan I requiring monthly payments of $118,724, including interest at 11.25% through December 1, 2003, at which time the remaining unpaid principal will be due. (A)
2) $5,469,543 Loan II requiring monthly payments of interest only at 8% over the prime rate through December 1, 1997. Beginning January 1, 1998, monthly principal payments of $50,000, plus interest at 8% over the prime rate, are required through March 1, 1998. Beginning April 1, 1998, monthly principal payments of $100,000, plus interest at 8% over the prime rate, will be required until the loan is retired in June 2002. (A)
3) $820,336 Loan III (marina) requiring monthly payments of interest only at 11.25%. Principal payments of $35,000 are required at the time of the sale of any of the marina condominium units. Any remaining outstanding balance of principal and accrued interest is due September 1, 2000. As of November 30, 1997, the loan balance was $820,336 and the Company had $75,000 of available borrowings under the loan. (A)
4) $2,037,111 revolving term loan requiring minimum monthly payments of $43,313, including interest at 1% over the prime rate, through February 2005 when any remaining unpaid principal will be due. The required monthly payments may be offset by additional borrowings up to the unused available borrowings. The Company had $690,691 of available unused borrowings at November 30, 1997. The loan is secured by substantially all of the assets of Wendy's of Michigan and guaranteed by the Company.
5) $452,197 equipment note payable requiring monthly payments of $8,774, including interest at 8.8%, through October 2000.
6) $770,767 note payable to the Company's Chairman of the Board of Directors. The loan requires the Company to make monthly payments of interest only at the prime rate plus 8% provided the Company is not in default under its long-term debt with its primary lender. Unpaid principal and accrued interest must be paid 91 days after Loans I, II and III are paid off. (A)
(A) The loan agreement with the Company's primary lender was amended September 30, 1997 (Amendment No. 2). This amendment addressed three provisions of the loan agreement including (i) the waiver of certain financial covenants, (ii) a principal and interest payment moratorium, and (iii) interest rates charged on Loans I and III. With regard to the first provision, a waiver was obtained through December 31, 1998 for loan covenants regarding the maintenance of a prescribed amount of net worth and certain financial ratios. Second, Amendment No. 2 provided a moratorium on principal and interest payments due in the last three months of 1997 on Loans I, II and III. Finally, Amendment No. 2 increased the interest rates on Loans I and III effective November 1, 1997 as described above.
Based on the terms of the loan agreement, the principal and interest payment moratorium obtained in Amendment No. 2 extends to the payments due on the note payable to the Company's Chairman of the Board of Directors. As a result, the interest due on the monthly payments that were waived was added to the principal balances of the loans resulting in approximately $643,000 of additional long-term debt as of December 31, 1997.
A summary of the financial covenants as well as the Company's compliance with them is as follows:
The following schedule details the upcoming financial covenant requirements as contained in the amended loan agreement:
FINANCIAL COVENANT - MINIMUM NET WORTH
FINANCIAL COVENANT - COVERAGE RATIO - EBITDA OF HOTELS : DEBT SERVICE
FINANCIAL COVENANT - COVERAGE RATIO - EBITDA OF HOTELS LESS CAPITAL EXPENDITURES : DEBT SERVICE
The Company faced significant cash flow and liquidity issues during the second half of the fiscal year ended November 30, 1997. The Company completed two transactions at or shortly after fiscal year end which provided cash flow relief. The first transaction was the sale of the St. Clair Inn for $3,800,000 on November 30, 1997. Approximately $3,200,000 of the proceeds were used to pay down long term debt, thereby reducing the Company's debt service requirements. The sale of the St. Clair Inn also provided cash flow relief as the hotel had historically operated with negative cash flow during the off-season. The other transaction was the acquisition of the remaining 46% of the Dissolved Partnership, thus giving the Company access to the cash flow provided by the Wendy's operations. With the access to that cash flow and the reduced cash flow needs resulting from the sale of the St. Clair Inn, the Company was able to become current on its loan payments and its property taxes, and has the ability to pay amounts that are past due to vendors. While the Company's cash flow issues have been greatly relieved, had the Company not obtained the waiver from its primary lender through December 31, 1998, it would not currently meet certain financial performance covenants described above.
As the Company enters the current fiscal year, it faces the cash flow and liquidity issues that are typical in a seasonal business. Due to the high level of fixed costs required to operate the hotels, significant expenditures necessary to the hotel operations cannot be reduced at the same rate that the revenues decrease during the off-season. As such, the Company is in a cash flow situation that requires it to manage relationships with vendors to allow for extension of credit terms during the off-season, with the Company bringing its accounts current during the high season (summer) months. In addition to the cash flow and liquidity issues faced due to the seasonal nature of the business, the Company is in a situation where it has been forced to carry the high interest rate Loan II (prime plus 8% bridge loan) with its primary lender for a much longer period of time than was originally contemplated. As a result, the outstanding balance of Loan II is greater than anticipated and thus, carries greater debt service than was planned. However, the Company anticipates that it will be able to meet its current obligations over the next twelve months by:
Attempting to sell the vacant land held for expansion valued at approximately $1,200,000.
Continuing its efforts to sell one or more of the Company's hotel properties. See "Sale of Hotel Properties" included in Item 1 describing the current agreement regarding the sale of the Thomas Edison Inn.
Borrowing on the available revolving term loan, which was approximately $700,000 as of January 31, 1998.
Deferring the payment of the $160,000 annual general partner fee owed to MCC Food Service.
Attempting to refinance the mortgage loan on the real estate owned by Wendy's of Michigan which would net the Company approximately $2,000,000 from the transaction after closing costs and retirement of the underlying mortgage loans on the Wendy's properties. The $2,000,000 would be used to replace a portion of the Company's high interest rate Loan II which would result in a reduction in the Company's annual debt service.
Exploring the financing of certain of the planned capital expenditures as opposed to a cash payment for the capital improvements, specifically with respect to planned renovations at the Wendy's restaurants.
Managing relationships with vendors during the off-season to obtain an extension of the credit terms.
Reducing or deferring capital expenditures described below.
There can be no assurances, however, that the Company will be able to complete the above activities or that completion would yield the results expected.
The Company estimates capital expenditures for the next twelve months to be approximately $900,000 for building improvements and furniture, fixtures and equipment purchases, at its hotels and existing Wendy's restaurants. The Company has received various proposals to finance (through debt or lease) both the real estate and furniture,
fixtures and equipment of any new Wendy's restaurants. Of the total expected amount of capital expenditures, the Company estimates expenditures at its full service hotels to be approximately $300,000. This estimate does not include approximately $80,000 of final expenditures on Grand Harbor Yacht Club.
On January 30, 1998, the Company issued 1,772,359 shares of Common Stock as part of the acquisition of the remaining assets of the Dissolved Partnership.
INFLATION AND CHANGING PRICES
Both the lodging and food service industries have been affected by the increase in the minimum wage and the availability of management and hourly employees. Rising wage rates had a negative impact on the Company's operating results for fiscal 1997. Increases in labor costs, along with periodic increases in food and other operating expenses, are normally passed on to customers in the form of price increases. However, highly competitive market conditions have minimized the Company's ability to offset higher costs through price increases to its customers.
COMPUTER SYSTEMS - YEAR 2000 IMPACT
The Company and its vendors have become increasingly reliant on computer systems to process transactions and to provide relevant business information. The majority of computer systems designed prior to the mid-1990's are susceptible to a well publicized problem associated with an inability to process date related information beyond the year 2000. Almost all of the Company's computer hardware was acquired within the past two years. The Company is in the process of reviewing its computer software with the assistance of the software designers to insure that all significant software applications are year 2000 compliant, and anticipates completing its review during fiscal 1998. However, the Company can make no assurance that all year 2000 risks to the Company and to its critical vendor systems can be identified and successfully negated through modification of existing programs. The Company does not expect to incur significant costs to review its computer systems to determine what measures, if any, are required to be year 2000 compliant.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements and supplementary data included in the report under this Item are set forth at the end of this report beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Directors, Executive Officers and Significant Employees
The following is information concerning the current directors, executive officers and significant employees of the Company as of February 10, 1998:
(1) Unless otherwise indicated, the persons named have sole voting and investment power and beneficial ownership of the securities.
(2) Includes options held by all non-employee directors to acquire 6,000 Common Shares.
(3) Compensation Committee Member
(4) Executive Committee Member
(5) Nominating Committee Member
(6) Includes 2,000 shares held directly by Mr. Schermer, Sr.'s wife.
(7) Includes Common Shares issuable upon conversion of Series A Convertible Preferred Stock which is immediately convertible.
(8) See description of Common Share ownership contained in "Principal Shareholders" above.
(9) Includes options exercisable for Mr. Hewett of 20,000 shares, Mr. Schermer, Jr. of 18,000 shares, and Mr. Saalfeld of 5,500 shares; and also includes options exercisable within 60 days for Ms. Krywanski of 2,000 shares.
(10) Includes 600 shares held by Mr. Schermer, Jr. as a custodian for his minor child.
(11) Audit Committee Member
(12) Includes 2,000 shares held by Mr. Maggini jointly with his wife, 1,100 shares held directly by his wife, and 1,000 shares held directly by his son.
* Less than 1%
Robert E. Schermer, Sr. has been a director of the Company since January 25, 1996. He is currently Senior Vice President, Regional Manager for the State of Michigan and a member of the Board of Directors of Robert W. Baird & Co. Incorporated, an investment banking and securities brokerage firm headquartered in Milwaukee, Wisconsin. Mr. Schermer has held this position for more than five years. He is the father of Robert E. Schermer, Jr.
Christopher B. Hewett has been President, Chief Executive Officer and a director of the Company since January 25, 1996. He has served as President of MCC since its inception in 1993. Mr. Hewett was Executive Vice President (1990 to 1991) and President (1991 to 1997) of Ocean Reef Club, Inc., an affiliate of American Financial Group Inc., which was the owner, developer and operator of the Ocean Reef Club, a 5,000 acre mixed-use residential resort community in Key Largo, Florida. In 1993, Ocean Reef Club, Inc. sold the Ocean Reef Club. Mr. Hewett is also a director of Frisch's Restaurants, Inc., which operates more than 80 Big Boy Restaurants.
Robert E. Schermer, Jr. has been Executive Vice President and a director of the Company since January 25, 1996. From January 25, 1996 until September 16, 1996, Mr. Schermer also served as Treasurer of the Company. Mr. Schermer has served as Executive Vice President of MCC since 1993. From 1989 until 1993, he was Executive Vice President of Landquest Ltd, a private investment partnership which financed and developed residential real estate and hotel investments. He is the son of Robert E. Schermer, Sr.
Pauline M. Krywanski has been Vice President, Treasurer and Chief Financial Officer of the Company since May 20, 1997. From 1988 to 1997, Ms. Krywanski was with American Medical Response, a nationwide provider of healthcare transportation and a wholly-owned subsidiary of Laidlaw, Inc. Her most recent position with American Medical Response was Director of Financial Operations for the Midwest Region. Ms. Krywanski is a Certified Public Accountant.
James R. Saalfeld has been Vice President, Secretary and General Counsel of the Company since March 20, 1996. From 1992 until 1996, Mr. Saalfeld was an attorney with Dykema Gossett PLLC, a Grand Rapids, Michigan law firm.
Ray E. Quada has been the Chief Operating Officer of Wendy's of Michigan since its inception on January 30, 1998, and was the Chief Operating Officer of its predecessor since March 1990. From 1994 through 1997, Mr. Quada was a director of First Michigan Bank.
Gary R. Garrabrant has been a director of the Company since October 24, 1996. Mr. Garrabrant is Executive Vice President of Equity Group Investments, Inc., a private investment company headquartered in Chicago, with significant real estate and corporate holdings. He joined Equity Group as a Senior Vice President in January 1996. Previously, Mr. Garrabrant was director of Sentinel Securities Corporation and co-founded Genesis Realty Capital Management, both of which were based in New York, and specialized in real estate securities investment management. From 1989 to 1994, he was associated with The Bankers Trust Company in New York. Mr. Garrabrant is also a director of Capital Trust, a real estate finance company based in San Francisco.
David S. Lundeen has been a director of the Company since January 25, 1996. Mr. Lundeen is presently a private investor. From 1995 to September 1997, he served as Executive Vice President and Chief Financial Officer of BSG Corporation, Austin, Texas, an information technology consulting company. From 1992 to 1995, Mr. Lundeen was President of Blockbuster Technology, a division of Blockbuster Entertainment. From 1990 to 1992, he worked for Blockbuster Entertainment as Director of
Mergers & Acquisitions and Corporate Finance. Prior to 1990, Mr. Lundeen was an investment banker at Drexel Burnham Lambert in New York City.
Joseph L. Maggini has been a director of the Company since January 25, 1996. Since founding it in 1974, he has served as President and Chairman of the Board of the Magic Steel Corporation, Grand Rapids, Michigan, a steel service center.
Jerry L. Ruyan has been a director of the Company since October 24, 1996. Since 1995, Mr. Ruyan has been a partner in Redwood Ventures, LLC, an investment/venture capital company located in Cincinnati, Ohio. Mr. Ruyan is also a founder of Cincinnati-based Meridian Diagnostics, Inc., which is engaged in the production of medical diagnostic products, and has been a member of its Board of Directors since 1977. Mr. Ruyan's other positions with Meridian Diagnostics, Inc. included Chief Executive Officer (1992 to 1995), and President and Chief Operating Officer (1986 to 1992). Mr. Ruyan is also a director of Frisch's Restaurants, Inc.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers, directors and persons who own more than ten percent of the Company's Common Shares to file reports of ownership with the SEC and to furnish the Company with copies of these reports. Based solely upon its review of reports received by it, or upon written representation from certain reporting persons that no reports were required, the Company believes that during fiscal 1997 all filing requirements were met, except for Mr. Maggini's late reporting of the purchase of 1,000 Common Shares by his son, which transaction was reported on his Form 5 upon discovery of this omission.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The following table sets forth information regarding compensation paid by the Company to its Chief Executive Officer and executive officers or significant employees earning in excess of $100,000:
(1) MCC acquired majority control of the Company on January 25, 1996 and Messrs. Hewett and Schermer, Jr. assumed their positions as officers on that date.
(2) Represents Series A Convertible Preferred Stock which Messrs. Hewett and Schermer, Jr. elected to receive in lieu of a year-end cash bonus.
(3) Includes 2,000 shares of Meritage Common Stock valued at $10,000.
STOCK OPTIONS
The following tables contain information concerning the grant of stock options to the executives and employees identified in the Summary Compensation Table and the appreciation of such options:
(1) The Compensation Committee established the exercise price as $7.00 per share. Because the stock at fiscal year end was trading for less than $7.00 per share, no value for the options is shown.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following persons are the only shareholders known by the Company to own beneficially 5% or more of its outstanding Common Shares as of February 10, 1998:
Mr. Hewett's beneficial ownership includes (i) 31,800 Series A Convertible Preferred Shares which, if converted, would equal 45,429 Common Shares, (ii) 20,000 vested stock options granted pursuant to the 1996 Management Equity Incentive Plan, and (iii) 1,551,300 shares held by MCC of which Mr. Hewett is the majority shareholder, an executive officer and a director. All of MCC's Common Shares are pledged to GALIC as security for the loan between the Company and GALIC described in Item 2 "Financing and Encumbrances." In the event of a default by the Company under the loan agreement with GALIC, GALIC may enforce its rights under the loan agreement, including the right to register the pledged stock in its name and exercise all voting and corporate rights with respect to the pledged stock.
The business address of Mr. Hewett is 40 Pearl Street, N.W., Suite 900, Grand Rapids, Michigan 49503.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Management believes that the following transactions were on terms no less favorable to the Company than those that could be obtained from unaffiliated parties.
At November 30, 1997, MCC, owned by Messrs. Hewett and Schermer, Jr., owed the Company $9,750,000 pursuant to a secured, non-interest bearing note in the original amount of $10,500,000 issued to the Company in payment for 1,500,000 Common Shares. The note was analyzed by Roney & Co., a nationally recognized investment banking firm, as part of its review in delivering a fairness opinion in 1995 regarding this transaction.
In March 1997, the Company borrowed $750,000 from Robert E. Schermer, Sr. The note is unsecured and requires monthly payments of interest only at prime plus 8% provided the Company is not in default under Loans I, II and III with GALIC. Unpaid principal and accrued interest must be paid 91 days after Loans I, II and III are paid off. Effective October 1, 1997 the Company obtained a moratorium on payments due in the last three months of 1997 on Loans I, II and III. Based on the terms of the loan agreement, the principal and interest payment moratorium extends to the payments due on the note payable to Mr. Schermer, and were added to the outstanding principal balance of the loan. The loan had an outstanding principal balance of $770,767 as of November 30, 1997.
In January and May 1997, the Board of Directors authorized agreements whereby MCC, its principals and its subsidiary, will be indemnified by the Company and its applicable subsidiaries for any losses or expenses that they may incur as guarantors of the Company's obligations to (i) its primary financing institutions and (ii) its past and present franchisors.
In May 1997, the Company and its subsidiary indemnified MCC Food Service upon its appointment as general partner of the Dissolved Partnership. MCC Food Service and the Company agreed that MCC Food Service would be entitled to receive the Partnership Administration Fee of $160,000 per year provided, however, that the Company shall hold this fee and not remit it to MCC Food Service until such time as Loan II is repaid or the Company's long-term lender agrees that the fee should be released to MCC Food Service. Also, the Company's subsidiary indemnified Ray E. Quada, the President of MCC Food Service, regarding the removal and replacement of the former general partner of the Dissolved Partnership.
While former Board of Director member Raymond A. Weigel, III served as a director of the Company (until May 20, 1997), he was also a shareholder of the former general partner of the Dissolved Partnership. During fiscal 1997, the Dissolved Partnership paid management fees to the former general partner of approximately $75,000. In addition, the former general partner also served as general partner of a limited partnership that leased property to the Dissolved Partnership for use in its restaurant operations. During the period in fiscal 1997 that Mr. Weigel served as a director of the Company, the Dissolved Partnership made lease payments of approximately $205,000 to this entity affiliated with Mr. Weigel.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) and (2) Financial Statements and Schedules.
All financial statements and schedules required to be filed by Item 8 of this Form and included in this report are set forth at the end of this report beginning on page. No additional financial statements or schedules are being filed since the requirements of paragraph (d) under Item 14 are not applicable to the Company.
(a)(3) Exhibit List.
The following documents are exhibits to this Annual Report:
MANAGEMENT COMPENSATORY CONTRACTS
----------------------------------
(b) Reports on Form 8-K.
The Company filed a report on Form 8-K on December 15, 1997 to report the sale of the real and personal property owned by its wholly-owned subsidiary, St. Clair Inn, Inc., for $3,800,000.
The Company filed a report on Form 8-K on February 3, 1998 to report the acquisition of the remaining 46% of the Wendy's of West Michigan Limited Partnership in exchange for 1,772,359 Common Shares.
On February 10, 1998, the Company filed a report on Form 8-K to report that a contract had been entered into regarding the sale of real and personal property comprising, among other things, one of the Company's remaining hotel assets. The sale price is $12,200,000, for which the Company received a $500,000 non-refundable deposit from the prospective purchaser.
On February 11, 1998, the Company filed Amendment No. 1 to the Form 8-K filed on December 15, 1997 regarding the sale of the St. Clair Inn. This amendment included unaudited pro forma consolidated financial statements relating to the sale.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MERITAGE HOSPITALITY GROUP INC.
Dated: February 25, 1998 By /s/ Christopher B. Hewett -------------------------------------- Christopher B. Hewett President and Chief Executive Officer (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors Meritage Hospitality Group Inc.
We have audited the accompanying consolidated balance sheets of Meritage Hospitality Group Inc. (a Michigan corporation) and subsidiaries as of November 30, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended November 30, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Wendy's of West Michigan Limited Partnership, a majority owned subsidiary, which statements reflect total assets and revenues constituting 29 percent and 65 percent, respectively, of the related consolidated totals for November 30, 1997. Those statements were audited by other auditors, whose report thereon has been furnished to us and our opinion, insofar as it relates to the amounts included for Wendy's of West Michigan Limited Partnership, is based solely on the report of the other auditors.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, based on our audit and the report of the other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Meritage Hospitality Group Inc. and subsidiaries as of November 30, 1997 and 1996 and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended November 30, 1997, in conformity with generally accepted accounting principles.
We have also audited Schedule I of Meritage Hospitality Group Inc. and Subsidiaries as of and for the year ended November 30, 1997 and Schedule II for the years ended November 30, 1997, 1996 and 1995. In our opinion these schedules present fairly, in all material respects, the information required to be set forth therein.
Detroit, Michigan January 12, 1998 (except for Note O as to which the date is January 30, 1998 and Note P as to which the date is February 9, 1998)
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
NOVEMBER 30,
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - CONTINUED
NOVEMBER 30,
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED NOVEMBER 30,
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED NOVEMBER 30, 1997, 1996 AND 1995
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED NOVEMBER 30,
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
YEARS ENDED NOVEMBER 30,
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
YEARS ENDED NOVEMBER 30,
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
The Company conducts its operations in two business segments. The lodging industry segment consists of three full service hotels, one which was sold on November 30, 1997 (see Note C). The food service industry segment consists of a limited partnership which operates twenty-five Wendy's Old Fashioned Hamburger restaurants under franchise agreements with Wendy's International, Inc. All operations of the Company are located in Michigan.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and the following wholly-owned subsidiaries:
St. Clair Inn, Inc. Thomas Edison Inn, Incorporated Grand Harbor Resort Inc. Grand Harbor Yacht Club Inc. MHG Food Service Inc.
All significant intercompany balances and transactions have been eliminated.
INVENTORIES
Inventories are stated at the lower of cost or market as determined by the first-in, first-out method. Inventories consist of restaurant food items, beverages and food serving supplies.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. Depreciation is computed principally using the straight-line method based upon estimated useful lives ranging from 3 to 40 years. Amortization of leasehold improvements is provided over the terms of the various leases.
INCOME TAXES
Income taxes are accounted for by using an asset and liability approach. Deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial basis and tax basis of assets and liabilities. Assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
FRANCHISE FEES
Franchise fees for one of the Company's hotels and the Company's restaurant units are amortized using the straight-line method over the terms of the individual franchise agreements. Effective October 15, 1997, the Company and its hotel franchisor terminated their franchise agreement pursuant to the terms of a voluntary termination agreement between the parties. As a result, $59,792 of unamortized franchise fees were written off in October 1997.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FINANCING COSTS
Financing costs are amortized using the straight-line method over the terms of the various loan agreements.
GOODWILL AND LONG-LIVED ASSETS
Goodwill is amortized using the straight-line method over periods of up to twenty years.
The Company performs a review for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Undiscounted future cash flows of an asset are compared with its carrying value and if the cash flows are less than the carrying value, an impairment loss is recognized. There is no impact on the financial statements due to this review.
OBLIGATIONS UNDER CAPITALIZED LEASES
Lease transactions relating to certain restaurant buildings and equipment are classified as capital leases. These assets have been capitalized and the related obligations recorded based on the fair market value of the assets at the inception of the leases. Amounts capitalized are being amortized over the terms of the leases.
FRANCHISE COSTS AND OTHER ADVERTISING COSTS
Royalties and national advertising costs are based on a percentage of monthly sales. These costs and other advertising costs are charged to operations as incurred.
USE OF ESTIMATES
In the preparation of financial statements management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. Actual results could differ from those estimates.
LOSS PER SHARE
Loss per share is computed based upon the weighted average number of shares outstanding during each year.
CASH EQUIVALENTS
For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments approximate their fair values.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE A - NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NEW PRONOUNCEMENTS
In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," which is effective for fiscal years beginning after December 15, 1997. Early adoption of the standard is not permitted. The new standard eliminates primary and fully diluted earnings per share and requires presentation of basic and diluted earnings per share together with disclosure of how the per share amounts were computed. The adoption of this new standard is not expected to have a significant impact on the disclosure of earnings per share in the financial statements.
In June 1997, the FASB issued SFAS No. 130, "Reporting of Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of financial statements. This statement also requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. This statement is effective for fiscal years beginning after December 15, 1997. Earlier application is permitted. Reclassification of financial statements for earlier periods provided for comparative purposes is required. The Company does not anticipate that adoption of SFAS No. 130 will have a significant effect on its financial statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to stockholders. This statement also establishes standards for related disclosures about products and services, geographic areas, and major customers. This statement requires the reporting of financial and descriptive information about an enterprise's reportable operating segments. This statement is effective for financial statements for fiscal years beginning after December 15, 1997. In the initial year of application, comparative information for earlier years is to be restated. The Company does not anticipate that the adoption of SFAS No. 131 will have a significant effect on its financial statements.
NOTE B - ACQUISITION
During 1996, the Company purchased 54% of the partnership interest in Wendy's of West Michigan Limited Partnership (the "Wendy's Partnership") and at November 30, 1997 the Company had a majority interest (54.0%). Certain of the units in the Wendy's Partnership were purchased from Stockholders/Directors at prices no more favorable than that paid to non-related parties. The Company then transferred this interest to its wholly-owned subsidiary, MHG Food Service Inc.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE B - ACQUISITION (CONTINUED)
The acquisition has been accounted for as a purchase and the acquisition cost has been allocated to assets acquired and liabilities assumed based upon estimates of their fair values. A total of $1,719,819, representing the excess of acquisition cost over the fair value of assets acquired has been allocated to goodwill.
The Company's consolidated results of operations include the Wendy's Partnership activity from November 1, 1996 (effective date of acquisition). The unaudited pro forma information below presents combined results of operations as if the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma information is not necessarily indicative of the results of operations of the combined company had the acquisition occurred at the beginning of the periods presented.
NOTE C - SALE OF HOTEL ASSETS
The Company sold substantially all of the hotel assets of the St. Clair Inn on November 30, 1997 for $3,800,000. The sale resulted in a gain of $1,479,095 before the extraordinary charge of $177,291 related to a prepayment penalty and the write off of existing finance costs on the related long-term debt. The Company's equity increased $1,301,804 as a result of this transaction. The Company ceased operating the hotel on November 30, 1997.
A portion of the receivable from the sale of the hotel assets, in the amount of $3,329,282, is restricted for the payment of debt and related prepayment penalties, which was paid in December 1997.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE D - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are summarized as follows at November 30,:
Depreciation and amortization expense was approximately $1,822,000, $1,012,000 and $883,000 for the years ended November 30, 1997, 1996 and 1995, respectively.
NOTE E - AMOUNTS DUE FROM RELATED PARTIES AND RELATED PARTY TRANSACTIONS
A Partnership administration fee is payable by the Wendy's Partnership to the General Partner equal to 2% of gross partnership revenues from operations, as defined in the Partnership Agreement. The General Partner has elected to reduce the Partnership administration fee to the General Partner from 2% of gross partnership revenues from operations to $160,000 in 1997 and $13,333 in 1996 (effective date of the Wendy's Partnership acquisition was November 1, 1996.)
The Company has entered into a note payable with the Chairman of the Board (see Note G).
The Wendy's Partnership leases certain land and buildings from a partnership related through common general partnership ownership with the former general partner (see Note I).
NOTE F - ACCRUED EXPENSES
Accrued expenses consist of the following:
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE G - LONG-TERM DEBT
Long-term debt consists of the following obligations at November 30,:
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE G - LONG-TERM DEBT (CONTINUED)
The prime lending rate was 8.5% at November 30, 1997.
(1) The mortgage is collateralized by the hotel properties.
(2) The mortgage is collateralized by the Meritage Capital Corp. note, common stock of the Company, life insurance policies in the amount of $5,100,000, other property and equipment and a second security interest in the hotel properties.
(3) The note is collateralized by certain equipment.
(4) The note is collateralized by substantially all of the assets of the Wendy's Partnership and by the guaranty of the General Partner and the personal guarantees of the shareholders of the General Partner.
(5) Effective October 1, 1997 the Company obtained a moratorium on payments due in the last three months of 1997 on its mortgage notes payable. These amounts were added to the principal of the related notes. Based on terms of the loan agreement, the payment moratorium extends to the payments due on the note payable to the Chairman of the Board.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE G - LONG TERM DEBT (CONTINUED)
Minimum principal payments on long-term debt to maturity as of November 30, 1997 are as follows:
Loan covenants of the various loan agreements include a requirement for maintenance of a prescribed amount of net worth and certain financial ratios and restrictions on certain common stock purchases, dividends, additional indebtedness and executive compensation. At November 30, 1997 the Company failed to meet certain of the financial covenants in its agreements with the insurance company. A waiver has been obtained through December 31, 1998.
NOTE H - INCOME TAXES
Income tax expense is summarized as follows:
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
NOTE H - INCOME TAXES (CONTINUED)
Deferred tax assets and liabilities at November 30, consist of the following:
The net operating loss carryforwards expire in years 2010 - 2012.
The income tax provision reconciled to the tax computed at the statutory Federal rate was as follows:
NOTE I - LEASE COMMITMENTS
The Wendy's Partnership leases land and buildings used in operations under operating agreements, with remaining lease terms (including renewal options of up to thirteen years) ranging from one to twenty-three years. Included in the leases are five with a real estate partnership related through common general partnership ownership through May 19, 1997 when the former general partner was removed (see Note O).
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE I - LEASE COMMITMENTS (CONTINUED)
Total lease expense (including taxes, insurance and maintenance when included in rent) related to all operating leases and all percentage rentals is as follows:
Certain restaurant leases (eight restaurant buildings, excluding land which is accounted for as an operating lease) and equipment leases have been capitalized. Minimum future obligations under capital leases and noncancellable operating leases in effect are as follows:
The present value of minimum rental obligations is reflected in the balance sheets as current and long-term obligations under capital leases.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE I - LEASE COMMITMENTS (CONTINUED)
Accumulated amortization of leased property under capital leases was $1,814,346 and $1,648,146, at November 30, 1997 and 1996, respectively.
In addition to minimum future obligations, percentage rentals may be paid under all restaurant leases on the basis of percentage of sales in excess of minimum prescribed amounts.
NOTE J - SERIES A CONVERTIBLE CUMULATIVE PREFERRED STOCK
In 1996, the Company designated a series of non-voting preferred stock consisting of 200,000 shares of $0.01 par value. The shares have an annual dividend rate of $0.90 per share and the payment of the dividends are cumulative. The shares are also convertible into common shares at the conversion price of $7.00 per share. The shares have a liquidation value of $10.00 per share.
Under certain conditions relating to the market value of the Company's common stock, the Company has the option to cause the preferred stock to be converted into common stock.
NOTE K - NOTE RECEIVABLE FROM SALE OF SHARES
On September 19, 1995, a stock purchase and sale agreement (Agreement) was executed by the Company, its then principal stockholder, and Meritage Capital Corp. ("MCC"). Under the agreement, the Company sold 1,500,000 shares of previously authorized newly issued common stock to MCC at a total price of $10,500,000. Upon execution of the agreement, MCC gave the Company a non-interest bearing promissory note in the amount of $10,500,000. The Note provides that MCC does not have to make any payments to the Company for five years from the date of the Note (September 19, 1995). Beginning on the fifth anniversary of the Note, MCC is required to make six annual payments of $1,625,000.
The Note is secured by the shares issued to MCC under the Agreement. The Note was discounted at 11% and is recorded as a reduction of stockholders' equity.
During the year ended November 30, 1996 the Company received an unscheduled principal payment of $750,000. As a result, the present value of the note was recalculated and reduced by approximately $290,000.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE L - EMPLOYEE BENEFIT PLANS
The Company maintains a defined contribution 401(k) plan that covers substantially all employees of the lodging industry segment and corporate employees. Contributions to the Plan may be made by the Company (which are discretionary) or by plan participants through elective salary reductions. No contributions were made to the plan by the Company during the years ended November 30, 1997, 1996 and 1995. The plan was terminated November 30, 1997. All plan assets will be distributed to plan participants subsequent and subject to various governmental regulations.
The Wendy's Partnership maintains a 401(k) profit sharing plan that covers substantially all of its employees. Contributions to the plan may be made by the subsidiary (which are discretionary) or by plan participants through elective salary reductions. Contributions to the plan by the subsidiary totaled $22,000 and $2,000 in 1997 and 1996, respectively.
The Wendy's Partnership had a deferred compensation agreement with a key employee which provided for the payment of $150,000 upon the completion of the five-year term of the agreement in December 1998. The agreement was funded by the Wendy's Partnership through payment of premiums on a split dollar life insurance contract. The agreement was terminated in April 1997.
In 1996, the Company established an Employee Stock Purchase Plan which provides eligible employees the opportunity to purchase common shares of the Company. Shares may be purchased through payroll deductions at a price equal to 85% of the market value at the date of purchase.
NOTE M - STOCK OPTION PLANS
The 1996 Management Equity Incentive Plan ("Incentive Plan") and, the 1996 Directors' Share Option Plan ("Directors' Plan") were approved by stockholders on May 21, 1996. Amendments to the Incentive Plan and the Director's Plan which increase the number of shares of common stock available for grant were approved by stockholders on May 20, 1997.
The Incentive Plan, as amended, provides for 475,000 shares of common stock to be reserved for options that may be issued under the plan. The Board of Directors has the discretion to designate an option to be an Incentive Share Option or a non-qualified share option. The plan provides that the option price is not less than the fair market value of the common stock at the date of grant. Unless the option agreement provides otherwise, options granted under the plan become exercisable on a cumulative basis at the rate of 20 percent during each of the second through fifth years after the date of grant. Options granted under the plan may have a term of from one to ten years.
The Directors' Plan, as amended, provides for the non-discretionary grant of options to non-employee directors of the Company to purchase a combined maximum of 120,000 shares. The plan provides that the option price is not less than the greater of the fair
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE M - STOCK OPTION PLANS (CONTINUED)
market value of the common stock on the date of grant or $7.00 per share. The plan provides that each non-employee director, on the date such person becomes a non-employee director, will be granted options to purchase 5,000 shares of stock. Provided that such person is still serving as a non-employee director, they will automatically be granted options to purchase 1,000 additional shares each year thereafter on the date of the Annual Shareholders' Meeting. Options granted under the plan have a term of ten years.
The following table summarizes the changes in the number of common shares under stock options granted pursuant to the preceding plans:
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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The Financial Accounting Standard Board has issued Statement No. 123, "Accounting for Stock Based Compensation" ("SFAS No. 123"). The Statement established a fair value method of accounting for employee stock options and similar equity instruments such as warrants, and encourages all companies to adopt that method of accounting for all of their stock compensation plans. However, the statement allows companies to continue measuring compensation for such plans using accounting guidance in place prior to SFAS No. 123. Companies that elect to remain with the former method of accounting must make pro-forma disclosures of net earnings and earnings per share as if the fair value method provided for in SFAS No. 123 had been adopted.
The fair value of each grant is estimated on the date of grant using the Black-Scholes option - pricing model with the following weighted average assumptions for grants in 1997: dividend yield of 0%, expected volatility ranging from 10.5%-63.4%, risk-free interest rates ranging from 6.2%-7% and expected life of ten years.
The Company has not adopted the fair value accounting provisions of SFAS No. 123. Accordingly, SFAS No. 123 has no impact on the Company's financial position or results of operations.
The Company accounts for the stock option plan under APB Opinion No. 25, "Accounting for Stock Issued to Employees." No compensation costs have been recognized. Had compensation cost for the plan been determined based on the fair value of the options at the grant dates consistent with the method of SFAS No. 123, the Company's net loss and loss per share would have been as follows:
NOTE N - BUSINESS SEGMENT INFORMATION
The Company operates in two business segments, lodging and food service operations. Intersegment transactions are not reported separately since they are not significant.
Identifiable assets are those assets applicable to the respective industry segment.
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE N - BUSINESS SEGMENT INFORMATION (CONTINUED)
Data by business segment for the year ended November 30, 1997 is as follows:
NOTE O - LEGAL PROCEEDINGS
The Company is involved in certain routine legal proceedings which are incidental to the business. Except as described below, all of these proceedings arose in the ordinary course of the Company's business and, in the opinion of the Company, any potential liability of the Company with respect to these legal actions will not, in the aggregate, be material to the Company's financial condition. The Company maintains various types of insurance which cover most of the actions brought against the Company.
On December 5, 1996, the Company received a notice from the Internal Revenue Service that approximately $2.1 million, which the Company deducted as a business expense in connection with the litigation in 1995 and 1996 relating to the replacement and restructuring of former management, should be treated as a capital expenditure and, therefore, disallowed as a deduction. In January 1998, the Company and IRS reached a settlement in principle whereby the IRS agreed to reduce its claim by 65% resulting in a total tax liability for the Company of approximately $76,000. This settlement will have no impact on the Company's net earnings nor on its cash flow.
On May 19, 1997, a majority limited interest of the Wendy's Partnership removed Wendy's West Michigan, Inc. as general partner of the Wendy's Partnership and appointed MCC Food Service Inc., an affiliate of the Company, as the substitute general partner. Approximately 180 unit holders (from whom the Company acquired 482.55 of its total partnership units) had previously consented to the removal and substitution of the former general partner. This action was carried out in connection with the Company's prior acquisition of a controlling interest in the Wendy's Partnership. The former general partner subsequently commenced a lawsuit against the Company and its affiliates seeking, among other things, (i) a declaration that Wendy's West Michigan, Inc. is the general partner of the Wendy's Partnership, (ii) injunctive relief in the form of a temporary restraining order or a preliminary injunction which would prohibit the defendants from participating in the management of the Wendy's Partnership, (iii) unspecified damages for breach of contract, and (iv) unspecified damages for various business torts and misrepresentation. The former general partner's motion for a temporary restraining order was denied on May 21, 1997. In September 1997, the
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MERITAGE HOSPITALITY GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOVEMBER 30, 1997, 1996 AND 1995
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NOTE O - LEGAL PROCEEDINGS (CONTINUED)
Wendy's Partnership, the Company and certain of its affiliates filed claims against the former general partner and its principal shareholders alleging (i) breach of contract, (ii) violation of SEC Rule 10b-5, (iii) business defamation, (iv) tortious interference, and (v) breach of fiduciary duty. In January 1998, the former general partner filed a motion to enjoin the dissolution of the Wendy's Partnership. The court denied this motion and the Wendy's Partnership was thereafter dissolved on January 30, 1998. Wendy's International has consented to MCC Food Service Inc. serving as the general partner of the Wendy's Partnership and to the dissolution of the Wendy's Partnership.
NOTE P - SUBSEQUENT EVENTS
The Company acquired the remaining 46% of the Wendy's Partnership in exchange for 1,772,359 Common Shares on January 30, 1998.
The Company has entered into a contract for the sale of real and personal property comprising, among other things, one of the Company's two remaining hotel properties. A non-refundable deposit of $500,000 has been paid by the prospective purchaser. If the sale is closed, the Company will receive approximately $12,200,000 which will result in a pre-tax gain of approximately $2,000,000 and long-term debt will be reduced by approximately $9,000,000. The closing is scheduled for April 1, 1998, but there can be no assurances that the sale will close.
M-24 SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MERITAGE HOSPITALITY GROUP INC. CONDENSED BALANCE SHEET NOVEMBER 30, 1997
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SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
MERITAGE HOSPITALITY GROUP INC. CONDENSED STATEMENT OF OPERATIONS YEAR ENDED NOVEMBER 30, 1997
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SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
MERITAGE HOSPITALITY GROUP INC. CONDENSED STATEMENT OF CASH FLOWS YEAR ENDED NOVEMBER 30, 1997
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SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
* Amount written off as uncollectible
VALUATION ALLOWANCE FOR DEFERRED TAX ASSETS:
Year ended November 30:
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INDEPENDENT AUDITORS' REPORT
To the Partners Wendy's of West Michigan Limited Partnership Kalamazoo, Michigan
We have audited the accompanying balance sheets of Wendy's of West Michigan Limited Partnership as of November 30, 1997 and 1996, and the related statements of income, changes in partners' equity and cash flows for the year ended November 30, 1997, eleven months ended November 30, 1996 and year ended December 31, 1995. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Wendy's of West Michigan Limited Partnership at November 30, 1997 and 1996, and the results of its operations and its cash flows for the year ended November 30, 1997, eleven months ended November 30, 1996 and year ended December 31, 1995, in conformity with generally accepted accounting principles.
January 9, 1998, except for Notes 6 and 7 which are as of January 30, 1998
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
BALANCE SHEETS
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
BALANCE SHEETS
See accompanying notes to financial statements.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
STATEMENTS OF INCOME
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
STATEMENTS OF INCOME
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See accompanying notes to financial statements.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
STATEMENTS OF CHANGES IN PARTNERS' EQUITY
See accompanying notes to financial statements.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
STATEMENTS OF CASH FLOWS
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
STATEMENTS OF CASH FLOWS
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See accompanying notes to financial statements.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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1. SUMMARY OF ORGANIZATION SIGNIFICANT ACCOUNTING Wendy's of West Michigan Limited Partnership POLICIES (Partnership) is a Michigan limited partnership organized on July 31, 1986. The Partnership presently operates 25 Wendy's Old Fashioned Hamburger restaurants in western Michigan under franchise agreements with Wendy's International, Inc. In August 1997, the Partnership closed one of its restaurants due to continuing operating losses. As a result of this restaurant closing and the Partnership not exercising its option to extend its lease of the restaurant building, the Partnership incurred a loss on disposal of assets of $197,102.
Subject to the consent of the Limited Partners where required by the Partnership Agreement, the General Partner has the exclusive right to manage the Partnership. The Limited Partners are not liable for Partnership debts beyond the amount of their original contributions and share of undistributed net profits. The financial statements do not reflect assets the partners may have outside their interests in the partnership, nor any personal obligations, including income taxes, of the individual partners.
The Partnership Agreement provides that the Limited Partners (as a group) are to share in 99% of the Partnership's net income or loss, except as discussed in the following paragraph, and receive 99% of all cash flow from operations as defined by the Partnership Agreement.
The net profits of the Partnership arising from the sale or other disposition, whether as a result of foreclosure, condemnation or otherwise, of all or part of the property, shall be allocated among the Partners in accordance with the provisions of the Partnership Agreement.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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A Partnership administration fee is payable to the General Partner equal to 2% of gross partnership revenues from operations, as defined in the Partnership Agreement. The General Partner has elected to reduce the Partnership administration fee to the General Partner from 2% of gross partnership revenues from operations to $160,000, $146,667 and $160,000 for 1997, 1996 and 1995, respectively.
The Partnership shall exist until December 31, 2026, unless terminated sooner as provided in the Partnership Agreement (see Note 7). A Limited Partner may, in accordance with the agreement, assign his/her interest in the Partnership by a properly executed and acknowledged instrument, the terms of which are not inconsistent with or contrary to the provisions of the Partnership Agreement and are otherwise satisfactory to the General Partner, subject to the approval of the General Partner.
During the period ended November 30, 1996, MHG Food Service Inc. (MHG), a wholly owned subsidiary of Meritage Hospitality Group Inc. (Meritage), acquired 680.8 units of limited partnership interest, representing approximately 54% of the outstanding limited partner units. As a result, the Partnership changed its fiscal year-end to November 30 to conform with Meritage's fiscal year-end.
CONCENTRATION OF CREDIT RISK
Competition in the quick-service restaurant industry is intense. Most of the Partnership's restaurants are in close proximity to other quick-service restaurants which compete on the basis of price, service and product quality and variety. The General Partner believes that the Partnership competes effectively in these areas.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out) or market. Inventories consist of restaurant food items and food serving supplies.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Expenditures for renewals and betterments which extend the originally estimated economic life of assets are capitalized. Expenditures for maintenance or repairs are charged to expense when incurred. For financial reporting purposes, depreciation is computed using the straight-line method over the estimated economic lives of the assets. For tax purposes, useful lives and methods are used as permitted by the Internal Revenue Code. Amortization of leasehold improvements is provided over the primary terms of the various leases.
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS
In 1995, the Partnership adopted Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. This statement requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. This statement also requires that long-lived assets and certain identifiable intangibles to be disposed of be reported at the lower of carrying amount or fair value less cost to sell. This new accounting standard had no impact on the financial statements.
OTHER ASSETS
Franchise fees for restaurant units are being amortized over the terms of the individual restaurant franchise agreements. Loan costs are being amortized over 120 months, the period of the loan. All amortization is under the straight-line method.
The excess of cost over fair value of net assets acquired (goodwill) is being amortized on the straight-line method over 240 months. Amortization expense for goodwill for the periods 1997, 1996 and 1995 amounted to $198,120, $181,610 and $198,120, respectively. The Partnership evaluates the recoverability of the goodwill whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable and considers whether the goodwill should be completely or partially written off or the amortization period accelerated. The Partnership assesses the recoverability of goodwill based on undiscounted estimated future operating cash flows. If the Partnership determines that the carrying value of the goodwill has been impaired, the measurement of the impairment will be based on discounted estimated future operating cash flows.
FRANCHISE COSTS AND OTHER ADVERTISING COSTS
Royalties and national advertising costs are based on a percentage of monthly sales. These costs and other advertising costs are charged to operations as incurred.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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CAPITALIZED LEASE OBLIGATIONS
Lease transactions relating to certain restaurant buildings and equipment are classified as capital leases. These assets have been capitalized and the related obligations recorded based on the fair market value of the assets at the inception of the leases. Amounts capitalized are being amortized over the terms of the leases.
INCOME TAXES
No provision for income taxes has been made in the accompanying financial statements. A Partner's share of the income or loss of the Partnership is includable in the individual tax returns of the Partners.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of the Partnership's financial instruments, consisting of cash, receivables, accounts payable and long-term debt, approximate their fair value.
2. DEFERRED The Partnership had a deferred compensation COMPENSATION agreement with a key employee which provided for the payment of $150,000 upon the completion of the five-year term of the agreement in December 1998. The agreement was funded by the Partnership through payment of premiums on a split dollar life insurance contract. The agreement was terminated in April 1997. Charges to operations related to this agreement were $10,630, $27,913 and $25,295 for 1997, 1996 and 1995, respectively.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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3. LONG-TERM DEBT Long-term debt at November 30, 1997 and 1996 consisted of the following:
The revolving term note payable - bank is secured by substantially all assets of the Partnership and by the unsecured corporate guaranty of Meritage. The loan agreement requires monthly payments of $43,313, including interest at 1% over prime (effectively 9.5% at November 30, 1997) through February 2005 when any remaining unpaid principal will be due. Under the revolving loan agreement, the required monthly payments described above may be offset by additional borrowings up to the unused available borrowings. The total available borrowings under the loan agreement were $2,727,802 as of November 30, 1997. The total available borrowings decrease monthly based on the original term note amortization over 120 months. The loan agreement also requires that the Partnership maintain certain cash availability, financial ratios and a minimum tangible net worth, as defined in the loan agreement, of approximately $968,000. The Partnership was in compliance with these covenants at November 30, 1997. The loan agreement also requires that the Partnership not exceed $400,000 of capital expenditures in any one year. During 1997, the Partnership's capital expenditures exceeded the covenant. The bank agreed to waive the covenant for 1997.
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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The equipment note payable is unsecured and requires monthly payments of $11,290, including interest at 10% through January 1999.
The following is a schedule by year of annual maturities under the loan agreements:
4. DESCRIPTION OF The Partnership leases land and buildings used LEASING in operations under operating agreements, with ARRANGEMENTS remaining lease terms (including renewal (INCLUDING THOSE options of up to thirteen years) ranging from WITH AFFILIATED one to twenty-three years. Included in the PARTNERSHIP) leases are five leases with parties related through common ownership with the former general partner. (See Note 6.)
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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Total lease expense (including taxes, insurance and maintenance when included in rent) related to all operating leases and all percentage rentals is as follows:
Certain restaurant leases (eight restaurant buildings, excluding land which is accounted for as an operating lease) and equipment leases have been capitalized. Minimum future obligations under capital leases and noncancelable operating leases in effect are as follows:
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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The present value of minimum rental obligations is reflected in the balance sheets as current and long-term obligations under capital leases.
Accumulated amortization of leased property under capital leases was $1,814,346 and $1,648,146 at November 30, 1997 and 1996, respectively.
In addition to minimum future obligations, percentage rentals may be paid under all restaurant leases on the basis of percentage of sales in excess of minimum prescribed amounts.
5. PROFIT-SHARING The Partnership maintains a 401(k) PLAN profit-sharing plan. The plan covers substantially all employees of the Partnership who are at least 21 years old and who have completed at least one year of service (of at least 1,000 hours) with the Partnership. Contributions to the plan may be made by the Partnership (which are purely discretionary in nature) or by plan participants through elective salary deductions. Contributions to the plan by the Partnership for the periods ended 1997, 1996 and 1995, totaled $22,000, $30,721 and $12,000, respectively.
6. LEGAL PROCEEDINGS On May 19, 1997, a majority limited interest of the Partnership removed Wendy's West Michigan, Inc. as general partner of the Partnership and appointed MCC Food Service Inc. (MCC), an affiliate of Meritage, as the substitute general partner. Approximately 180 unit holders (from whom MHG Food Service Inc. (MHG) acquired 482.55 of its total partnership units) had previously consented to the removal and substitution of the former general partner. This action was carried out in connection with MHG's prior acquisition of a controlling interest in the Partnership. The former general partner subsequently commenced a lawsuit against Meritage and its affiliates seeking, among other things, (i) a declaration that Wendy's West Michigan, Inc. is the general partner of the Partnership, (ii) injunctive relief in the form of a temporary restraining order or a preliminary injunction which
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WENDY'S OF WEST MICHIGAN LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
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would prohibit the defendants from participating in the management of the Partnership, (iii) unspecified damages for breach of contract, and (iv) unspecified damages for various business torts and misrepresentation. The former general partner's motion for a temporary restraining order was denied on May 21, 1997. In September 1997, the Partnership, Meritage and certain of its affiliates filed claims against the former general partner and its principal shareholders alleging (i) breach of contract, (ii) violation of SEC Rule 10b-5, (iii) business defamation, (iv) tortious interference, and (v) breach of fiduciary duty. In January 1998, the former general partner filed a motion to enjoin the dissolution of the Partnership. The court denied this motion and the Partnership was thereafter dissolved on January 30, 1998. Wendy's International, the franchisor, has consented to MCC serving as the general partner of the Partnership and to the dissolution of the Partnership. Management believes there is no basis for the Plaintiffs' claims but cannot at this time predict the likely outcome of this litigation. It is management's opinion that these proceedings are not expected to have a material adverse effect on the Partnership's operations or financial position.
7. DISSOLUTION OF Through the filing of Form S-4 with the PARTNERSHIP Securities and Exchange Commission, which was effective on November 25, 1997, the holders of limited partnership units of the Partnership were notified of the sale of all the assets of the Partnership to a limited partnership affiliated with Meritage and the subsequent dissolution of the Partnership. As a result of the transaction, on January 30, 1998, the newly formed limited partnership acquired all the assets and assumed all the liabilities of the Partnership and succeeded to all business operations that had been conducted by the Partnership. Upon dissolution, Meritage common shares were distributed to non-affiliated limited partners on the basis of that number of Meritage common shares that had a value of $7,500 per unit, based on the average high and low bid price quoted on the OTC Bulletin Board for the 10 trading days preceding the date of dissolution ($2.4375 per share).
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